Direxion
Funds
Statement
of Additional Information
|
1301
Avenue of the Americas (6th Avenue), 28th Floor |
New
York, New York 10019 |
(800)
851-0511 |
www.direxion.com
The
Direxion Funds (the “Trust”) is an investment company that offers shares of a
variety of mutual funds to the public. This Statement of Additional
Information (“SAI”) relates to the Investor Class Shares of the Funds listed
below.
|
Bull
Funds |
Bear
Funds |
|
Direxion
Monthly S&P 500® Bull 1.75X
Fund (DXSLX)
(formerly
Direxion Monthly S&P 500® Bull 2X
Fund) |
Direxion
Monthly S&P 500® Bear 1.75X
Fund (DXSSX)
(formerly
Direxion Monthly S&P 500® Bear 2X
Fund) |
|
Direxion
Monthly NASDAQ-100® Bull 1.75X
Fund (DXQLX)
(formerly
Direxion Monthly NASDAQ-100® Bull 2X
Fund) |
|
|
Direxion
Monthly Small Cap Bull 1.75X Fund (DXRLX)
(formerly
Direxion Monthly Small Cap Bull 2X Fund) |
Direxion
Monthly Small Cap Bear 1.75X Fund (DXRSX)
(formerly
Direxion Monthly Small Cap Bear 2X Fund) |
|
Direxion
Monthly 7-10 Year Treasury Bull 1.75X Fund (DXKLX)
(formerly
Direxion Monthly 7-10 Year Treasury Bull 2X Fund) |
Direxion
Monthly 7-10 Year Treasury Bear 1.75X Fund (DXKSX)
(formerly
Direxion Monthly 7-10 Year Treasury Bear 2X
Fund) |
Investor
Class
The
funds offered in this SAI (each a “Fund” and collectively the “Funds”)
seek
calendar month leveraged
investment results and are riskier than most mutual funds because the Funds seek
1.75 times the calendar month performance of a respective underlying index. The
Funds with “Bull” in their names attempt to provide calendar month investment
results that correspond to 1.75 times the calendar month performance of an
underlying index and are collectively referred to as the “Bull Funds.” The Funds
with “Bear” in their names attempt to provide calendar month investment results
that correspond to 1.75 times the inverse (or opposite) of the performance of an
underlying index, a result that is the opposite of most mutual funds, and are
collectively referred to as the “Bear Funds.”
The
Funds are not suitable for all investors. The Funds are designed to be utilized
only by sophisticated investors, such as traders and active
investors employing dynamic strategies. Investors in the Funds
should:
(a)
understand
the risks associated with the use of leverage,
(b)
understand
the consequences of seeking calendar month leveraged investment
results,
(c)
for
a Bear Fund, understand the risk of shorting, and
(d)
actively
monitor and manage their investments.
Investors
who do not understand the Funds or do not intend to actively manage and monitor
their investments should not buy the Funds.
There
is no assurance that any Fund will achieve its investment objective and an
investment in a Fund could lose money. No single Fund
is a complete investment program.
An
investor who purchases shares on a day other than the last business day of a
calendar month will generally receive more, or less, than
175% (for a Bull Fund) or -175% (for a Bear Fund) exposure to the underlying
index from that point until the end of the month. The actual exposure is a
function of the performance of the underlying index from the end of the prior
calendar month to an investor’s purchase date. If a Fund’s shares are held for a
period other than a calendar month, the Fund’s performance is likely to deviate
from 175% (for a Bull Fund) or -175% (for a Bear Fund) of the underlying index’s
performance for the period the Fund is held. This deviation will increase with
higher underlying index volatility and longer holding periods.
This SAI, dated
December 29, 2022, is
not a prospectus. It should be read in conjunction with the Funds' prospectus
dated December 29, 2022 (“Prospectus”). This SAI is incorporated by reference
into the Prospectus. In other words, it is legally part of the Prospectus. To
receive a copy of the Prospectus, without charge, write or call the Trust at the
address or telephone number listed above.
December 29,
2022
The
Direxion Funds
The Trust is a
Massachusetts business trust organized on June 6, 1997 and is registered with
the Securities and Exchange Commission (“SEC”) as an open-end
management investment company under the Investment Company Act of 1940, as
amended (the “1940 Act”). The Trust currently consists of 10 separate series. On
April 28, 2006, the Trust changed its name to Direxion Funds. Prior to that
date, the Trust was known as Potomac Funds.
The
Funds described in this SAI seek 175% or -175% of the performance, before fees
and expenses, of an underlying index for a given
calendar month.
Prior to
August 1, 2022, the
Funds sought calendar month investment results, before fees and expenses, of
200% or -200%, as applicable, of the performance of their respective underlying
indices, under their former names which included “2X” instead of “1.75X” in each
name.
There
is no assurance that each Fund will achieve its investment objectives and an
investment in a Fund could lose money. The Funds are not
a complete investment program. Each Fund offers Investor Class shares. Investor
Class shares are designed for sale directly to investors without a sales charge.
The Investor Class of each Fund are subject to fees under Rule
12b-1.
Classification
of the Funds
Each
Fund is a “non-diversified” series of the Trust pursuant to the 1940 Act. A Fund
is considered “non-diversified” because a relatively high
percentage of its assets may be invested in the securities of a limited number
of issuers. To the extent that a Fund assumes large positions in the securities
of a small number of issuers, the Fund’s net asset value ("NAV") may fluctuate
to a greater extent than that of a diversified company as a result of changes in
the financial condition or in the market’s assessment of the issuers, and the
Fund may be more susceptible to any single economic, political or regulatory
occurrence than a diversified company.
Investment
Policies and Techniques
Each Fund seeks
investment results that correspond to the performance of an underlying
index, before fees
and expenses, as follows:
|
Fund |
Underlying
Index |
Monthly
Leveraged
Investment
Objective |
|
Direxion
Monthly S&P 500®
Bull 1.75X Fund |
S&P
500®
Index |
175% |
|
Direxion
Monthly S&P 500®
Bear 1.75X Fund |
-175% | |
|
Direxion
Monthly NASDAQ-100®
Bull 1.75X Fund |
NASDAQ-100®
Index |
175% |
|
Direxion
Monthly Small Cap Bull 1.75X Fund |
Russell
2000®
Index |
175% |
|
Direxion
Monthly Small Cap Bear 1.75X Fund |
-175% | |
|
Direxion
Monthly 7-10 Year Treasury Bull 1.75X Fund |
ICE U.S.
Treasury 7-10 Year Bond Index |
175% |
|
Direxion
Monthly 7-10 Year Treasury Bear 1.75X Fund |
-175% |
Each
Fund with the word “Bull” in its name (a “Bull Fund”) attempts to provide
investment results that correlate positively to the return of
an underlying index, meaning the Bull Fund attempts to move in the same
direction as its underlying index. The term “bull” is used in financial markets
to describe a market in which share prices are rising. Generally, “bull” mutual
funds attempt to profit from the anticipated increases in the value of a
security, industry or market.
Each
Fund with the word “Bear” in its name (a “Bear Fund”) attempts to provide
investment results that correlate negatively to the return of
its underlying index, meaning that the Bear Fund attempts to move in the
opposite or inverse direction of the underlying index. The term “bear” is used
in the financial markets to describe a market that is declining in value.
Generally, “bear” mutual funds attempt to profit from anticipated declines in
the value of a security, industry, or market and may use aggressive techniques
like selling short in pursuit of their objectives.
There
is no assurance that each Fund will achieve its investment objectives and an
investment in a Fund could lose money. The Funds are not
a complete investment program. Each Fund offers Investor Class shares. Investor
Class shares are designed for sale directly to investors without a sales charge.
The Investor Class of each Fund are subject to fees under Rule
12b-1.
Each
Fund’s investment objective is a non-fundamental policy of the Fund that may be
changed by the Board without shareholder
approval.
1
Subject
to the limitations described in the “Investment Restrictions” section, each Fund
may engage in the investment strategies
discussed below.
Asset-Backed
Securities
A
Fund may invest in asset-backed securities of any rating or maturity.
Asset-backed securities are securities issued by trusts and special
purpose entities that are backed by pools of assets, such as automobile and
credit-card receivables and home equity loans, which pass through the payments
on the underlying obligations to the security holders (less servicing fees paid
to the originator or fees for any credit enhancement). Typically, the originator
of the loan or accounts receivable paper transfers it to a specially created
trust, which repackages it as securities with a minimum denomination and a
specific term. The securities are then privately placed or publicly offered.
Examples include certificates for automobile receivables and so-called plastic
bonds, backed by credit card receivables.
The
value of an asset-backed security is affected by, among other things, changes in
the market’s perception of the asset backing the
security, the creditworthiness of the servicing agent for the loan pool, the
originator of the loans and the financial institution providing any credit
enhancement. Payments of principal and interest passed through to holders of
asset-backed securities are frequently supported by some form of credit
enhancement, such as a letter of credit, surety bond, limited guarantee by
another entity or by having a priority to certain of the borrower’s other
assets. The degree of credit enhancement varies, and generally applies to only a
portion of the asset-backed security’s par value. Value is also affected if any
credit enhancement has been exhausted.
Bank
Obligations
Money
Market Instruments. A Fund may
invest in bankers’ acceptances, certificates of deposit, demand and time
deposits, savings shares and commercial paper of domestic banks and savings and
loans that have assets of at least $1 billion and capital, surplus, and
undivided profits of over $100 million as of the close of their most recent
fiscal year, or instruments that are insured by the Bank Insurance Fund or the
Savings Institution Insurance Fund of the Federal Deposit Insurance Corporation
(“FDIC”). A Fund also may invest in high quality, short-term, corporate debt
obligations, including variable rate demand notes, having terms-to-maturity of
less than 397 days. Because there is no secondary trading market in demand
notes, the inability of the issuer to make required payments could impact
adversely a Fund’s ability to resell when it deems advisable to do
so.
A
Fund may invest in foreign money market instruments, which typically involve
more risk than investing in U.S. money market
instruments. See “Foreign Securities” below. These risks include, among others,
higher brokerage commissions, less public information, and less liquid markets
in which to sell and meet large shareholder redemption requests.
Bankers’
Acceptances. Bankers’
acceptances generally are negotiable instruments (time drafts) drawn to finance
the export, import, domestic shipment or storage of goods. They are termed
“accepted” when a bank writes on the draft its agreement to pay it at maturity,
using the word “accepted.” The bank is, in effect, unconditionally guaranteeing
to pay the face value of the instrument on its maturity date. The acceptance may
then be held by the accepting bank as an asset, or it may be sold in the
secondary market at the going rate of interest for a specified
maturity.
Certificates
of Deposit (“CDs”). The FDIC is an
agency of the U.S. government that insures the deposits of certain banks and
savings and loan associations up to $250,000 per deposit. The interest on such
deposits may not be insured to the extent this limit is exceeded. Current
federal regulations also permit such institutions to issue insured negotiable
CDs in amounts of $250,000 or more without regard to the interest rate ceilings
on other deposits. To remain fully insured, these investments must be limited to
$250,000 per insured bank or savings and loan association.
Commercial
Paper. Commercial
paper includes notes, drafts or similar instruments payable on demand or having
a maturity at the time of issuance not exceeding nine months, exclusive of days
of grace or any renewal thereof. A Fund may invest in commercial paper rated A-l
or A-2 by Standard & Poor’s® Ratings Services
(“S&P®”) or Prime-1 or
Prime-2 by Moody’s Investors Service®, Inc.
(“Moody’s”), and in other lower quality commercial paper.
Caps,
Floors and Collars
A
Fund may enter into caps, floors and collars relating to securities, interest
rates or currencies. In a cap or floor, the buyer pays a premium
(which is generally, but not always, a single up-front amount) for the right to
receive payments from the other party if, on specified payment dates, the
applicable rate, index or asset is greater than (in the case of a cap) or less
than (in the case of a floor) an agreed level, for the period involved and the
applicable notional amount. A collar is a combination instrument in which the
same party buys a cap and sells a floor. Depending upon the terms of the cap and
floor comprising the collar, the premiums will partially, or entirely, offset
each other. The notional amount of a cap, collar or floor is used to calculate
payments, but is not itself exchanged. A Fund may be both a buyer and seller of
these instruments.
2
In
addition, a Fund may engage in combinations of put and call options on
securities (also commonly known as collars), which may involve
physical delivery of securities. Like swaps, caps, floors and collars are very
flexible products. The terms of the transactions entered by the Funds may vary
from the typical examples described here.
Corporate
Debt Securities
A
Fund may invest in investment grade corporate debt securities of any rating or
maturity. Investment grade corporate bonds are those
rated BBB or better by S&P® or Baa or better
by Moody’s. Securities rated BBB by S&P® are considered
investment grade, but Moody’s considers securities rated Baa to have speculative
characteristics. See Appendix A for a description of corporate bond ratings. A
Fund may also invest in unrated securities.
Corporate
debt securities are fixed-income securities issued by businesses to finance
their operations, although corporate debt instruments
may also include bank loans to companies. Notes, bonds, debentures and
commercial paper are the most common types of corporate debt securities, with
the primary difference being their maturities and secured or un-secured status.
Commercial paper has the shortest term and is usually unsecured.
The
broad category of corporate debt securities includes debt issued by domestic or
foreign companies of all kinds, including those with
small-, mid- and large-capitalizations. Corporate debt may be rated
investment-grade or below investment-grade and may carry variable or floating
rates of interest.
Because
of the wide range of types and maturities of corporate debt securities, as well
as the range of creditworthiness of its issuers,
corporate debt securities have widely varying potentials for return and risk
profiles. For example, commercial paper issued by a large established domestic
corporation that is rated investment grade may have a modest return on
principal, but carries relatively limited risk. On the other hand, a long-term
corporate note issued by a small foreign corporation from an emerging market
country that has not been rated may have the potential for relatively large
returns on principal, but carries a relatively high degree of risk.
Corporate
debt securities carry both credit risk and interest rate risk. Credit risk is
the risk that a Fund could lose money if the issuer of a
corporate debt security is unable to pay interest or repay principal when it is
due. Some corporate debt securities that are rated below investment grade are
generally considered speculative because they present a greater risk of loss,
including default, than higher-quality debt securities. The credit risk of a
particular issuer’s debt security may vary based on its priority for repayment.
For example, higher ranking (senior) debt securities have a higher priority than
lower ranking (subordinated) securities. This means that the issuer might not
make payments on subordinated securities while continuing to make payments on
senior securities. In addition, in the event of bankruptcy, holders of
higher-ranking senior securities may receive amounts otherwise payable to the
holders of more junior securities. Interest rate risk is the risk that the value
of certain corporate debt securities will tend to fall when interest rates rise.
In general, corporate debt securities with longer terms tend to fall more in
value when interest rates rise than corporate debt securities with shorter
terms.
A
Fund may invest in certain debt securities, derivatives or other financial
instruments that utilize the London Interbank Offered Rate
(“LIBOR”) as a benchmark or reference rate for various interest rate
calculations. LIBOR may be a significant factor in determining a Fund’s payment
obligations under a derivative investment, the cost of financing to a Fund or an
investment’s value or return to a Fund, and may be used in other ways that
affect a Fund’s investment performance.
On July 27,
2017, the head of the United Kingdom’s (“UK”) Financial Conduct Authority (the
“FCA”) announced that it would cease its active
encouragement of banks to provide quotations needed to sustain the LIBOR rate,
which means that the LIBOR rate may no longer be published. Also in 2017, the
Alternative Reference Rates Committee, a group of large US banks working with
the Federal Reserve, announced its selection of a new Secured Overnight Funding
Rate (“SOFR”), which is a broad measure of the cost of overnight borrowings
secured by Treasury Department securities, as an appropriate replacement for
LIBOR. Bank working groups and regulators in other countries have suggested
other alternatives for their markets, including the Sterling Overnight Interbank
Average Rate (“SONIA”) in England. As
previously announced
by the FCA, most maturities and currencies of LIBOR were phased out at the end
of 2021, with the remaining ones to be phased out on
June 30, 2023. There
is a risk that remaining
LIBOR maturities may
cease to be published before this date. This announcement impacted several LIBOR
transition dates, including the EU Benchmark Regulations regarding the European
Commission designating one or more LIBOR replacement rates. Additionally,
fallback language that was voluntarily entered into by contractual parties,
including those related to corporate debt or other securities may be impacted by
the FCA’s announcement, thereby triggering transition dates for various
instruments.
The Federal
Reserve Bank of New York began publishing SOFR in April 2018, with the
expectation that it could be used on a voluntary basis in new
USD-denominated instruments and for new transactions under existing instruments.
However, SOFR is fundamentally different from LIBOR. It is a secured, nearly
risk-free rate, while LIBOR is an unsecured rate that includes an element of
bank credit risk. Also, while term SOFR for various maturities has begun to be
adopted by some parties and for some types of transactions, SOFR is strictly an
overnight rate, while LIBOR historically has been published for various
maturities, ranging from overnight to one year. Thus, LIBOR may be expected to
be higher than SOFR, and the spread between the two is likely to widen in times
of market stress. Certain existing contracts provide for a spread adjustment
3
when
transitioning to SOFR from LIBOR, but there is no assurance that it will provide
adequate compensation. Term SOFR rates for various maturities may
not be available, recommended, or operationally feasible at the applicable
benchmark replacement date.
Various
financial industry groups have planned for the transition from
LIBOR to SOFR (or another new benchmark), but there are obstacles to converting
certain longer term securities and transactions. Neither the effect of the
transition process nor its ultimate success can yet be known. The transition
process might lead to increased volatility and illiquidity in markets that
currently rely on the LIBOR to determine interest rates. It also could lead to a
reduction in the value of some LIBOR-based investments and reduce the
effectiveness of new hedges placed against existing LIBOR-based instruments. New
York has passed legislation to ease the transition from LIBOR and federal LIBOR
transition relief legislation has been proposed, but there is no assurance
whether or when such legislation will be enacted or if it will adequately
address all issues or be subject to litigation. Among other negative
consequences, the transition away from LIBOR could:
•
Adversely impact
the pricing, liquidity, value of, return on and trading for a broad array of
financial products, including any LIBOR-linked securities, loans and derivatives
in which a Fund may invest;
•
Require extensive
negotiations of and/or amendments to agreements and other documentation
governing LIBOR-linked investments products;
•
Lead to disputes,
litigation or other actions with counterparties or portfolio companies regarding
the interpretation and enforceability of “fall back” provisions that provide for
an alternative reference rate in the event of LIBOR’s unavailability;
or
•
Cause a Fund to
incur additional costs in relation to any of the above factors.
The
risks associated with the above factors are heightened with respect to
investments in LIBOR-based products that do not include a
fall back provision that addresses how interest rates will be determined after
LIBOR stops being published. Other important factors include the pace of the
transition, the specific terms of alternative reference rates accepted in the
market and the depth of the market for investments based on alternative
reference rates. The risks associated with this discontinuation and transition
may be exacerbated if the work necessary to effect an orderly transition to an
alternative reference rate is not completed in a timely manner. Any such effects
of the transition away from LIBOR, as well as other unforeseen effects, could
result in losses to a Fund.
Cybersecurity
Risk
The Funds may be
susceptible to operational risks through breaches in cybersecurity. A
cybersecurity incident may refer to either intentional or
unintentional events that allow an unauthorized party to gain access to fund
assets, investor data, or proprietary information, or cause a Fund or a service
provider to suffer data corruption or lose operational functionality. A
cybersecurity incident could, among other things, result in the loss or theft of
investor data or funds, employees being unable to access electronic systems
(“denial of services”), loss or theft of proprietary information or corporate
data, physical damage to a computer or network system, or remediation costs
associated with system repairs. Any of these results could have a substantial
impact on the Funds. For example, if a cybersecurity incident results in a
denial of service, employees
could be unable to
access electronic systems to perform critical duties for the Funds, such as
trading, NAV calculation, shareholder accounting or fulfillment of Fund share
purchases and redemptions. Cybersecurity incidents could cause a Fund, Rafferty
Asset Management, LLC ("Rafferty" or "Adviser") or any of its service providers
to incur regulatory penalties, reputational damage, additional compliance costs
associated with corrective measures, or financial loss of a significant
magnitude. They may also cause a Fund to violate applicable privacy and other
laws. The Funds' Adviser and service providers have established risk management
program and systems that seek to reduce the risks associated with cybersecurity,
as well as business continuity plans in the event there is a cybersecurity
breach. However, there is no guarantee that such efforts will succeed,
especially since a Fund does not directly control the cybersecurity systems of
the issuers of securities in which each Fund invests or the Funds' third party
service providers (including the Funds' transfer agent and
custodian).
Depositary
Receipts
To
the extent a Fund invests in stocks of foreign corporations, a Fund’s investment
in such stocks may also be in the form of depositary
receipts or other securities convertible into securities of foreign issuers.
Depository receipts are receipts, typically issued by a financial institution,
with evidence of underlying securities issued by a non-U.S. issuer. Types of
depositary receipts include American Depositary Receipts (“ADRs”), Global
Depositary Receipts (“GDRs”) and European Depositary Receipts (“EDRs”).
Depository receipts may not necessarily be denominated in the same currency as
the underlying securities into which they may be converted.
ADRs
are receipts typically issued by an American bank or trust company that evidence
ownership of underlying securities issued by a
foreign corporation. Investments in ADRs have certain advantages over direct
investment in the underlying foreign securities because: (i) ADRs are U.S.
dollar-denominated investments that are easily transferable and for which
4
market
quotations are readily available, and (ii) issuers whose securities are
represented by ADRs are generally subject to auditing,
accounting and financial reporting standards similar to those applied to
domestic issuers. By investing in ADRs rather than directly in the stock of
foreign issuers outside the U.S. a Fund may avoid certain risks related to
investing in foreign securities in non-U.S. markets, however, ADRs do not
eliminate all risks inherent in investing in the securities of foreign
issuers.
EDRs
are receipts issued in Europe that evidence a similar ownership arrangement.
GDRs are receipts issued throughout the world that
evidence a similar arrangement. Generally, ADRs, in registered form, are
designed for use in the U.S. securities markets, and EDRs, in bearer form, are
designed for use in European securities markets. GDRs are tradable both in the
United States and in Europe and are designed for use throughout the
world.
Depositary
receipts may be purchased through “sponsored” or “unsponsored” facilities, in
which a Fund may invest. A sponsored
facility is established jointly by the issuer of the underlying security and a
depositary, whereas a depositary may establish an unsponsored facility without
participation by the issuer of the depositary security. Holders of unsponsored
depositary receipts generally bear all the costs of such facilities and the
depositary of an unsponsored facility frequently is under no obligation to
distribute shareholder communications received from the issuer of the deposited
security or to pass through voting rights to the holders of such receipts of the
deposited securities.
Fund
investments in depositary receipts, which include ADRs, GDRs and EDRs, are
deemed to be investments in foreign securities for
purposes of a Fund’s investment strategy.
Equity
Securities
Common
Stocks. A Fund may
invest in common stocks. Common stocks represent the residual ownership interest
in the issuer and are entitled to the income and increase in the value of the
assets and business of the entity after all of its obligations and preferred
stock are satisfied. Common stocks generally have voting rights. Common stocks
fluctuate in price in response to many factors including historical and
prospective earnings of the issuer, the value of its assets, general economic
conditions, interest rates, investor perceptions and market
liquidity.
Convertible
Securities. A Fund may
invest in convertible securities that may be considered high yield securities.
Convertible securities include corporate bonds, notes and preferred stock that
can be converted into or exchanged for a prescribed amount of common stock of
the same or a different issue within a particular period of time at a specified
price or formula. A convertible security entitles the holder to receive interest
paid or accrued on debt or dividends paid on preferred stock until the
convertible stock matures or is redeemed, converted or exchanged. While no
securities investment is without some risk, investments in convertible
securities generally entail less risk than the issuer’s common stock, although
the extent to which such risk is reduced depends in large measure upon the
degree to which the convertible security sells above its value as a fixed income
security. The market value of convertible securities tends to decline as
interest rates increase and, conversely, to increase as interest rates decline.
While convertible securities generally offer lower interest or dividend yields
than nonconvertible debt securities of similar quality, they do enable the
investor to benefit from increases in the market price of the underlying common
stock. When investing in convertible securities, a Fund may invest in the lowest
credit rating category.
Preferred
Stock. A Fund may
invest in preferred stock. A preferred stock blends the characteristics of a
bond and common stock. It can offer the higher yield of a bond and has priority
over common stock in equity ownership, but does not have the seniority of a bond
and its participation in the issuer’s growth may be limited. Preferred stock has
preference over common stock in the receipt of dividends and in any residual
assets after payment to creditors if the issuer is dissolved. Although the
dividend is set at a fixed annual rate, in some circumstances it can be changed
or omitted by the issuer. When investing in preferred stocks, a Fund may invest
in the lowest credit rating category.
Warrants
and Rights. A Fund may
purchase warrants and rights, which are instruments that permit a Fund to
acquire, by subscription, the capital stock of a corporation at a set price,
regardless of the market price for such stock. Warrants may be either perpetual
or of limited duration, but they usually do not have voting rights or pay
dividends. The market price of warrants is usually significantly less than the
current price of the underlying stock. Thus, there is a greater risk that
warrants might drop in value at a faster rate than the underlying
stock.
Foreign
Currencies
A
Fund may invest directly and indirectly in foreign currencies. Investments in
foreign currencies are subject to numerous risks not least
being the fluctuation of foreign currency exchange rates with respect to the
U.S. Dollar. Exchange rates fluctuate for a number of reasons.
Inflation. Exchange rates
change to reflect changes in a currency’s buying power. Different countries
experience different inflation rates due to different monetary and fiscal
policies, different product and labor market conditions, and a host of other
factors.
5
Trade
Deficits. Countries with
trade deficits tend to experience a depreciating currency. Inflation may be the
cause of a trade deficit, making a country’s goods more expensive and less
competitive and so reducing demand for its currency.
Interest
Rates. High interest
rates may raise currency values in the short term by making such currencies more
attractive to investors. However, since high interest rates are often the result
of high inflation, long-term results may be the opposite.
Budget
Deficits and Low Savings Rates. Countries that
run large budget deficits and save little of their national income tend to
suffer a depreciating currency because they are forced to borrow abroad to
finance their deficits. Payments of interest on this debt can inundate the
currency markets with the currency of the debtor nation. Budget deficits also
can indirectly contribute to currency depreciation if a government chooses
inflationary measures to cope with its deficits and debt.
Political
Factors. Political
instability in a country can cause a currency to depreciate. Demand for a
certain currency may fall if a country appears a less desirable place in which
to invest and do business.
Government
Control. Through their
own buying and selling of currencies, the world’s central banks sometimes
manipulate exchange rate movements. In addition, governments occasionally issue
statements to influence people’s expectations about the direction of exchange
rates, or they may instigate policies with an exchange rate target as the
goal.
The
value of a Fund’s investments is calculated in U.S. Dollars each day that the
New York Stock Exchange (“NYSE”) is open for business. As
a result, to the extent that a Fund’s assets are invested in instruments
denominated in foreign currencies and the currencies appreciate relative to the
U.S. Dollar, a Fund’s NAV per share as expressed in U.S. Dollars (and,
therefore, the value of your investment) should increase. If the U.S. Dollar
appreciates relative to the other currencies, the opposite should
occur.
The
currency-related gains and losses experienced by a Fund will be based on changes
in the value of portfolio securities attributable to
currency fluctuations only in relation to the original purchase price of such
securities as stated in U.S. Dollars. Gains or losses on shares of a Fund will
be based on changes attributable to fluctuations in the NAV of such shares,
expressed in U.S. Dollars, in relation to the original U.S. Dollar purchase
price of the shares. The amount of appreciation or depreciation in a Fund’s
assets also will be affected by the net investment income generated by the money
market instruments in which each Fund invests and by changes in the value of the
securities that are unrelated to changes in currency exchange rates.
A
Fund may incur currency exchange costs when it sells instruments denominated in
one currency and buys instruments denominated in
another.
Currency
Transactions. A Fund conducts
currency exchange transactions on a spot basis. Currency transactions made on a
spot basis are for cash at the spot rate prevailing in the currency exchange
market for buying or selling currency. A Fund also enters into forward currency
contracts. See “Futures Contracts, Options, and Other Derivative Strategies”
section below. A forward currency contract is an obligation to buy or sell a
specific currency at a future date, which may be any fixed number of days from
the date of the contract agreed upon by the parties, at a price set at the time
of the contract. These contracts are entered into on the interbank market
conducted directly between currency traders (usually large commercial banks) and
their customers. A currency forward contract will tend to reduce or eliminate
exposure to the currency that is sold, and increase exposure to the currency
that is purchased, similar to when a fund sells a security denominated in one
currency and purchases a security denominated in another currency. For example,
a Fund may enter into a forward contract when it owns a security that is
denominated in a non-U.S. currency and desires to “lock in” the U.S. dollar
value of the security.
A
Fund may invest in a combination of forward currency contracts and U.S.
Dollar-denominated market instruments in an attempt to obtain
an investment result that is substantially the same as a direct investment in a
foreign currency-denominated instrument. This investment technique creates a
“synthetic” position in the particular foreign-currency instrument whose
performance the Adviser is trying to duplicate. For example, the combination of
U.S. Dollar-denominated instruments with “long” forward currency exchange
contracts creates a position economically equivalent to a money market
instrument denominated in the foreign currency itself. Such combined positions
are sometimes necessary when the money market in a particular foreign currency
is small or relatively illiquid.
A
Fund may invest in forward currency contracts to hedge either specific
transactions (transaction hedging) or portfolio positions
(position hedging). Transaction hedging is the purchase or sale of forward
currency contracts with respect to specific receivables or payables of a Fund in
connection with the purchase and sale of portfolio securities. Position hedging
is the sale of a forward currency contract on a particular currency with respect
to portfolio positions denominated or quoted in that currency.
A
Fund may use forward currency contracts for position hedging if consistent with
its policy of trying to expose its net assets to foreign
currencies. A Fund is not required to enter into forward currency contracts for
hedging purposes and it is possible that a Fund may not be able to hedge against
a currency devaluation that is so generally anticipated that a Fund is unable to
contract to sell the currency at a price above the devaluation level it
anticipates. It also is possible, under certain circumstances, that a Fund may
have to limit its currency transactions to qualify as a “regulated investment
company” (“RIC”) under Subchapter M of Chapter 1 of Subtitle A of the Internal
Revenue Code of 1986, as amended (“Code”). See “Dividends, Other Distributions
and Taxes.”
6
Each
Fund currently does not intend to enter into a forward currency contract with a
term of more than one year, or to engage in
position hedging with respect to the currency of a particular country to more
than the aggregate market value (at the time the hedging transaction is entered
into) of its portfolio securities denominated in (or quoted in or currently
convertible into or directly related through the use of forward currency
contracts in conjunction with money market instruments to) that particular
currency.
Under
definitions adopted by the Commodity Futures Trading Commission (“CFTC”) and
SEC, non-deliverable forwards are considered swaps,
and therefore are included in the definition of “commodity interests.” Although
non-deliverable forwards have historically been traded in the over-the-counter
(“OTC”) market, as swaps they may in the future be required to be centrally
cleared and traded on public facilities. For more information on central
clearing and trading of cleared swaps, see “Cleared swaps,” “Risks of cleared
swaps,” “Comprehensive swaps regulation” and “Developing government regulation
of derivatives.” Currency forwards that qualify as deliverable forwards are not
regulated as swaps for most purposes, and are not included in the definition of
“commodity interests.” However these forwards are subject to some requirements
applicable to swaps, including reporting to swap data repositories,
documentation requirements, and business conduct rules applicable to swap
dealers. CFTC regulation of currency forwards, especially non-deliverable
forwards, may restrict a Fund’s ability to use these instruments in the manner
described above or subject the investment manager to CFTC registration and
regulation as a commodity pool operator (“CPO”).
At
or before the maturity of a forward currency contract, a Fund may either sell a
portfolio security and make delivery of the currency, or
retain the security and terminate its contractual obligation to deliver the
currency by buying an “offsetting” contract obligating it to buy, on the same
maturity date, the same amount of the currency. If a Fund engages in an
offsetting transaction, it may later enter into a new forward currency contract
to sell the currency.
If
a Fund engages in an offsetting transaction, it will incur a gain or loss to the
extent that there has been movement in forward currency
contract prices. If forward prices go down during the period between the date a
Fund enters into a forward currency contract for the sale of a currency and the
date it enters into an offsetting contract for the purchase of the currency, a
Fund will realize a gain to the extent that the price of the currency it has
agreed to sell exceeds the price of the currency it has agreed to buy. If
forward prices go up, a Fund will suffer a loss to the extent the price of the
currency it has agreed to buy exceeds the price of the currency it has agreed to
sell.
Since
a Fund invests in money market instruments denominated in foreign currencies, it
may hold foreign currencies pending investment or
conversion into U.S. Dollars. Although a Fund values its assets daily in U.S.
Dollars, it does not convert its holdings of foreign currencies into U.S.
Dollars on a daily basis. A Fund will convert its holdings from time to time,
however, and incur the costs of currency conversion. Foreign exchange dealers do
not charge a fee for conversion, but they do realize a profit based on the
difference between the prices at which they buy and sell various currencies.
Thus, a dealer may offer to sell a foreign currency to a Fund at one rate, and
offer to buy the currency at a lower rate if a Fund tries to resell the currency
to the dealer.
Risks
of currency forward contracts.
Should exchange
rates move in an unexpected manner, a Fund may not achieve the anticipated
benefits of the transaction, or it may realize losses. In addition, these
techniques could result in a loss if the counterparty to the transaction does
not perform as promised, including because of the counterparty’s bankruptcy or
insolvency. While a Fund uses only counterparties that meet its credit quality
standards, in unusual or extreme market conditions, a counterparty’s
creditworthiness and ability to perform may deteriorate rapidly, and the
availability of suitable replacement counterparties may become limited. Currency
forward contracts may limit potential gain from a positive change in the
relationship between the U.S. Dollar and foreign currencies. Unanticipated
changes in currency prices may result in poorer overall performance for a Fund
than if it had not engaged in such contracts. Moreover, there may be an
imperfect correlation between a Fund’s portfolio holdings of securities
denominated in a particular currency and the currencies bought or sold in the
forward contracts entered into by a Fund. This imperfect correlation may cause a
Fund to sustain losses that will prevent the Fund from achieving a complete
hedge or expose the Fund to risk of foreign exchange loss.
Foreign
Currency Options. A Fund may
invest in foreign currency-denominated securities and may buy or sell put and
call options on foreign currencies. A Fund may buy or sell put and call options
on foreign currencies either on exchanges or in the OTC market. A put option on
a foreign currency gives the purchaser of the option the right to sell a foreign
currency at the exercise price until the option expires. A call option on a
foreign currency gives the purchaser of the option the right to purchase the
currency at the exercise price until the option expires. Currency options traded
on U.S. or other exchanges may be subject to position limits which may limit the
ability of a Fund to reduce foreign currency risk using such options. OTC
options differ from traded options in that they are two-party contracts with
price and other terms negotiated between buyer and seller, and generally do not
have as much market liquidity as exchange-traded options.
Foreign
Currency Exchange-Related Securities
Foreign
Currency Warrants. Foreign
currency warrants such as Currency Exchange WarrantsSM
(“CEWsSM”) are warrants
which entitle the holder to receive from their issuer an amount of cash
(generally, for warrants issued in the United States, in U.S. Dollars) which is
calculated pursuant to a predetermined formula and based on the exchange rate
between a specified
7
foreign
currency and the U.S. Dollar as of the exercise date of the warrant. Foreign
currency warrants generally are exercisable upon their
issuance and expire as of a specified date and time. Foreign currency warrants
have been issued in connection with U.S. Dollar-denominated debt offerings by
major corporate issuers in an attempt to reduce the foreign currency exchange
risk which, from the point of view of prospective purchasers of the securities,
is inherent in the international fixed-income marketplace. Foreign currency
warrants may attempt to reduce the foreign exchange risk assumed by purchasers
of a security by, for example, providing for a supplemental payment in the event
that the U.S. Dollar depreciates against the value of a major foreign currency
such as the Japanese yen or the Euro. The formula used to determine the amount
payable upon exercise of a foreign currency warrant may make the warrant
worthless unless the applicable foreign currency exchange rate moves in a
particular direction (e.g., unless the U.S.
Dollar appreciates or depreciates against the particular foreign currency to
which the warrant is linked or indexed). Foreign currency warrants are severable
from the debt obligations with which they may be offered, and may be listed on
exchanges. Foreign currency warrants may be exercisable only in certain minimum
amounts, and an investor wishing to exercise warrants who possesses less than
the minimum number required for exercise may be required either to sell the
warrants or to purchase additional warrants, thereby incurring additional
transaction costs. In the case of any exercise of warrants, there may be a time
delay between the time a holder of warrants gives instructions to exercise and
the time the exchange rate relating to exercise is determined, during which time
the exchange rate could change significantly, thereby affecting both the market
and cash settlement values of the warrants being exercised. The expiration date
of the warrants may be accelerated if the warrants should be delisted from an
exchange or if their trading should be suspended permanently, which would result
in the loss of any remaining “time value” of the warrants (i.e., the difference
between the current market value and the exercise value of the warrants), and,
in the case the warrants were “out-of-the-money,” in a total loss of the
purchase price of the warrants.
Warrants
are generally unsecured obligations of their issuers and are not standardized
foreign currency options issued by the Options
Clearing Corporation (“OCC”). Unlike foreign currency options issued by OCC, the
terms of foreign exchange warrants generally will not be amended in the event of
governmental or regulatory actions affecting exchange rates or in the event of
the imposition of other regulatory controls affecting the international currency
markets. The initial public offering price of foreign currency warrants is
generally considerably in excess of the price that a commercial user of foreign
currencies might pay in the interbank market for a comparable option involving
significantly larger amounts of foreign currencies. Foreign currency warrants
are subject to significant foreign exchange risk, including risks arising from
complex political or economic factors.
Principal
Exchange Rate Linked Securities. Principal
exchange rate linked securities (“PERLsSM”) are debt
obligations the principal on which is payable at maturity in an amount that may
vary based on the exchange rate between the U.S. Dollar and a particular foreign
currency at or about that time. The return on “standard” principal exchange rate
linked securities is enhanced if the foreign currency to which the security is
linked appreciates against the U.S. Dollar, and is adversely affected by
increases in the foreign exchange value of the U.S. Dollar; “reverse” principal
exchange rate linked securities are like the “standard” securities, except that
their return is enhanced by increases in the value of the U.S. Dollar and
adversely impacted by increases in the value of foreign currency. Interest
payments on the securities are generally made in U.S. Dollars at rates that
reflect the degree of foreign currency risk assumed or given up by the purchaser
of the notes (i.e., at relatively
higher interest rates if the purchaser has assumed some of the foreign exchange
risk, or relatively lower interest rates if the issuer has assumed some of the
foreign exchange risk, based on the expectations of the current market).
Principal exchange rate linked securities may in limited cases be subject to
acceleration of maturity (generally, not without the consent of the holders of
the securities), which may have an adverse impact on the value of the principal
payment to be made at maturity.
Performance
Indexed Paper. Performance
indexed paper (“PIPsSM”) is U.S.
Dollar-denominated commercial paper the yield of which is linked to certain
foreign exchange rate movements. The yield to the investor on performance
indexed paper is established at maturity as a function of spot exchange rates
between the U.S. Dollar and a designated currency as of or about that time
(generally, the index maturity two days prior to maturity). The yield to the
investor will be within a range stipulated at the time of purchase of the
obligation, generally with a guaranteed minimum rate of return that is below,
and a potential maximum rate of return that is above, market yields on U.S.
Dollar-denominated commercial paper, with both the minimum and maximum rates of
return on the investment corresponding to the minimum and maximum values of the
spot exchange rate two business days prior to maturity.
Foreign
Securities
A
Fund may have both direct and indirect exposure to foreign securities through
investments in publicly traded securities such as stocks
and bonds, stock index futures contracts, options on stock index futures
contracts and options on securities and on stock indices to foreign securities.
In most cases, the best available market for foreign securities will be on
exchanges or in over-the-counter ("OTC") markets located outside the United
States.
Investing
in foreign securities carries political and economic risks distinct from those
associated with investing in the United States. Non-U.S.
securities may be subject to currency risks or to foreign government taxes.
There may be less information publicly available about a non-U.S. issuer than
about a U.S. issuer, and a foreign issuer may or may not be subject uniform
8
accounting,
auditing and financial reporting standards and practices comparable to those in
the U.S. Other risks of investing in such
securities include political or economic instability in the country involved,
the difficulty of predicting international trade patterns and the possibility of
the imposition of exchange controls. The prices of such securities may be more
volatile than those of U.S. securities. There maybe also be the possibility of
expropriation of assets or nationalization, imposition of withholding taxes on
dividend or interest payments, difficulty obtaining and enforcing judgments
against foreign entities or diplomatic developments which could affect
investment in these countries. Losses and other expenses may be incurred in
converting currencies in connection with purchases and sales of foreign
securities.
Non-U.S.
stock markets may not be as developed or efficient as, and may be more volatile
than, those in the U.S. While the volume of
shares traded on non-U.S. stock markets generally has been growing, such markets
usually have substantially less volume than U.S. markets. Therefore, a Fund’s
investment in non-U.S. equity securities may be less liquid and subject to more
rapid and erratic price movements than comparable securities listed for trading
on U.S. exchanges. Non-U.S. equity securities may trade at price/earnings
multiples higher than comparable U.S. securities and such levels may not be
sustainable. There may be less government supervision and regulation of foreign
stock exchanges, brokers, banks and listed companies abroad than in the U.S.
Moreover, settlement practices for transactions in foreign markets may differ
from those in U.S. markets. Such differences may include delays beyond periods
customary in the U.S. and practices, such as delivery of securities prior to
receipt of payment, that increase the likelihood of a failed settlement, which
can result in losses to a Fund. The value of non-U.S. investments and the
investment income derived from them may also be affected unfavorably by changes
in currency exchange control regulations. Foreign brokerage commissions,
custodial expenses and other fees are also generally higher than for securities
traded in the U.S. This may cause a Fund to incur higher portfolio transaction
costs than domestic equity funds. Fluctuations in exchanges rates may also
affect the earning power and asset value of the foreign entity issuing a
security, even on denominated in U.S. dollars. Dividend and interest payments
may be repatriated based on the exchange rate at the time of disbursement, and
restrictions on capital flows may be imposed.
Developing
and Emerging Markets. Emerging and
developing markets abroad may offer special opportunities for investing, but may
have greater risks than more developed foreign markets, such as those in Europe,
Canada, Australia, New Zealand and Japan. There may be even less liquidity in
their securities markets, and settlements of purchases and sales of securities
may be subject to additional delays. They are subject to greater risks of
limitations on the repatriation of income and profits because of currency
restrictions imposed by local governments. Those countries may also be subject
to the risk of greater political and economic instability, which can greatly
affect the volatility of prices of securities in those countries.
Investing
in emerging market securities imposes risks different from, or greater than,
risks of investing in foreign developed countries. These
risks include: smaller market capitalization of securities markets, which may
suffer periods of relative illiquidity; significant price volatility;
restrictions on foreign investment; and possible repatriation of investment
income and capital. In addition, foreign investors may be required to register
the proceeds of sales and future economic or political crises could lead to
price controls, forced mergers, expropriation or confiscatory taxation, seizure,
nationalization, or creation of government monopolies. The currencies of
emerging market countries may experience significant declines against the U.S.
Dollar. Inflation and rapid fluctuations in inflation rates have had, and may
continue to have, negative effects on the economies and securities markets of
certain emerging market countries. Additional risks of emerging markets
securities may include: greater social, economic and political uncertainty and
instability; more substantial governmental involvement in the economy; less
governmental supervision and regulation; unavailability of currency hedging
techniques; companies that are newly organized and small; differences in
auditing and financial reporting standards, which may result in unavailability
of material information about issuers; and less developed legal systems.
Shareholder claims and legal remedies that are common in the United States may
be difficult or impossible to pursue in many emerging market countries. In
addition, due to jurisdictional limitations, matters of comity and various other
factors, U.S. authorities may be limited in their ability to bring enforcement
actions against non-U.S. companies and non-U.S. persons in certain emerging
market countries. In addition, emerging securities markets may have different
clearance and settlement procedures, which may be unable to keep pace with the
volume of securities transactions or otherwise make it difficult to engage in
such transactions.
Asia-Pacific
Countries. In addition to
the risks associated with foreign and emerging markets, the developing market
Asia-Pacific countries in which a Fund may invest are subject to certain
additional or specific risks. A Fund may make substantial investments in
Asia-Pacific countries. In the Asia-Pacific markets, there is a high
concentration of market capitalization and trading volume in a small number of
issuers representing a limited number of industries, as well as a high
concentration of investors and financial intermediaries. Many of these markets
also may be affected by developments with respect to more established markets in
the region, such as Japan and Hong Kong. Brokers in developing market
Asia-Pacific countries typically are fewer in number and less well-capitalized
than brokers in the United States. These factors, combined with the U.S.
regulatory requirements for open-end investment companies and the restrictions
on foreign investment, result in potentially fewer investment opportunities for
a Fund and may have an adverse impact on a Fund’s investment
performance.
Many
of the developing market Asia-Pacific countries may be subject to a greater
degree of economic, political and social instability than
is the case in the United States and Western European countries. Such
instability may result from, among other things: (i) authoritarian governments
or military involvement in political and economic decision-making, including
changes in government through extra-constitutional means; (ii) popular unrest
associated with demands for improved political, economic and social conditions;
(iii) internal insurgencies; (iv) hostile relations with neighboring countries;
and/or (v) ethnic,
9
religious
and racial disaffection. In addition, the governments of many of such countries,
such as Indonesia, have a heavy role in
regulating and supervising the economy.
An
additional risk common to most such countries is that the economy is heavily
export-oriented and, accordingly, is dependent upon
international trade. The existence of overburdened infrastructure and obsolete
financial systems also present risks in certain countries, as do environmental
problems. Certain economies also depend to a significant degree upon exports of
primary commodities and, therefore, are vulnerable to changes in commodity
prices that, in turn, may be affected by a variety of factors. The legal systems
in certain developing market Asia-Pacific countries also may have an adverse
impact on a Fund. For example, while the potential liability of a shareholder in
a U.S. corporation with respect to acts of the corporation is generally limited
to the amount of the shareholder's investment, the notion of limited liability
is less clear in certain emerging market Asia-Pacific countries. Similarly, the
rights of investors in developing market Asia-Pacific companies may be more
limited than those of shareholders of U.S. corporations. It may be difficult or
impossible to obtain and/or enforce a judgment in a developing market
Asia-Pacific country.
Governments
of many developing market Asia-Pacific countries have exercised and continue to
exercise substantial influence over many aspects
of the private sector. In certain cases, the government owns or controls many
companies, including the largest in the country. Accordingly, government actions
in the future could have a significant effect on economic conditions in
developing market Asia-Pacific countries, which could affect private sector
companies and a Fund itself, as well as the value of securities in a Fund's
portfolio. In addition, economic statistics of developing market Asia-Pacific
countries may be less reliable than economic statistics of more developed
nations.
It
is possible that developing market Asia-Pacific issuers may not be subject to
the same accounting, auditing and financial reporting
standards as U.S. companies. Inflation accounting rules in some developing
market Asia-Pacific countries require companies that keep accounting records in
the local currency, for both tax and accounting purposes, to restate certain
assets and liabilities on the company’s balance sheet in order to express items
in terms of currency of constant purchasing power. Inflation accounting may
indirectly generate losses or profits for certain developing market Asia-Pacific
companies. In addition, satisfactory custodial services for investment
securities may not be available in some developing Asia-Pacific countries, which
may result in a Fund incurring additional costs and delays in providing
transportation and custody services for such securities outside such
countries.
Certain
developing Asia-Pacific countries are especially large debtors to commercial
banks and foreign governments. Fund management may
determine that, notwithstanding otherwise favorable investment criteria, it may
not be practicable or appropriate to invest in a particular developing
Asia-Pacific country. A Fund may invest in countries in which foreign investors,
including management of the Fund, have had no or limited prior
experience.
Brazil. Investing in Brazil involves
certain considerations not typically associated with investing in the United
States. Additional considerations include: (i) investment and repatriation
controls, which could affect a Fund’s ability to operate, and to qualify for the
favorable tax treatment afforded to RICs for U.S. federal income tax purposes;
(ii) fluctuations in the rate of exchange between the Brazilian Real and the
U.S. Dollar; (iii) the generally greater price volatility and lesser liquidity
that characterize Brazilian securities markets, as compared with U.S. markets;
(iv) the effect that balance of trade could have on Brazilian economic stability
and the Brazilian government's economic policy; (v) potentially high rates of
inflation, a rising unemployment rate, and a high level of debt, each of which
may hinder economic growth; (vi) governmental involvement in and influence on
the private sector; (vii) Brazilian accounting, auditing and financial standards
and requirements, which differ from those in the United States; (viii) political
and other considerations, including changes in applicable Brazilian tax laws;
and (ix) restrictions on investments by foreigners. In addition, commodities,
such as oil, gas and minerals, represent a significant percentage of Brazil’s
exports and, therefore, its economy is particularly sensitive to fluctuations in
commodity prices. Additionally, an investment in Brazil is subject to certain
risks stemming from political and economic corruption.
China. Investing in
China involves special considerations not typically associated with investing in
countries with more democratic governments or more established economies or
currency markets. These risks include: (i) the risk of nationalization or
expropriation of assets or confiscatory taxation; (ii) greater governmental
involvement in and control over the economy, interest rates and currency
exchange rates; (iii) controls on foreign investment and limitations on
repatriation of invested capital; (iv) greater social, economic and political
uncertainty ; (v) dependency on exports and the corresponding importance of
international trade; (vi) currency exchange rate fluctuations; (vii) differences
in, or lack of, auditing and financial reporting standards that may result in
unavailability of material information about issuers and restrictions on
issuers’ ability to access the U.S. capital markets; and (viii) the risk that
certain companies, including those in which the Fund may invest, may have
dealings with countries subject to sanctions or embargoes imposed by the U.S.
government or identified as state sponsors of terrorism.
For
over three decades, the Chinese government has been reforming economic and
market practice and has been providing a larger sphere
for private ownership of property. While currently contributing to growth and
prosperity, the government could technically decide not to continue to support
these economic reform programs and return to the completely centrally planned
economy that existed prior to 1978. There is also a greater risk in China than
in many other countries of currency fluctuations, currency non-convertibility,
interest rate fluctuations and higher rates of inflation as a result of internal
social unrest or conflicts with other countries. China is an emerging market and
demonstrates significantly higher volatility from time to time in comparison to
developed markets. The government of China maintains strict currency controls in
support
10
of
economic, trade and political objectives and regularly intervenes in the
currency market. The government's actions in this respect may
not be transparent or predictable. As a result, the value of the Yuan (or
renminbi), and the value of securities designed to provide exposure to the Yuan,
can change quickly and arbitrarily. Furthermore, it is difficult for foreign
investors to directly access money market securities in China because of
investment and trading restrictions. Chinese law also prohibits direct foreign
investments in certain issuers in certain industries. Chinese companies listed
on U.S. exchanges often use variable interest entities (“VIEs”) in their
structure. Instead of directly owning the equity securities of a Chinese
operating company, in a VIE structure, a non-U.S. shell company (often organized
in the Cayman Islands) that is listed and traded on a U.S. exchange enters into
service contracts and other contracts with the Chinese operating company which
provide the foreign shell company with exposure to the Chinese company. Although
the U.S. listed shell company has no equity ownership of the Chinese operating
company, the contractual arrangements provide the U.S. listed shell company
economic exposure to the Chinese operating company and permit the U.S. listed
shell company to consolidate the Chinese operating company into its financial
statements. VIE structures are subject to legal and regulatory uncertainties and
risks. Intervention by the Chinese government with respect to VIE structures or
the non-enforcement of VIE-related contractual rights could significantly affect
a Chinese operating company's business, the enforceability of the U.S. listed
shell company's contractual arrangements with the Chinese operating company and
the value of the U.S. listed stock. Intervention by the Chinese government could
include nationalization of the Chinese operating company, confiscation of its
assets, restrictions on operations and/or constraints on the use of VIE
structures. In addition, because the Chinese operating company is not owned,
directly or indirectly, by the U.S. listed shell company, the U.S. listed shell
company cannot control the Chinese operating company and must rely on the
Chinese operating company to perform its contractual obligations in order for
the U.S. listed company to receive economic benefits.
While
the economy of China has enjoyed substantial economic growth in recent years,
there can be no guarantee this growth will
continue. Reduction in spending on Chinese products and services, the
institution of additional tariffs or other trade barriers, including as a result
of heightened trade tensions between China and the United States, or a downturn
in any of the economies of China’s key trading partners may have an adverse
impact on the Chinese economy. Actions like these may have unanticipated and
disruptive effects on the Chinese economy. Any such response that targets
Chinese financial markets or securities exchanges could interfere with orderly
trading, delay settlement or cause market disruptions. These and other factors
may decrease the value and liquidity of a Fund's investments. The Chinese
economy may experience a significant slowdown as a result of, among other
things, a deterioration of global demand for Chinese exports, as well as
contraction in spending on domestic goods by Chinese consumers. In addition,
China may experience substantial rates of inflation or economic recessions,
which would have a negative effect on its economy and securities
market.
Hong Kong
reverted to Chinese sovereignty on July 1, 1997 as a Special Administrative
Region of the PRC under the principle of “one country, two systems.”
Although China is obligated to maintain the current capitalist economic and
social system of Hong Kong through June 30, 2047, the continuation of economic
and social freedoms enjoyed in Hong Kong is dependent on the government of
China. Since 1997, there have been tensions between the Chinese government and
many people in Hong Kong regarding China's perceived tightening of control over
Hong Kong's semi-autonomous liberal political, economic, legal, and social
framework. Recent protests may prompt the Chinese and Hong Kong governments to
rapidly address Hong Kong's future relationship with mainland China, which
remains unresolved. Due to the interconnected nature of the Hong Kong and
Chinese economies, this instability in Hong Kong may cause uncertainty in the
Hong Kong and Chinese markets.
There has been
increased attention from the U.S. government and U.S. regulators, including the
Department of the Treasury (“DOT”) and its Office of Foreign
Assets Control (“OFAC”). In a series of executive orders issued between November
2020 and June 2021, the DOT prohibited investment by U.S. investors in certain
companies tied to the Chinese military or China's surveillance technology
sector. The prohibited companies were described in the executive orders as
“Chinese Military Industrial Complex Companies,” and the restrictions on
investing in such companies was interpreted by OFAC to extend to instruments
that are derivative of, or designed to provide investment exposure to, these
companies, including diversified investment companies. The orders only contained
a limited exception for transactions that made solely for the purpose of
divestment through June 3, 2022. As a result, prior to that date, the Funds will
sell any positions in such companies and will not make future investments in
them, notwithstanding their potential inclusion in a Fund's underlying
index.
There has also
been increased attention from the SEC and the Public Company Accounting
Oversight Board (“PCAOB”) with regard to international
auditing standards of U.S.-listed companies with operations in China as well as
PCAOB-registered auditing firms in China. The Holding Foreign Companies
Accountable Act ("HFCAA") requires the SEC to identify reporting public
companies that use public accounting firms with a branch or office located in a
foreign jurisdiction that the PCAOB determines that it is unable to inspect or
investigate completely because of a position taken by a governmental entity in
that jurisdiction ("Commission-Identified Issuers"). If an issuer is identified
as a Commission-Identified Issuer for three consecutive years, the issuer's
shares will be prohibited in U.S. exchange and over-the-counter markets. On
March 8, 2022, pursuant to the implementing regulations established by the SEC
as required by the HFCAA, the SEC began to identify companies as provisional
Commission-Identified Issuers. Although the PCAOB in 2021 had determined that
positions taken by PRC authorities prevented the PCAOB from inspecting and
investigating audit firms headquartered in mainland China and Hong Kong, in
December 2022 the PCAOB announced that it had been able to secure complete
access to inspect and investigate audit
11
firms in the PRC
for the first time in history. As a result, on December 15, 2022, the PCAOB
voted to vacate the previous 2021 determinations. Depending on
the PRC's continued cooperation, under the HFCAA, PCAOB determinations may
result in certain issuers becoming Commission-Identified Issuers.
The
current political climate has intensified concerns about trade tariffs and a
potential trade war between China and the United States,
despite the United States’ signing a partial trade agreement with China that
reduced some U.S. tariffs on Chinese goods while boosting Chinese purchases of
American goods. However, this agreement left in place a number of existing
tariffs, and it is unclear whether further trade agreements may be reached in
the future. The ability and willingness of China to comply with the trade deal
may determine to some degree the extent to which its economy will be adversely
affected, which cannot be predicted at the present time. Future tariffs imposed
by China and the United States on the other country’s products, or other
escalating actions, may trigger a significant reduction in international trade,
the oversupply of certain manufactured goods, substantial price reductions of
goods and possible failure of individual companies and/or large segments of
China’s export industry with a potentially negative impact to a
Fund.
For
decades, a state of hostility has existed between Taiwan and the PRC. Beijing
has long deemed Taiwan a part of the “one China” and
has made a nationalist cause of recovering it. This situation poses a threat to
Taiwan’s economy and could negatively affect its stock market. In addition,
China could be affected by military events on the Korean peninsula or internal
instability within North Korea. These situations may cause uncertainty in the
Chinese market and may adversely affect performance of the Chinese
economy.
China A-shares
are equity securities of companies based in mainland China that trade on Chinese
stock exchanges such as the Shanghai Stock Exchange
(“SSE”) and the Shenzhen Stock Exchange (“SZSE”) (“A-shares”). The ability of a
Fund to invest in China A-Shares is dependent, in part, on the availability of
A-Shares either through the trading and clearing facilities of a participating
exchange located outside of mainland China (“Stock Connect Programs”) which
currently include the Shanghai-Hong Kong Stock Connect, Shenzhen-Hong Kong Stock
Connect, Shanghai-London Stock Connect, and China-Japan Stock Connect, and/or
through a QFII or RQFII license and quota allocation from the Chinese regulator.
Thus, the Fund’s investment in A-Shares may be limited by the A-Shares quota
obtained by the RQFII or QFII licensee and allocated to the Fund and by the
amount of A-Shares available through the Stock Connect Programs. Regulations
that came into effect on June 6, 2020 supersede certain post-registration rules
applicable to QFII and RQFII regimes and remove prior quota restrictions on
investment in A-shares. However, this is a relatively new development, and there
is no guarantee that the quotas will continue to be relaxed.
The
Stock Connect Programs are subject to daily and aggregate quota limitations, and
an investor cannot purchase and sell the same
security on the same trading day, which may restrict a Fund’s ability to invest
in A-Shares through the Stock Connect Programs and to enter into or exit trades
on a timely basis. The Shanghai and Shenzhen markets may be open at a time when
the participating exchanges located outside of mainland China are not active,
with the result that prices of A-Shares may fluctuate at times when a Fund is
unable to add to or exit a position. Only certain A-Shares are eligible to be
accessed through the Stock Connect Programs. Such securities may lose their
eligibility at any time, in which case they may no longer be able to be
purchased or sold through the Stock Connect Programs. Because the Stock Connect
Programs are still evolving, the actual effect on the market for trading
A-Shares with the introduction of large numbers of foreign investors is still
relatively unknown. In addition, there is no assurance that the necessary
systems required to operate the Stock Connect Programs will function properly or
will continue to be adapted to changes and developments in both markets. In the
event that the relevant systems do not function properly, trading through the
Stock Connect Programs could be disrupted. The Stock Connect Programs are
subject to regulations promulgated by regulatory authorities for both exchanges
and further regulations or restrictions, such as limitations on redemptions or
suspension of trading, may adversely impact the Stock Connect Programs, if the
authorities believe it necessary to assure orderly markets or for other reasons.
There is no guarantee that the participating exchanges will continue to support
the Stock Connect Programs in the future. Each of the foregoing could restrict a
Fund from selling its investments, adversely affect the value of its holdings
and negatively affect a Fund’s ability to meet shareholder
redemptions.
Europe. Investing in
European countries may impose economic and political risks associated with
Europe in general and the specific European countries in which it invests. The
economies and markets of European countries are often closely connected and
interdependent, and events in one European country can have an adverse impact on
other European countries. A Fund makes investments in securities of issuers that
are domiciled in, or have significant operations in, member countries of the
Economic and Monetary Union of the European Union (the “EU”), which requires
member countries to comply with restrictions on inflation rates, deficits,
interest rates, debt levels and fiscal and monetary controls, each of which may
significantly affect every country in Europe. Decreasing imports or exports,
changes in governmental or EU regulations on trade, changes in the exchange rate
of the euro (the common currency of certain EU countries), the default or threat
of default by an EU member country on its sovereign debt, and/or an economic
recession in an EU member country may have a significant adverse effect on the
economies of EU member countries and their trading partners, including some or
all of the emerging markets materials sector countries. Although certain
European countries do not use the euro, many of these countries are obliged to
meet the criteria for joining the euro zone. Consequently, these countries must
comply with many of the restrictions noted above. The European financial markets
have experienced volatility and adverse trends in recent years due to concerns
about economic downturns, rising government debt levels and the possible default
of government debt in several European
12
countries,
including Greece, Ireland, Italy, Portugal and Spain. In order to prevent
further economic deterioration, certain countries,
without prior warning, can institute “capital controls.” Countries may use these
controls to restrict volatile movements of capital entering and exiting their
country. Such controls may negatively affect a Fund’s investments. A default or
debt restructuring by any European country would adversely impact holders of
that country’s debt and sellers of credit default swaps linked to that country’s
creditworthiness, which may be located in countries other than those listed
above. In addition, the credit ratings of certain European countries were
recently downgraded. These downgrades may result in further deterioration of
investor confidence. These events have adversely affected the value and exchange
rate of the euro and may continue to significantly affect the economies of every
country in Europe, including countries that do not use the euro and non-EU
member countries. Responses to the financial problems by European governments,
central banks and others, including austerity measures and reforms, may not
produce the desired results, may result in social unrest and may limit future
growth and economic recovery or have other unintended consequences. Further
defaults or restructurings by governments and other entities of their debt could
have additional adverse effects on economies, financial markets and asset
valuations around the world. In addition, one or more countries may abandon the
euro and/or withdraw from the EU. The impact of these actions, especially if
they occur in a disorderly fashion, is not clear but could be significant and
far-reaching and could adversely impact the value of investments in the
region.
In a referendum
held on June 23, 2016, the United Kingdom (the “UK”) resolved to leave the EU
(referred to as “Brexit”). On January 31, 2020, the UK
officially withdrew from the EU pursuant to a withdrawal agreement, providing
for a transition period in which the UK negotiated and finalized a trade deal
with the EU, the EU-UK Trade and Cooperation Agreement (the “Trade Agreement”).
As a result, since January 1, 2021, the United Kingdom is no longer part of the
EU customs union and single market, nor is it subject to EU policies and
international agreements. The Trade Agreement, among other things, provides for
zero tariffs and zero quotas on all goods that comply with appropriate rules of
origin and establishes the treatment and level of access the United Kingdom and
EU have agreed to grant each other’s service suppliers and investors. The Trade
Agreement also covers digital trade, intellectual property, public procurement,
aviation and road transport, energy, fisheries, social security coordination,
law enforcement and judicial cooperation in criminal matters, thematic
cooperation and participation in EU programs. Even with the Trade Agreement in
place, the UK’s withdrawal from the EU may create new barriers to trade in goods
and services and to cross-border mobility and exchanges.
The
UK has one of the largest economies in Europe, and member countries of the EU
are substantial trading partners of the UK. The City
of London’s economy is dominated by financial services and uncertainty remains
regarding the treatment of cross-border trade in financial services. While the
Trade Agreement includes certain provisions to support cross-border trade in
financial services, it is not comprehensively addressed in the Trade Agreement
and the parties continue to discuss ‘equivalence’ rights to allow market access
for cross-border financial services. In March 2021, the EU and the UK reached a
memorandum of understanding, establishing a framework for voluntary regulatory
cooperation on financial services. Without access to the EU single market,
certain financial services in the UK may move outside of the UK as a result of
its withdrawal from the EU. In addition, financial services firms in the UK may
need to move staff and comply with two separate sets of rules or lose business
to financial services firms in the EU. Furthermore, the withdrawal from the EU
creates the potential for decreased trade, the possibility of capital outflows,
devaluation of the pound sterling, the cost of higher corporate bond spreads due
to continued uncertainty, and the risk that all the above could damage business
and consumer spending as well as foreign direct investment. As a result of the
withdrawal from the EU, the British economy and its currency may be negatively
impacted by changes to its economic and political relations with the EU.
Additional member countries seeking to withdraw from the EU would likely cause
additional market disruption globally and introduce new legal and regulatory
uncertainties.
Brexit
may also have a destabilizing impact on the EU to the extent that other member
states similarly seek to withdraw from the EU. Any
further exits from the EU would likely cause additional market disruptions
globally and introduce new legal and regulatory uncertainties.
Russia's
increasing international assertiveness could negatively impact EU economic
activity. The effect on the economies of EU countries of the
Russia/Ukraine war and Russia's response to sanctions imposed by the US and
other countries are impossible to predict, but have been and could continue to
be significant.
India. Investments in
India involve special considerations not typically associated with investing in
countries with more established economies or currency markets. Political,
religious, and border disputes persist in India. India has recently experienced
and may continue to experience civil unrest and hostilities with certain of its
neighboring countries, including Pakistan, and the Indian government has
confronted separatist movements in several Indian states, including Kashmir.
Government control over the economy, currency fluctuations or blockage, and the
risk of nationalization or expropriation of assets offer higher potential
losses. Governmental actions could have a negative effect on the economic
conditions in India, which could adversely affect the value and liquidity of
investments made by a Fund. The securities markets in India are comparatively
underdeveloped with some exceptions and consist of a small number of listed
companies with small market capitalization, greater price volatility and
substantially less liquidity than companies in more developed markets. The
limited liquidity of the Indian securities market may also affect a Fund’s
ability to acquire or dispose of securities at the price or time that it desires
or the Fund’s ability to track its underlying index.
13
The
Indian government exercises significant influence over many aspects of the
economy, and the number of public sector enterprises in
India is substantial. While the Indian government has implemented economic
structural reform with the objectives of liberalizing India's exchange and trade
policies, reducing the fiscal deficit, controlling inflation, promoting a sound
monetary policy, reforming the financial sector, and placing greater reliance on
market mechanisms to direct economic activity, there can be no assurance that
these policies will continue or that the economic recovery will be
sustained.
Global
factors and foreign actions may inhibit the flow of foreign capital on which
India is dependent to sustain its growth. In addition, the
Reserve Bank of India has imposed limits on foreign ownership of Indian
companies, which may decrease the liquidity of a Fund’s portfolio and result in
extreme volatility in the prices of Indian securities. In November 2016, the
Indian government eliminated certain large denomination cash notes as legal
tender, causing uncertainty in certain financial markets. These factors, coupled
with the lack of extensive accounting, auditing and financial reporting
standards and practices, as applicable in the United States, may increase the
risk of loss for a Fund.
Securities
laws in India are relatively new and unsettled and, as a result, there is a risk
of significant and unpredictable change in laws
governing foreign investment, securities regulation, title to securities and
shareholder rights. Foreign investors in particular may be adversely affected by
new or amended laws and regulations. Certain Indian regulatory approvals,
including approvals from the Securities and Exchange Board of India, the central
government and the tax authorities (to the extent that tax benefits need to be
utilized), may be required before a Fund can make investments in Indian
companies. Foreign investors in India still face burdensome taxes on investments
in income producing securities.
While
the Indian economy has enjoyed substantial economic growth in recent years,
there can be no guarantee this growth will continue.
Technology and software sectors represent a significant portion of the total
capitalization of the Indian securities markets. The value of these companies
will generally fluctuate in response to technological and regulatory
developments, and, as a result, a Fund’s holdings are expected to experience
correlated fluctuations. Natural disasters, such as tsunamis, flooding or
droughts, could occur in India or surrounding areas and could negatively affect
the Indian economy. Agriculture occupies a prominent position in the Indian
economy, therefore, it may be negatively affected by adverse weather conditions
and the effects of global climate change. These and other factors may decrease
the value and liquidity of a Fund's investments.
Italy. Investment in
Italian issuers involves risks that are specific to Italy, including,
regulatory, political, currency, and economic risks. Italy’s economy is
dependent upon external trade with other economies—specifically
Germany, France and other Western European
developed countries. As a result, Italy is dependent on the economies of these
other countries and any change in the price or demand for Italy’s exports may
have an adverse impact on its economy. Interest rates on Italy’s debt may rise
to levels that may make it difficult for it to service high debt levels without
significant financial help from the EU and could potentially lead to default.
Recently, the Italian economy has experienced volatility due to concerns about
economic downturn and rising government debt levels. Italy has been warned by
the Economic and Monetary Union of the EU to reduce its public spending and debt
and actions by Italy to cut spending or increase taxes in response could have
significant adverse effects on the Italian economy. These events have adversely
impacted the Italian economy, causing credit agencies to lower Italy’s sovereign
debt rating and could decrease outside investment in Italian companies. High
amounts of debt and public spending may stifle Italian economic growth or cause
prolonged periods of recession.
Japan. Japanese investments may be
significantly affected by events influencing Japan’s economy and changes in the
exchange rate between the Japanese yen and the U.S. Dollar. Japan’s economy fell
into a long recession in the 1990s. After a few years of mild recovery in the
mid-2000s, Japan’s economy fell into another recession as a result of the recent
global economic crisis. In December 2019, Japan’s government approved a fiscal
stimulus package of nearly $120 billion in order to stimulate its slowing
economy, which has been negatively affected by decreased demand from China and
by recent political conflicts with South Korea. Japan is heavily dependent on
exports and foreign oil and may be adversely affected by higher commodity
prices, trade tariffs, protectionist measures, competition from emerging
economies, and the economic conditions of its trading partners, such as China.
Furthermore, Japan is located in a seismically active area, and in 2011
experienced an earthquake and a tsunami that significantly affected important
elements of its infrastructure and resulted in a nuclear crisis. Since these
events, Japan’s financial markets have fluctuated dramatically. The full extent
of the impact of these events on Japan’s economy and on foreign investment in
Japan is difficult to estimate. The risks of natural disaster of varying
degrees, such as earthquakes and tsunamis, and the resulting damage, continue to
exist. Japan’s economic prospects may be affected by the political and military
situations of its near neighbors, notably North and South Korea, China, and
Russia. In addition,
the Japanese
economic growth rate could be impacted by Bank of Japan monetary policies,
rising interest rates, tax increases, budget deficits, consumer confidence and
volatility in the Japanese yen. Japan’s labor market is adapting to an aging
workforce, declining population, and demand for increased labor mobility. These
demographic shifts and fundamental structural changes to the labor markets may
negatively impact Japan’s economic competitiveness.
South
Korea. South Korean
investments may be significantly affected by events influencing its economy,
which is heavily dependent on exports and the demand for certain finished goods.
South Korea’s main industries include electronics, automobile production,
chemicals, shipbuilding, steel, textiles, clothing, footwear, and food
processing. Conditions that weaken demand for such products worldwide or in
other Asian countries could have a negative impact on the South Korean economy
as a whole. The South Korean economy’s reliance on international trade makes it
highly sensitive to fluctuations in international commodity prices, currency
exchanges rates and government regulation, and vulnerable to downturns of the
world economy, particularly with respects to its four largest export markets
(the EU, Japan, United States, and China). South Korea has
14
experienced
modest economic growth in recent years, but such continued growth may slow due,
in part, to the economic slowdown in China
and the increased competitive advantage of Japanese exports with the weakened
yen. The South Korean economy’s long-term challenges include an aging
population, inflexible labor market, and overdependence on exports to drive
economic growth. Relations between South Korea and North Korea remain tense, as
exemplified in periodic acts of hostility, and the possibility of serious
military engagement still exists. Armed conflict between North Korea and South
Korea could have a severe adverse impact on the South Korean economy and its
securities markets.
Latin
America. The economies
of certain Latin American countries have experienced high interest rates,
economic volatility, inflation, currency devaluations, government defaults, high
unemployment rates and political instability which can adversely affect issuers
in these countries. In addition, commodities (such as oil, gas and minerals)
represent a significant percentage of the region’s exports and many economies in
this region are particularly sensitive to fluctuations in commodity prices.
Adverse economic events in one country may have a significant adverse effect on
other countries of this region. The governments of certain countries in Latin
America may exercise substantial influence over many aspects of the private
sector and may own or control many companies. Future government actions could
have a significant effect on the economic conditions in such countries, which
could have a negative impact on the securities in which a Fund invests.
Diplomatic developments may also adversely affect investments in certain
countries in Latin America. Some countries in Latin America may be affected by
public corruption and crime, including organized crime. Certain countries in
Latin America may be heavily dependent upon international trade and,
consequently, have been and may continue to be negatively affected by trade
barriers, exchange controls, managed adjustments in relative currency values and
other protectionist measures imposed or negotiated by the countries with which
they trade. These countries also have been and may continue to be adversely
affected by economic conditions in the countries with which they trade. In
addition, certain issuers located in countries in Latin America in which a Fund
invests may be the subject of sanctions (for example, the U.S. has imposed
sanctions on certain Venezuelan individuals, corporate entities and the
Venezuelan government) or have dealings with countries subject to sanctions
and/or embargoes imposed by the U.S. government and the United Nations and/or
countries identified by the U.S. government as state sponsors of terrorism. An
issuer may sustain damage to its reputation if it is identified as an issuer
that has dealings with such countries. A Fund may be adversely affected if it
invests in such issuers. Certain Latin American countries may also have managed
currencies, which are maintained at artificial levels to the U.S. Dollar rather
than at levels determined by the market. This type of system can lead to sudden
and large adjustments in the currency which, in turn, can have a disruptive and
negative effect on foreign investors. Certain Latin American countries also
restrict the free conversion of their currency into foreign currencies,
including the U.S. Dollar. There is no significant foreign exchange market for
many currencies and it would, as a result, be difficult for the Fund to engage
in foreign currency transactions designed to protect the value of the Fund’s
interests in securities denominated in such currencies. Finally, a number of
Latin American countries are among the largest debtors of developing countries.
There have been moratoria on, and reschedulings of, repayment with respect to
these debts. Such events can restrict the flexibility of these debtor nations in
the international markets and result in the imposition of onerous conditions on
their economies.
Mexico. Investment in
Mexican issuers involves risks that are specific to Mexico, including
regulatory, political, and economic risks. In the past, Mexico has experienced
high interest rates, economic volatility, significant devaluation of its
currency (the peso), and high unemployment rates. The Mexican economy is
dependent upon external trade with other economies, specifically with the United
States and certain Latin American countries. Additionally, a high level of
foreign investment in Mexican assets may increase Mexico’s exposure to risks
associated with changes in international investor sentiment. In 2018, the United
States, Mexico and Canada signed and ratified the United States-Mexico-Canada
Agreement (“USMCA”), which replaces the current North American Free Trade
Agreement among the three countries. The adoption of USMCA may have a
significant impact on Mexico’s economy and, consequently, the value of the
securities held by a Fund.
The
Mexican economy is heavily dependent on trade with, and foreign investment from,
the U.S. and Canada, which are Mexico’s
principal trading partners. Any changes in the supply, demand, price or other
economic component of Mexico’s imports or exports, as well as any reductions in
foreign investment from, or changes in the economies of, the U.S. or Canada, may
have an adverse impact on the Mexican economy. Because commodities such as oil
and gas, minerals and metals represent a large portion of the region’s exports,
the economies of these countries are particularly sensitive to fluctuations in
commodity prices. Mexico’s economy has also become increasingly
manufacturing-oriented. Because Mexico’s top export is automotive vehicles, its
economy is strongly tied to the U.S. automotive market, and changes to certain
segments in the U.S. market could have an impact on the Mexican economy. The
automotive industry and other industrial products can be highly cyclical, and
companies in these industries may suffer periodic operating losses. These
industries can also be significantly affected by labor relations and fluctuating
component prices. The agricultural and mining sectors of Mexico’s economy also
account for a large portion of its exports, and Mexico is susceptible to
fluctuations in the price and demand for agricultural products and natural
resources. In addition, Mexico has privatized or has begun the process of
privatization of certain entities and industries, and some investors have
suffered losses due to the inability of the newly privatized entities to adjust
to a competitive environment and changing regulatory standards.
Mexico
has been destabilized by local insurrections, social upheavals and drug-related
violence. Additionally, violence near border areas,
border-related political disputes, and other social upheaval may lead to
strained international relations. Mexico has also experienced contentious and
very closely decided elections. Changes in political parties and other political
events
15
may
affect the economy and contribute to additional instability. Recurrence of these
or similar conditions may adversely impact the
Mexican economy.
Russia. Investing in
Russia involves risks and special considerations not typically associated with
investing in United States. Since the breakup of the Soviet Union at the end of
1991, Russia has experienced dramatic political, economic, and social change.
The political system in Russia is emerging from a long history of extensive
state involvement in economic affairs. The country is undergoing a rapid
transition from a centrally-controlled command system to a market-oriented,
democratic model. As a result, companies in Russia are characterized by a lack
of: (i) management with experience of operating in a market economy; (ii) modern
technology; and, (iii) a sufficient capital base with which to develop and
expand their operations. It is unclear what will be the future effect on Russian
companies, if any, of Russia’s continued attempts to move toward a more
market-oriented economy. Russia’s economy has been characterized by high rates
of inflation, high rates of unemployment, declining gross domestic product,
deficit government spending, and a devalued currency. The economic reform
program has involved major disruptions and dislocations in various sectors of
the economy, and those problems have been exacerbated by growing liquidity
problems. Russia’s economy is also heavily reliant on the energy and
defense-related sectors, and is therefore susceptible to the risks associated
with these industries. Further, Russia presently receives significant financial
assistance from a number of countries through various programs. To the extent
these programs are reduced or eliminated in the future, Russian economic
development may be adversely impacted. The laws and regulations in Russia
affecting Western business investment continue to evolve in an unpredictable
manner. Russian laws and regulations, particularly those involving taxation,
foreign investment and trade, title to property or securities, and transfer of
title, which may be applicable to a Fund’s activities are relatively new and can
change quickly and unpredictably in a manner far more volatile than in the
United States or other developed market economies. Although basic commercial
laws are in place, they are often unclear or contradictory and subject to
varying interpretation, and may at any time be amended, modified, repealed or
replaced in a manner adverse to the interest of the Funds.
Russia’s invasion of the
Ukraine,
and corresponding
events in late February 2022, have had, and could continue to have, severe
adverse effects on regional and global economic markets for securities and
commodities. Following Russia’s actions, various governments, including the
United States,
have issued
broad-ranging economic sanctions against Russia, including,
among other
actions,
a prohibition on
doing business with certain Russian companies, large financial institutions,
officials and oligarchs;
the removal by
certain countries and the European Union
of
selected
Russian banks from
the Society for Worldwide Interbank Financial Telecommunications (“SWIFT”), the
electronic banking network that connects banks globally;
and restrictive
measures to
prevent the Russian
Central Bank from undermining the impact of the sanctions. The current
events,
including
sanctions and the
potential for future sanctions, including any impacting Russia’s energy sector,
and other actions, and Russia’s retaliatory responses to those sanctions and
actions, may continue to adversely impact the Russian economy and economies of
surrounding countries and may result in the further decline of the value and
liquidity of Russian securities and securities of surrounding countries, a
continued weakening of currencies in the region and continued exchange closures,
and may have other adverse consequences on the economies of countries in the
region that could impact the value of investments in the region and impair the
ability of a Fund to buy, sell, receive or deliver securities of companies in
the region or a Fund’s ability to collect interest payments on fixed income
securities in the region. For example, exports in Eastern Europe have been
disrupted for certain key commodities, pushing commodity prices to record highs,
and energy prices in Europe have increased significantly. Moreover, those events
have, and could continue to have, an adverse effect on global markets
performance and liquidity, thereby negatively affecting the value of a Fund’s
investments beyond any direct exposure to issuers in the region. The duration of
ongoing hostilities and the vast array of sanctions and related events cannot be
predicted. Those events present material uncertainty and risk with respect to
markets globally and the performance of a Fund and its investments or operations
could be negatively impacted.
Hybrid
Instruments
A
Fund may invest in hybrid instruments. A hybrid instrument is a type of
potentially high-risk derivative that combines a traditional
stock, bond, or commodity with an option or forward contract. Generally, the
principal amount, amount payable upon maturity or redemption, or interest rate
of a hybrid is tied (positively or negatively) to the price of some commodity,
currency or securities index or another interest rate or some other economic
factor (each a “benchmark”). The interest rate or (unlike most fixed income
securities) the principal amount payable at maturity of a hybrid security may be
increased or decreased, depending on changes in the value of the benchmark. A
hybrid could be, for example, a bond issued by an oil company that pays a small
base level of interest, in addition to interest that accrues when oil prices
exceed a certain predetermined level. Such a hybrid instrument would be a
combination of a bond and a call option on oil.
Hybrids
can be used as an efficient means of pursuing a variety of investment goals,
including currency hedging, and increased total return.
Hybrids may not bear interest or pay dividends. The value of a hybrid or its
interest rate may be a multiple of a benchmark and, as a result, may be
leveraged and move (up or down) more steeply and rapidly than the benchmark.
These benchmarks may be sensitive to economic and political events, such as
commodity shortages and currency devaluations, which cannot be readily foreseen
by the purchaser of a hybrid. Under certain conditions, the redemption value of
a hybrid could be zero. Thus, an investment in a hybrid may entail significant
market risks that are not associated with a similar
16
investment
in a traditional, U.S. Dollar-denominated bond that has a fixed principal amount
and pays a fixed rate or floating rate of interest.
The purchase of hybrids also exposes a Fund to the credit risk of the issuer of
the hybrids. These risks may cause significant fluctuations in the NAV of a
Fund.
Certain
issuers of structured products such as hybrid instruments may be deemed to be
investment companies as defined in the 1940 Act.
As a result, a Fund’s investment in these products may be subject to limits
applicable to investments in investment companies and may be subject to
restrictions contained in the 1940 Act.
Illiquid
Investments and Restricted Securities
Each
Fund may purchase and hold illiquid investments. The term “illiquid investments”
for this purpose means any investment that a Fund
reasonably expects cannot be sold or disposed of in current market conditions in
seven calendar days or less without the sale or disposition significantly
changing the market value of the investment. A Fund will not acquire illiquid
securities if, as a result, such securities would comprise more than 15% of the
value of the Fund’s net assets. Rafferty, subject to oversight by the Board of
Trustees, has the ultimate authority to determine, to the extent permissible
under the federal securities laws, which securities are liquid or illiquid for
purposes of this 15% limitation under a Fund’s liquidity risk management
program, adopted pursuant to Rule 22e-4 under the 1940 Act. Illiquid securities
will be priced at fair value as determined in good faith under procedures
adopted by the Board of Trustees. If, through the appreciation of illiquid
securities or the depreciation of liquid securities, a Fund should be in a
position where more than 15% of the value of its net assets are invested in
illiquid securities, including restricted securities which are not readily
marketable, Rafferty will report such occurrence to the Board of Trustees and
take such steps as are deemed advisable to protect liquidity in accordance with
a Fund’s liquidity risk management program.
A
Fund may not be able to sell illiquid investments when Rafferty considers it
desirable to do so or may have to sell such investments at a
price that is lower than the price that could be obtained if the investments
were liquid. In addition, the sale of illiquid investments may require more time
and result in higher dealer discounts and other selling expenses than does the
sale of investments that are not illiquid. Illiquid investments also may be more
difficult to value due to the unavailability of reliable market quotations for
such investments, and investment in illiquid investments may have an adverse
impact on NAV.
Rule
144A establishes a “safe harbor” from the registration requirements of the 1933
Act for resales of certain securities to qualified
institutional buyers. Institutional markets for restricted securities that have
developed as a result of Rule 144A provide both readily ascertainable values for
certain restricted securities and the ability to liquidate an investment to
satisfy share redemption orders. This policy does not include restricted
securities eligible for resale pursuant to Rule 144A under the Securities Act of
1933, as amended (“1933 Act”), which the Trust’s Board of Trustees (“Board” or
“Trustees”), or Rafferty, under Board-approved guidelines, has determined are
liquid. Each Fund currently does not anticipate investing in such restricted
securities. However, to the extent that a Fund does invest in such restricted
securities, an insufficient number of qualified institutional buyers interested
in purchasing Rule 144A-eligible securities held by a Fund could adversely
affect the marketability of such portfolio securities, and a Fund may be unable
to dispose of such securities promptly or at reasonable prices.
Indexed
Securities
A
Fund may purchase indexed securities, which are securities, the value of which
varies positively or negatively in relation to the value of
other securities, securities indices or other financial indicators, consistent
with its investment objective. Indexed securities may be debt securities or
deposits whose value at maturity or coupon rate is determined by reference to a
specific instrument or statistic. Recent issuers of indexed securities have
included banks, corporations and certain U.S. government agencies.
The
performance of indexed securities depends to a great extent on the performance
of the security or other instrument to which they are
indexed and also may be influenced by interest rate changes in the United States
and abroad. At the same time, indexed securities are subject to the credit risks
associated with the issuer of the security, and their values may decline
substantially if the issuer’s creditworthiness deteriorates. Indexed securities
may be more volatile than the underlying instruments. Certain indexed securities
that are not traded on an established market may be deemed illiquid. See
“Illiquid Investments and Restricted Securities” above.
Junk
Bonds
A
Fund may invest in lower-rated debt securities, including securities in the
lowest credit rating category, of any maturity, otherwise known
as “junk bonds.”
17
Junk
bonds generally offer a higher current yield than that available for
higher-grade issues. However, lower-rated securities involve higher
risks, in that they are especially subject to adverse changes in general
economic conditions and in the industries in which the issuers are engaged, to
changes in the financial condition of the issuers and to price fluctuations in
response to changes in interest rates. During periods of economic downturn or
rising interest rates, highly leveraged issuers may experience financial stress
that could adversely affect their ability to make payments of interest and
principal and increase the possibility of default. In addition, the market for
lower-rated debt securities has expanded rapidly in recent years, and its growth
paralleled a long economic expansion. At times in recent years, the prices of
many lower-rated debt securities declined substantially, reflecting an
expectation that many issuers of such securities might experience financial
difficulties. As a result, the yields on lower-rated debt securities rose
dramatically, but such higher yields did not reflect the value of the income
stream that holders of such securities expected, but rather, the risk that
holders of such securities could lose a substantial portion of their value as a
result of the issuers’ financial restructuring or default. There can be no
assurance that such declines will not recur.
The
market for lower-rated debt issues generally is thinner and less active than
that for higher quality securities, which may limit a
Fund’s ability to sell such securities at fair value in response to changes in
the economy or financial markets. Adverse publicity and investor perceptions,
whether or not based on fundamental analysis, may also decrease the values and
liquidity of lower-rated securities, especially in a thinly traded market.
Changes by recognized rating services in their rating of a fixed-income security
may affect the value of these investments. A Fund will not necessarily dispose
of a security when its rating is reduced below its rating at the time of
purchase. However, Rafferty will monitor the investment to determine whether
continued investment in the security will assist in meeting a Fund’s investment
objective.
Mortgage-Backed
Securities
A
Fund may invest in mortgage-backed securities. A mortgage-backed security is a
type of pass-through security, which is a security
representing pooled debt obligations repackaged as interests that pass income
through an intermediary to investors. In the case of mortgage-backed securities,
the ownership interest is in a pool of mortgage loans.
Mortgage-backed
securities are most commonly issued or guaranteed by the Government National
Mortgage Association (“Ginnie
Mae®” or “GNMA”),
Federal National Mortgage Association (“Fannie Mae®” or “FNMA”) or
Federal Home Loan Mortgage Corporation (“Freddie Mac®” or “FHLMC”),
but may also be issued or guaranteed by other private issuers. GNMA is a
government-owned corporation that is an agency of the U.S. Department of Housing
and Urban Development. It guarantees, with the full faith and credit of the
United States, full and timely payment of all monthly principal and interest on
its mortgage-backed securities. FNMA is a publicly owned, government-sponsored
corporation that mostly packages mortgages backed by the Federal Housing
Administration, but also sells some non-governmentally backed mortgages.
Pass-through securities issued by FNMA are guaranteed as to timely payment of
principal and interest only by FNMA. FHLMC is a publicly chartered agency that
buys qualifying residential mortgages from lenders, re-packages them and
provides certain guarantees. Pass-through securities issued by FHLMC are
guaranteed as to timely payment of principal and interest only by
FHLMC.
The
Federal Housing Finance Agency (“FHFA”) mandated that Fannie Mae and Freddie Mac
cease issuing their own mortgage-backed
securities and begin issuing "Uniform Mortgage-Backed Securities" or "UMBS" in
2019. Each UMBS has a 55-day remittance cycle and can be used as collateral in
either a Fannie Mae or Freddie Mac security or held for investment.
Mortgage-backed securities issued by private issuers, whether or not such
obligations are subject to guarantees by the private issuer, may entail greater
risk than obligations directly guaranteed by the U.S. government. The average
life of a mortgage-backed security is likely to be substantially less than the
original maturity of the mortgage pools underlying the securities. Prepayments
of principal by mortgagors and mortgage foreclosures will usually result in the
return of the greater part of principal invested far in advance of the maturity
of the mortgages in the pool.
Collateralized
mortgage obligations (“CMOs”) are debt obligations collateralized by mortgage
loans or mortgage pass-through securities
(collateral collectively hereinafter referred to as “Mortgage Assets”).
Multi-class pass-through securities are interests in a trust composed of
Mortgage Assets and all references in this section to CMOs include multi-class
pass-through securities. Principal prepayments on the Mortgage Assets may cause
the CMOs to be retired substantially earlier than their stated maturities or
final distribution dates, resulting in a loss of all or part of the premium if
any has been paid. Interest is paid or accrues on all classes of the CMOs on a
monthly, quarterly or semi-annual basis. The principal and interest payments on
the Mortgage Assets may be allocated among the various classes of CMOs in
several ways. Typically, payments of principal, including any prepayments, on
the underlying mortgages are applied to the classes in the order of their
respective stated maturities or final distribution dates, so that no payment of
principal is made on CMOs of a class until all CMOs of other classes having
earlier stated maturities or final distribution dates have been paid in
full.
Stripped
mortgage-backed securities (“SMBS”) are derivative multi-class mortgage
securities. A Fund will only invest in SMBS issued by
Ginnie Mae, which are obligations backed by the full faith and credit of the
U.S. government. SMBS are usually structured with two or more classes that
receive different proportions of the interest and principal distributions from a
pool of Mortgage Assets. A Fund will only invest in SMBS whose Mortgage Assets
are U.S. government obligations. A common type of SMBS will be structured so
that one class receives some of the interest and most of the principal from
18
the
Mortgage Assets, while the other class receives most of the interest and the
remainder of the principal. If the underlying Mortgage Assets
experience greater than anticipated prepayments of principal, each Fund may fail
to fully recoup its initial investment in these securities. The market value of
any class which consists primarily, or entirely, of principal payments generally
is unusually volatile in response to changes in interest rates.
Investment
in mortgage-backed securities poses several risks, including among others,
prepayment, market and credit risk. Prepayment risk
reflects the risk that borrowers may prepay their mortgages faster than
expected, thereby affecting the investment’s average life and perhaps its yield.
Whether or not a mortgage loan is prepaid is almost entirely controlled by the
borrower. Borrowers are most likely to exercise prepayment options at the time
when it is least advantageous to investors, generally prepaying mortgages as
interest rates fall, and slowing payments as interest rates rise. Besides the
effect of prevailing interest rates, the rate of prepayment and refinancing of
mortgages may also be affected by home value appreciation, ease of the
refinancing process and local economic conditions. Market risk reflects the risk
that the price of a security may fluctuate over time. The price of
mortgage-backed securities may be particularly sensitive to prevailing interest
rates, the length of time the security is expected to be outstanding, and the
liquidity of the issue. In a period of unstable interest rates, there may be
decreased demand for certain types of mortgage-backed securities, and a Fund
invested in such securities wishing to sell them may find it difficult to find a
buyer, which may in turn decrease the price at which they may be sold. Credit
risk reflects the risk that a Fund may not receive all or part of its principal
because the issuer or credit enhancer has defaulted on its obligations.
Obligations issued by U.S. government-sponsored entities are guaranteed as to
the payment of principal and interest, but are not backed by the full faith and
credit of the U.S. government. The performance of private label mortgage-backed
securities, issued by private institutions, is based on the financial health of
those institutions. With respect to GNMA certificates, although GNMA guarantees
timely payment even if homeowners delay or default, tracking the “pass-through”
payments may, at times, be difficult.
Municipal
Obligations
A
Fund may invest in municipal obligations. Municipal securities are fixed-income
securities issued by states, counties, cities and other
political subdivisions and authorities. Although most municipal securities are
exempt from federal income tax, municipalities also may issue taxable
securities. Tax exempt securities are generally classified by their source of
payment. In addition to the usual risks associated with investing for income,
the value of municipal obligations can be affected by changes in the actual or
perceived credit quality of the issuers. The credit quality of a municipal
obligation can be affected by, among other factors: a) the financial condition
of the issuer or guarantor; b) the issuer’s future borrowing plans and sources
of revenue; c) the economic feasibility of the revenue bond project or general
borrowing purpose; d) political or economic developments in the region or
jurisdiction where the security is issued; and e) the liquidity of the security.
Because municipal obligations are generally traded OTC, the liquidity of a
particular issue often depends on the willingness of dealers to make a market in
the security. The liquidity of some municipal issues can be enhanced by demand
features, which enable a Fund to demand payment from the issuer or a financial
intermediary on short notice.
Futures
Contracts, Options, and Other Derivative Strategies
Generally,
derivatives are financial instruments whose value depends on, or is derived
from, the value of one or more underlying assets, reference
rates, or indices or other market factors (“reference assets”) and may relate to
stocks, bonds, interest rates, credit, currencies, commodities, digital assets
or related indices. Derivative instruments can provide an efficient means to
gain long or short exposure to the value of a reference asset without actually
owning or selling the instrument. Examples of derivative instruments include
futures contracts, swap agreements, options, options on futures contracts and
forward currently contracts.
Each
Fund may enter into derivatives instruments which may include futures contracts,
forward contracts, options on currencies, commodities,
indices, or futures contracts and swaps which provide long and short exposure to
reference assets. Derivatives may be more sensitive to changes in interest rates
or to sudden fluctuations in market prices and thus a Fund’s losses may be
greater if it invests in derivatives than if it invests in non-derivative
instruments. Derivatives are also subject to counterparty risk, which is the
risk that the other party in the transaction will not fulfill its contractual
obligations.
The
use of derivative instruments is subject to applicable regulations of the SEC,
the several exchanges upon which they are traded and
the CFTC. In addition, a Fund’s ability to use derivative instruments will be
limited by tax considerations. See “Dividends, Other Distributions and
Taxes.”
Under
current CFTC regulations, if a Fund uses commodity interests (such as futures
contracts, options on futures contracts and swaps) other
than for bona fide hedging purposes (as defined by the CFTC) the aggregate
initial margin and premiums required to establish these positions (after taking
into account unrealized profits and unrealized losses on any such positions and
excluding the amount by which options that are “in-the-money” at the time of
purchase) may not exceed 5% of a Fund’s NAV, or alternatively, the aggregate net
notional value of those positions, as determined at the time the most recent
position was established, may not exceed 100% of the fund’s NAV (after taking
into account unrealized profits and unrealized
19
losses
on any such positions). Accordingly, each Fund has registered as a commodity
pool, and the Adviser has registered as a commodity
pool operator, with the National Futures Association.
Each Fund is
subject to the risk that a change in U.S. law and related regulations will
impact the way a Fund operates, increase the particular costs of
a Fund’s operation and/or change the competitive landscape. In this regard, any
further amendment to the Commodity Exchange Act or its related regulations that
subject a Fund to additional regulation may have adverse impacts on a Fund’s
operations and expenses. Rule 18f-4 under the 1940 Act, which governs the use of
derivatives by registered investment companies,
imposes limits on
the amount of derivatives a fund could enter into
and
eliminated
the asset
segregation framework previously used by funds to comply with Section 18 of the
1940 Act, and requires funds whose use of derivatives is more than a limited
specified exposure to establish and maintain a derivatives risk management
program and appoint a derivatives risk manager. The Funds are in compliance with
the requirements of Rule
18f-4.
In addition to
the instruments, strategies and risks described below and in the Prospectus,
Rafferty may discover additional derivative instruments and other
similar or related techniques. These new opportunities may become available as
Rafferty develops new techniques, as regulatory authorities broaden the range of
permitted transactions and as new derivative instruments or other techniques are
developed. Rafferty may utilize these instruments or other similar or related
techniques
to the extent that
they are consistent with a Fund’s investment objective and permitted by a Fund’s
investment limitations and applicable regulatory authorities. A Fund’s
Prospectus or this SAI will be supplemented to the extent that new products or
techniques involve materially different risks than those described below or in
the Prospectus.
Special
Risks. The use of
derivative instruments involves special considerations and risks, certain of
which are described below. Risks pertaining to particular derivative instruments
are described in the sections that follow.
(1)
Options and futures prices can diverge from the prices of their underlying
instruments. Options and futures prices are affected by such
factors as current and anticipated short-term interest rates, changes in
volatility of the underlying instrument and the time remaining until expiration
of the contract, which may not affect security prices the same way. Imperfect or
no correlation also may result from differing levels of demand in the options
and futures markets and the securities markets, from structural differences in
how options and futures and securities are traded, and from imposition of daily
price fluctuation limits or trading halts.
(2)
As described below, a Fund might be required to maintain assets as “cover,”
maintain segregated accounts or make margin payments
when it takes positions in Financial Instruments involving obligations to third
parties (e.g., Financial
Instruments other than purchased options). If a Fund were unable to close out
its positions in such Financial Instruments, it might be required to continue to
maintain such assets or accounts or make such payments until the position
expired or matured. These requirements might impair a Fund’s ability to sell a
portfolio security or make an investment when it would otherwise be favorable to
do so or require that a Fund sell a portfolio security at a disadvantageous
time. A Fund’s ability to close out a position in a Financial Instrument prior
to expiration or maturity depends on the existence of a liquid secondary market
or, in the absence of such a market, the ability and willingness of the other
party to the transaction (the “counterparty”) to enter into a transaction
closing out the position. Therefore, there is no assurance that any position can
be closed out at a time and price that is favorable to a Fund.
(3)
Losses may arise due to unanticipated market price movements, lack of a liquid
secondary market for any particular instrument at a
particular time or due to losses from premiums paid by a Fund on options
transactions.
Cover. Transactions using derivative
instruments, other than purchased options, expose a Fund to an obligation to
another party. A Fund may not enter into any such transactions unless it owns
either (1) an offsetting (“covered”) position in securities or other options or
futures contracts or (2) cash and liquid assets with a value, marked-to-market
daily, sufficient to cover its potential obligations to the extent not covered
as provided in (1) above. Each Fund will comply with contractual
requirements
regarding cover for
these instruments and will, if the requirements so require, set aside cash or
liquid assets in an account with its custodian, U.S. Bank, N.A. (“Custodian”),
in the prescribed amount as determined daily.
Assets
used as cover or held in an account cannot be sold while the position in the
corresponding derivative instrument is open, unless they
are replaced with other appropriate assets. As a result, the commitment of a
large portion of a Fund’s assets to cover or accounts could impede portfolio
management or a Fund’s ability to meet redemption requests or other current
obligations.
Futures
Contracts. A Fund may use
certain options (traded on an exchange or OTC), futures contracts (sometimes
referred to as “futures”) and options on futures contracts as a substitute for a
comparable market position in the underlying security or index, to attempt to
hedge or limit the exposure of a Fund’s position, to create a synthetic money
market position, for certain tax-related purposes or to effect closing
transactions.
Generally,
a futures contract is a standard binding agreement to buy or sell a specified
quantity of an underlying reference instrument, such
as a specific security, currency or commodity, at a specified price at a
specified later date. A “sale” of a futures contract means the acquisition of a
contractual obligation to deliver the underlying reference instrument called for
by the contract at a specified price on a specified date. A “purchase” of a
futures contract means the acquisition of a contractual obligation to acquire
the underlying reference instrument called for by the contract at a specified
price on a
20
specified
date. The purchase or sale of a futures contract will allow a Fund to increase
or decrease its exposure to the underlying
reference instrument without having to buy the actual instrument.
The
underlying reference instruments to which futures contracts may relate include
non-U.S. currencies, interest rates, stock and bond indices
and debt securities, including U.S. government debt obligations. In most cases
the contractual obligation under a futures contract may be offset, or “closed
out,” before the settlement date so that the parties do not have to make or take
delivery. The closing out of a contractual obligation is usually accomplished by
buying or selling, as the case may be, an identical, offsetting futures
contract. This transaction, which is effected through a member of an exchange,
cancels the obligation to make or take delivery of the underlying instrument or
asset. If the original position entered into is a long position (futures
contract purchased), there will be a gain (loss) if the offsetting sell
transaction is carried out at a higher (lower) price, inclusive of commissions.
If the original position entered into is a short position (futures contract
sold) there will be a gain (loss) if the offsetting buy transaction is carried
out at a lower (higher) price, inclusive of commissions.
Certain
futures contracts are cash-settled, meaning the futures contract obligates the
seller to deliver (and purchaser to accept) an amount
of cash equal to a specific dollar amount multiplied by the difference between
the final settlement price of a specific futures contract and the price at which
the agreement is made. No physical delivery of the underlying asset is
made.
Whether
a Fund realizes a gain/loss from futures activities depends generally upon the
movements in the underlying reference asset (generally
a commodity, currency, security or index). The extent of a Fund’s loss from an
unhedged short position in a futures contract is potentially unlimited, and
investors may lose the amount that they invest plus any profits recognized on
their investment.
Futures
contracts may be bought and sold on U.S. and non-U.S. exchanges. Futures
contracts in the U.S. have been designed by exchanges that
have been designated “contract markets” by the CFTC and must be executed through
a futures commission merchant (“FCM”), which is a brokerage firm that is a
member of the relevant contract market. Each exchange guarantees performance of
the contracts as between the clearing members of the exchange, thereby reducing
the risk of counterparty default. Because all transactions in the futures market
are made, offset, or fulfilled by an FCM through a clearinghouse associated with
the exchange on which the contracts are traded, a Fund will incur brokerage fees
when it buys or sells futures contracts. A Fund generally buys and sells futures
contracts only on contract markets (including exchanges or boards of trade)
where there appears to be an active market for the futures contracts, but there
is no assurance that an active market will exist for any particular contract or
at any particular time. An active market makes it more likely that futures
contracts will be liquid and bought and sold at competitive market prices. In
addition, many of the futures contracts available may be relatively new
instruments without a significant trading history. As a result, there can be no
assurance that an active market will develop or continue to exist.
When
a Fund enters into a futures contract, it must deliver to an account controlled
by the FCM (that has been selected by the Fund), an
amount referred to as “initial margin” that is typically calculated as an amount
equal to the volatility in market value of a contract over a fixed period.
Initial margin requirements are determined by the respective exchanges on which
the futures contracts are traded and the FCM. Thereafter, a “variation margin”
amount may be required to be paid by a Fund or received by a Fund in accordance
with margin controls set for such accounts, depending upon changes in the
marked-to-market value of the futures contract. The account is marked-to-market
daily and the variation margin is monitored by a Fund’s investment manager and
custodian on a daily basis. When the futures contract is closed out, if a Fund
has a loss equal to, or greater than, the margin amount, the margin amount is
paid to the FCM along with any loss in excess of the margin amount. If a Fund
has a loss of less than the margin amount, the excess margin is returned to a
Fund. If a Fund has a gain, the full margin amount and the amount of the gain is
paid to the Fund. Some futures contracts provide for the delivery of securities
that are different than those that are specified in the contract. For a futures
contract for delivery of debt securities, on the settlement date of the
contract, adjustments to the contract can be made to recognize differences in
value arising from the delivery of debt securities with a different interest
rate from that of the particular debt securities that were specified in the
contract. In some cases, securities called for by a futures contract may not
have been issued when the contract was written.
Risks
of futures contracts. A Fund’s use of
futures contracts is subject to the risks associated with derivative instruments
generally. A Fund may not be able to properly effect its strategy when a liquid
market is unavailable for the futures contract the Fund wishes to close, which
may at times occur. If a Fund were unable to liquidate a futures position due to
the absence of a liquid secondary market or the imposition of price limits, it
could incur substantial losses. A Fund would continue to be subject to market
risk with respect to the position. In addition, a Fund would continue to be
required to make daily variation margin payments and might be required to
maintain cash or liquid assets in an account.
A
purchase or sale of a futures contract may result in losses to a Fund in excess
of the amount that the Fund delivered as initial margin.
Because of the relatively low margin deposits required, futures trading involves
a high degree of leverage; as a result, a relatively small price movement in a
futures contract may result in immediate and substantial loss, or gain, to a
Fund. In addition, if a Fund has insufficient cash to meet daily variation
margin requirements or close out a futures position, it may have to sell
securities from its portfolio at a time when it may be disadvantageous to do so.
Adverse market movements could cause a Fund to experience substantial losses on
an investment in a futures contract. There is a risk of
21
loss
by a Fund of the initial and variation margin deposits in the event of
bankruptcy of the FCM with which the Fund has an open position
in a futures contract. The assets of a Fund may not be fully protected in the
event of the bankruptcy of the FCM or central counterparty because the Fund
might be limited to recovering only a pro rata share of all available funds and
margin segregated on behalf of an FCM’s customers. If the FCM does not provide
accurate reporting, a Fund is also subject to the risk that the FCM could use a
Fund’s assets, which are held in an omnibus account with assets belonging to the
FCM’s other customers, to satisfy its own financial obligations or the payment
obligations of another customer to the central counterparty.
The
difference (called the “spread”) between prices in the cash market for the
purchase and sale of the underlying reference instrument and
the prices in the futures market is subject to fluctuations and distortions due
to differences in the nature of those two markets. First, all participants in
the futures market are subject to initial deposit and variation margin
requirements. Rather than meeting additional variation margin requirements,
investors may close futures contracts through offsetting transactions that could
distort the normal pricing spread between the cash and futures markets. Second,
the liquidity of the futures markets depends on participants entering into
offsetting transactions rather than making or taking delivery of the underlying
instrument. To the extent participants decide to make or take delivery,
liquidity in the futures market could be reduced, resulting in pricing
distortion. Third, from the point of view of speculators, the margin deposit
requirements that apply in the futures market are less onerous than similar
margin requirements in the securities market. Therefore, increased participation
by speculators in the futures market may cause temporary price distortions. When
such distortions occur, a correct forecast of general trends in the price of an
underlying reference instrument by the investment manager may still not
necessarily result in a profitable transaction.
Futures
contracts that are traded on non-U.S. exchanges may not be as liquid as those
purchased on CFTC-designated contract markets. In
addition, non-U.S. futures contracts may be subject to varied regulatory
oversight. The price of any non-U.S. futures contract and, therefore, the
potential profit and loss thereon, may be affected by any change in the non-U.S.
exchange rate between the time a particular order is placed and the time it is
liquidated, offset or exercised.
The
CFTC and the various exchanges have established limits referred to as
“speculative position limits” on the maximum net long or net
short position that any person, such as a Fund, may hold or control in a
particular futures contract. Trading limits are also imposed on the maximum
number of contracts that any person may trade on a particular trading day. An
exchange may order the liquidation of positions found to be in violation of
these limits and it may impose other sanctions or restrictions. The regulation
of futures, as well as other derivatives, is a rapidly changing area of
law.
Futures
exchanges may also limit the amount of fluctuation permitted in certain futures
contract prices during a single trading day. This
daily limit establishes the maximum amount that the price of a futures contract
may vary either up or down from the previous day’s settlement price. Once the
daily limit has been reached in a futures contract subject to the limit, no more
trades may be made on that day at a price beyond that limit. The daily limit
governs only price movements during a particular trading day and does not limit
potential losses because the limit may prevent the liquidation of unfavorable
positions. For example, futures prices have occasionally moved to the daily
limit for several consecutive trading days with little or no trading, thereby
preventing prompt liquidation of positions and subjecting some holders of
futures contracts to substantial losses.
Risks
Associated with Commodity Futures Contracts. There are
several additional risks associated with transactions in commodity futures
contracts.
Unlike
the financial futures markets, in the commodity futures markets there are costs
of physical storage associated with purchasing the
underlying commodity. The price of the commodity futures contract will reflect
the storage costs of purchasing the physical commodity, including the time value
of money invested in the physical commodity. To the extent that the storage
costs for an underlying commodity change while a Fund is invested in futures
contracts on that commodity, the value of the futures contract may change
proportionately.
In
the commodity futures markets, producers of the underlying commodity may decide
to hedge the price risk of selling the commodity by
selling futures contracts today to lock in the price of the commodity at
delivery tomorrow. In order to induce speculators to purchase the other side of
the same futures contract, the commodity producer generally must sell the
futures contract at a lower price than the expected future spot price.
Conversely, if most hedgers in the futures market are purchasing futures
contracts to hedge against a rise in prices, then speculators will only sell the
other side of the futures contract at a higher futures price than the expected
future spot price of the commodity. The changing nature of the hedgers and
speculators in the commodity markets will influence whether futures prices are
above or below the expected future spot price, which can have significant
implications for a Fund. If the nature of hedgers and speculators in futures
markets has shifted when it is time for a Fund to reinvest the proceeds of a
maturing contract in a new futures contract, the Fund might reinvest at higher
or lower futures prices, or choose to pursue other investments.
The
commodities which underlie commodity futures contracts may be subject to
additional economic and non-economic variables, such
as drought, floods, weather, livestock disease, embargoes, tariffs, and
international economic, political and regulatory developments. These factors may
have a larger impact on commodity prices and commodity-linked instruments,
including futures contracts, than on traditional securities. Certain commodities
are also subject to limited pricing flexibility because of supply and demand
factors. Others are subject to broad price fluctuations as a result of the
volatility of the
22
prices
for certain raw materials and the instability of supplies of other materials.
These additional variables may create additional
investment risks which subject a Fund’s investments to greater volatility than
investments in traditional securities.
Forward
Contracts. Each Fund may
enter into equity, equity index or interest rate forward contracts for purposes
of attempting to gain exposure to an index or group of securities without
actually purchasing these securities, or to hedge a position. Forward contracts
are two-party contracts pursuant to which one party agrees to pay the
counterparty a fixed price for an agreed upon amount of commodities, securities,
or the cash value of the commodities, securities or the securities index, at an
agreed upon date. Because they are two-party contracts and may have terms
greater than seven days, forward contracts may be considered to be illiquid for
a Fund’s illiquid investment limitations. A Fund will not enter into any forward
contract unless Rafferty believes that the other party to the transaction is
creditworthy. A Fund bears the risk of loss of the amount expected to be
received under a forward contract in the event of the default or bankruptcy of a
counterparty. If such a default occurs, a Fund will have contractual remedies
pursuant to the forward contract, but such remedies may be subject to bankruptcy
and insolvency laws which could affect the Fund’s rights as a
creditor.
Options. The value of an
option position will reflect, among other things, the current market value of
the underlying investment, the time remaining until expiration, the relationship
of the exercise price to the market price of the underlying investment and
general market conditions. Options that expire unexercised have no value.
Options currently are traded on the Chicago Board Options Exchange® and other
exchanges, as well as the OTC markets.
By
buying a call option on a security, a Fund has the right, in return for the
premium paid, to buy the security underlying the option at the
exercise price. By writing (selling) a call option and receiving a premium, a
Fund becomes obligated during the term of the option to deliver securities
underlying the option at the exercise price if the option is exercised. By
buying a put option, a Fund has the right, in return for the premium, to sell
the security underlying the option at the exercise price. By writing a put
option, a Fund becomes obligated during the term of the option to purchase the
securities underlying the option at the exercise price.
Because
options premiums paid or received by a Fund are small in relation to the market
value of the investments underlying the options,
buying and selling put and call options can be more speculative than investing
directly in securities.
A
Fund may effectively terminate its right or obligation under an option by
entering into a closing transaction. For example, a Fund may
terminate its obligation under a call or put option that it had written by
purchasing an identical call or put option; this is known as a closing purchase
transaction. Conversely, a Fund may terminate a position in a put or call option
it had purchased by writing an identical put or call option; this is known as a
closing sale transaction. Closing transactions permit a Fund to realize profits
or limit losses on an option position prior to its exercise or
expiration.
Risks
of Options on Currencies and Securities. Exchange-traded
options in the United States are issued by a clearing organization affiliated
with the exchange on which the option is listed that, in effect, guarantees
completion of every exchange-traded option transaction. In contrast, OTC options
are contracts between a Fund and its counterparty (usually a securities dealer
or a bank) with no clearing organization guarantee. Thus, when a Fund purchases
an OTC option, it relies on the counterparty from which it purchased the option
to make or take delivery of the underlying investment upon exercise of the
option. Failure by the counterparty to do so would result in the loss of any
premium paid by a Fund as well as the loss of any expected benefit of the
transaction.
A
Fund’s ability to establish and close out positions in exchange-traded options
depends on the existence of a liquid market. However, there
can be no assurance that such a market will exist at any particular time.
Closing transactions can be made for OTC options only by negotiating directly
with the counterparty, or by a transaction in the secondary market if any such
market exists. There can be no assurance that a Fund will in fact be able to
close out an OTC option position at a favorable price prior to expiration. In
the event of insolvency of the counterparty, a Fund might be unable to close out
an OTC option position at any time prior to its expiration.
If
a Fund were unable to effect a closing transaction for an option it had
purchased, it would have to exercise the option to realize any
profit. The inability to enter into a closing purchase transaction for a covered
call option written by a Fund could cause material losses because a Fund would
be unable to sell the investment used as cover for the written option until the
option expires or is exercised.
Options
on Indices. An index
fluctuates with changes in the market values of the securities included in the
index. Options on indices give the holder the right to receive an amount of cash
upon exercise of the option. Receipt of this cash amount will depend upon the
closing level of the index upon which the option is based being greater than (in
the case of a call) or less than (in the case of a put) the exercise price of
the option. Some stock index options are based on a broad market index that
includes more than nine
constituents or on a
narrower index which is generally considered to include only nine or fewer
constituents.
Each
of the exchanges has established limitations governing the maximum number of
call or put options on the same index that may be
bought or written by a single investor, whether acting alone or in concert with
others (regardless of whether such options are written on the same or different
exchanges or are held or written on one or more accounts or through one or more
brokers). Under these limitations, option positions of all investment companies
advised by Rafferty are combined
23
for
purposes of these limits. Pursuant to these limitations, an exchange may order
the liquidation of positions and may impose other
sanctions or restrictions. These position limits may restrict the number of
listed options that a Fund may buy or sell.
Puts
and calls on indices are similar to puts and calls on securities or futures
contracts except that all settlements are in cash and gain or
loss depends on changes in the index in question rather than on price movements
in individual securities or futures contracts. When a Fund writes a call on an
index, it receives a premium and agrees that, prior to the expiration date, the
purchaser of the call, upon exercise of the call, will receive from a Fund an
amount of cash if the closing level of the index upon which the call is based is
greater than the exercise price of the call. The amount of cash is equal to the
difference between the closing price of the index and the exercise price of the
call multiplied by a specific factor (“multiplier”), which determines the total
value for each point of such difference. When a Fund buys a call on an index, it
pays a premium and has the same rights to such call as are indicated above. When
a Fund buys a put on an index, it pays a premium and has the right, prior to the
expiration date, to require the seller of the put, upon a Fund’s exercise of the
put, to deliver to a Fund an amount of cash if the closing level of the index
upon which the put is based is less than the exercise price of the put, which
amount of cash is determined by the multiplier, as described above for calls.
When a Fund writes a put on an index, it receives a premium and the purchaser of
the put has the right, prior to the expiration date, to require a Fund to
deliver to it an amount of cash equal to the difference between the closing
level of the index and the exercise price times the multiplier if the closing
level is less than the exercise price.
Risks
of Options on Indices. If a Fund has
purchased an index option and exercises it before the closing index value for
that day is available, it runs the risk that the level of the index may
subsequently change. If such a change causes the exercised option to fall
out-of-the-money, a Fund will be required to pay the difference between the
closing index value and the exercise price of the option (times the applicable
multiplier) to the assigned writer.
OTC
Options. Unlike
exchange-traded options, which are standardized with respect to the underlying
instrument, expiration date, contract size and strike price, the terms of OTC
options (options not traded on exchanges) generally are established through
negotiation with the other party to the option contract. While this type of
arrangement allows a Fund great flexibility to tailor the option to its needs,
OTC options generally involve greater risk than exchange-traded options, which
are guaranteed by the clearing organization of the exchanges where they are
traded.
Options
on Futures Contracts. When a Fund
writes an option on a futures contract, it becomes obligated, in return for the
premium paid, to assume a position in the futures contract at a specified
exercise price at any time during the term of the option. If a Fund writes a
call, it assumes a short futures position. If it writes a put, it assumes a long
futures position. When a Fund purchases an option on a futures contract, it
acquires the right in return for the premium it pays to assume a position in a
futures contract (a long position if the option is a call and a short position
if the option is a put).
Whether
a Fund realizes a gain or loss from futures activities depends upon movements in
the underlying security or index. The extent of a
Fund’s loss from an unhedged short position from writing unhedged call options
on futures contracts is potentially unlimited. A Fund only purchases and sells
options on futures contracts that are traded on a U.S. exchange or board of
trade.
Purchasers
and sellers of options on futures can enter into offsetting closing
transactions, similar to closing transactions in options, by
selling or purchasing, respectively, an instrument identical to the instrument
purchased or sold. Positions in options on futures contracts may be closed only
on an exchange or board of trade that provides a secondary market. However,
there can be no assurance that a liquid secondary market will exist for a
particular contract at a particular time. In such event, it may not be possible
to close a futures contract or options position.
Under
certain circumstances, futures exchanges may establish daily limits on the
amount that the price of an option on a futures contract
can vary from the previous day’s settlement price; once that limit is reached,
no trades may be made that day at a price beyond the limit. Daily price limits
do not limit potential losses because prices could move to the daily limit for
several consecutive days with little or no trading, thereby preventing
liquidation of unfavorable positions.
If
a Fund were unable to liquidate an option on a futures position due to the
absence of a liquid secondary market or the imposition of
price limits, it could incur substantial losses. A Fund would continue to be
subject to market risk with respect to the position. In addition, except in the
case of purchased options, a Fund would continue to be required to make daily
variation margin payments and might be required to maintain cash or liquid
assets in an account.
Risks
of Options on Futures Contracts. The ordinary
spreads between prices in the cash and futures markets (including the options on
futures markets), due to differences in the natures of those markets, are
subject to the following factors, which may create distortions. First, all
participants in the futures market are subject to margin deposit and maintenance
requirements. Rather than meeting additional margin deposit requirements,
investors may close futures contracts through offsetting transactions, which
could distort the normal relationships between the cash and futures markets.
Second, the liquidity of the futures market depends on participants entering
into offsetting transactions rather than making or taking delivery. To the
extent participants decide to make or take delivery, liquidity in the futures
market could be reduced, thus producing distortion. Third, from the point of
view of speculators, the deposit requirements in the futures market are less
onerous than margin requirements in the securities market. Therefore, increased
participation by speculators in the futures market may cause temporary price
distortions.
24
Combined
Positions. A Fund may
purchase and write options in combination with each other. For example, a Fund
may purchase a put option and write a call option on the same underlying
instrument, in order to construct a combined position whose risk and return
characteristics are similar to selling a futures contract. Another possible
combined position would involve writing a call option at one strike price and
buying a call option at a lower price, in order to reduce the risk of the
written call option in the event of a substantial price increase. Because
combined options positions involve multiple trades, they result in higher
transaction costs and may be more difficult to open and close out.
Other
Investment Companies
Each
Fund may invest in the securities of other investment companies, including open-
and closed-end funds and exchange-traded funds ("ETFs").
Investments in the securities of other investment companies may involve
duplication of advisory fees and certain other expenses. By investing in another
investment company, a Fund becomes a shareholder of that investment company. As
a result, Fund shareholders indirectly will bear a Fund’s proportionate share of
the fees and expenses of the other investment company, in addition to the fees
and expenses Fund shareholders bear in connection with a Fund’s own
operations.
Each
Fund intends to limit its investments in securities issued by other investment
companies in accordance with the 1940 Act and the rules
promulgated thereunder. Section 12(d)(1) of the 1940 Act precludes a Fund from
acquiring (i) more than 3% of the total outstanding shares of another investment
company; (ii) shares of another investment company having an aggregate value in
excess of 5% of the value of the total assets of the Fund; or (iii) shares of
another registered investment company and all other investment companies having
an aggregate value in excess of 10% of the value of the total assets of the
Fund. In addition, the Fund is subject to Section 12(d)(1)(C), which provides
that the Fund may not acquire shares of a closed-end fund if, immediately after
such acquisition, the Fund and other investment companies having the same
adviser as the Fund would hold more than 10% of the closed-end fund’s total
outstanding voting stock.
Section
12(d)(1)(F) of the 1940 Act provides that the provisions of paragraph
12(d)(1)(A) and (B) shall not apply to securities of an
unaffiliated investment company purchased or otherwise acquired by a Fund if (i)
immediately after such purchase or acquisition not more than 3% of the total
outstanding shares of such investment company is owned by the Fund and all
affiliated persons of the Fund; and (ii) the Fund has not offered or sold, and
is not proposing to offer or sell its shares through a principal underwriter or
otherwise at a public or offering price that includes a sales load of more than
1 1/2%. If a Fund invests in unaffiliated investment companies pursuant to
Section 12(d)(1)(F), it must comply with the following voting restrictions: when
the Fund exercises voting rights, by proxy or otherwise, with respect to
unaffiliated investment companies owned by the Fund, the Fund will either seek
instruction from the Funds' shareholders with regard to the voting of all
proxies and vote in accordance with such instructions, or vote the shares held
by a Fund in the same proportion as the vote of all other holders of such
security. In addition, an unaffiliated investment company purchased by a Fund
pursuant to Section 12(d)(1)(F) shall not be required to redeem its shares in an
amount exceeding 1% of such investment company’s total outstanding shares in any
period of less than thirty days.
To
the extent that a Fund invests in open-end or closed-end investment companies
that invest primarily in the securities of companies
located outside the United States, see the risks related to foreign securities
set forth above.
Rule 12d1-4
allows a fund or ETF
to acquire the securities of another fund in excess of the limitations imposed
by Section 12 of the 1940 Act without obtaining an exemptive order from the SEC
subject to certain limitations and conditions. Prior to a fund acquiring
securities of another fund that exceed the limits of Section 12(d)(1) of the
1940 Act, the acquiring fund must enter into a Fund of Funds Agreement with the
acquired fund. Rule 12d1-4 outlines the requirements of the Fund of Funds
Agreements and specifies the responsibilities of Fund management related to
“fund of funds” arrangements. Rule 12d1-4 was effective as of January 19, 2021
and its requirements have been
implemented by the Funds that will be part of a fund of funds
arrangement.
Exchange-Traded
Products. Each Fund may
invest in exchange traded products (“ETPs”), which include ETFs, partnerships,
commodity pools or trusts that are bought and sold on a securities exchange.
ETPs trade like stocks on a securities exchange at market price rather than NAV
and, as a result, ETP shares may trade at a price greater than NAV (premium) or
less than NAV (discount). A Fund may also invest in exchange-traded notes
(“ETNs”), which are structured debt securities, whereby the issuer of the ETN
promises to pay ETN holders the return on an index or market segment over a
certain period of time and then return the principal of the investment at
maturity. Whereas ETPs’ liabilities are secured by their portfolio securities,
ETNs’ liabilities are unsecured general obligations of the issuer. Therefore,
ETNs are subject to the credit risk of the issuer of the ETN, which is different
than other ETPs. The value of an ETN security should also be expected to
fluctuate with the credit rating of the issuer. Most ETPs and ETNs are designed
to track a particular market segment or index, although an ETP or ETN may be
actively managed. ETPs and ETNs share expenses associated with their operation,
typically including advisory fees and other management expenses. When a Fund
invests in an ETP or ETN, in addition to directly bearing expenses associated
with its own operations, it will bear its pro rata portion of the ETP’s or ETN’s
expenses. ETPs and ETNs trade like stocks on a securities exchange at market
prices rather than NAV and as a result ETP or ETN shares may trade at a price
greater than NAV (premium) or less than NAV (discount). The risks of owning an
ETP or ETN generally reflect the risks of
25
owning
the underlying securities the ETP or ETN is designed to track, although lack of
liquidity in an ETP or ETN could result in it
being more volatile than the underlying portfolio of securities. In addition,
because of ETP or ETN expenses, compared to owning the underlying securities
directly, it may be more costly to own an ETP or ETN.
Additionally,
a Fund may invest in swap agreements referencing ETFs. If a Fund invests in ETFs
or swap agreements referencing ETFs, the
underlying ETFs may not necessarily track the same index as a Fund.
Money
Market Funds. Money market
funds are open-end registered investment companies that historically have traded
at a stable $1.00 per share price. However, money market funds that do not meet
the definition of a “retail money market fund” or “government money market fund”
under the 1940 Act are required to transact at a floating NAV per share
(i.e., in a manner
similar to how all other non-money market mutual funds transact), instead of at
a $1.00 stable share price. Money market funds may also impose liquidity fees
and redemption gates for use in times of market stress. If a Fund invests in a
money market fund with a floating NAV, the impact on the trading and value of
the money market instruments may negatively affect the Fund's return
potential.
Repurchase
Agreements
A
Fund may enter into repurchase agreements with banks that are members of the
Federal Reserve System or securities dealers who are
members of a national securities exchange or are primary dealers in U.S.
government securities. Repurchase agreements generally are for a short period of
time, usually less than a week. Under a repurchase agreement, a Fund purchases a
U.S. government security and simultaneously agrees to sell the security back to
the seller at a mutually agreed-upon future price and date, normally one day or
a few days later. The resale price is greater than the purchase price,
reflecting an agreed-upon market interest rate during a Fund’s holding period.
While the maturities of the underlying securities in repurchase agreement
transactions may be more than one year, the term of each repurchase agreement
always will be less than one year. Repurchase agreements with a maturity of more
than seven days are considered to be illiquid investments. A Fund may not enter
into such a repurchase agreement if, as a result, more than 15% of the value of
its net assets would then be invested in such repurchase agreements and other
illiquid investments. See “Illiquid Investments and Restricted Securities”
above.
A
Fund will always receive, as collateral, securities whose market value,
including accrued interest, at all times will be at least equal to
100% of the dollar amount invested by a Fund in each repurchase agreement. In
the event of default or bankruptcy by the seller, a Fund will liquidate those
securities (whose market value, including accrued interest, must be at least
100% of the amount invested by a Fund) held under the applicable repurchase
agreement, which securities constitute collateral for the seller’s obligation to
repurchase the security. If the seller defaults, a Fund might incur a loss if
the value of the collateral securing the repurchase agreement declines and might
incur disposition costs in connection with liquidating the collateral. In
addition, if bankruptcy or similar proceedings are commenced with respect to the
seller of the security, realization upon the collateral by a Fund may be delayed
or limited.
Reverse
Repurchase Agreements
A
Fund may borrow by entering into reverse repurchase agreements with the same
parties with whom it may enter into repurchase
agreements. Under a reverse repurchase agreement, a Fund sells securities and
agrees to repurchase them at a mutually agreed to price. At the time a Fund
enters into a reverse repurchase agreement, it will establish and maintain a
segregated account with an approved custodian containing liquid high-grade
securities, marked-to-market daily, having a value not less than the repurchase
price (including accrued interest). Reverse repurchase agreements involve the
risk that the market value of securities retained in lieu of sale by a Fund may
decline below the price of the securities a Fund has sold but is obliged to
repurchase. If the buyer of securities under a reverse repurchase agreement
files for bankruptcy or becomes insolvent, such buyer or its trustee or receiver
may receive an extension of time to determine whether to enforce a Fund’s
obligation to repurchase the securities. During that time, a Fund’s use of the
proceeds of the reverse repurchase agreement effectively may be restricted.
Reverse repurchase agreements create leverage, a speculative factor, and are
considered borrowings for the purpose of a Fund’s limitation on
borrowing.
Short
Sales
A
Fund may engage in short sale transactions under which a Fund sells a security
it does not own. To complete such a transaction, a
Fund must borrow the security to make delivery to the buyer. A Fund then is
obligated to replace the security borrowed by purchasing the security at the
market price at the time of replacement. The price at such time may be more or
less than the price at which the security was sold by a Fund. Until the security
is replaced, a Fund is required to pay to the lender amounts equal to any
dividends that accrue during the period of the loan. The proceeds of the short
sale will be retained by the broker, to the extent necessary to meet the margin
requirements, until the short position is closed out. A Fund will also incur
transactions costs when conducting short sales.
26
Until
a Fund closes its short position or replaces the borrowed stock, a Fund will:
(1) maintain an account containing cash or liquid assets
at such a level that (a) the amount deposited in the account plus the amount
deposited with the broker as collateral will equal the current value of the
stock sold short and (b) the amount deposited in the account plus the amount
deposited with the broker as collateral will not be less than the market value
of the stock at the time the stock was sold short; or (2) otherwise cover a
Fund’s short position.
A
Fund will incur a loss as a result of a short sales or short exposure to
reference assets utilizing derivatives if the price of the security or
reference asset increases between the date of the short sale or exposure and the
date on which a Fund replaces the borrowed security or terminates the
derivatives providing short exposure. A Fund will realize a gain if the price of
a security or reference asset declines in price between those dates. The amount
of any gain will be decreased, and the amount of any loss will be increased, by
the amount of the premium, dividends or interest a Fund may be required to pay,
if any, in connection with a short sale or derivatives that provide short
exposure.
Swap
Agreements
A
Fund may enter into swap and other derivatives to obtain long and/or short
exposure to an underlying asset without actually
purchasing such asset. Swap agreements are generally two-party contracts entered
into primarily by institutional investors for periods ranging from a day to more
than one year. In a standard “swap” transaction, two parties agree to exchange
the returns (or differentials in rates of return) earned or realized on
particular predetermined investments or instruments. The gross returns to be
exchanged or “swapped” between the parties are calculated with respect to a
“notional amount,” i.e., the return on,
or increase/decrease, in value of a particular dollar amount invested in a
security or “basket” of securities representing a particular index or an ETF
representing a particular index or group of securities.
Each
Fund may enter into swaps to invest in a market without owning or taking
physical custody of securities. For example, in one common
type of total return swap, a Fund’s counterparty will agree to pay the Fund the
rate at which the specified asset or indicator (e.g., security, an
ETF, or securities comprising a benchmark index, plus the dividends or interest
that would have been received on those assets) increased in value multiplied by
the relevant notional amount of the swap. A Fund will agree to pay to the
counterparty an interest fee (based on the notional amount) and the rate at
which, the specified asset or indicator would decreased in value multiplied by
the notional amount of the swap, plus, in certain instances, commissions or
trading spreads on the notional amount.
As
a result, the swap has a similar economic effect as if a Fund were to invest in
the assets underlying the swap in an amount equal to the
notional amount of the swap. The return to the Fund on such swap should be the
gain or loss on the notional amount plus dividends or interest on the assets
less the interest paid by a Fund on the notional amount. However, unlike cash
investments in the underlying assets, a Fund will not be an owner of the
underlying assets and will not have voting or similar rights in respect of such
assets.
As
a trading technique, Rafferty may substitute physical securities with a swap
having investment characteristics substantially similar to the
underlying securities. A Fund may also enter into swaps that provide the
opposite return of their benchmark or a security. Their operations are similar
to that of the swaps discussed above except that the counterparty pays interest
to each Fund on the notional amount outstanding and that dividends or interest
on the underlying instruments reduce the value of the swap, plus, in certain
instances, each Fund will agree to pay to the counterparty commissions or
trading spreads on the notional amount. These amounts are often netted with any
unrealized gain or loss to determine the value of the swap.
The
use of swaps is a highly specialized activity which involves investment
techniques and risks in addition to, and in some cases different
from, those associated with ordinary portfolio securities transactions. The
primary risks associated with the use of swaps are mispricing or improper
valuation, imperfect correlation between movements in the notional amount and
the price of the underlying investments, and the inability of the counterparties
or clearing organization to perform. If a counterparty’s creditworthiness for an
over-the-counter swap declines, the value of the swap would likely decline.
Moreover, there is no guarantee that a Fund could eliminate its exposure under
an outstanding swap by entering into an offsetting swap with the same or another
party. In addition, a Fund may use a combination of swaps on an underlying index
and/or swaps on an ETF that is designed to track the performance of that index.
The performance of an ETF may deviate from the performance of its underlying
index due to embedded costs and other factors. Thus, to the extent a Fund
invests in swaps that use an ETF as the reference asset, the Fund may be subject
to greater correlation risk and may not achieve as high a degree of correlation
with its underlying index as it would if a Fund used only swaps on the
underlying index. Rafferty, under the supervision of the Board of Trustees, is
responsible for determining and monitoring the liquidity of a Fund’s
transactions in swaps.
Common
Types of Swaps
A
Fund may enter into any of several types of swaps, including:
Total
Return Swaps. Total return
swaps may be used either as economically similar substitutes for owning the
reference asset specified in the swap, such as the securities that comprise a
given market index, particular securities or commodities,
27
or
other assets or indicators. They also may be used as a means of obtaining
exposure in markets where the reference asset is unavailable or
it may otherwise be impossible or impracticable for a Fund to own that asset.
“Total return” refers to the payment (or receipt) of the total return on the
underlying reference asset, which is then exchanged for the receipt (or payment)
of an interest rate. Total return swaps provide a Fund with the additional
flexibility of gaining exposure to a market or sector index by using the most
cost-effective vehicle available.
Interest
Rate Swaps. Interest rate
swaps, in their most basic form, involve the exchange by a Fund with another
party of their respective commitments to pay or receive interest. For example, a
Fund might exchange its right to receive certain floating rate payments in
exchange for another party’s right to receive fixed rate payments. Interest rate
swaps can take a variety of other forms, such as agreements to pay the net
differences between two different interest indexes or rates. Despite their
differences in form, the function of interest rate swaps is generally the same:
to increase or decrease a Fund’s exposure to long- or short-term interest rates.
For example, a Fund may enter into an interest rate swap to preserve a return or
spread on a particular investment or a portion of its portfolio or to protect
against any increase in the price of securities a Fund anticipates purchasing at
a later date.
Other
Financial Instruments. Other forms of
swaps that a Fund may enter into include: interest rate caps, under which, in
return for a premium, one party agrees to make payments to the other to the
extent that interest rates exceed a specified rate, or “cap”; interest rate
floors, under which, in return for a premium, one party agrees to make payments
to the other to the extent that interest rates fall below a specified level, or
“floor,” and interest rate collars, under which a party sells a cap and
purchases a floor or vice versa in an attempt to protect itself against interest
rate movements exceeding given minimum or maximum levels.
Mechanics
of Swaps
Payments. Most swaps
entered into by a Fund calculate and settle the obligations of the parties to
the agreement on a “net basis” with a single payment. Consequently, a Fund’s
current obligations (or rights) under a swap will generally be equal only to the
net amount to be paid or received under the agreement based on the relative
values of the positions held by each party to the agreement (the “net amount”).
Other swaps may require initial premium (discount) payments as well as periodic
payments (receipts) related to the interest leg of the swap or to the default of
the reference entity. A Fund’s current obligations under most swaps
(e.g., total return
swaps, equity/index swaps, interest rate swaps) will be accrued daily (offset
against any amounts owed to a Fund by the counterparty to the swap) and any
accrued but unpaid net amounts owed to a swap counterparty will be covered by
segregating or earmarking cash or other assets determined to be liquid. However,
typically no payments will be made until the settlement date. The net amount of
the excess, if any, of a Fund’s obligations over its entitlements with respect
to a swap agreement entered into on a net basis will be accrued daily and an
amount of cash or liquid asset having an aggregate NAV at least equal to the
accrued excess will be maintained in an account with the Custodian that
satisfies the 1940 Act. A Fund also will establish and maintain such accounts
with respect to its total obligations under any swaps that are not entered into
on a net basis. Obligations under swap agreements so covered will not be
construed to be “senior securities” for purposes of a Fund’s investment
restriction concerning senior securities.
Counterparty
Credit Risk. A Fund will not
enter into any uncleared swap (i.e., not cleared by
a central counterparty) unless Rafferty believes that the other party to the
transaction is creditworthy. The counterparty to an uncleared swap will
typically be a major global financial institution. A Fund bears the risk of loss
of the amount expected to be received under a swap in the event of the default
or bankruptcy of a swap counterparty. If such a default occurs, a Fund will have
contractual remedies pursuant to the swaps, but such remedies may be subject to
bankruptcy and insolvency laws that could affect the Fund’s rights as a
creditor. The counterparty risk for cleared swaps is generally lower than for
uncleared over-the-counter swaps because, in a cleared swap, a clearing
organization becomes substituted for each counterparty to a cleared swap. The
clearing organization takes on the obligations of each side of the swap and a
Fund would only to the clearing organization for performance of financial
obligations. However, there can be no assurance that the clearing organization,
or its members, will satisfy its obligations to a Fund. Upon entering into a
cleared swap, a Fund may be required to deposit with its futures commission
merchant an amount of cash or cash equivalents equal to a small percentage of
the notional amount (this amount is subject to change by the clearing
organization that clears the trade). This amount is in the nature of a
performance bond or good faith deposit on the cleared swap and is returned to a
Fund upon termination of the swap, assuming all contractual obligations have
been satisfied. Subsequent payments to and from the broker will be made daily as
the price of the swap fluctuates, making the long and short position in the swap
contract more or less valuable, a process known as “marking-to-market.” The
premium (discount) payments are built into the daily price of the swap and thus
are amortized through the subsequent payments. The subsequent payment also
includes the daily portion of the periodic payment stream.
Termination
and Default Risk. Swap agreements
do not involve the delivery of securities or other underlying assets.
Accordingly, if a swap is entered into on a net basis, if the other party to a
swap agreement defaults, a Fund’s risk of loss consists of the net amount of
payments that the Fund is contractually entitled to receive, if any.
Swap
Regulation
In
recent years, regulators across the globe, including the CFTC and the U.S.
banking regulators, have adopted collateral requirements
applicable to uncleared swaps. While a Fund is not directly subject to these
requirements, where a Fund’s
28
counterparty
is subject to the requirements, uncleared swaps between a Fund and that
counterparty are required to be marked-to-market
on a daily basis, and collateral is required to be exchanged to account for any
changes in the value of such swaps. The rules impose a number of requirements as
to these exchanges of collateral, including as to the timing of transfers, the
type of collateral (and valuations for such collateral) and other matters that
may be different than what a Fund would agree with its counterparty in the
absence of such regulation. In all events, where a Fund is required to post
collateral to its swap counterparty, such collateral will be posted to an
independent bank custodian, where access to the collateral by the swap
counterparty will generally not be permitted unless a Fund is in default on its
obligations to the swap counterparty.
In
addition to the marked-to-market collateral requirements, regulators have
adopted “initial” collateral requirements applicable to
uncleared swaps. Where applicable, these rules require parties to an uncleared
swap to post, to a custodian that is independent from the parties to the swap,
collateral (in addition to any marked-to-market collateral noted above) in an
amount that is either (i) specified in a schedule in the rules or (ii)
calculated by the regulated party in accordance with a model that has been
approved by that party’s regulator(s). Effective September 1, 2022, the initial
collateral rules will apply to the swap trading relationships of Funds with
average aggregate notional amounts that exceed $8 billion. These rules may
impose significant costs on a Fund’s ability to engage in uncleared swaps and,
as such, could adversely affect Rafferty’s ability to manage a Fund, may impair
a Fund’s ability to achieve its investment objective and/or may result in
reduced returns to a Fund’s investors.
Comprehensive
swaps regulation. The Dodd-Frank
Wall Street Reform and Consumer Protection Act of 2010 (the “Dodd-Frank Act”)
and related regulatory developments have imposed comprehensive new regulatory
requirements on swaps and swap market participants. The regulatory framework
includes: (1) registration and regulation of swap dealers and major swap
participants; (2) requiring central clearing and execution of standardized
swaps; (3) imposing collateral requirements on swap transactions; (4) regulating
and monitoring swap transactions through position limits and large trader
reporting requirements; and (5) imposing recordkeeping and centralized and
public reporting requirements, on an anonymous basis, for most swaps. The CFTC
is responsible for the regulation of most swaps. The SEC has jurisdiction over a
small segment of the market referred to as “security-based swaps,” which
includes swaps on single securities or credits, or narrow-based indices of
securities or credits.
Uncleared
swaps. In an uncleared
swap, the swap counterparty is typically a brokerage firm, bank or other
financial institution. A Fund customarily enters into uncleared swaps based on
the standard terms and conditions of an International Swaps and Derivatives
Association (“ISDA”) Master Agreement. ISDA is a voluntary industry association
of participants in the OTC derivatives markets that has developed standardized
contracts used by such participants that have agreed to be bound by such
standardized contracts. In the event that one party to a swap transaction
defaults and the transaction is terminated prior to its scheduled termination
date, one of the parties may be required to make an early termination payment to
the other. An early termination payment may be payable by either the defaulting
or non-defaulting party, depending upon which of them is “in-the-money” with
respect to the swap at the time of its termination. Early termination payments
may be calculated in various ways, but are intended to approximate the amount
the “in-the-money” party would have to pay to replace the swap as of the date of
its termination. During the term of an uncleared swap, a Fund will be required
to pledge to the swap counterparty, from time to time, an amount of cash and/or
other assets equal to the total net amount (if any) that would be payable by a
Fund to the counterparty if all outstanding swaps between the parties were
terminated on the date in question, including any early termination payments.
Periodically, changes in the amount pledged are made to recognize changes in
value of the contract resulting from, among other things, interest on the
notional value of the contract, market value changes in the underlying
investment, and/or dividends paid by the issuer of the underlying instrument.
Likewise, the counterparty will be required to pledge cash or other assets to
cover its obligations to a Fund. However, the amount pledged may not always be
equal to or more than the amount due to the other party. Therefore, if a
counterparty defaults in its obligations to a Fund, the amount pledged by the
counterparty and available to a Fund may not be sufficient to cover all the
amounts due to a Fund and the Fund may sustain a loss. Rules requiring initial
collateral to be posted by certain market participants for uncleared swaps have
been adopted and are being phased in over time. When these rules take effect
with respect to the Funds, if a Fund is deemed to have material swaps exposure
under applicable swap regulations, it will be required to post initial
collateral in addition to marked-to-market collateral.
Cleared
swaps. Certain
standardized swaps are subject to mandatory central clearing and
exchange-trading. The Dodd-Frank Act and implementing rules will ultimately
require the clearing and exchange-trading of many swaps. Mandatory
exchange-trading and clearing will occur on a phased-in basis based on the type
of market participant, CFTC approval of contracts for central clearing and
public trading facilities making such cleared swaps available to trade. To date,
the CFTC has designated only certain of the most common types of credit default
index swaps and interest rate swaps as subject to mandatory clearing and certain
public trading facilities have made certain of those cleared swaps available to
trade, but it is expected that additional categories of swaps will in the future
be designated as subject to mandatory clearing and trade execution requirements.
Central clearing is intended to reduce counterparty credit risk and increase
liquidity, but central clearing does not eliminate these risks and may involve
additional costs and risks not involved with uncleared swaps. For more
information, see “Risks of cleared swaps” below.
29
In
a cleared swap, a Fund’s ultimate counterparty is a central clearinghouse rather
than a brokerage firm, bank or other financial
institution. Cleared swaps are submitted for clearing through each party’s FCM,
which must be a member of the clearinghouse that serves as the central
counterparty. Transactions executed on a swap execution facility may increase
market transparency and liquidity but may require a Fund to incur increased
expenses to access the same types of swaps that it has used in the past. When a
Fund enters into a cleared swap, it must deliver to the central counterparty
(via the FCM) initial collateral. The initial collateral requirements are
determined by the central counterparty, and are typically calculated as an
amount equal to the volatility in market value of the cleared swap over a fixed
period, but an FCM may require additional collateral above the amount required
by the central counterparty. During the term of the swap agreement, an
additional collateral amount may also be required to be paid by a Fund or may be
received by a Fund in accordance with collateral controls set for such accounts.
If the value of the Fund’s cleared swap declines, the Fund will be required to
make additional payments to the FCM to settle the change in value. Conversely,
if the market value of a Fund’s position increases, the FCM will post additional
amounts to the Fund’s account. At the conclusion of the term of the swap
agreement, if a Fund has a loss equal to or greater than the collateral amount,
the collateral amount is paid to the FCM along with any loss in excess of the
collateral amount. If a Fund has a loss of less than the collateral amount, the
excess collateral is returned to a Fund. If a Fund has a gain, the full
collateral amount and the amount of the gain is paid to a Fund.
Risks
of swaps generally. The use of swap
transactions is a highly specialized activity, which involves investment
techniques and risks different from those associated with ordinary portfolio
securities transactions. Whether a Fund will be successful in using swap
agreements to achieve its investment goal depends on the ability of the Adviser
to correctly predict which types of investments are likely to produce greater
returns. If the Adviser, in using swap agreements, is incorrect in its forecasts
of market values, interest rates, inflation, currency exchange rates or other
applicable factors, the investment performance of a Fund will be less than its
performance would have been if it had not used the swap agreements. The risk of
loss to a Fund for swap transactions that are entered into on a net basis
depends on which party is obligated to pay the net amount to the other party. If
the counterparty is obligated to pay the net amount to a Fund, the risk of loss
to the Fund is loss of the entire amount that the Fund is entitled to receive.
If a Fund is obligated to pay the net amount, the Fund’s risk of loss is
generally limited to that net amount. If the swap agreement involves the
exchange of the entire principal value of a security, the entire principal value
of that security is subject to the risk that the other party to the swap will
default on its contractual delivery obligations. In addition, a Fund’s risk of
loss also includes any collateral at risk in the event of default by the
counterparty (in an uncleared swap) or the central counterparty or FCM (in a
cleared swap), plus any transaction costs.
Because
bilateral swap agreements are structured as two-party contracts and may have
terms of greater than seven days, these swaps may
be considered to be illiquid and, therefore, subject to a Fund’s limitation on
investments in illiquid securities. If a swap transaction is particularly large
or if the relevant market is illiquid, a Fund may not be able to establish or
liquidate a position at an advantageous time or price, which may result in
significant losses. Participants in the swap markets are not required to make
continuous markets in the swap contracts they trade. Participants could refuse
to quote prices for swap contracts or quote prices with an unusually wide spread
between the price at which they are prepared to buy and the price at which they
are prepared to sell. Some swap agreements entail complex terms and may require
a greater degree of subjectivity in their valuation. However, the swap markets
have grown substantially in recent years, with a large number of financial
institutions acting both as principals and agents, utilizing standardized swap
documentation. As a result, the swap markets have become increasingly liquid. In
addition, central clearing and the trading of cleared swaps on public facilities
are intended to increase liquidity.
Rafferty,
under the supervision of the Board of Trustees, is responsible for determining
and monitoring the liquidity of a Fund’s swap
transactions. Rules adopted under the Dodd-Frank Act require centralized
reporting of detailed information about many swaps, whether cleared or
uncleared. This information is available to regulators and also, to a more
limited extent and on an anonymous basis, to the public. Reporting of swap data
is intended to result in greater market transparency. This may be beneficial to
funds that use swaps in their trading strategies. However, public reporting
imposes additional recordkeeping burdens on these funds, and the safeguards
established to protect anonymity are not yet tested and may not provide
protection of a Fund’s identity as intended. Certain IRS positions may limit a
Fund’s ability to use swap agreements in a desired tax strategy. It is possible
that developments in the swap markets and/or the laws relating to swap
agreements, including potential government regulation, could adversely affect
the Fund’s ability to benefit from using swap agreements, or could have adverse
tax consequences. For more information about potentially changing regulation,
see “Developing government regulation of derivatives” below.
Risks
of uncleared swaps. Uncleared swaps
are typically executed bilaterally with a swap dealer rather than traded on
exchanges. As a result, swap participants may not be as protected as
participants on organized exchanges. Performance of a swap agreement is the
responsibility only of the swap counterparty and not of any exchange or
clearinghouse. As a result, a Fund is subject to the risk that a counterparty
will be unable or will refuse to perform under such agreement, including because
of the counterparty’s bankruptcy or insolvency. A Fund risks the loss of the
accrued but unpaid amounts under a swap agreement, which could be substantial,
in the event of a default, insolvency or bankruptcy by a swap counterparty. In
such an event, a Fund will have contractual remedies pursuant to the swap
agreements, but bankruptcy and insolvency laws could affect the Fund’s rights as
a creditor. If the counterparty’s creditworthiness declines, the value of a swap
agreement
30
would
likely decline, potentially resulting in losses. The Adviser will only approve a
swap agreement counterparty for a Fund if the
Adviser deems the counterparty to be creditworthy. However, in unusual or
extreme market conditions, a counterparty’s creditworthiness and ability to
perform may deteriorate rapidly, and the availability of suitable replacement
counterparties may become limited.
Risks
of cleared swaps. As noted above,
under recent financial reforms, certain types of swaps are, and others
eventually are expected to be, required to be cleared through a central
counterparty, which may affect counterparty risk and other risks faced by a
Fund.
Central
clearing is designed to reduce counterparty credit risk and increase liquidity
compared to uncleared swaps because central clearing
interposes the central clearinghouse as the counterparty to each participant’s
swap, but it does not eliminate those risks completely and may involve
additional costs and risks not involved with uncleared swaps. There is also a
risk of loss by a Fund of the initial and variation collateral deposits in the
event of bankruptcy of the FCM with which a Fund has an open position, or the
central counterparty in a swap contract. The assets of a Fund may not be fully
protected in the event of the bankruptcy of the FCM or central counterparty
because a Fund might be limited to recovering only a pro rata share of all
available funds and collateral segregated on behalf of an FCM’s customers. If
the FCM does not provide accurate reporting, a Fund is also subject to the risk
that the FCM could use the Fund’s assets, which are held in an omnibus account
with assets belonging to the FCM’s other customers, to satisfy its own financial
obligations or the payment obligations of another customer to the central
counterparty. Credit risk of cleared swap participants is concentrated in a few
clearinghouses, and the consequences of insolvency of a clearinghouse are not
clear.
With
cleared swaps, a Fund may not be able to obtain terms as favorable as it would
be able to negotiate for a bilateral, uncleared swap.
In addition, an FCM may unilaterally amend the terms of its agreement with the
Fund, which may include the imposition of position limits or additional
collateral requirements with respect to a Fund’s investment in certain types of
swaps. Central counterparties and FCMs can require termination of existing
cleared swap transactions upon the occurrence of certain events, and can also
require increases in collateral above the amount that is required at the
initiation of the swap agreement. Currently, depending on a number of factors,
the collateral required under the rules of the clearinghouse and FCM may be in
excess of the collateral required to be posted by a Fund to support its
obligations under a similar uncleared swap. However, regulators have proposed
and are expected to adopt rules imposing certain requirements on uncleared swaps
in the near future, which are likely to impose higher collateral requirements on
uncleared swaps.
Finally,
a Fund is subject to the risk that, after entering into a cleared swap with an
executing broker, no FCM or central counterparty is
willing or able to clear the transaction. In such an event, a Fund may be
required to break the trade and make an early termination payment to the
executing broker.
Developing
government regulation of derivatives. The regulation of
cleared and uncleared swaps, as well as other derivatives, is a rapidly changing
area of law and is subject to modification by government and judicial action. In
addition, the SEC, CFTC and the exchanges are authorized to take extraordinary
actions in the event of a market emergency, including, for example, the
implementation or reduction of speculative position limits, the implementation
of higher collateral requirements, the establishment of daily price limits and
the suspension of trading. It is not possible to predict fully the effects of
current or future regulation. However, it is possible that developments in
government regulation of various types of derivative instruments, such as
speculative position limits on certain types of derivatives, or limits or
restrictions on the counterparties with which a Fund engages in derivative
transactions, may limit or prevent the Fund from using or limit the Fund’s use
of these instruments effectively as a part of its investment strategy, and could
adversely affect the Fund’s ability to achieve its investment goal(s). The
Adviser will continue to monitor developments in the area, particularly to the
extent regulatory changes affect a Fund’s ability to enter into desired swap
agreements. New requirements, even if not directly applicable to a Fund, may
increase the cost of a Fund’s investments and cost of doing
business.
Unrated
Debt Securities
A
Fund may also invest in unrated debt securities. Unrated debt, while not
necessarily lower in quality than rated securities, may not have as
broad a market. Because of the size and perceived demand for the issue, among
other factors, certain issuers may decide not to pay the cost of getting a
rating for their bonds. The creditworthiness of the issuer, as well as any
financial institution or other party responsible for payments on the security,
will be analyzed to determine whether to purchase unrated bonds.
U.S.
Government Securities
A
Fund may invest in securities issued or guaranteed by the U.S. government or its
agencies or instrumentalities (“U.S. government
securities”) in pursuit of its investment objective, in order to deposit such
securities as initial or variation margin, as “cover” for the investment
techniques it employs, as part of a cash reserve or for liquidity
purposes.
31
U.S.
government securities are high-quality instruments issued or guaranteed as to
principal or interest by the U.S. Treasury Department (“U.S.
Treasury”) or by an agency or instrumentality of the U.S. government. Not all
U.S. government securities are backed by the full faith and credit of the United
States. Some are backed by the right of the issuer to borrow from the U.S.
Treasury; others are backed by discretionary authority of the U.S. government to
purchase the agencies’ obligations; while others are supported only by the
credit of the instrumentality. In the case of securities not backed by the full
faith and credit of the United States, the investor must look principally to the
agency issuing or guaranteeing the obligation for ultimate
repayment.
Yields
on short-, intermediate- and long-term U.S. government securities are dependent
on a variety of factors, including the general
conditions of the money and bond markets, the size of a particular offering and
the maturity of the obligation. Debt securities with longer maturities tend to
produce higher capital appreciation and depreciation than obligations with
shorter maturities and lower yields. The market value of U.S. government
securities generally varies inversely with changes in the market interest rates.
An increase in interest rates, therefore, generally would reduce the market
value of a Fund’s portfolio investments in U.S. government securities, while a
decline in interest rates generally would increase the market value of a Fund’s
portfolio investments in these securities. U.S. government securities include
U.S. Treasury obligations, which includes U.S. Treasury Bills (which mature
within one year of the date they are issued), U.S. Treasury Notes (which have
maturities of one to ten years) and U.S. Treasury Bonds (which generally have
maturities of more than 10 years). All such U.S. Treasury obligations are backed
by the full faith and credit of the United States.
U.S.
government securities also include obligations issued by U.S. government
agencies and instrumentalities (“GSEs”) that are backed by the
full faith and credit of the U.S. government (such as securities issued or
guaranteed by the Federal Housing Administration, Ginnie Mae®, the
Export-Import Bank of the United States, the General Services Administration and
the Maritime Administration and certain securities issued by the Small Business
Administration).
Also,
U.S. government securities include securities that are guaranteed by U.S.
government-sponsored entities that are not backed by the
full faith and credit of the U.S. government (such as Fannie Mae, Freddie Mac,
or the Federal Home Loan Banks). These U.S. government-sponsored entities,
although chartered and sponsored by the U.S. Congress, are not guaranteed, nor
insured, by the U.S. government. They are supported only by the credit of the
issuing agency, instrumentality or corporation.
Since
2008, Fannie Mae and Freddie Mac have been in conservatorship and have received
significant capital support through U.S. Treasury
preferred stock purchases, as well as U.S. Treasury and Federal Reserve
purchases of their mortgage backed securities (“MBS”). The FHFA and the U.S.
Treasury (through its agreement to purchase Fannie Mae and Freddie Mac preferred
stock) have imposed strict limits on the size of their mortgage portfolios. The
MBS purchase programs technically ended in 2010 but the U.S. Treasury has
continued its support for the entities’ capital as necessary to prevent a
negative net worth through at least 2012 and other governmental entities have
provided significant support to Fannie Mae and Freddie Mac.
There is no
guarantee, however, that they will continue to do so. An FHFA stress test
suggested that in a “severely adverse scenario” additional Treasury support of
between $42.1 billion and $77.6 billion (depending on the treatment of deferred
tax assets) might be required. Since then Congress has permanently reduced the
corporate income tax rate from 35% to 21% starting January 1, 2018. This
reduction could cause a substantial net loss and net worth deficit for the year
in which the legislation is enacted. Should they experience such a net worth
deficit, they could be required to draw additional funds from the U.S. Treasury
to avoid being placed in receivership. Accordingly, no assurance can be given
that Fannie Mae and Freddie Mac will remain successful in meeting their
obligations with respect to the debt and MBSs that they issue.
In
addition, the problems faced by Fannie Mae and Freddie Mac, resulting in their
being placed into federal conservatorship and receiving
significant U.S. government support, have sparked serious debate among federal
policy makers regarding the continued role of the U.S. government in providing
liquidity for mortgage loans. In December 2011, Congress enacted the Temporary
Payroll Tax Cut Continuation Act (“TCCA”) of 2011 which, among other provisions,
requires that Fannie Mae and Freddie Mac increase their single-family guaranty
fees by at least 10 basis points and remit this increase to Treasury with
respect to all loans acquired by Fannie Mae or Freddie Mac on or after April 1,
2012 and before January 1, 2022. Nevertheless, discussions among policymakers
have continued as to whether Fannie Mae and Freddie Mac should be nationalized,
privatized, restructured, or eliminated altogether. In September 2019, the U.S.
Treasury released its plan to reform the housing finance system, which includes
reforms to Fannie Mae and Freddie Mac. The impact of these reforms are not yet
known. Fannie Mae and Freddie Mac also are the subject of several continuing
legal actions and investigations related to certain accounting, disclosure, or
corporate governance matters, which (along with any resulting financial
restatements) may continue to have an adverse effect on the guaranteeing
entities. Congress is currently considering several pieces of legislation that
would reform GSEs, proposing to address their structure, mission, portfolio
limits, and guarantee fees, among other issues.
U.S.
Government Sponsored Enterprises
U.S.
government sponsored enterprises (“GSE”) securities are securities issued by the
U.S. government or its agencies or instrumentalities.
Some obligations issued by GSEs are supported by the discretionary authority of
the U.S. government to purchase certain obligations of the agency or
instrumentality and others only by the credit of the agency or instrumentality.
32
Those
securities bear fixed, floating or variable rates of interest. Interest may
fluctuate based on generally recognized reference rates
or the relationship of rates. While the U.S. government currently provides
financial support to such GSEs or instrumentalities, no assurance can be given
that it will always do so, since it is not so obligated by law.
Certain
U.S. government debt securities, such as securities of the Federal Home Loan
Banks, are supported by the right of the issuer to
borrow from the U.S. Treasury. Others, such as securities issued by Fannie
Mae® and Freddie
Mac®, are supported
only by the credit of the corporation. In the case of securities not backed by
the full faith and credit of the United States, a fund must look principally to
the agency issuing or guaranteeing the obligation in the event the agency or
instrumentality does not meet its commitments. The U.S. government may choose
not to provide financial support to GSEs or instrumentalities if it is not
legally obligated to do so. A fund will invest in securities of such
instrumentalities only when Rafferty is satisfied that the credit risk with
respect to any such instrumentality is comparatively minimal.
When-Issued
Securities
A
Fund may enter into firm commitment agreements for the purchase of securities on
a specified future date. A Fund may purchase, for
example, new issues of fixed-income instruments on a when-issued basis, whereby
the payment obligation, or yield to maturity, or coupon rate on the instruments
may not be fixed at the time of transaction. A Fund will not purchase securities
on a when-issued basis if, as a result, more than 15% of its net assets would be
so invested. If a Fund enters into a firm commitment agreement, liability for
the purchase price and the rights and risks of ownership of the security accrue
to a Fund at the time it becomes obligated to purchase such security, although
delivery and payment occur at a later date. Accordingly, if the market price of
the security should decline, the effect of such an agreement would be to
obligate a Fund to purchase the security at a price above the current market
price on the date of delivery and payment. During the time a Fund is obligated
to purchase such a security, it will be required to segregate assets with an
approved custodian in an amount sufficient to settle the
transaction.
Zero-Coupon,
Payment-In-Kind and Strip Securities
A
Fund may invest in zero-coupon, payment-in-kind and strip securities of any
rating or maturity. Zero-coupon securities make no periodic
interest payment but are sold at a deep discount from their face value,
otherwise known as “original issue discount” or “OID.” The buyer earns a rate of
return determined by the gradual appreciation of the security, which is redeemed
at face value on a specified maturity date. The OID varies depending on the time
remaining until maturity, as well as market interest rates, liquidity of the
security, and the issuer’s perceived credit quality. If the issuer defaults, a
Fund may not receive any return on its investment. Because zero-coupon
securities bear no interest and compound semi-annually at the rate fixed at the
time of issuance, their value generally is more volatile than the value of other
fixed-income securities. Since zero-coupon security holders do not receive
interest payments, when interest rates rise, zero-coupon securities fall more
dramatically in value than securities paying interest on a current basis. When
interest rates fall, zero-coupon securities rise more rapidly in value because
the securities reflect a fixed rate of return. Payment-in-kind securities allow
the issuer, at its option, to make current interest payments either in cash or
in additional debt obligations of the issuer. Both zero-coupon securities and
payment-in-kind securities allow an issuer to avoid the need to generate cash to
meet current interest payments.
An
investment in zero-coupon securities and delayed interest securities (which do
not make interest payments until after a specified time)
may cause a Fund to recognize income and be required to make distributions
thereof to shareholders before it receives any cash payments on its investment.
Moreover, even though payment-in-kind securities do not pay current interest in
cash, a Fund nonetheless is required to accrue interest income on these
investments and to distribute the interest income at least annually to
shareholders. See “Dividends, Other Distributions and Taxes –
Income from Zero Coupon and Payment-in-Kind
Securities.” Thus, a Fund could be required at times to liquidate other
investments to satisfy distribution requirements.
A
Fund may also invest in strips, which are debt securities whose interest coupons
are taken out and traded separately after the
securities are issued but otherwise are comparable to zero-coupon securities.
Like zero-coupon securities and payment-in-kind securities, strips are generally
more sensitive to interest rate fluctuations than interest paying securities of
comparable term and quality.
Other
Investment Risks and Practices
Borrowing. A Fund may
borrow money for investment purposes, which is a form of leveraging. Leveraging
investments, by purchasing securities with borrowed money, is a speculative
technique that increases investment risk while increasing investment
opportunity. Leverage will magnify changes in a Fund’s NAV and on a Fund’s
investments. Although the principal of such borrowings will be fixed, a Fund’s
assets may change in value during the time the borrowing is outstanding.
Leverage also creates interest expenses for a Fund. To the extent the income
derived from securities purchased with borrowed funds exceeds the interest a
Fund will have to pay, that Fund’s net income will be greater than it would be
if leverage were not
33
used.
Conversely, if the income from the assets obtained with borrowed funds is not
sufficient to cover the cost of leveraging, the net income of
a Fund will be less than it would be if leverage were not used, and therefore
the amount available for shareholders will be reduced.
A
Fund may borrow money to facilitate management of a Fund’s portfolio by enabling
a Fund to meet redemption requests when the
liquidation of portfolio instruments would be inconvenient or disadvantageous.
Such borrowing is not for investment purposes and will be repaid by the
borrowing Fund promptly.
As
required by the 1940 Act, a Fund must maintain continuous asset coverage (total
assets, including assets acquired with borrowed funds,
less liabilities exclusive of borrowings) of 300% of all amounts borrowed. If at
any time the value of the required asset coverage declines as a result of market
fluctuations or other reasons, a Fund may be required to sell some of its
portfolio investments within three days to reduce the amount of its borrowings
and restore the 300% asset coverage, even though it may be disadvantageous from
an investment standpoint to sell portfolio instruments at that
time.
Portfolio
Turnover. The Trust
anticipates that each Fund’s annual portfolio turnover may vary year to year. A
Fund’s portfolio turnover rate is calculated by the value of the securities
purchased or securities sold, excluding all securities whose terms-to-maturity
at the time of acquisition were less than 397 days, divided by the average
monthly value of such securities owned during the year. Based on this
calculation, instruments with remaining terms-to-maturity of less than 397 days
are excluded from the portfolio turnover rate. Such instruments generally would
include futures contracts and options, since such contracts generally have
remaining terms-to-maturity of less than 397 days. In any given period, all of a
Fund’s investments may have remaining terms-to-maturity of less than 397 days;
in that case, the portfolio turnover rate for that period would be equal to
zero. However, each Fund’s portfolio turnover rate calculated with all
securities whose terms-to-maturity were less than 397 days is anticipated to be
unusually high.
High
portfolio turnover involves correspondingly greater expenses to a Fund,
including brokerage commissions or dealer mark-ups and
other transaction costs on the sale of securities and reinvestments in other
securities. Such sales also may result in adverse tax consequences to a Fund’s
shareholders resulting from its distributions of increased net capital gains, if
any, recognized as a result of the sales. The trading costs and tax effects
associated with portfolio turnover may adversely affect a Fund’s
performance.
For the fiscal
year ended August 31, 2022, the Direxion Monthly 7-10
Year Treasury Bull 1.75X Fund's portfolio turnover increased significantly from
the portfolio turnover for the fiscal year ended August 31, 2021 due to greater
asset fluctuations resulting in more transactions.
Securities
Lending
Each
Fund may lend portfolio securities to certain borrowers that Rafferty determines
to be creditworthy. The borrowers provide
collateral that is maintained in an amount at least equal to the current market
value of the securities loaned, marked to market daily. Borrowers continuously
secure their obligations to return securities on loan from a Fund by depositing
any combination of short-term U.S. government securities and cash as collateral
with a Fund. No securities loan will be made on behalf of a Fund if, as a
result, the aggregate value of all securities loaned by a Fund exceeds one-third
of the value of the Fund's total assets (including the value of the collateral
received) or such lower limit as set by Rafferty or the Board. A Fund may
terminate a loan at any time and obtain the return of the securities loaned.
Each Fund receives, by way of substitute payment, the value of any interest or
cash or non-cash distributions paid on the loaned securities that it would have
received if the securities were not on loan. Any gain or loss in the market
price of the borrowed securities that occurs during the term of the loan inures
to the lending Fund and that Fund’s shareholders.
With respect to
loans that are collateralized by cash, the borrower may be entitled to receive a
fee based on the amount of cash collateral. A Fund is
typically compensated by the difference between the amount earned on the
reinvestment of cash collateral and the fee paid to the borrower. In the case of
collateral other than cash, a Fund is typically compensated by a fee paid by the
borrower equal to a percentage of the market value of the loaned securities. A
Fund may also receive such fees on “special” loans that are cash-collateralized.
Any cash collateral may be reinvested in money market funds. Such money market
fund shares will not be subject to a sales load, redemption fee, distribution
fee or service fee. However, such investments are subject to investment
risk.
Securities
lending involves exposure to certain risks, including operational risk
(i.e., the risk of
losses resulting from problems in the settlement and accounting process), “gap”
risk (i.e., the risk of a
mismatch between the return of cash collateral reinvestments and the fees a Fund
has agreed to pay a borrower), and credit, legal, counterparty and market risk.
If a securities lending counterparty were to default, a Fund would be subject to
the risk of a possible delay in receiving collateral or in recovering the loaned
securities, or to a possible loss of rights in the collateral. In the event a
borrower does not return a Fund’s securities as agreed, the Fund could
experience losses if the proceeds received from liquidating the collateral do
not at least equal the value of the loaned security at the time the collateral
is liquidated, plus the transaction costs incurred in purchasing replacement
securities. This event could trigger adverse tax consequences for a Fund. A Fund
could lose money if its investment of cash collateral declines in value over the
period of the loan. Substitute payments for dividends received by a Fund while
its securities are loaned out will not be considered qualified dividend
income.
34
Correlation
and Tracking Risk
Several
factors may affect a Fund’s ability to obtain its monthly leveraged or inverse
leveraged investment objective. Among these factors
are: (1) Fund expenses, including brokerage expenses and commissions and
financing costs related to derivatives (which may be increased by high portfolio
turnover) and other transactions costs and fees; (2) less than all of the
securities in the underlying index being held by a Fund and securities not
included in the underlying index being held by a Fund; (3) an imperfect
correlation between the performance of instruments held by a Fund, such as other
investment companies, including ETFs, swap agreements, futures contracts and
options, and the performance of the underlying securities in the cash market
comprising an underlying index; (4) bid-ask spreads (the effect of which may be
increased by portfolio turnover); (5) a Fund holding instruments that are
illiquid or the market for which becomes disrupted; (6) the need to conform a
Fund’s portfolio holdings to comply with that Fund’s investment restrictions or
policies, or regulatory or tax law requirements; (7) income items, valuation
methodologies and accounting standards; (8) significant purchase and redemption
activity by shareholders; and (9) market movements that run counter to a
leveraged Fund’s investments (which will cause divergence between a Fund and its
underlying index over time due to the mathematical effects of
leveraging).
There
can be no guarantee that a Fund will achieve a high degree of correlation with
its leveraged or inverse leveraged investment
objective relative to its underlying index. Failure to achieve a high degree of
correlation may prevent a Fund from achieving its investment objective.
Activities surrounding index reconstitutions and other index repositioning
events may hinder a Fund’s ability to meet its calendar month leveraged or
inverse leveraged investment objective.
A
Fund may not have investment exposure to all securities in its underlying index,
or its weighting of investment exposure to such stocks or
industries may be different from that of its underlying index. In addition, a
Fund may invest in securities or financial instruments not included in its
underlying index. A Fund may take or refrain from taking positions in order to
improve tax efficiency or comply with regulatory restrictions, either of which
may negatively affect a Fund’s leveraged or inverse leveraged correlation with
its underlying index. A Fund may be subject to large movements of assets into
and out of a Fund, potentially resulting in a Fund being over- or under-exposed
to its underlying index. Additionally, securities in a Fund's underlying index
may trade on markets that may not be open on the same day as a Fund, which may
cause a difference between the performance of a Fund and its underlying
index.
Because
an underlying index may include instruments that trade on a different market
than a Fund, a Fund’s return may vary from the
leveraged or inverse leveraged performance of an underlying index because
different markets may close before the Exchange opens or may not be open for
business on the same calendar days as a Fund. Additionally, due to differences
in trading hours between these different markets, and because the value of the
underlying index may be determined using prices obtained at times other than a
Fund’s NAV calculation time, correlation to the underlying index may be measured
by comparing the Fund’s monthly return to the inverse of a multiple of the
calendar month performance of an underlying index or by comparing the monthly
change in a Fund’s NAV per share to leveraged or inverse leveraged calendar
month performance of one or more U.S. ETFs that reflect the values of the
securities underlying an underlying index as of a Fund’s NAV calculation time.
It is important to note that correlation to these ETFs may vary from the
correlation to an underlying index due to embedded costs and other
factors.
Any
of these factors individually or in combination with other factors could
decrease the correlation between the monthly leveraged or
inverse leveraged performance of a Fund and its underlying index and may hinder
a Fund’s ability to meet its investment objective.
Negative
Implications of Leveraged Monthly Goals in Volatile
Markets
As
discussed in the Prospectus, each Fund is “leveraged” in the sense that each has
an investment objective that is 175% or -175% of the
performance of an underlying index in one calendar month. Each Fund seeks to
provide a return which is 175% or -175% of the calendar month performance of its
underlying index. No Fund attempts to, and no Fund should be expected to,
provide returns which are a multiple of the return of the underlying index for
periods longer than a single month. Each Fund repositions its portfolio on the
last business day of each calendar month, increasing exposure in response to
that calendar month’s gains or reducing exposure in response to that calendar
month’s losses. If adverse calendar month performance of a Fund's underlying
index reduces the amount of a shareholder’s investment, any further adverse
calendar month performance will lead to a smaller dollar loss because the
shareholder’s investment had already been reduced by the prior adverse
performance. Equally, however, if favorable calendar month performance of a
Fund's underlying index increases the amount of a shareholder’s investment, the
dollar amount lost due to future adverse performance will increase
correspondingly.
For
Bull Funds, even if there is a perfect correlation between a Bull Fund and the
return of its underlying index on a calendar month basis, the
symmetry between the changes in the underlying index and the changes in a Bull
Fund’s NAV can be altered significantly over time by a compounding effect. For
example, if a Bull Fund achieved a perfect correlation with its underlying index
in every calendar month over an extended period and the level of returns of that
underlying index
35
significantly
increased during that period, a compounding effect for that period would result,
causing an increase in a Bull Fund’s NAV by a
percentage that is somewhat greater than the percentage that the underlying
index’s returns increased. Conversely, if a Bull Fund maintained a perfect
correlation with its underlying index over an extended period and if the level
of returns of that underlying index significantly decreased over that period, a
compounding effect would result, causing a decrease of a Bull Fund’s NAV by a
percentage that would be somewhat greater than the percentage that the
underlying index's returns decreased.
In
the case of Bear Funds whose NAVs are intended to move inversely from their
underlying indices the factor of compounding also may lead to
tracking error. Even if there is a perfect inverse correlation between a Bear
Fund and the return of its underlying index on a calendar month basis, the
symmetry between the changes in the underlying index and the changes in a Bear
Fund’s NAV can be altered significantly over time by a compounding effect. For
example, if a Bear Fund achieved a perfect inverse correlation with its
underlying index in every calendar month over an extended period and the level
of returns of that underlying index significantly decreased during that period,
a compounding effect for that period would result, causing an increase in a Bear
Fund’s NAV by a percentage that is somewhat greater than the percentage that the
underlying index’s returns decreased. Conversely, if a Bear Fund maintained a
perfect inverse correlation with its underlying index over an extended period
and if the level of returns of that underlying index significantly increased
over that period, a compounding effect would result, causing a decrease of a
Bear Fund’s NAV by a percentage that would be somewhat less than the percentage
that the underlying index returns increased.
An
index’s volatility rate is a statistical measure of the magnitude of
fluctuations in the returns of an index. Since market volatility, like
that experienced by the markets currently, has negative implications for Funds
which rebalance monthly, investors should be sure to monitor and manage their
investments in the Funds in volatile markets.
A
Fund’s return for periods longer than one calendar month is primarily a function
of the following:
a)
underlying index
performance;
b)
underlying index
volatility;
c)
financing rates
associated with leverage;
d)
investments in
other ETFs, either directly or indirectly as a reference asset for derivative
instruments;
e)
other fund
expenses;
f)
dividends paid by
companies in the underlying index; and
g)
period of
time.
Monthly
repositioning will impair a Fund’s performance if the underlying index
experiences significant volatility.
For
instance, a hypothetical Bull Fund would be expected to lose 9.8% if its
underlying benchmark were flat over a hypothetical one
year period during which its underlying index experienced annualized volatility
of 25%. If the underlying index’s annualized volatility were to rise to 50%, the
hypothetical loss for a one year period would increase to approximately
31.4%.
A
hypothetical Bear Fund would be expected to lose 9.8% if its underlying
benchmark were flat over a hypothetical one year period
during which its underlying index experienced annualized volatility of 25%. If
the underlying index’s annualized volatility were to rise to 50%, the
hypothetical loss for a one year period would widen to approximately
30.3%.
Intra-Calendar
Month Investments. Each Fund seeks
calendar month leveraged investment results which should not be equated with
seeking a leveraged goal for shorter than a calendar month. Thus, an investor
who purchases shares on a day other than the last business day of a calendar
month will likely have more, or less, than 175% leveraged investment exposure to
the underlying index, depending upon the movement of the underlying index from
the end of the prior calendar month until the point of purchase. If the
underlying index moves in a direction favorable to the Fund, the investor will
receive exposure to the underlying index less than 175%. Conversely, if the
underlying index moves in a direction adverse to the Fund, the investor will
receive exposure to the underlying index greater than 175%. Each Fund’s
prospectus provides a detailed discussion of such risk.
Leverage. If you invest
in a Fund you are exposed to the risks related to the use of leverage which may
result in the adverse performance of a Fund. This means that if a Fund's
underlying index experiences an adverse calendar month performance, your
investment in the Fund will be reduced by an amount equal to 2% for every 1% of
adverse performance, not including the cost of financing the portfolio and the
impact of operating expenses, which would further lower your investment. A Fund
could theoretically lose an amount greater than its net assets in the event of a
movement of its underlying index in excess of 50% in a direction adverse to the
Fund (meaning a decline in the value of the underlying index of a Bull Fund and
a gain in the value of the underlying index for a Bear Fund). Further,
purchasing shares intra-calendar month may result in greater than 175% or -175%
exposure to the performance of the underlying index if the underlying index
moved in a direction adverse to the Fund between the end of the last calendar
month and the time the investor purchased Fund shares. Each Fund’s prospectus
provides a detailed discussion of such risks.
36
Investment
Restrictions
The
Trust, on behalf of each Fund, has adopted the following investment policies
which are fundamental policies that may not be changed
without the affirmative vote of a majority of the outstanding voting securities
of the Fund. As defined by the 1940 Act, a “vote of a majority of the
outstanding voting securities of the Fund” means the affirmative vote of the
lesser of (1) more than 50% of the outstanding shares of the Fund or (2) 67% or
more of the shares present at a shareholders’ meeting, if more than 50% of the
outstanding shares are represented at the meeting in person or by
proxy.
For
purposes of the following limitations, all percentage limitations apply
immediately after a purchase or initial investment. Except with
respect to borrowing money, if a percentage limitation is adhered to at the time
of the investment, a later increase or decrease in the percentage resulting from
any change in value or net assets will not result in a violation of such
restrictions. If at any time a Fund’s borrowings exceed its limitations due to a
decline in net assets, such borrowings will be reduced within three days (not
including Sundays and holidays), or such longer period as may be permitted by
the 1940 Act, to the extent necessary to comply with the one-third
limitation.
A
Fund shall not:
1.
Lend any security
or make any other loan if, as a result, more than 33 1/3% of the value of a
Fund’s total assets would be lent to other parties, except (1) through the
purchase of a portion of an issue of debt securities in accordance with a Fund’s
investment objective, policies and limitations; or (2) by engaging in repurchase
agreements with respect to portfolio securities.
2.
Underwrite
securities of any other issuer.
3.
Purchase, hold,
or deal in real estate or oil and gas interests.
4.
Pledge, mortgage,
or hypothecate a Fund’s assets, except (1) to the extent necessary to secure
permitted borrowings; (2) in connection with the purchase of securities on a
forward-commitment or delayed-delivery basis or the sale of securities on a
delayed-delivery basis; and (3) in connection with options, futures contracts,
options on futures contracts, forward contracts, swaps, caps, floors, collars
and other financial instruments.
5.
Invest in
physical commodities, except that a Fund may purchase and sell foreign currency,
options, futures contracts, options on futures contracts, forward contracts,
swaps, caps, floors, collars, securities on a forward-commitment or
delayed-delivery basis, and other financial instruments.
6.
Issue any “senior
security” (as such term is defined in Section 18(f) of the 1940 Act) (including
the amount of senior securities issued by excluding liabilities and indebtedness
not constituting senior securities), except (1) that a Fund may issue senior
securities in connection with transactions in options, futures, options on
futures and forward contracts, swaps, caps, floors, collars and other similar
investments; (2) as otherwise permitted herein and in Limitation 4 above and 7
below; and (3) each Fund, except the Direxion Monthly Small Cap Bull 1.75X Fund,
may make short sales of securities.
7.
Borrowing
Each
Fund, except the Direxion Monthly Small Cap Bull 1.75X Fund, the Direxion
Monthly Small Cap Bear 1.75X Fund,
the Direxion Monthly 7-10 Year Treasury Bull 1.75X Fund, and the Direxion
Monthly 7-10 Year Treasury Bear 1.75X Fund, has adopted the following investment
limitation:
A
Fund shall not:
Borrow
money, except (1) to the extent permitted under the 1940 Act (which currently
limits borrowing to no more than 33 1/3%
of the value of the Fund’s total assets); (2) to enter into reverse repurchase
agreements; or (3) to lend portfolio securities. For purposes of this investment
limitation, the purchase or sale of options, futures contracts, options on
futures contracts, forward contracts, swaps, caps, floors, collars and other
financial instruments shall not constitute borrowing.
The
Direxion Monthly Small Cap Bull 1.75X Fund, the Direxion Monthly 7-10 Year
Treasury Bull 1.75X Fund, and the
Direxion Monthly 7-10 Year Treasury Bear 1.75X Fund have each adopted the
following investment limitation:
A
Fund shall not:
Borrow
money, except (1) to the extent permitted under the 1940 Act (which currently
limits borrowing to no more than 33 1/3%
of the value of each Fund’s total assets; (2) as a temporary measure and then
only in amounts not to exceed 5% of the value of each Fund’s total assets; (3)
to enter into reverse repurchase agreements; or (4) to lend portfolio
securities. For purposes of this investment limitation, the purchase or sale of
options, futures contracts, options on futures contracts, forward contracts,
swaps, caps, floors, collars and other financial instruments shall not
constitute borrowing.
The
Direxion Monthly Small Cap Bear 1.75X Fund has adopted the following investment
limitation:
A
Fund shall not:
37
Borrow
money, except (1) as a temporary measure for extraordinary or emergency purposes
and then only in amounts not to exceed 5%
of the value of a Fund’s total assets; (2) in an amount up to 33 1/3% of the
value of a Fund’s total assets, including the amount borrowed, in order to meet
redemption requests without immediately selling portfolio securities; (3) to
enter into reverse repurchase agreements; and (4) to lend portfolio securities.
For purposes of this investment limitation, the purchase or sale of options,
futures contracts, options on futures contracts, forward contracts, swaps, caps,
floors, collars and other financial instruments shall not constitute
borrowing.
8.
Short
Sales
The
Direxion Monthly Small Cap Bull 1.75X Fund has adopted the following investment
limitation:
A
Fund shall not:
Make
short sales of portfolio securities or purchase any portfolio securities on
margin but may make short sales “against the
box,” obtain such short-term credits as are necessary for the clearance of
transactions, and make margin payments in connection with options, futures
contracts, options on futures contracts, forward contracts, swaps, caps, floors,
collars and other financial instruments.
9.
25%
Limitation
Each
Fund has adopted the following investment limitation:
A
Fund shall not:
Invest
more than 25% of the value of its net assets in the securities of issuers in any
single industry, provided that there shall be no
limitation on the purchase of obligations issued or guaranteed by the U.S.
government, its agencies or instrumentalities.
Each
Fund has adopted the following investment policy that enables it to invest in
another investment company or series thereof that has
substantially similar investment objectives and policies:
Notwithstanding
any other limitation, a Fund may invest all of its investable assets in an
open-end management investment
company with substantially the same investment objectives, policies and
limitations as a Fund. For this purpose, “all of a Fund’s investable assets”
means that the only investment securities that will be held by the Fund will be
the Fund’s interest in the investment company.
Portfolio
Transactions and Brokerage
Subject
to the general supervision by the Trustees, Rafferty is responsible for
decisions to buy and sell securities and derivatives for each Fund,
the selection of broker-dealers to effect the transactions, and the negotiation
of brokerage commissions, if any. Rafferty expects that a Fund may execute
brokerage or other agency transactions through registered broker-dealers, for a
commission, in conformity with the 1940 Act, the Securities Exchange Act of
1934, as amended (the “Exchange Act”), and the rules and regulations
thereunder.
When
selecting a broker or dealer to execute portfolio transactions, Rafferty
considers many factors, including the rate of commission or the
size of the broker-dealer’s “spread,” the size and difficulty of the order, the
nature of the market for the security, operational capabilities of the
broker-dealer and the research, statistical and economic data furnished by the
broker-dealer to Rafferty.
In
effecting portfolio transactions for a Fund, Rafferty seeks to receive the
closing prices of securities that are in line with those of the
securities included in a Fund's underlying index and seeks to execute trades of
such securities at the commission rates reasonably available. With respect to
agency transactions, Rafferty may execute trades at a higher rate of commission
if reasonable in relation to brokerage and research services provided to a Fund
or Rafferty. Such services may include the following: information as to the
availability of securities for purchase or sale; statistical or factual
information or opinions pertaining to investment; wire services; and appraisals
or evaluations of portfolio securities. Each Fund believes that the requirement
to always seek the lowest possible commission cost could impede effective
portfolio management and preclude a Fund and Rafferty from obtaining a high
quality of brokerage and research services. In seeking to determine the
reasonableness of brokerage commissions paid in any transaction, Rafferty relies
upon its experience and knowledge regarding commissions generally charged by
various brokers and on its judgment in evaluating the brokerage and research
services received from the broker effecting the transaction. In addition to
commission rates, when selecting a broker for a particular transaction, Rafferty
considers the following factors, among others: the broker’s availability,
willingness to commit capital, reputation and integrity, facilities reliability,
access to research, execution capacity and responsiveness.
For
purchases and sales of derivatives (i.e., financial
instruments whose value is derived from the value of an underlying asset,
interest rate or index), Rafferty evaluates counterparties on the following
factors: reputation and financial strength; execution prices, commission costs,
ability to handle complex orders; ability to provide prompt and full execution;
accuracy
38
of
reports and confirmation provided; reliability; type and quality of research
provided; financing and other associated costs related to
the transaction; and whether the total cost or proceeds in each transaction is
the most favorable under the circumstances.
Rafferty
may use research and services provided to it by brokers in servicing a Fund;
however, not all such services may be used by Rafferty
in connection with a Fund. While the receipt of such information and services is
useful in varying degrees and may reduce the amount of research or services
otherwise provided to a Fund by Rafferty, the receipt of such information and
these services does not reduce the investment advisory fee paid by a
Fund.
Purchases
and sales of U.S. government securities normally are transacted through issuers,
underwriters or major dealers in U.S.
government securities acting as principals. Such transactions are made on a net
basis and do not involve payment of brokerage commissions. The cost of
securities purchased from an underwriter usually includes a commission paid by
the issuer to the underwriters; transactions with dealers normally reflect the
spread between bid and asked prices.
For
each Fund, brokerage fees paid may change significantly from year to year due to
Fund asset inflows and outflows stemming from
market timing activities. As discussed in the Prospectus, Rafferty expects a
significant portion of the assets of the Funds to come from professional money
managers and investors who use a Fund as part of “asset allocation” and “market
timing” investment strategies. If a large number of investors purchase or sell a
Fund, the Fund will need to reposition its portfolio and incur related brokerage
fees. Depending on frequency and magnitude of these portfolio transactions, over
the course of a year the total impact on brokerage fees paid can vary greatly
from year to year. Additionally, the Funds will invest significantly in
over-the-counter financial instruments with negotiated terms. These financial
instruments often include a provision that requires the Funds to close out its
position during periods of higher market volatility. In such instances, a Fund
would then reinvest in similar financial instruments in order to continue to
seek its investment objective. As a result, depending on the market volatility
that a Fund has experienced in the course of a year, the resulting brokerage
commissions could vary significantly.
Aggregate
brokerage commissions paid by each Fund for the periods shown are set forth in
the tables below.
|
Direxion
Monthly NASDAQ-100®
Bull 1.75X Fund |
Brokerage
Fees Paid |
|
Year Ended
August 31, 2022 |
$318,274 |
|
Year Ended
August 31, 2021 |
$384,344 |
|
Year Ended
August 31, 2020 |
$363,500 |
|
Direxion
Monthly S&P 500®
Bull 1.75X Fund |
Brokerage
Fees Paid |
|
Year Ended
August 31, 2022 |
$239,550 |
|
Year Ended
August 31, 2021 |
$156,400 |
|
Year Ended
August 31, 2020 |
$85,608 |
|
Direxion
Monthly S&P 500®
Bear 1.75X Fund |
Brokerage
Fees Paid |
|
Year Ended
August 31, 2022 |
$24,663 |
|
Year Ended
August 31, 2021 |
$9,857 |
|
Year Ended
August 31, 2020 |
$72,058 |
|
Direxion
Monthly Small Cap Bull 1.75X Fund |
Brokerage
Fees Paid |
|
Year Ended
August 31, 2022 |
$29,883 |
|
Year Ended
August 31, 2021 |
$27,076 |
|
Year Ended
August 31, 2020 |
$33,378 |
|
Direxion
Monthly Small Cap Bear 1.75X Fund |
Brokerage
Fees Paid |
|
Year Ended
August 31, 2022 |
$47,679 |
|
Year Ended
August 31, 2021 |
$60,270 |
|
Year Ended
August 31, 2020 |
$30,018 |
|
Direxion
Monthly 7-10 Year Treasury Bull 1.75X Fund |
Brokerage
Fees Paid |
|
Year Ended
August 31, 2022 |
$48,223 |
|
Year Ended
August 31, 2021 |
$112,071 |
|
Year Ended
August 31, 2020 |
$103,085 |
39
|
Direxion
Monthly 7-10 Year Treasury Bear 1.75X Fund |
Brokerage
Fees Paid |
|
Year Ended
August 31, 2022 |
$13,147 |
|
Year Ended
August 31, 2021 |
$6,976 |
|
Year Ended
August 31, 2020 |
$6,308 |
For the fiscal
year ended August 31, 2022, the brokerage commissions
for the Direxion Monthly S&P 500® Bull 1.75X Fund,
Direxion Monthly
S&P 500® Bear 1.75X Fund, and the
Direxion Monthly 7-10 Year Treasury Bear 1.75X Fund increased from the brokerage
commissions from the fiscal year ended August 31, 2021 as a result of higher
assets and/or higher volatility in assets.
For the fiscal year ended August 31, 2022, the brokerage commissions for the Direxion Monthly 7-10 Year Treasury Bull 1.75X Fund decreased from the brokerage commissions from the fiscal year ended August 31, 2021 as a result of a decrease in swap transactions.
For the fiscal year ended August 31, 2022, the brokerage commissions for the Direxion Monthly 7-10 Year Treasury Bull 1.75X Fund decreased from the brokerage commissions from the fiscal year ended August 31, 2021 as a result of a decrease in swap transactions.
Portfolio
Holdings Information
The
Trust maintains portfolio holdings disclosure policies that govern the timing
and circumstances of disclosure to shareholders and third parties
of information regarding a Fund’s portfolio investments to ensure that such
disclosure is in the best interests of a Fund’s shareholders. In adopting the
policies, the Board considered actual and potential material conflicts that
could arise between the interest of Fund shareholders, the Adviser, the Funds'
distributor, or any other affiliated person of a Fund. Disclosure of the Funds'
complete holdings is required to be made quarterly within 60 days of the end of
each fiscal quarter in the Annual Report and Semi-Annual Report to Fund
shareholders and in the quarterly holdings report on Form N-PORT. These reports
are available, free of charge, on the EDGAR database on the SEC’s website at
www.sec.gov.
From
time to time, rating and ranking organizations such as Standard &
Poor’s® and
Morningstar®, Inc. may
request complete portfolio holdings information in connection with rating a
Fund. Similarly, pension plan sponsors, consultants and/or other financial
institutions may request a complete list of portfolio holdings in order to
assess the risks of the Funds' portfolio along with related performance
attribution statistics. The Trust believes that these third parties have
legitimate objectives in requesting such portfolio holdings information. To
prevent such parties from potentially misusing the complete portfolio holdings
information, a Fund will generally only disclose such information as of the end
of the most recent calendar quarter, with a lag of approximately 60 days. In
addition, the Funds' Chief Compliance Officer (“CCO”) may grant exceptions to
permit additional disclosure of the complete portfolio holdings information at
differing times and with differing lag times to rating agencies and to the
parties noted above, provided that (1) the recipient is subject to a
confidentiality agreement; (2) the recipient will utilize the information to
reach certain conclusions about the investment management characteristics of a
Fund and will not use the information to facilitate or assist in any investment
program; and (3) the recipient will not provide access to third parties to this
information. The CCO shall report any disclosures made pursuant to this
exception to the Board.
In
addition, the Funds' service providers, such as custodian, administrator,
transfer agent, distributor, legal counsel and independent
registered public accounting firm may receive portfolio holdings information in
connection with their services to a Fund. In no event shall the Adviser, any
affiliates or employees, or a Fund receive any direct or indirect compensation
in connection with the disclosure of information about the Funds' portfolio
holdings.
In
the event a portfolio holdings disclosure to be made pursuant to the policies
presents a conflict of interest between the Funds'
shareholders and the Adviser, the Funds' distributor and their affiliates or
employees and any affiliated person of a Fund, the disclosure will not be made
unless a majority of the Board members who are not “interested persons” of the
Funds as defined in Section 2(a)(19) of the 1940 Act (“Independent Trustees”)
approves such disclosure.
Management
of the Trust
The
Board of Trustees
The
Trust is governed by its Board of Trustees (the “Board”). The Board is
responsible for and oversees the overall management and operations of
the Trust and the Funds, which includes the general oversight and review of the
Funds' investment activities, in accordance with federal law and the law of the
Commonwealth of Massachusetts, as well as the stated policies of the Funds. The
Board oversees the Trust’s officers and service providers, including Rafferty,
which is responsible for the management of the day-to-day operations of the
Funds based on policies and agreements reviewed and approved by the Board. In
carrying out these responsibilities, the Board regularly interacts with and
receives reports from senior personnel of service providers, including personnel
from Rafferty. The Board also is assisted by the Trust’s independent auditor
(who reports directly to the Trust’s Audit Committee), independent counsel and
other professionals as appropriate.
40
Risk
Oversight
Consistent
with its responsibility for oversight of the Trust and the Funds, the Board
oversees the management of risks relating to the
administration and operation of the Trust and the Funds. Rafferty, as part of
its responsibilities for the day-to-day operations of the Funds, is responsible
for day-to-day risk management for the Funds. The Board, in the exercise of its
reasonable business judgment performs its risk management oversight directly
and, as to certain matters, through its committees (described below) and through
the Board members who are not “interested persons” of the Funds as defined in
Section 2(a)(19) of the 1940 Act (“Independent Trustees”). The following
provides an overview of the principal, but not all, aspects of the Board’s
oversight of risk management for the Trust and the Funds.
The
Board has adopted, and periodically reviews, policies and procedures designed to
address risks to the Trust and the Funds. In
addition, under the general oversight of the Board, Rafferty and other service
providers to the Funds have themselves adopted a variety of policies, procedures
and controls designed to address particular risks to the Funds. Different
processes, procedures and controls are employed with respect to different types
of risks.
The
Board also oversees risk management for the Trust and the Funds through review
of regular reports, presentations and other
information from officers of the Trust and other persons. The Trust’s CCO and
senior officers of Rafferty regularly report to the Board on a range of matters,
including those relating to risk management. The Board also regularly receives
reports from Rafferty and U.S. Bancorp Fund Services, LLC (“USBFS”) with respect
to the Funds' investments. In addition to regular reports from these parties,
the Board also receives reports regarding other service providers to the Trust,
either directly or through Rafferty, USBFS or the CCO, on a periodic or regular
basis. At least annually, the Board receives a report from the CCO regarding the
effectiveness of the Funds' compliance program. Also, the Board receives regular
reports, presentations and other information from Rafferty, including in
connection with the Board’s consideration of the renewal of each of the Trust’s
agreements with Rafferty and the Trust’s distribution plan under Rule 12b-1
under the 1940 Act.
The
CCO reports regularly to the Board on Fund valuation matters. The Audit
Committee receives regular reports from the Trust’s
independent registered public accounting firm on internal control and financial
reporting matters. On at least a quarterly basis, the Independent Trustees meet
with the CCO to discuss matters relating to the Funds' compliance
program.
Board
Structure and Related Matters
Independent
Trustees constitute at least two-thirds of the Board. The Trustees discharge
their responsibilities collectively as a Board, as
well as through Board committees, each of which operates pursuant to a charter
approved by the Board that delineates the specific responsibilities of that
committee. The Board has established three standing committees: the Audit
Committee, the Nominating and Governance Committee and the Qualified Legal
Compliance Committee. For example, the Audit Committee is responsible for
specific matters related to oversight of the Funds' independent auditors,
subject to approval of the Audit Committee’s recommendations by the Board. The
members and responsibilities of each Board committee are summarized
below.
The
Board periodically evaluates its structure and composition as well as various
aspects of its operations. The Chairman of the Board is
not an Independent Trustee and the Board has chosen not to have a lead
Independent Trustee. However, the Board believes that its leadership structure,
including its Independent Trustees and Board committees, is appropriate for the
Trust in light of, among other factors, the asset size and nature of the Funds,
the number of funds overseen by the Board, the arrangements for the conduct of
the Funds' operations, the number of Trustees, and the Board’s responsibilities.
On an annual basis, the Board conducts a self-evaluation that considers, among
other matters, whether the Board and its committees are functioning effectively
and whether, given the size and composition of the Board and each of its
committees, the Trustees are able to oversee effectively the number of funds in
the complex.
The Trust is
part of the Direxion Family of Investment Companies, which is comprised of the
10 separate series
within the Trust,
148 separate series
within the Direxion Shares ETF Trust and no separate series within the Direxion
Insurance Trust. The same persons who constitute the Board also constitute the
Board of Trustees of the Direxion Insurance Trust and the Direxion Shares ETF
Trust.
The
Board holds four regularly scheduled meetings each year and the Independent
Trustees hold one additional meeting in connection
with the annual contract renewals. The Board may hold special meetings, as
needed, to address matters arising between regular meetings. During a portion of
each meeting, the Independent Trustees meet outside of management’s presence.
The Independent Trustees may hold special meetings, as needed.
The
Trustees of the Trust are identified in the tables below, which provide
information regarding their age, business address and principal
occupation during the past five years including any affiliation with Rafferty,
the length of service to the Trust, and the position, if any, that they hold on
the board of directors of companies other than the Trust as of the date of this
SAI. Each of the Trustees of the Trust also serve on the Board of the Direxion
Insurance Trust and Direxion Shares ETF Trust, the other registered investment
companies in the Direxion mutual fund complex. Unless otherwise noted, an
individual’s business address is 1301 Avenue of the Americas (6th Avenue), 28th
Floor, New York, New York 10019.
41
Interested
Trustees
|
Name,
Address and Age |
Position(s)
Held
with
Fund |
Term of
Office
and Length
of
Time
Served |
Principal
Occupation(s)
During
Past Five
Years |
# of
Portfolios in
Direxion
Family of
Investment
Companies
Overseen
by
Trustee(4)
|
Other
Trusteeships/
Directorships
Held
by Trustee
During
Past Five
Years |
|
Daniel D.
O’Neill(1)
Age:
54 |
Chairman of the
Board of
Trustees |
Lifetime of Trust
until removal or
resignation;
Since 2014
|
Chief Executive
Officer, Rafferty
Asset
Management,
LLC, April 2021 –
September 2022;
Managing
Director, Rafferty
Asset
Management,
LLC, January 1999
– January
2019. |
158 |
None. |
|
Angela
Brickl(2)
Age:
46 |
Trustee |
Lifetime of Trust
until removal or
resignation; Since
2022 |
President, Rafferty
Asset
Management, LLC
since September
2022; Chief
Operating Officer,
Rafferty Asset
Management, LLC
May 2021 –
September 2022;
General Counsel,
Rafferty Asset
Management LLC,
since October
2010; Chief
Compliance
Officer, Rafferty
Asset
Management,
LLC, September
2012–
September
2022. |
158 |
None. |
Independent
Trustees
|
Name,
Address and Age |
Position(s)
Held
with
Fund |
Term of
Office
and Length
of
Time
Served |
Principal
Occupation(s)
During
Past Five
Years |
# of
Portfolios in
Direxion
Family of
Investment
Companies
Overseen
by
Trustee(4)
|
Other
Trusteeships/
Directorships
Held
by Trustee
During
Past Five
Years |
|
David L.
Driscoll
Age:
53 |
Trustee |
Lifetime of Trust
until removal or
resignation;
Since
2014 |
Partner, King
Associates, LLP,
since 2004; Board
Advisor, University
Common Real
Estate, since 2012;
Principal, Grey
Oaks LLP, since
2003; Member,
Kendrick LLC,
since 2006.
|
158 |
None. |
|
Jacob C.
Gaffey(3)
Age:
75 |
Trustee |
Lifetime of Trust
until removal or
resignation;
Since
2014 |
Managing
Director, Loomis &
Co., 2012 –2019.
|
158 |
None.
|
42
|
Name,
Address and Age |
Position(s)
Held
with
Fund |
Term of
Office
and Length
of
Time
Served |
Principal
Occupation(s)
During
Past Five
Years |
# of
Portfolios in
Direxion
Family of
Investment
Companies
Overseen
by
Trustee(4) |
Other
Trusteeships/
Directorships
Held
by Trustee
During
Past Five
Years |
|
Henry W.
Mulholland(3)
Age:
59 |
Trustee |
Lifetime of Trust
until removal or
resignation; Since
2017 |
Managing
Partner, Grove Hill
Partners LLC, since
2016. |
158 |
None. |
|
Kathleen
M. Berkery
Age:
55 |
Trustee |
Lifetime of Trust
until removal or
resignation; Since
2019 |
Chief Financial
Officer, Student
Sponsor Partners,
since November
2021; Senior
Manager - Trusts
& Estates, Rynkar,
Vail & Barrett,
LLC, since 2018;
Financial Advisor,
Lee, Nolan &
Koroghlian Life
Planning Group,
2010–2017. |
158 |
None. |
|
Carlyle
Peake
Age:
51 |
Trustee |
Lifetime of Trust
until removal or
resignation; Since
2022 |
Head of US &
LATAM Debt
Syndicate, BBVA
Securities, Inc.,
since
2011. |
158 |
None. |
|
Mary Jo
Collins
Age:
66 |
Trustee |
Lifetime of Trust
until removal or
resignation; Since
2022 |
Managing
Director, Imperial
Capital LLC, since
2020; Director,
Royal Bank of
Canada, 2014 –
2020. |
158 |
None. |
(1)
Mr. O’Neill is
affiliated with Rafferty and Direxion because he owns a beneficial interest in
Rafferty.
(2)
Ms. Brickl is
affiliated with Rafferty because she serves as an officer of
Rafferty.
(3)
Effective December 31, 2022, Mr.
Gaffey and Mr. Mulholland resigned as members of the Board.
(4)
The Direxion Family of Investment
Companies consists of the Direxion Shares ETF Trust which, as of the date of
this SAI, offers for sale to the public 87 of the 148 funds registered with the
SEC
and the Direxion Funds
which, as of the date of this SAI, offers for sale to the public 10 funds registered with the
SEC.
In
addition to the information set forth in the tables above and other relevant
qualifications, experience, attributes or skills applicable
to a particular Trustee, the following provides further information about the
qualifications and experience of each Trustee.
Daniel D.
O’Neill: Mr. O’Neill has extensive experience in the investment management
business. Mr.
O’Neill was the Managing Director of Rafferty from 1999 through January 2019 and
Chief Executive Officer at Rafferty from April 2021 through September
2022.
Angela Brickl:
Ms. Brickl has extensive experience in the investment management business,
including serving as President of Rafferty since September 2022.
Ms. Brickl also serves as Rafferty’s General Counsel and Chief Compliance
Officer.
David
L. Driscoll: Mr. Driscoll has extensive experience with risk assessment and
strategic planning as a partner and manager of various real
estate partnerships and companies.
Jacob
C. Gaffey: Mr. Gaffey has extensive experience with providing investment banking
and valuation services to various companies.
Henry
W. Mulholland: Mr. Mulholland has extensive experience with equity trading, risk
management, equity market structure as well as
managing regulatory and compliance matters.
Kathleen
M. Berkery: Ms. Berkery has extensive experience with estate planning, estate
administration, fiduciary income taxation,
financial planning, finance, as well as business sales and development, and
marketing.
Carlyle
Peake: Mr. Peake has extensive global capital markets experience, as well as
experience with client relations and sales of
securities by issuers and investors and valuing, structuring, and negotiating
complex debt issues for corporate and sovereign entities.
43
Mary
Jo Collins: Ms. Collins has extensive experience evaluating credit risk of
investment grade securities, including corporate bonds, preferred
stocks, and hybrid securities, as well as managing relationships with retail and
institutional investors.
Board
Committees
The Trust has an
Audit Committee, consisting of each Independent Trustee. The
primary responsibilities of the Trust’s Audit Committee are set forth in its
charter, which include making recommendations to the Board as to the engagement
or discharge of the Trust’s independent registered public accounting firm
(including the audit fees charged by the auditors), supervising investigations
into matters relating to audit matters, reviewing with the independent
registered public accounting firm of the results of audits, and addressing any
other matters regarding audits. The Audit Committee met three times during the
Trust’s most recent fiscal year.
The Trust also
has a Nominating and Governance Committee, consisting of each Independent Trustee. The
primary responsibilities of the Nominating and Governance Committee are to make
recommendations to the Board on issues related to the composition and operation
of the Board, and communicate with management on those issues. The Nominating
and Governance Committee also evaluates and nominates Board member candidates.
In evaluating Board member candidates, the Nominating and Governance Committee
considers the extent to which potential candidates possess sufficiently diverse
skill sets and diversity characteristics that would contribute to the Board’s
overall effectiveness. The Nominating and Governance Committee will consider
nominees recommended by shareholders. Such recommendations should be in writing
and addressed to a Fund with attention to the Nominating and Governance
Committee Chair. The recommendations must include the following preliminary
information regarding the nominee: (1) name; (2) date of birth; (3) education;
(4) business professional or other relevant experience and areas of expertise;
(5) current business, professional or other relevant experience and areas of
expertise; (6) current business and home addresses and contact information; (7)
other board positions or prior experience; and (8) any knowledge and experience
relating to investment companies and investment company governance. The
Nominating and Governance Committee met three times during the Trust’s most
recent fiscal year.
The Trust has a
Qualified Legal Compliance Committee, consisting of each Independent Trustee. The
primary responsibility of the Trust’s Qualified Legal Compliance Committee is to
receive, review and take appropriate action with respect to any report made or
referred to the Committee by an attorney of evidence of a material violation of
applicable U.S. federal or state securities law, material breach of a fiduciary
duty under U.S. federal or state law or a similar material violation by the
Trust or by any officer, director, employee or agent of the Trust. The Audit
Committee serves as the Qualified Legal Compliance Committee. The Qualified
Legal Compliance Committee did not meet during the Trust’s most recent fiscal
year.
Principal
Officers of the Trust
The
officers of the Trust conduct and supervise its daily business. Unless otherwise
noted, an individual’s business address is 1301 Avenue of
the Americas (6th Avenue), 28th Floor, New York, New York 10019. As of the date
of this SAI, the officers of the Trust, their ages, their business address and
their principal occupations during the past five years are as
follows:
44
|
Name,
Address and Age |
Position(s)
Held
with
Fund |
Term of
Office
and Length
of
Time
Served |
Principal
Occupation(s)
During
Past Five
Years |
# of
Portfolios in
the
Direxion
Family of
Investment
Companies
Overseen
by
Trustee(2)
|
Other
Trusteeships/
Directorships
Held
by Trustee
During
Past Five
Years |
|
Angela
Brickl
Age:
46 |
President |
One Year; Since
2022
|
President, Rafferty
Asset
Management,
LLC, since
September 2022;
Chief Operating
Officer, Rafferty
Asset
Management,
LLC, May 2021 –
September 2022;
General Counsel,
Rafferty Asset
Management LLC,
since October
2010; Chief
Compliance
Officer, Rafferty
Asset
Management,
LLC, September
2012–
September 2022.
|
N/A |
N/A |
|
Chief Compliance
Officer |
One Year; Since
2018 | ||||
|
Patrick J.
Rudnick
Age:
49 |
Principal Executive
Officer |
One Year;
Since
2018 |
Senior Vice
President, Rafferty
Asset
Management,
LLC, since March
2013.
|
N/A |
N/A |
|
Corey
Noltner
Age:
33 |
Principal Financial
Officer |
One Year;
Since
2021 |
Senior Business
Analyst, Rafferty
Asset
Management,
LLC, since October
2015. |
N/A |
N/A |
|
Alyssa
Sherman
Age:
33 |
Secretary |
One Year;
Since
2022 |
Associate General
Counsel, Rafferty
Asset
Management,
LLC, since April
2021; Associate,
K&L Gates LLP,
September 2015
– March
2021. |
N/A |
N/A |
(1)
Ms. Brickl serves on the Board of
Trustees of the Direxion Funds and Direxion Shares ETF
Trust.
(2)
The Direxion Family of Investment
Companies consists of the Direxion Shares ETF Trust which, as of the date of
this SAI, offers for sale to the public 87 of the 148 funds registered with the
SEC
and the Direxion Funds
which, as of the date of this SAI, offers for sale to the public 10 funds registered with the
SEC.
The
following table shows the amount of equity securities owned in each of the Funds
and the Direxion Family of Investment Companies by the
Trustees as of the calendar year ended December 31, 2021:
45
|
Dollar
Range of Equity
Securities
Owned: |
Interested
Trustee(2): |
Independent
Trustees(2): | |||
|
|
Daniel
D.
O’Neill |
David
L.
Driscoll |
Jacob
C.
Gaffey |
Henry
W.
Mulholland |
Kathleen
M.
Berkery |
|
Direxion
Monthly S&P 500® Bull
1.75X
Fund |
$0 |
$0 |
$0 |
$0 |
$0 |
|
Direxion
Monthly S&P 500®
Bear 1.75X
Fund |
$0 |
$0 |
$0 |
$0 |
$0 |
|
Direxion
Monthly NASDAQ-
100® Bull
1.75X Shares |
$0 |
$0 |
$0 |
$0 |
$0 |
|
Direxion
Monthly Small Cap
Bull 1.75X
Fund |
$0 |
$0 |
$0 |
$0 |
$0 |
|
Direxion
Monthly Small Cap
Bear 1.75X
Shares |
$0 |
$0 |
$0 |
$0 |
$0 |
|
Direxion
Monthly 7-10 Year
Treasury
Bull 1.75X Shares |
$0 |
$0 |
$0 |
$0 |
$0 |
|
Direxion
Monthly 7-10 Year
Treasury
Bear 1.75X Shares |
$0 |
$0 |
$0 |
$0 |
$0 |
|
Aggregate
Dollar Range of
Equity
Securities in the
Direxion
Family of Investment
Companies(1)
|
Over
$100,000 |
$0 |
$0 |
$0 |
$0 |
(1)
The Direxion Family of Investment
Companies consists of the Direxion Shares ETF Trust which, as of the date of
this SAI, offers for sale to the public 87 of the 148 funds registered with the
SEC, the Direxion Funds which, as of the date of this SAI, offers for sale to
the public 10 funds registered with the SEC and the Direxion Insurance Trust
which, as of the date of this SAI, does not have any funds registered with the
SEC.
(2)
Angela Brickl, Mary Jo Collins and
Carlyle Peake were elected to the Board of Trustees on March 11, 2022 and
therefore were not Trustees as of the calendar year ended December 31,
2021.
The
Trust’s Declaration of Trust provides that the Trustees will not be liable for
errors of judgment or mistakes of fact or law. However,
they are not protected against any liability to which they would otherwise be
subject by reason of willful misfeasance, bad faith, gross negligence or
reckless disregard of the duties involved in the conduct of their
office.
No officer,
director or employee of Rafferty receives any compensation from the Funds for
acting as a Trustee or officer of the Trust. The following table
shows the compensation earned by each Trustee for the Trust’s fiscal year ended
August 31, 2022:
|
Name
of Person,
Position |
Aggregate
Compensation
From
the
Trust(1)
|
Pension
or
Retirement
Benefits
Accrued
As Part of
the
Trust’s
Expenses |
Estimated
Annual
Benefits
Upon
Retirement |
Aggregate
Compensation
From the
Direxion
Family
of
Investment
Companies
Paid
to the
Trustees(2)
|
|
Interested
Trustee | ||||
|
Daniel D.
O’Neill |
$0 |
$0 |
$0 |
$0 |
|
Angela
Brickl |
$0 |
$0 |
$0 |
$0 |
|
Independent
Trustees | ||||
|
David L.
Driscoll |
$42,708 |
$0 |
$0 |
$170,833 |
|
Jacob C.
Gaffey |
$42,708 |
$0 |
$0 |
$170,833 |
|
Henry W.
Mulholland |
$42,708 |
$0 |
$0 |
$170,833 |
|
Kathleen
M. Berkery |
$42,708 |
$0 |
$0 |
$170,833 |
|
Mary Jo
Collins |
$33,803 |
$0 |
$0 |
$135,208 |
|
Carlyle
Peake |
$33,803 |
$0 |
$0 |
$135,208 |
(1)
Trustee
compensation is allocated across the operational Funds of the Trust based on the
proportion of the Fund’s net assets to the total net assets of the operational
Funds of the Trust.
(2)
For the fiscal year ended August
31, 2022, Trustees’ fees and expenses in the amount of $238,438 were incurred by
the Trust.
Principal
Shareholders, Control Persons and Management Ownership
A
principal shareholder is any person who owns of record or beneficially 5% or
more of the outstanding shares of a Fund. A control person
is a shareholder that owns beneficially or through controlled companies more
than 25% of the voting
46
securities
of a company or acknowledges the existence of control. Shareholders owning
voting securities in excess of 25% may determine the
outcome of any matter affecting and voted on by shareholders of a
Fund.
As of
December 1, 2022,
the following shareholders were considered to be either a principal shareholder
or control person of the Funds:
Direxion
Monthly S&P 500® Bull 1.75X
Fund
|
Name
and Address |
Parent
Company |
Jurisdiction |
%
Ownership |
Type
of
Ownership |
|
Charles
Schwab & Co Inc.
211 Main
Street
San
Francisco, CA 94105-1905 |
The Charles
Schwab
Corporation |
DE |
44.07% |
Record |
|
National
Financial Services LLC
499
Washington Boulevard
Jersey
City, NJ 07310-2010 |
Fidelity Global
Brokerage Group,
Inc. |
DE |
19.18% |
Record |
|
TD
Ameritrade Inc.
PO Box
2226
Omaha, NE
68103-2226 |
N/A |
N/A |
12.99% |
Record |
|
Axos
Clearing LLC
FBO #75 PO
Box 6503
Englewood,
CO 80155-6503 |
N/A |
N/A |
11.71% |
Record |
Direxion
Monthly S&P 500® Bear 1.75X
Fund
|
Name
and Address |
Parent
Company |
Jurisdiction |
%
Ownership |
Type
of
Ownership |
|
National
Financial Services LLC
499
Washington Boulevard
Jersey
City, NJ 07310-2010 |
Fidelity Global
Brokerage Group,
Inc. |
DE |
37.24% |
Record |
|
Charles
Schwab & Co Inc.
211 Main
Street
San
Francisco, CA 94105-1905 |
N/A |
N/A |
20.70% |
Record |
|
Axos
Clearing LLC
FBO #699
PO Box 6503
Englewood,
CO 80155-6503 |
N/A |
N/A |
20.29% |
Record |
|
TD
Ameritrade Inc.
PO Box
2226
Omaha, NE
68103-2226 |
N/A |
N/A |
10.82% |
N/A |
Direxion
Monthly NASDAQ-100® Bull 1.75X
Fund
|
Name
and Address |
Parent
Company |
Jurisdiction |
%
Ownership |
Type
of
Ownership |
|
Charles
Schwab & Co Inc.
211 Main
Street
San
Francisco, CA 94105-1905 |
The Charles
Schwab
Corporation |
DE |
34.97% |
Record |
|
National
Financial Services LLC
499
Washington Boulevard
Jersey
City, NJ 07310-2010 |
Fidelity Global
Brokerage Group,
Inc. |
DE |
34.22% |
Record |
|
TD
Ameritrade Inc.
PO Box
2226
Omaha, NE
68103-2226 |
N/A |
N/A |
16.78% |
Record |
Direxion
Monthly Small Cap Bull 1.75X Fund
|
Name
and Address |
Parent
Company |
Jurisdiction |
%
Ownership |
Type
of
Ownership |
|
National
Financial Services LLC
499
Washington Boulevard
Jersey
City, NJ 07310-2010 |
Fidelity Global
Brokerage Group,
Inc. |
DE |
40.60% |
Record |
|
Charles
Schwab & Co Inc.
211 Main
Street
San
Francisco, CA 94105-1905 |
N/A |
N/A |
19.74% |
Record |
|
TD
Ameritrade Inc.
PO Box
2226
Omaha, NE
68103-2226 |
N/A |
N/A |
15.62% |
N/A
|
47
|
Name
and Address |
Parent
Company |
Jurisdiction |
%
Ownership |
Type
of
Ownership |
|
Pershing
LLC
PO Box
2052
Jersey
City, NJ 070303-2052 |
N/A |
N/A |
9.07% |
Record |
Direxion
Monthly Small Cap Bear 1.75X Fund
|
Name
and Address |
Parent
Company |
Jurisdiction |
%
Ownership |
Type
of
Ownership |
|
National
Financial Services LLC
499
Washington Boulevard
Jersey
City, NJ 07310-2010 |
Fidelity Global
Brokerage Group,
Inc. |
DE |
34.09% |
Record |
|
Charles
Schwab & Co Inc.
211 Main
Street
San
Francisco, CA 94105-1905 |
N/A |
N/A |
22.45% |
N/A |
|
TD
Ameritrade Inc.
PO Box
2226
Omaha, NE
68103-2226 |
N/A |
N/A |
20.53% |
Record |
|
US Bank NA
Custodian for Barbara J Feldman
IRA
3100
Gaylord Avenue
Pittsburgh,
PA 15216-2420 |
N/A |
N/A |
8.33% |
N/A |
Direxion
Monthly 7-10 Year Treasury Bull 1.75X Fund
|
Name
and Address |
Parent
Company |
Jurisdiction |
%
Ownership |
Type
of
Ownership |
|
TD
Ameritrade Inc.
PO Box
2226
Omaha, NE
68103-2226 |
TD Ameritrade
Holding
Corporation |
NY |
37.80% |
Record |
|
National
Financial Services LLC
499
Washington Boulevard
Jersey
City, NJ 07310-2010 |
Fidelity Global
Brokerage Group,
Inc. |
DE |
34.24% |
Record |
|
Charles
Schwab & Co Inc.
211 Main
Street
San
Francisco, CA 94105-1905 |
N/A |
N/A |
12.44% |
Record |
|
Axos
Clearing LLC
FBO #75 PO
Box 6503
Englewood,
CO 80155-6503 |
N/A |
N/A |
6.30% |
Record |
Direxion
Monthly 7-10 Year Treasury Bear 1.75X Fund
|
Name
and Address |
Parent
Company |
Jurisdiction |
%
Ownership |
Type
of
Ownership |
|
National
Financial Services LLC
499
Washington Boulevard
Jersey
City, NJ 07310-2010 |
Fidelity Global
Brokerage Group,
Inc. |
DE |
74.32% |
Record |
|
Charles
Schwab & Co Inc.
211 Main
Street
San
Francisco, CA 94105-1905 |
N/A |
N/A |
10.38% |
N/A |
|
Axos
Clearing LLC
FBO #75 PO
Box 6503
Englewood,
CO 80155-6503 |
N/A |
N/A |
7.17% |
N/A |
In addition, as
of December 1, 2022,
the Trustees and Officers as a group did not own any of the outstanding shares
of each Fund.
Investment
Adviser
Rafferty,
1301 Avenue of the Americas (6th Avenue), 28th Floor, New York, New York 10019,
provides investment advice to the Funds.
Rafferty was organized as a New York limited liability company in June 1997.
Michael Rafferty and Kathleen Rafferty Hay control Rafferty through their
ownership in Rafferty Holdings, LLC and Daniel D. O’Neill controls Rafferty
through his ownership in Minakian Partners, LLC.
Under
an Investment Advisory Agreement (“Advisory Agreement”) between Rafferty and the
Trust, on behalf of each Fund, Rafferty provides
a continuous investment program for each Fund’s assets in accordance with its
investment objectives,
48
policies
and limitations, and oversees the day-to-day operations of each Fund, subject to
the supervision of the Trustees. Rafferty shall
not be liable to the Trust or any Fund for anything done or omitted by it,
except acts or omissions involving willful misfeasance, bad faith, negligence or
reckless disregard of the duties imposed upon it by its agreement with the Trust
or for any losses that may be sustained in the purchase, holding or sale of any
security. Rafferty bears all costs associated with providing these advisory
services and the expenses of the Trustees who are affiliated with or interested
persons of Rafferty. The Trust bears all other expenses that are not assumed by
Rafferty as described in the Prospectus. The Trust also is liable for
nonrecurring expenses as may arise, including litigation to which a Fund may be
a party. The Trust also may have an obligation to indemnify its Trustees and
officers with respect to any such litigation.
The
Advisory Agreement was initially approved by the Trustees (including all
Independent Trustees) and Rafferty, as sole shareholder of
each Fund in compliance with the 1940 Act. After an initial approval period of
two years, the Advisory Agreement is renewable with respect to each Fund, so
long as its continuance is approved at least annually (1) by the vote, cast at a
meeting called for that purpose, of a majority of the Independent Trustees of
the Trust; and (2) by the majority vote of either the full Board or the vote of
a majority of the outstanding shares of a Fund. The Advisory Agreement
automatically terminates on assignment and is terminable upon a 60-day written
notice either by the Trust or Rafferty.
Pursuant
to the Advisory Agreement, each Fund pays Rafferty a fee at an annualized rate
based on a percentage of its average daily net
assets of 0.75%.
Although each
Fund is responsible for its own operating expenses, Rafferty has entered into an
Operating Expense Limitation Agreement with each Fund. Under
this Operating Expense Limitation Agreement, Rafferty has contractually agreed
to cap all or a portion of its advisory fees and management services and/or
reimburse each Fund for Other Expenses (excluding, as applicable, among other
expenses, taxes, swap financing and related costs, acquired fund fees and
expenses, dividends or interest on short positions, other interest expenses,
brokerage commissions and extraordinary expenses) through September 1, 2024 to the extent that each Fund’s
Total Annual Fund Operating Expenses exceed 1.35% of each Fund’s average daily
net assets. Any expense waiver or reimbursement is subject to recoupment by the
Adviser within the three years after the expense was waived/reimbursed only if
Total Annual Fund Operating Expenses fall below the lesser of this percentage
limitation and any percentage limitation in place at the time the expense was
waived/reimbursed. This agreement may be terminated or revised at any time at
the discretion of the Board upon notice to the Adviser and without the approval
of Fund shareholders.
The tables below
show the advisory fees incurred by each of the Funds, the amount of fees waived
and/or reimbursed by Rafferty, and the total amount of
fees paid to Rafferty by each of the Funds for the last three fiscal years ended
August 31.
|
Direxion
Monthly NASDAQ-100(R) Bull 1.75X Fund |
Advisory
fee accrued |
Fees
waived and
expenses
absorbed by
Adviser |
Total
fees paid to
(waived
by)
Adviser |
|
Year Ended
August 31, 2022(1) |
$3,294,725 |
$77,085 |
$3,302,113 |
|
Year Ended
August 31, 2021(2) |
$3,290,788 |
$4,997 |
$3,285,791 |
|
Year Ended
August 31, 2020 |
$1,904,167 |
$51,960 |
$1,852,207 |
(1)
For the fiscal year ended August
31, 2022, the Adviser recouped previously waived expenses in the amount of
$84,473.
(2)
For the fiscal year ended August
31, 2021, the Adviser recouped previously waived expenses in the amount of
$141,900.
|
Direxion
Monthly S&P 500(R) Bull 1.75X Fund |
Advisory
fee accrued |
Fees
waived and
expenses
absorbed by
Adviser |
Total
fees paid to
(waived
by)
Adviser |
|
Year Ended
August 31, 2022(1) |
$846,645 |
$40,440 |
$842,146 |
|
Year Ended
August 31, 2021(2) |
$791,365 |
$7,319 |
$784,046 |
|
Year Ended
August 31, 2020 |
$555,860 |
$41,947 |
$513,913 |
(1)
For the fiscal year ended August
31, 2022, the Adviser recouped previously waived expenses in the amount of
$35,941.
(2)
For the fiscal year ended August
31, 2021, the Adviser recouped previously waived expenses in the amount of
$24,191.
|
Direxion
Monthly S&P 500(R) Bear 1.75X Fund |
Advisory
fee accrued |
Fees
waived and
expenses
absorbed by
Adviser |
Total
fees paid to
(waived
by)
Adviser |
|
Year Ended
August 31, 2022 |
$54,271 |
$40,678 |
$13,593 |
|
Year Ended
August 31, 2021 |
$60,936 |
$48,970 |
$11,966 |
|
Year Ended
August 31, 2020 |
$83,388 |
$49,489 |
$33,899 |
49
|
Direxion
Monthly Small Cap Bull 1.75X Fund |
Advisory
fee accrued |
Fees
waived and
expenses
absorbed by
Adviser |
Total
fees paid to
(waived
by)
Adviser |
|
Year Ended
August 31, 2022(1) |
$113,206 |
$38,003 |
$75,753 |
|
Year Ended
August 31, 2021 |
$159,416 |
$40,407 |
$119,009 |
|
Year Ended
August 31, 2020 |
$103,149 |
$38,346 |
$64,803 |
(1)
For the fiscal year ended August
31, 2022, the Adviser recouped previously waived expenses in the amount of
$550.
|
Direxion
Monthly Small Cap Bear 1.75X Fund |
Advisory
fee accrued |
Fees
waived and
expenses
absorbed by
Adviser |
Total
fees paid to
(waived
by)
Adviser |
|
Year Ended
August 31, 2022 |
$34,012 |
$40,158 |
$(6,146) |
|
Year Ended
August 31, 2021 |
$43,114 |
$44,525 |
$(1,411) |
|
Year Ended
August 31, 2020 |
$58,287 |
$44,010 |
$14,277 |
|
Direxion
Monthly 7-10 Year Treasury Bull 1.75X Fund |
Advisory
fee accrued |
Fees
waived and
expenses
absorbed by
Adviser |
Total
fees paid to
(waived
by)
Adviser |
|
Year Ended
August 31, 2022 |
$103,339 |
$43,334 |
$60,005 |
|
Year Ended
August 31, 2021(1) |
$228,761 |
$35,897 |
$192,864 |
|
Year Ended
August 31, 2020 |
$335,714 |
$57,505 |
$278,209 |
(1)
For the fiscal year
ended August 31, 2021, the Adviser recouped previously waived expenses in the
amount of $8,028.
|
Direxion
Monthly 7-10 Year Treasury Bear 1.75X Fund |
Advisory
fee accrued |
Fees
waived and
expenses
absorbed by
Adviser |
Total
fees paid to
(waived
by)
Adviser |
|
Year Ended
August 31, 2022 |
$38,827 |
$46,998 |
$(8,171) |
|
Year Ended
August 31, 2021 |
$30,221 |
$49,028 |
$(18,807) |
|
Year Ended
August 31, 2020 |
$13,165 |
$52,430 |
$(39,265) |
Pursuant
to the Management Services Agreement, Rafferty performs certain administrative
services on behalf of the Funds, such as
negotiating, coordinating and implementing the Trust’s contractual obligations
with the Funds' service providers; monitoring, overseeing and reviewing the
performance of such service providers to ensure adherence to applicable
contractual obligations; preparing or coordinating reports and presentations to
the Board of Trustees with respect to such service providers as requested or as
deemed necessary; and other services that are described in the Management
Services Agreement. For these services, the Trust pays to Rafferty a fee at the
annual rate of 0.026% on the first $10 billion of the aggregate average daily
net assets of the Funds in the Trust and 0.024% on the aggregate net assets
above $10 billion. This Management Services Fee may be waived under the
Operating Expense Limitation Agreement that Rafferty has entered into with each
Fund. This arrangement may be terminated at any time by the Board.
The
tables below show the Management Services Fees paid by each Fund as of the
fiscal years ended August 31:
|
Direxion
Monthly NASDAQ-100®
Bull 1.75X Fund |
Management
Fees Paid |
|
Year Ended
August 31, 2022 |
$108,263 |
|
Year Ended
August 31, 2021 |
$109,223 |
|
Year Ended
August 31, 2020 |
$64,578 |
|
Direxion
Monthly S&P 500®
Bull
1.75X Fund |
Management
Fees Paid |
|
Year Ended
August 31, 2022 |
$27,842 |
|
Year Ended
August 31, 2021 |
$26,274 |
|
Year Ended
August 31, 2020 |
$18,828 |
|
Direxion
Monthly S&P 500®
Bear
1.75X Fund |
Management
Fees Paid |
|
Year Ended
August 31, 2022 |
$1,788 |
|
Year Ended
August 31, 2021 |
$2,030 |
|
Year Ended
August 31, 2020 |
$2,833 |
50
|
Direxion
Monthly Small Cap Bull 1.75X Fund |
Management
Fees Paid |
|
Year Ended
August 31, 2022 |
$3,717 |
|
Year Ended
August 31, 2021 |
$5,298 |
|
Year Ended
August 31, 2020 |
$3,499 |
|
Direxion
Monthly Small Cap Bear 1.75X Fund |
Management
Fees Paid |
|
Year Ended
August 31, 2022 |
$1,121 |
|
Year Ended
August 31, 2021 |
$1,438 |
|
Year Ended
August 31, 2020 |
$1,982 |
|
Direxion
Monthly 7-10 Year Treasury Bull 1.75X Fund |
Management
Fees Paid |
|
Year Ended
August 31, 2022 |
$3,387 |
|
Year Ended
August 31, 2021 |
$7,623 |
|
Year Ended
August 31, 2020 |
$11,403 |
|
Direxion
Monthly 7-10 Year Treasury Bear 1.75X Fund |
Management
Fees Paid |
|
Year Ended
August 31, 2022 |
$1,275 |
|
Year Ended
August 31, 2021 |
$1,002 |
|
Year Ended
August 31, 2020 |
$447 |
Pursuant
to Section 17(j) of the 1940 Act and Rule 17j-1 thereunder, the Trust, Rafferty
and the Funds' distributor have adopted Codes of
Ethics. These codes permit portfolio managers and other access persons of a Fund
to invest in securities that may be owned by a Fund, subject to certain
restrictions.
Portfolio
Managers
Paul
Brigandi and Tony Ng are jointly and primarily responsible for the day-to-day
management of the Funds. An investment trading team of
Rafferty employees assists Mr. Brigandi and Mr. Ng in the day-to-day management
of the Funds subject to their primary responsibility and oversight. The
Portfolio Managers work with the investment trading team to decide the target
allocation of each Fund’s investments and, on a day-to-day basis, an individual
portfolio trader executes transactions for the Funds consistent with the target
allocation. The members of the investment trading team rotate periodically among
the various series of the Trust, including the Funds, so that no single
individual is assigned to a specific Fund for extended periods of
time.
In addition to
the Funds, Mr. Brigandi and Mr. Ng manage the following other accounts as of
August 31,
2022:
|
Accounts |
Total
Number
of
Accounts |
Total
Assets
(In
Billions) |
Total
Number of
Accounts
with
Performance
Based
Fees |
Total
Assets
of
Accounts
with
Performance
Based
Fees |
|
Registered
Investment Companies |
90 |
$20.4 |
0 |
$0 |
|
Other
Pooled Investment Vehicles |
0 |
$0 |
0 |
$0 |
|
Other
Accounts |
0 |
$0 |
0 |
$0 |
Rafferty
manages no other accounts with investment objectives similar to those of the
Funds. However, two or more funds advised by
Rafferty may invest in the same securities but the nature of each investment
(long or short) may be opposite and in different proportions. Rafferty
ordinarily executes transactions for a Fund “market-on-close,” in which funds
purchasing or selling the same security receive the same closing
price.
Rafferty
has not identified any additional material conflicts between a Fund and other
accounts managed by the investment team. However,
other actual or apparent conflicts of interest may arise in connection with the
day-to-day management of a Fund and other accounts. The management of a Fund and
other accounts may result in unequal time and attention being devoted to a Fund
and other accounts. Rafferty’s management fees for the services it provides to
other accounts varies and may be higher or lower than the advisory fees it
receives from a Fund. This could create potential conflicts of interest in which
the portfolio manager may appear to favor one investment vehicle over another
resulting in an account paying higher fees or one investment vehicle out
performing another.
The
investment team’s compensation is paid by Rafferty. Their compensation primarily
consists of a fixed base salary and a bonus. The
investment team’s salary is reviewed annually and increases are determined by
factors such as performance and seniority. Bonuses are determined by the
individual performance of an employee including factors such as attention
51
to
detail, process, and efficiency, and are impacted by the overall performance of
the firm. The investment team’s salary and bonus are not
based on a Fund’s performance and as a result, no benchmarks are used. Along
with all other employees of Rafferty, the investment team may participate in the
firm’s 401(k) retirement plan where Rafferty may make matching contributions up
to a defined percentage of their salary.
Mr. Brigandi
and Mr. Ng did not own any shares of the Funds as of August 31, 2022.
Proxy
Voting Policies and Procedures
The
Board has adopted policies and procedures with respect to voting proxies (the
“Proxy Policy”) related to portfolio securities of the
Funds. Pursuant to these policies and procedures the Board of the Trust has
delegated responsibility for voting such proxies to the Adviser, subject to the
Board’s continuing oversight.
The
Proxy Policy is intended to protect shareholder interests and comply with
applicable state and federal corporate and securities laws.
It applies to any voting rights with respect to securities held in accounts of
the Funds. To assist the Adviser in its responsibility for voting proxies and
administering the overall proxy voting process, the Adviser has retained
Institutional Shareholder Services (“ISS”) as an expert in the proxy voting and
corporate governance area. ISS is a subsidiary of Vestar Capital Partners VI,
L.P.; a leading U.S. middle market private equity firm. The services provided by
ISS include in-depth research, global issuer analysis, and voting
recommendations as well as vote execution, reporting and record keeping. ISS
issues monthly reports which are reviewed by the Adviser to assure proxies are
being voted properly. The Adviser and ISS also perform checks on a quarterly
basis to match the voting activity with available shareholder meeting
information. ISS’ management meets on a regular basis to discuss its approach to
new developments and amendments to existing proxy voting guidelines (the
“Guidelines”). Information on such developments and amendments are then provided
to the Adviser.
The
Guidelines are maintained and implemented by ISS and are an extensive list of
common proxy voting issues with recommended voting actions
based on the overall goal of achieving maximum shareholder value and protection
of shareholder interests and rights. Generally, proxies are voted in accordance
with the voting recommendations contained in the Guidelines. If necessary, the
Adviser will be consulted by ISS on non-routine issues. Proxy issues and factors
considered when resolving proxy issues in the Guidelines include, but are not
limited to:
•
Election of
Directors –
considering all factors such as director qualifications, term of office and age
limits.
•
Proxy Contests
–
considering factors such as voting nominees in contested elections and
reimbursement of expenses.
•
Election of
Auditors –
considering factors such as independence and reputation of the auditing
firm.
•
Proxy Contest
Defenses –
considering factors such as board structure and cumulative voting.
•
Tender Offer
Defenses –
considering factors such as poison pills (stock purchase rights plans) and fair
price provisions.
•
Miscellaneous
Governance Issues –
considering factors such as confidential voting and equal access.
•
Capital Structure
–
considering factors such as common stock authorization and stock
distributions.
•
Executive and
Director Compensation –
considering factors such as performance goals and employee stock purchase
plans.
•
State of
Incorporation –
considering factors such as state takeover statutes and voting on
reincorporation proposals.
•
Mergers and
Corporate Restructuring –
considering factors such as spin-offs and asset sales.
•
Mutual Fund Proxy
Voting –
considering factors such as election of directors and proxy
contests.
•
Social and
Corporate Responsibility Issues –
considering factors such as social, environmental, and labor issues.
A
full description of the Guidelines and voting policy is maintain by the Adviser,
and a complete copy of the Guidelines is available without
charge, upon request by calling the Adviser at (800)
851-0511.
Conflicts
of Interest
From time to
time, proxy issues may pose a material conflict of interest between the Funds'
shareholders and the Adviser, the Distributor or any affiliates
thereof. Due to the limited nature of the Adviser’s activities (e.g., no underwriting business, no
publicly-traded affiliates, no investment banking activities, and no research
recommendations), conflicts of interest are likely to be infrequent.
Nevertheless, it is the duty of the Adviser to monitor potential conflicts of
interest. In the event a conflict of interest arises, the Adviser will be
responsible for voting the proxy,
will communicate how
the proxy should be voted to ISS, and will confirm ISS voted the proxy
consistent with the Adviser’s direction.
Proxy
Voting Recordkeeping
The
Adviser, with the assistance of ISS, maintains for a period of at least five
years, a record of each proxy statement received and materials
that were considered when the proxy was voted during the calendar year.
Information on how the Funds voted proxies relating to portfolio securities for
the 12-month (or shorter) period ended June 30 is available without charge, upon
request, by calling the Adviser at (800)
851-0511 or on the SEC’s
website at http://www.sec.gov.
52
Fund
Administrator, Fund Accountant, Transfer Agent and Custodian
U.S.
Bancorp Fund Services, LLC (“Administrator”), 615 East Michigan Street,
Milwaukee, Wisconsin 53202, provides administrative, fund accounting
and transfer agent services to the Funds. U.S. Bank, N.A., Custody Operations,
1555 N. River Center Drive, Suite 302, Milwaukee, Wisconsin, 53202, an affiliate
of the Administrator, provides custodian services to the Funds.
Pursuant
to an Administration Servicing Agreement (“Service Agreement”) between the Trust
and the Administrator, the Administrator
provides the Trust with administrative and certain management services (other
than investment advisory services). As compensation for these services, the
Trust pays the Administrator a fee based on the Trust’s total average daily net
assets. The Administrator also is entitled to certain out-of-pocket
expenses.
Pursuant
to a Fund Accounting Servicing Agreement between the Trust and U.S. Bancorp Fund
Services, LLC (“Fund Accountant”), the Fund
Accountant provides the Trust with accounting services, including portfolio
accounting services, tax accounting services and furnishing financial reports.
For these services, the Trust pays the Fund Accountant a fee based on the
Trust’s total average daily net assets. The Fund Accountant also is entitled to
certain out-of-pocket expenses, including pricing expenses.
Pursuant
to a Custody Agreement, U.S. Bank N.A. (“Custodian”) serves as the custodian of
the Fund’s assets. The Custodian holds and
administers the assets in the Fund’s portfolios. Pursuant to the Custody
Agreement, the Custodian receives an annual fee based on the Trust’s total
average daily net assets. The Custodian also is entitled to certain
out-of-pocket expenses. U.S. Bank N.A. and/or its affiliates receive revenue
from certain broker-dealers that may receive Rule 12b-1 fees or other payments
from mutual funds in which the Fund may invest. In recognition of this revenue,
each Fund has received credits and may receive credits in future years from U.S.
Bank N.A. and/or its affiliates for fees otherwise payable by the
Funds.
The
amount of fees paid by the Trust pursuant to the Agreements noted above, for the
fiscal years indicated, is set forth in the table below.
|
|
Fees paid
to the Administrator |
|
Year Ended
August 31, 2022 |
$95,209 |
|
Year Ended
August 31, 2021 |
$107,840 |
|
Year Ended
August 31, 2020 |
$99,265 |
Distributor
Foreside
Fund Services, LLC, located at 3 Canal Plaza, Suite 100, Portland, Maine 04101,
serves as the distributor (“Distributor”) in connection
with the continuous offering of each Fund’s shares. The Distributor is a
broker-dealer registered with the SEC under the Exchange Act and a member of the
Financial Industry Regulatory Authority. The Distributor and participating
dealers with whom it has entered into dealer agreements offer shares of each
Fund as agents on a best efforts basis and are not obligated to sell any
specific amount of shares.
Distribution
Plan and Service Fees
Rule
12b-1 under the 1940 Act, as amended (the “Rule”), provides that an investment
company may bear expenses of distributing its
shares only pursuant to a plan adopted in accordance with the Rule. The Trustees
have adopted a Rule 12b-1 Investor Class Plan of Distribution (the “Investor
Class Plan”) for shares of each Fund pursuant to which each Fund may pay certain
expenses incurred in the distribution of its shares and the servicing and
maintenance of existing shareholder accounts. The Distributor, as the Funds'
principal underwriter, and Rafferty may have a direct or indirect financial
interest in the Investor Class Plan or any related agreement.
Pursuant
to the Investor Class Plan, each Fund may pay up to 1.00% of the shares’ average
daily net assets. The Board has authorized each
Fund to pay 0.25% of the Fund’s average daily net assets.
Under
an agreement with the Funds, your financial advisor may provide services, as
described in the Prospectus, and as described above,
and receive Rule 12b-1 fees from the Funds.
The
Investor Class Plan was approved by the Trustees and the Independent Trustees of
the Funds. In approving the Investor Class Plan, the
Trustees determined that there is a reasonable likelihood that the Investor
Class Plan will benefit each Fund and its shareholders. The Trustees will review
quarterly and annually a written report provided by the Treasurer of the amounts
expended under the Investor Class Plan and the purpose for which such
expenditures were made.
The
Investor Class Plan permits payments to be made by each Fund to the Distributor
or other third parties for expenditures incurred in
connection with the distribution of Fund shares to investors. The Distributor or
other third parties are authorized to engage in advertising, the preparation and
distribution of sales literature and other promotional activities on behalf of
the Funds. In addition, the Investor Class Plan authorizes payments by the Funds
to the Distributor or other third parties
53
for
the cost related to selling or servicing efforts, preparing, printing and
distributing Fund prospectuses, statements of additional
information, and shareholder reports to investors.
The tables below
show the amount of Rule 12b-1 fees incurred and the allocation of such fees by
each Fund for the fiscal period ended August 31,
2022.
|
Fund
(Investor Class) |
12b-1
Fees
Incurred |
|
Direxion
Monthly NASDAQ-100®
Bull 1.75X
Fund |
$1,098,242 |
|
Direxion
Monthly S&P 500® Bull
1.75X
Fund |
$282,215 |
|
Direxion
Monthly S&P 500® Bear
1.75X
Fund |
$18,090 |
|
Direxion
Monthly Small Cap Bull
1.75X
Fund |
$37,736 |
|
Direxion
Monthly Small Cap
Bear 1.75X
Fund |
$11,337 |
|
Direxion
Monthly 7-10 Year
Treasury
Bull 1.75X Fund |