Beginning in January 2021, as permitted by regulations adopted by the Securities and Exchange Commission, the fund intends to no longer mail paper copies of
the funds shareholder reports, unless you specifically request paper copies of the reports from your financial intermediary (such as a broker-dealer or bank). Instead, the reports will be made available on a website, and you will be notified
by mail each time a report is posted and provided with a website link to access the report.
If you already elected to receive shareholder reports electronically
(e-delivery), you will not be affected by this change and you need not take any action. If you have not already elected e-delivery, you may elect to receive shareholder reports and other communications from the fund electronically by
contacting your financial intermediary.
You may elect to receive all future reports in paper free of charge by contacting your financial intermediary to request
that you continue to receive paper copies of your shareholder reports. Your election to receive reports in paper will apply to all Legg Mason Funds held in your account with your financial intermediary.
The Securities and Exchange Commission has not approved or disapproved these securities or
determined whether this Prospectus is accurate or complete. Any statement to the contrary is a crime.
Western Asset Total Return ETF (the fund) seeks to maximize total return, consistent with prudent investment management and liquidity needs.
The accompanying table describes the fees and expenses that you may pay if you buy and hold shares of the fund. You may also incur usual and customary brokerage
commissions and other charges when buying or selling shares of the fund, which are not reflected in the table. The management agreement between Legg Mason ETF Investment Trust (the Trust) and Legg Mason Partners Fund Advisor, LLC
(LMPFA or the manager) (the Management Agreement) provides that LMPFA will pay all operating expenses of the fund, except interest expenses, taxes, brokerage expenses, future Rule 12b-1 fees (if any), acquired
fund fees and expenses, extraordinary expenses and the management fee payable to LMPFA under the Management Agreement. LMPFA will also pay all subadvisory fees of the fund.
This example is intended to help you compare the cost of investing in the fund with the cost of investing in other funds. The example assumes:
You may also incur usual and customary
brokerage commissions and other charges when buying or selling shares of the fund, which are not reflected in the example.
Although your actual costs may be higher
or lower, based on these assumptions your costs would be:
Under normal market conditions, the fund will seek its investment objective by investing at least 80% of its assets in a
portfolio comprised of fixed income securities, debt instruments, derivatives, equity securities of any type acquired in reorganizations of issuers of fixed income securities or debt instruments (work out securities), non-convertible
preferred securities, warrants, cash and cash equivalents, foreign currencies, and exchange-traded funds (ETFs) that provide exposure to these investments (Principal Investments). Debt instruments include loans and similar
debt instruments.
As part of its 80% policy, the fund intends to invest in derivatives that (i) provide exposure to the Principal Investments,
(ii) are used to risk manage the funds holdings, and/or (iii) are used to enhance returns. The risk management uses of derivatives will include managing (i) investment-related risks, (ii) risks due to fluctuations in
securities prices, interest rates, or currency exchanges rates, (iii) risks due to the credit-worthiness of an issuer, and (iv) the effective duration of the funds portfolio. The types of derivatives in which the fund will invest
include swaps and security-based swaps, futures and options on futures, currency forwards, and currency options and security options. As a result of the funds use of derivatives and to serve as collateral, the fund may also hold significant
amounts of U.S. Treasury securities, cash and cash equivalents and foreign currencies in which certain derivatives are denominated.
The types of fixed income
securities in which the fund may invest include corporate debt securities, U.S. and non-U.S. government securities, asset-backed securities (ABS), mortgage-backed securities (MBS) (including commercial MBS (CMBS),
residential MBS (RMBS) and non-agency collateralized mortgage obligations (CMOs)), collateralized debt obligations (CDOs) and mortgage dollar rolls. The fixed income securities and debt instruments in which the
fund may invest may pay fixed, variable or floating rates of interest. The fund will not invest more than 20% of its portfolio in ABS and non-agency, non-government sponsored enterprise and privately-issued MBS or more than 10% of the funds
total assets in CDOs. The fund will also not invest more than 20% of its total assets in junior loans (e.g., debt instruments that are unsecured and subordinated).
Although the fund may invest in securities and debt instruments of any maturity, the fund expects the normal range of the funds effective duration to be
approximately 2 to 9 years. Effective duration seeks to measure the expected sensitivity of market price to changes in interest rates, taking into account the anticipated effects of structural complexities (for example, some bonds can be prepaid by
the issuer).
The fund may invest up to 30% of its assets in below investment grade fixed income securities or debt instruments. For these purposes, investment
grade is defined as investments with a rating at the time of purchase in one of the four highest categories of at least one nationally recognized statistical rating organization (NRSRO) (e.g., BBB- or higher or Baa3 or higher) or,
if unrated, securities of comparable quality at the time of purchase (as determined by the subadviser). Securities rated below investment grade (e.g., BB+ to D or Baa1 to C) or, if unrated, securities of comparable quality at the time of purchase
(as determined by the subadviser) are commonly known as junk bonds or high yield securities.
The fund may invest in securities issued by
both U.S. and non-U.S. issuers (including issuers in emerging markets), but the fund will not invest more than 30% of its total assets in securities or debt instruments of non-U.S. issuers or more than 25% of its total assets directly in non-U.S.
dollar denominated securities or debt instruments. For purposes of these limitations only, derivatives, warrants and U.S.-listed ETFs that provide indirect exposure to the investments described above will not be counted by the fund in calculating
its holdings in non-U.S. issuers or in non-U.S. dollar denominated securities or debt instruments.
Risk is inherent in all investing. The value of your investment in the fund, as well as the amount of return you receive on your investment,
may fluctuate significantly. You may lose part or all of your investment in the fund or your investment may not perform as well as other similar investments. An investment in the fund is not insured or guaranteed by the Federal Deposit
Insurance Corporation or by any bank or government agency. The following is a list of the principal risks of investing in the fund. The descriptions appear in alphabetical order, not order of importance.
Swap agreements tend to shift the funds investment exposure from one type of investment to another. For example, the fund may enter into interest rate swaps, which
involve the exchange of interest payments by the fund with another party, such as an exchange of floating rate payments for fixed interest rate payments with respect to a notional amount of principal. If an interest rate swap intended to be used as
a hedge negates a favorable interest rate movement, the investment performance of the fund would be less than what it would have been if the fund had not entered into the interest rate swap.
Credit default swap contracts involve heightened risks and may result in losses to the fund. Credit default swaps may be illiquid and difficult to value, and they
increase credit risk since the fund has exposure to both the issuer whose credit is the subject of the swap and the counterparty to the swap.
The primary risks associated with the use of futures contracts are: (a) the imperfect correlation between the change
in market value of the instruments held by the fund and the price of the futures contract; (b) the possible lack of a liquid secondary market for a futures contract and the resulting inability to close a futures contract when desired;
(c) losses caused by unanticipated market movements, which are potentially unlimited; (d) the subadvisers inability to predict correctly the direction of securities prices, interest rates, currency exchange rates and other economic
factors; and (e) the possibility that the counterparty will default in the performance of its obligations.
To the extent that the fund writes or sells an
option, in particular a naked option, if the decline or increase in the underlying asset is significantly below or above the exercise price of the written option, the fund could experience a substantial loss.
The value of investments in securities denominated in foreign currencies increases or decreases as the rates of exchange between those currencies and the U.S. dollar
change. Currency conversion costs and currency fluctuations could erase investment gains or add to investment losses. Currency exchange rates can be volatile, and are affected by factors such as general economic conditions, the actions of the
U.S. and foreign governments or central banks, the imposition of currency controls and speculation. The fund may be unable or may choose not to hedge its foreign currency exposure.
Less developed markets are more likely to experience problems with the clearing and settling of trades and the holding of securities by local banks, agents and
depositories. Settlement of trades in these markets can take longer than in other markets and the fund may not receive its proceeds from the sale of certain securities for an extended period (possibly several weeks or even longer).
The risks of foreign investments are heightened when investing in issuers in emerging market countries. Emerging market countries tend to have economic, political and
legal systems that are less developed and are less stable than those of more developed countries. They are often particularly sensitive to market movements because their market prices tend to reflect speculative expectations. Low trading
volumes may result in a lack of liquidity and in extreme price volatility.
additional investments or to meet the funds redemption obligations. Because junior loans are unsecured and subordinated and thus lower in priority of payment to senior loans, they are
subject to the additional risk that the cash flow of the borrower and property securing the loan or debt, if any, may be insufficient to meet scheduled payments after giving effect to the senior secured obligations of the borrower. Bank loans
may not be considered securities and therefore, the fund may not have the protections afforded by U.S. federal securities laws with respect to such investments.
The maturity of a security may be significantly
longer than its duration. A securitys maturity and other features may be more relevant than its duration in determining the securitys sensitivity to other factors affecting the issuer or markets generally such as changes in credit
quality or in the yield premium that the market may establish for certain types of securities.
The rapid and global spread of a highly contagious novel coronavirus respiratory disease, designated
COVID-19, first detected in China in December 2019, has resulted in extreme volatility in the financial markets and severe losses; reduced liquidity of many instruments; restrictions on international and, in some cases, local travel; significant
disruptions to business operations (including business closures); strained healthcare systems; disruptions to supply chains, consumer demand and employee availability; and widespread uncertainty regarding the duration and long-term effects of this
pandemic. Some sectors of the economy and individual issuers have experienced particularly large losses. In addition, the COVID-19 pandemic may result in a sustained economic downturn or a global recession, domestic and foreign political and social
instability, damage to diplomatic and international trade relations and increased volatility and/or decreased liquidity in the securities markets. The ultimate economic fallout from the pandemic, and the long-term impact on economies, markets,
industries and individual issuers, are not known. The U.S. government and the Federal Reserve, as well as certain foreign governments and central banks, are taking extraordinary actions to support local and global economies and the financial markets
in response to the COVID-19 pandemic, including by pushing interest rates to very low levels. This and other government intervention into the economy and financial markets to address the COVID-19 pandemic may not work as intended, particularly if
the efforts are perceived by investors as being unlikely to achieve the desired results. The COVID-19 pandemic could adversely affect the value and liquidity of the funds investments, impair the funds ability to satisfy redemption
requests, and negatively impact the funds performance. In addition, the outbreak of COVID-19, and measures taken to mitigate its effects, could result in disruptions to the services provided to the fund by its service providers.
may be less willing to transact in fund shares. The absence of an active market for the funds shares may contribute to the funds shares trading at a premium or discount to NAV.
These and other risks are discussed in more detail in the Prospectus or in the Statement of Additional Information.
Management
Investment manager: Legg Mason Partners Fund Advisor, LLC
(LMPFA)
Subadviser: Western Asset
Management Company, LLC
Sub-subadvisers: Western
Asset Management Company Limited in London (Western Asset London), Western Asset Management Company Pte. Ltd. in Singapore (Western Asset Singapore) and Western Asset Management Company Ltd in Japan (Western Asset
Japan). References to the subadviser include the subadviser and each applicable sub-subadviser.
On February 18, 2020,
Franklin Resources, Inc. (Franklin Resources) and Legg Mason, Inc. (Legg Mason) announced that they have entered into a definitive agreement for Franklin Resources to acquire Legg Mason in an all-cash transaction. As part of
this transaction, LMPFA and the subadviser(s), each currently a wholly owned subsidiary of Legg Mason, would become a wholly owned subsidiary of Franklin Resources. The transaction is subject to approval by Legg Masons shareholders and
customary closing conditions, including receipt of applicable regulatory approvals. Subject to such approvals and the satisfaction of the other conditions, the transaction is expected to be consummated in the latter part of 2020. Under the
Investment Company Act of 1940, as amended (the 1940 Act), consummation of the transaction will result in the automatic termination of the management and subadvisory agreements. Therefore, the funds Board of Trustees has approved
new management and subadvisory agreements that will be presented to the shareholders of the fund for their approval. Additional informational materials will be mailed to shareholders.
Investment professionals: Primary responsibility for the
day-to-day management of the fund lies with the following investment professionals. These investment professionals, all of whom are employed by Western Asset, work together with a broader investment management team.
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Investment professional
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Title
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Investment professional of the fund since
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S. Kenneth Leech
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Chief Investment Officer
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2018
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John Bellows
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Portfolio Manager and Research Analyst
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2018
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Mark S. Lindbloom
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Portfolio Manager
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2018
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Frederick R. Marki
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Portfolio Manager
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2018
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Julien A. Scholnick
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Portfolio Manager
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2018
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Purchase and sale of fund shares
The fund is an actively managed exchange-traded fund (commonly referred to as an ETF). Individual shares of the fund are listed on a national securities
exchange and are redeemable only by Authorized Participants in Creation Units (as defined in this section). Most investors will buy and sell shares of the fund through a broker-dealer. The price of fund shares is based on market price, and because
ETF shares trade at market prices rather than at net asset value, shares may trade at a price greater than net asset value (a premium) or less than net asset value (a discount). The fund will only issue or redeem shares that have been aggregated
into blocks of 100,000 shares or multiples thereof (Creation Units) to Authorized Participants who have entered into agreements with the funds distributor. The fund will issue or redeem Creation Units in return for a designated
portfolio of securities and/or cash that the fund specifies each day.
Tax information
The funds distributions are generally taxable and will be taxed as ordinary income or capital gains.
Payments to broker/dealers and other financial intermediaries
If you purchase shares of the fund through a broker-dealer or other financial intermediary (such as a bank), LMPFA or other related companies may pay the intermediary
for marketing activities and presentations, educational training programs, conferences, the development of technology platforms and reporting systems or other services related to the sale or promotion of the fund. These payments may create a
conflict of interest by influencing the broker-dealer or other intermediary and your salesperson to recommend the fund over another investment. Ask your salesperson or visit your financial intermediarys website for more information.
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More on the funds investment strategies, investments and risks
Introduction
The fund is an
actively managed exchange-traded fund (ETF), and the shares of the fund are listed for trading on NASDAQ. The market price for a share of the fund may be different from the funds most recent net asset value (NAV).
ETFs are funds that trade like other publicly traded securities. Unlike shares of a mutual fund, which can be bought and redeemed from the issuing fund by all
shareholders at a price based on NAV, shares of the fund may be purchased or redeemed directly from the fund at NAV solely by Authorized Participants. Also unlike shares of a mutual fund, shares of the fund are listed on a national securities
exchange and trade in the secondary market at market prices that change throughout the day.
Investment objective
The fund seeks to maximize total return, consistent with prudent investment management and liquidity needs.
Principal investment strategies
Under
normal market conditions, the fund will seek its investment objective by investing at least 80% of its assets in a portfolio comprised of fixed income securities, debt instruments, derivatives, equity securities of any type acquired in
reorganizations of issuers of fixed income securities or debt instruments (work out securities), non-convertible preferred securities, warrants, cash and cash equivalents, foreign currencies, and exchange-traded funds (ETFs)
that provide exposure to these investments (Principal Investments). Debt instruments include loans and similar debt instruments.
As part of its 80%
policy, the fund intends to invest in derivatives that (i) provide exposure to the Principal Investments, (ii) are used to risk manage the funds holdings, and/or (iii) are used to enhance returns, such as through covered call
strategies. The risk management uses of derivatives will include managing (i) investment-related risks, (ii) risks due to fluctuations in securities prices, interest rates, or currency exchanges rates, (iii) risks due to the
credit-worthiness of an issuer, and (iv) the effective duration of the funds portfolio. The types of derivatives in which the fund will invest include swaps and security-based swaps, futures and options on futures, currency forwards, and
currency options and security options. As a result of the funds use of derivatives and to serve as collateral, the fund may also hold significant amounts of U.S. Treasury securities, cash and cash equivalents and foreign currencies in which
certain derivatives are denominated.
The types of fixed income securities in which the fund may invest include corporate debt securities, U.S. and non-U.S.
government securities, asset-backed securities (ABS), mortgage-backed securities (MBS) (including commercial MBS (CMBS), residential MBS (RMBS) and non-agency collateralized mortgage obligations
(CMOs)), collateralized debt obligations (CDOs) and mortgage dollar rolls. The fixed income securities and debt instruments in which the fund may invest may pay fixed, variable or floating rates of interest. The fund will not
invest more than 20% of its portfolio in ABS and non-agency, non-government sponsored enterprise and privately-issued MBS or more than 10% of the funds total assets in CDOs. The fund will also not invest more than 20% of its total assets in
junior loans (e.g., debt instruments that are unsecured and subordinated).
Although the fund may invest in securities and debt instruments of any maturity, the
fund expects the normal range of the funds effective duration to be approximately 2 to 9 years. Effective duration seeks to measure the expected sensitivity of market price to changes in interest rates, taking into account the anticipated
effects of structural complexities (for example, some bonds can be prepaid by the issuer).
The fund may invest up to 30% of its assets in below investment grade
fixed income securities or debt instruments. For these purposes, investment grade is defined as investments with a rating at the time of purchase in one of the four highest categories of at least one nationally recognized statistical
rating organization (NRSRO) (e.g., BBB- or higher or Baa3 or higher) or, if unrated, securities of comparable quality at the time of purchase (as determined by the subadviser). Securities rated below investment grade (e.g., BB+ to D or
Baa1 to C) or, if unrated, securities of comparable quality at the time of purchase (as determined by the subadviser) are commonly known as junk bonds or high yield securities.
The fund may invest in securities issued by both U.S. and non-U.S. issuers (including issuers in emerging markets), but the fund will not invest more than 30% of its
total assets in securities or debt instruments of non-U.S. issuers or more than 25% of its total assets directly in non-U.S. dollar denominated securities or debt instruments. For purposes of these limitations only, derivatives, warrants and
U.S.-listed ETFs that provide indirect exposure to the investments described above will not be counted by the fund in calculating its holdings in non-U.S. issuers or in non-U.S. dollar denominated securities or debt instruments.
Investment Professionals and Security Selection. Western Assets investment process combines top-down and bottom-up analyses. Western Assets US Broad
Strategy Committee, which is chaired by the Chief Investment Officer, leads the investment process by considering macro-economic and securities-specific insights and ideas covering all major bond market segments from all of its macro-economic and
credit research teams around the globe, and formulates the broad top-down investment outlook, including a set of strategies around duration, yield curve, country, currency and sector.
The US Broad Market portfolios team is ultimately responsible for the funds portfolio construction, making sure that allocations are consistent with Western
Assets overall investment themes while adhering to strategy risk/return profiles and specific guidelines. This includes duration, curve, country, currency and sector positioning. The portfolio managers of the fund are S. Kenneth Leech, Mark S.
Lindbloom, Julien A. Scholnick, Frederick R. Marki and John L. Bellows. These investment professionals, all of whom are employed by Western Asset, work together with a broader investment management team (collectively, the Investment
Professionals).
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Western Asset Total Return ETF
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The Investment Professionals conduct bottom-up fundamental research and provide input into the top-down perspectives.
A top-down view incorporates macro-economic views on growth, inflation, and fiscal and monetary policy, as well as views on sectors (such as corporates which trade at spreads over U.S. Treasuries) and current general market conditions
and valuation levels. This top-down view translates into a set of strategies regarding duration, yield curve, country, currency and sector. The Investment Professionals provide fundamental analysis at sector and subsector levels. Incorporating the
macro-economic views of the US Broad Strategy Committee and the risk profile of the funds portfolio, the Investment Professionals balance these inputs with their industry/issuer insights in setting sector overweights and underweights.
Bottom up fundamental research involves detailed analysis of individual securities, issuers, sectors and sub-sectors. The Investment Professionals use a security-specific process in order to assess whether securities are mispriced or
undervalued in their opinion and select securities for the funds portfolio. The Investment Professionals conduct an ongoing assessment of changing credit characteristics and of securities with characteristics such as assets perceived to be
overlooked or under-appreciated, floating or fixed interest rates, credit quality and securities issued in mergers, as well as newly-issued securities. Using sector and issue analyses, the Investment Professionals select issues opportunistically in
order to exploit perceived mispricings versus long-term fundamental value that exist in the market.
The subadviser monitors a broad set of factors that may prompt
it to consider selling or reducing a position focused on the risk/reward characteristics of a credit. Factors include the following: whether total return and/or valuation targets have been realized, whether there have been significant changes in
macro/micro economic analyses indicating that sector emphasis should be changed, whether industry conditions have deteriorated, whether the issuer has changed its business strategy, whether credit fundamentals have deteriorated and whether the
subadviser finds better relative value elsewhere in the bond market.
Maturity and duration
The fund may invest in securities of any maturity. The maturity of a fixed income security is a measure of the time remaining until the final payment on the security is
due. The fund expects the normal range of the funds effective duration to be approximately 2 to 9 years. The effective duration of the fund may fall outside of its expected range due to market movements. If this happens, the funds
subadviser will take action to bring the funds effective duration back within its expected range within a reasonable period of time.
Effective duration seeks
to measure the expected sensitivity of market price to changes in interest rates, taking into account the anticipated effects of particular features of a security (for example, some bonds can be prepaid by the issuer). The assumptions that are made
about a securitys features and options when calculating effective duration may prove to be incorrect. As a result, investors should be aware that effective duration is not an exact measurement and may not reliably predict a securitys
price sensitivity to changes in yield or interest rates.
Generally, the longer a funds effective duration, the more sensitive it will be to changes in
interest rates. For example, if interest rates rise by 1%, a fund with a two year effective duration would expect the value of its portfolio to decrease by 2% and a fund with a ten year effective duration would expect the value of its portfolio to
decrease by 10%, all other factors being equal.
The maturity of a security may be significantly longer than its effective duration. A securitys maturity
may be more relevant than its effective duration in determining the securitys sensitivity to other factors such as changes in credit quality or in the difference in yield between U.S. Treasuries and certain other types of securities.
Credit quality
The continued holding of a
security downgraded below its rating at the time of purchase will be evaluated on a case by case basis. As a result, the fund may from time to time hold debt securities that are rated below investment grade in excess of the amounts described in its
investment limitations. Securities rated below investment grade are commonly known as junk bonds or high yield securities. To the extent not addressed above, in the event that NRSROs assign different ratings to the same
security, the subadviser will treat the security as being rated in the highest rating category received from any one NRSRO. Rating categories may include sub-categories or gradations indicating relative standing.
Derivatives
The fund may engage in a variety of
transactions using derivatives, such as swaps and security-based swaps, futures and options on futures, currency forwards, currency options and swaps, swaptions and other synthetic instruments. Derivatives are financial instruments whose value
depends upon, or is derived from, the value of something else, such as one or more underlying investments, indexes or currencies. Derivatives may be used by the fund for any of the following purposes:
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As a means of attempting to manage risk in the funds portfolio
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As a means of attempting to enhance returns, such as through covered call strategies
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As a means of providing exposure to Principal Investments
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The fund from time to time may sell protection on debt securities by entering into credit default swaps. In these transactions, the fund is generally required to pay the
par (or other agreed-upon) value of a referenced debt security to the counterparty in the event of a default on or downgrade of the debt security and/or a similar credit event. In return, the fund receives from the counterparty a periodic stream of
payments over the term of the contract. If no default occurs, the fund keeps the stream of payments and has no payment obligations. As the seller, the fund would effectively add leverage to its portfolio because, in addition to its net assets, the
fund would be subject to loss on the par (or other agreed-upon) value it had undertaken to pay. Credit default swaps may also be structured based on an index or the debt of a basket of issuers, rather than a single issuer, and
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Western Asset Total Return ETF
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may be customized with respect to the default event that triggers purchase or other factors (for example, a particular number of defaults within a basket, or defaults by a particular combination
of issuers within the basket, may trigger a payment obligation).
The fund may buy credit default swaps to hedge against the risk of default of debt securities held
in its portfolio or for other reasons. As the buyer of a credit default swap, the fund would make the stream of payments described in the preceding paragraph to the seller of the credit default swap and would expect to receive from the seller a
payment in the event of a default on the underlying debt security or other specified event.
Using derivatives, especially for non-hedging purposes, may involve
greater risks to the fund than investing directly in securities, particularly as these instruments may be very complex and may not behave in the manner anticipated by the fund. Certain derivative transactions may have a leveraging effect on the
fund.
Use of derivatives or similar instruments may have different tax consequences for the fund than an investment in the underlying security, and those
differences may affect the amount, timing and character of income distributed to shareholders.
When the fund enters into derivative transactions, it may be required
to segregate assets, or enter into offsetting positions, in accordance with applicable regulations. Such segregation will not limit the funds exposure to loss, however, and the fund will have investment risk with respect to both the derivative
itself and the assets that have been segregated to cover the funds derivative exposure. If the segregated assets represent a large portion of the funds portfolio, this may impede portfolio management or the funds ability to meet
redemption requests or other current obligations.
Instead of, and/or in addition to, investing directly in particular securities, the fund may use derivatives and
other synthetic instruments that are intended to provide economic exposure to securities, issuers or other measures of market or economic value. The fund may use one or more types of these instruments to the extent consistent with its 80% policy.
The funds subadviser may choose not to make use of derivatives.
Fixed income securities
Fixed income securities represent obligations of corporations, governments and other entities to repay money
borrowed, usually at the maturity of the security. These securities may pay fixed, variable or floating rates of interest. However, some fixed income securities, such as zero coupon bonds, do not pay current interest but are issued at a discount
from their face values. Other fixed income securities, such as certain MBS and ABS (as further described under Asset-backed and mortgage-backed securities), make periodic payments of interest and/or principal. Some fixed income
securities are partially or fully secured by collateral supporting the payment of interest and principal.
Variable and floating rate
securities
Variable rate securities reset at specified intervals, while floating rate securities reset whenever there is a change in a specified index
rate. In most cases, these reset provisions reduce the impact of changes in market interest rates on the value of the security. However, the value of these securities may decline if their interest rates do not rise as much, or as quickly,
as other interest rates. Conversely, these securities will not generally increase in value if interest rates decline. The fund may also invest in inverse floating rate debt instruments (inverse floaters). Interest payments on
inverse floaters vary inversely with changes in interest rates. Inverse floaters pay higher interest (and therefore generally increase in value) when interest rates decline, and vice versa. An inverse floater may exhibit greater price volatility
than a fixed rate obligation of similar credit quality.
Stripped securities
Certain fixed income securities, called stripped securities, represent the right to receive either payments of principal (POs) or payments of interest
(IOs) on underlying pools of mortgages or on government securities. The value of these types of instruments may change more drastically during periods of changing interest rates than debt securities that pay both principal and interest.
Interest-only and principal-only mortgage-backed securities are especially sensitive to interest rate changes, which can affect not only their prices but can also change the prepayment assumptions about those investments and income flows the fund
receives from them.
Corporate debt
Corporate debt securities are fixed income securities usually issued by businesses to finance their operations. Various types of business entities may issue these
securities, including corporations, trusts, limited partnerships, limited liability companies and other types of non-governmental legal entities. 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 unsecured status. Commercial paper has the shortest term and is usually unsecured. The broad category of corporate debt securities includes debt issued by U.S. or non-U.S.
companies of all kinds, including those with small, mid and large capitalizations. Corporate debt may carry variable or floating rates of interest.
Loans
The primary risk in an investment in loans is that borrowers may be unable to meet their interest and/or principal payment
obligations. Loans in which the fund invests may be made to finance highly leveraged borrowers which may make such loans especially vulnerable to adverse changes in economic or market conditions. Loans in which the fund may invest may be either
collateralized or uncollateralized and senior or subordinate (including covenant lite loans). Investments in uncollateralized and/or subordinate loans entail a greater risk of nonpayment than do investments in loans that hold a more senior position
in the borrowers capital structure and/or are secured with collateral. In addition, loans are generally subject
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to illiquidity risk. The fund may acquire an interest in loans by purchasing participations in and/or assignments of portions of loans from third parties or by investing in pools of loans, such
as collateralized debt obligations as further described under Collateralized debt obligations. Transactions in loans may settle on a delayed basis. As a result, the proceeds from the sale of a loan may not be available to make additional
investments or to meet the funds redemption obligations. Bank loans may not be considered securities and therefore, the fund may not have the protections afforded by U.S. federal securities laws with respect to such investments.
Government securities
U.S. government
securities are obligations of, or guaranteed by, the U.S. government, its agencies or government-sponsored entities. U.S. government securities include issues by non-governmental entities (like financial institutions) that carry direct guarantees
from U.S. government agencies as part of government initiatives in response to the market crisis or otherwise. Although the U.S. government guarantees principal and interest payments on securities issued by the U.S. government and some of its
agencies, such as securities issued by the Government National Mortgage Association (Ginnie Mae), this guarantee does not apply to losses resulting from declines in the market value of these securities. Some of the U.S. government
securities that the fund may hold are not guaranteed or backed by the full faith and credit of the U.S. government, such as those issued by Fannie Mae (formally known as the Federal National Mortgage Association) and Freddie Mac (formally known as
the Federal Home Loan Mortgage Corporation).
Sovereign debt
The fund may invest in sovereign debt, including emerging market sovereign debt. Sovereign debt securities may include:
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Fixed income securities issued or guaranteed by governments, governmental agencies or instrumentalities and their political
subdivisions
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Fixed income securities issued by government-owned, controlled or sponsored entities
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Interests issued for the purpose of restructuring the investment characteristics of instruments issued by any of the above
issuers
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Brady Bonds, which are debt securities issued under the framework of the Brady Plan as a means for debtor nations to
restructure their outstanding external indebtedness
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Participations in loans between governments and financial institutions
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Fixed income securities issued by supranational entities such as the World Bank. A supranational entity is a bank,
commission or company established or financially supported by the national governments of one or more countries to promote reconstruction or development
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Sovereign government and supranational debt involve many of the risks of foreign and emerging markets investments as well as the risk of debt moratorium, repudiation or
renegotiation and the fund may be unable to enforce its rights against the issuers.
Asset-backed and mortgage-backed securities
MBS represent direct or indirect participations in, or are collateralized by and payable from, mortgage loans secured by real property. MBS may be issued
by private issuers, by government-sponsored entities such as Fannie Mae or Freddie Mac or issued or guaranteed by agencies of the U.S. government, such as Ginnie Mae.
Unlike MBS issued or guaranteed by agencies of the U.S. government or government-sponsored entities, MBS issued by private issuers do not have a government or
government-sponsored entity guarantee (but may have other credit enhancement), and may, and frequently do, have less favorable collateral, credit risk or other underwriting characteristics.
A RMBS is comprised of a pool of mortgage loans created by banks and other financial institutions. CMBS are a type of MBS backed by commercial mortgages rather than
residential real estate.
CMOs are debt obligations collateralized by mortgage loans or mortgage pass-through securities. CMOs are a type of MBS. Typically, CMOs are
collateralized by Ginnie Mae, Fannie Mae or Freddie Mac Certificates, but may also be collateralized by whole loans or private pass-throughs (referred to as Mortgage Assets). Payments of principal and of interest on the Mortgage Assets,
and any reinvestment income thereon, provide the funds to pay debt service on the CMOs. In a CMO, a series of bonds or certificates is issued in multiple classes. Each class of CMOs, often referred to as a tranche, is issued at a
specified fixed or floating coupon rate and has a stated maturity or final distribution date. Principal prepayments on the Mortgage Assets may cause the CMOs to be retired substantially earlier than their stated maturities or final distribution
dates. Interest is paid or accrues on all classes of the CMOs on a monthly, quarterly or semi-annual basis. The principal of and interest on the Mortgage Assets may be allocated among the several classes of a series of a CMO in innumerable ways. As
market conditions change, and particularly during periods of rapid or unanticipated changes in market interest rates, the attractiveness of the CMO classes and the ability of the structure to provide the anticipated investment characteristics may be
significantly reduced. Such changes can result in volatility in the market value, and in some instances reduced liquidity, of the CMO class.
ABS are securities,
which may be issued by either a U.S. or foreign entity, that are collateralized by any type of financial asset, such as a consumer-related loan (e.g., credit card receivables, student loans and automobile loans), a lease, or a secured or unsecured
receivable. ABS exclude (1) securities collateralized by residential or commercial mortgage loans, MBS, or other financial assets derivatives of MBS and (2) CDOs.
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Collateralized debt obligations
CDOs are comprised of collateralized bond obligations (CBOs) and collateralized loan obligations (CLOs). CBOs are securities issued by a trust or
other special purpose entity that are backed by a diversified pool of fixed income securities issued by U.S. or foreign governmental entities or fixed income securities issued by U.S. or corporate issuers. CLOs are securities issued by a trust or
other special purpose entity that are collateralized by a pool of loans by U.S. banks and participations in loans by U.S. banks that are unsecured or secured by collateral other than real estate. CDOs are distinguishable from ABS because they are
collateralized by bank loans or by corporate or government fixed income securities and not by consumer, and other loans made by non-bank lenders, including student loans. Like CMOs, CDOs generally issue separate series or tranches which
vary with respect to risk and yield. These tranches can experience substantial losses due to actual defaults, increased sensitivity to defaults due to collateral default and disappearance of subordinate tranches, market anticipation of defaults, as
well as investor aversion to CDO securities as a class. Interest on certain tranches of a CDO may be paid in kind (paid in the form of obligations of the same type rather than cash), which involves continued exposure to default risk with respect to
such payments.
Municipal securities
Municipal securities include general obligation bonds, revenue bonds, housing authority bonds, private activity bonds, industrial development bonds, residual interest
bonds, tender option bonds, tax and revenue anticipation notes, bond anticipation notes, tax-exempt commercial paper, municipal leases, participation certificates and custodial receipts. General obligation bonds are backed by the full faith and
credit of the issuing entity. Revenue bonds are typically used to fund public works projects, such as toll roads, airports and transportation facilities, that are expected to produce income sufficient to make the payments on the bonds, since they
are not backed by the full taxing power of the municipality. Housing authority bonds are used primarily to fund low to middle income residential projects and may be backed by the payments made on the underlying mortgages. Tax and revenue
anticipation notes are generally issued in order to finance short-term cash needs or, occasionally, to finance construction. Tax and revenue anticipation notes are expected to be repaid from taxes or designated revenues in the related fiscal period,
and they may or may not be general obligations of the issuing entity. Bond anticipation notes are issued with the expectation that their principal and interest will be paid out of proceeds from renewal notes or bonds and may be issued to
finance such items as land acquisition, facility acquisition and/or construction and capital improvement projects.
Foreign and emerging
markets securities
The fund may invest its assets in securities of foreign issuers, including mortgage-backed securities and asset-backed securities
issued by foreign entities. The value of the funds foreign securities may decline because of unfavorable government actions, political instability or the more limited availability of accurate information about foreign issuers, as well as
factors affecting the particular issuers. The fund may invest in foreign securities issued by issuers located in emerging market countries. The fund considers a country to be an emerging market country, if, at the time of investment, it is
represented in the J.P. Morgan Emerging Market Bond Index Global or the J.P. Morgan Corporate Emerging Market Bond Index Broad or categorized by the World Bank in its annual categorization as middle- or low-income. To the extent the fund invests in
these securities, the risks associated with investment in foreign issuers will generally be more pronounced.
Preferred stock and
convertible securities
The fund may invest in preferred stock and convertible securities. Preferred stock represents equity ownership of an issuer
that generally entitles the holder to receive, in preference to the holders of common stock, dividends and a fixed share of the proceeds resulting from a liquidation of the company. Preferred stocks may pay dividends at fixed or variable
rates. Convertible fixed income securities convert into shares of common stock of their issuer. Preferred stock and convertible fixed income securities share investment characteristics of both fixed income and equity securities. However, the
value of these securities tends to vary more with fluctuations in the underlying common stock and less with fluctuations in interest rates and tends to exhibit greater volatility.
Equity securities
Although the fund invests
principally in fixed income securities and related investments, the fund may from time to time invest in or receive equity securities and equity-like securities, which include warrants, rights, exchange traded and over-the-counter common stocks,
baskets of equity securities such as exchange traded funds, depositary receipts, trust certificates, limited partnership interests and shares of other investment companies and real estate investment trusts.
Equity securities represent an ownership interest in the issuing company. Holders of equity securities are not creditors of the company, and in the event of the
liquidation of the company, would be entitled to their pro rata share of the companys assets, if any, after creditors, including the holders of fixed income securities, and holders of any senior equity securities are paid. Equity securities
generally have greater price volatility than fixed income securities.
Warrants and rights permit, but do not obligate, their holders to subscribe for other
securities. Warrants and rights are subject to the same market risks as stocks, but may be more volatile in price. An investment in warrants or rights may be considered speculative. In addition, the value of a warrant or right does not necessarily
change with the value of the underlying securities and a warrant or right ceases to have value if it is not exercised prior to its expiration date.
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Securities of other investment companies
The fund may invest in securities of other investment companies to the extent permitted under the Investment Company Act of 1940, as amended, and the rules thereunder
(the 1940 Act). The return on investments in other registered investment companies will be reduced by the operating expenses, including investment advisory expenses, of such companies, and by any sales loads or other distribution and/or
service fees or charges incurred in purchasing or selling shares of such companies, in addition to the funds own fees and expenses. As such, there is a layering of fees and expenses.
Credit downgrades and other credit events
Credit rating or credit quality of a security is determined at the time of purchase. If, after purchase, the credit rating on a security is downgraded or the credit
quality deteriorates, or if the duration of a security is extended, the subadviser will decide whether the security should be held or sold. Upon the occurrence of certain triggering events or defaults on a security held by the fund, or if an obligor
of such a security has difficulty meeting its obligations, the fund may obtain a new or restructured security or underlying assets. In that case, the fund may become the holder of securities or other assets that it could not purchase or might not
otherwise hold (for example, because they are of lower quality or are subordinated to other obligations of the issuer) at a time when those assets may be difficult to sell or can be sold only at a loss. In addition, the fund may incur expenses
in an effort to protect the funds interest in securities experiencing these events.
Zero coupon, pay-in-kind and deferred interest
securities
Zero coupon, pay-in-kind and deferred interest securities may be used by issuers to manage cash flow and maintain liquidity. Zero coupon
securities pay no interest during the life of the obligation but are issued at prices below their stated maturity value. Because zero coupon securities pay no interest until maturity, their prices may fluctuate more than other types of securities
with the same maturity in the secondary market. However, zero coupon bonds are useful as a tool for managing duration.
Pay-in-kind securities have a stated coupon,
but the interest is generally paid in the form of obligations of the same type as the underlying pay-in-kind securities (e.g., bonds) rather than in cash. These securities are more sensitive to the credit quality of the underlying issuer and their
secondary market prices may fluctuate more than other types of securities with the same maturity.
Deferred interest securities are obligations that generally
provide for a period of delay before the regular payment of interest begins and are issued at a significant discount from face value.
Certain zero coupon,
pay-in-kind and deferred interest securities are subject to tax rules applicable to debt obligations acquired with original issue discount. The fund would generally have to accrue income on these securities for federal income tax
purposes before it receives corresponding cash payments. Because the fund intends to make sufficient annual distributions of its taxable income, including accrued non-cash income, in order to maintain its federal income tax status and avoid
fund-level income and excise taxes, the fund might be required to liquidate portfolio securities at a disadvantageous time, or borrow cash, to make these distributions. The fund also accrues income on these securities prior to receipt for accounting
purposes. To the extent it is deemed collectible, accrued income is taken into account when calculating the value of these securities and the funds net asset value per share, in accordance with the funds valuation policies.
When-issued securities, delayed delivery, to be announced and forward commitment transactions
Securities purchased in when-issued, delayed delivery, to be announced or forward commitment transactions will not be delivered or paid for immediately. The fund will
set aside assets to pay for these securities at the time of the agreement. Such transactions involve a risk of loss, for example, if the value of the securities declines prior to the settlement date or if the assets set aside to pay for these
securities decline in value prior to the settlement date. Therefore, these transactions may have a leveraging effect on the fund, making the value of an investment in the fund more volatile and increasing the funds overall investment exposure.
Typically, no income accrues on securities the fund has committed to purchase prior to the time delivery of the securities is made, although the fund may earn income on securities it has set aside to cover these positions. Recently finalized rules
of the Financial Industry Regulatory Authority (FINRA) impose mandatory margin requirements for certain types of when-issued, to be announced or forward commitment transactions, with limited exceptions. Such transactions historically
have not been required to be collateralized, and mandatory collateralization could increase the cost of such transactions and impose added operational complexity.
Mortgage dollar roll transactions
In a mortgage
dollar roll transaction, there is a simultaneous sale and purchase of an MBS for different settlement dates, where the initial seller agrees to take delivery, upon settlement of the re-purchase transaction, of the same or substantially similar
securities. During the roll period, the fund forgoes principal and interest paid on the securities. The fund is compensated by the difference between the current sales price and the forward price for the future purchase as well as by the
interest earned on the cash proceeds of the initial sale. The fund may enter into a mortgage dollar roll transaction with the intention of entering into an offsetting transaction whereby, rather than accepting delivery of the security on the
specified date, the fund sells the security and agrees to repurchase a similar security at a later time.
Investments in mortgage dollar roll transactions involve a
risk of loss if the value of the securities that the fund is obligated to purchase declines below the purchase price prior to the repurchase date. Mortgage dollar roll transactions may have a leveraging effect on the fund (see When-issued
securities, delayed delivery, to be announced and forward commitment transactions).
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Short-term investments
The fund may invest in cash, money market instruments and short-term securities, including repurchase agreements, U.S. government securities, bank obligations and
commercial paper. Bank obligations include certificates of deposit, time deposits and bankers acceptances. A repurchase agreement is a transaction in which the fund purchases a security from a seller, subject to the obligation of the seller to
repurchase that security from the fund at a higher price. The repurchase agreement thereby determines the yield during the funds holding period, while the sellers obligation to repurchase is secured by the value of the underlying
security held by the fund. The fund may also invest in money market funds, which may or may not be registered under the 1940 Act and/or affiliated with the funds manager or the subadviser. The return on investment in these money market funds
may be reduced by such money market funds operating expenses in addition to the funds own fees and expenses. As such, there is a layering of fees and expenses.
Borrowings and reverse repurchase agreements
The fund may enter into borrowing transactions. Borrowing may make the value of an investment in the fund more volatile and increase the funds overall investment
exposure. The fund may be required to liquidate portfolio securities at a time when it would be disadvantageous to do so in order to make payments with respect to any borrowings. Interest on any borrowings will be a fund expense and will reduce
the value of the funds shares.
The fund may enter into reverse repurchase agreements, which have characteristics like borrowings. In a reverse repurchase
agreement, the fund sells securities to a counterparty, in return for cash, and the fund agrees to repurchase the securities at a later date and for a higher price, representing the cost to the fund for the cash received.
Restricted and illiquid securities
Restricted
securities are securities subject to legal or contractual restrictions on their resale. An illiquid security is any security which the 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 security. Such conditions might prevent the sale of such securities at a time when the sale would otherwise be desirable. The fund will not acquire
illiquid securities if such acquisition would cause the aggregate value of illiquid securities to exceed 15% of the funds net assets. The fund may determine that some restricted securities can be more readily sold, for example to
qualified institutional buyers pursuant to SEC Rule 144A, and therefore may treat certain such securities as liquid for purposes of limitations on the amount of illiquid securities it may own. Investing in these restricted securities
could have the effect of increasing the funds illiquidity if qualified buyers become, for a time, uninterested in buying these securities. These securities may be difficult to value, and the fund may have difficulty disposing of such
securities promptly. The fund does not consider non-U.S. securities to be restricted if they can be freely sold in the principal markets in which they are traded, even if they are not registered for sale in the United States.
Structured instruments
The fund may invest
in various types of structured instruments, including securities that have demand, tender or put features, or interest rate reset features. These may include instruments issued by structured investment or special purpose vehicles or conduits, and
may be asset-backed or mortgage-backed securities. Structured instruments may take the form of participation interests or receipts in underlying securities or other assets, and in some cases are backed by a financial institution serving as a
liquidity provider. The interest rate or principal amount payable at maturity on a structured instrument may vary based on changes in one or more specified reference factors, such as currencies, interest rates, commodities, indices or other
financial indicators. Changes in the underlying reference factors may result in disproportionate changes in amounts payable under a structured instrument. Some of these instruments may have an interest rate swap feature which substitutes a floating
or variable interest rate for the fixed interest rate on an underlying asset or index. Structured instruments are a type of derivative instrument and the payment and credit qualities of these instruments derive from the assets embedded in the
structure. For structured securities that have embedded leverage features, small changes in interest or prepayment rates may cause large and sudden price movements. Structured instruments are often subject to heightened illiquidity risk.
Non-U.S. currency transactions
The fund may
engage in non-U.S. currency exchange transactions in an effort to protect against uncertainty in the level of future exchange rates or to enhance returns based on expected changes in exchange rates. Non-U.S. currency exchange transactions may take
the form of options, futures, options on futures, swaps, warrants, structured notes, forwards or spot (cash) transactions. The value of these non-U.S. currency transactions depends on, and will vary based on fluctuations in, the value of the
underlying currency relative to the U.S. dollar.
Inflation-indexed, inflation-protected and related securities
Inflation-indexed and inflation-protected securities are fixed income securities that are structured to provide protection against inflation and whose principal value or
coupon (interest payment) is periodically adjusted according to the rate of inflation. If the index measuring inflation falls, the principal value or coupon of these securities will be adjusted downward. Consequently, the interest payable on these
securities will be reduced. Also, if the principal value of these securities is adjusted according to the rate of inflation, the adjusted principal value repaid at maturity may be less than the original principal.
Inflation-protected securities denominated in the U.S. dollar include U.S. Treasury Inflation Protected Securities (U.S. TIPS), as well as other bonds issued
by U.S. and non-U.S. government agencies and instrumentalities or corporations and derivatives related to these securities. U.S. TIPS are inflation-protected securities issued by the U.S. Department of the Treasury the principal amounts of which are
adjusted daily based upon changes in
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Western Asset Total Return ETF
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the rate of inflation (as currently represented by the non-seasonally adjusted Consumer Price Index for All Urban Consumers, calculated with a three-month lag). U.S. TIPS pay interest
semiannually, equal to a fixed percentage of the inflation-adjusted principal amount. The interest rate on these bonds is fixed at issuance, but over the life of the bond, this interest may be paid on an increasing or decreasing principal amount
that has been adjusted for inflation. The current market value of U.S. TIPS is not guaranteed and will fluctuate.
The value of inflation-indexed and
inflation-protected securities held by the fund fluctuates in response to changes in real interest rates. In addition, if nominal interest rates increase at a faster rate than inflation, causing real interest rates to rise, it will lead to a
decrease in the value of inflation-indexed or inflation-protected securities.
The fund may invest in other fixed-income securities that, in the belief of the
funds subadviser, will provide protection against inflation, including floating rate and other short duration securities. Floating rate securities bear interest at rates that are not fixed but vary with changes in specified market rates or
indices, such as the prime rate, and at specified intervals.
Exchange-traded funds (ETFs)
The fund may invest in ETFs that are registered as investment companies under the 1940 Act. Typically, an ETF seeks to track (positively or negatively) the performance
of an index by holding in its portfolio either the same securities that comprise the index or a representative sample of the index. Investing in an ETF gives the fund exposure to the securities comprising the index on which the ETF is based and the
fund will gain or lose value depending on the performance of the index. The fund will indirectly bear its proportionate share of the management fees and other expenses that are charged by the ETF in addition to the management fees and other expenses
paid by the fund. The fund will also pay brokerage commissions in connection with the purchase and sale of shares of ETFs.
Covered calls
The funds covered call strategy focuses on options on U.S. Treasury futures. In entering an options contract, the buyer is purchasing the right to
buy (called a call option) or to sell (called a put option) the underlying futures contract. For example, a call option on a 10-year U.S. Treasury Note, gives the buyer the right to assume a long position on it while the seller is obligated to take
a short position if the buyer chooses to exercise the option. In the case of a put option, the buyer has the right to a short position in the 10-year U.S. Treasury Note futures contract while the seller in this case must assume a long position in
the futures contract. An option is said to be covered if the option writer (seller) holds an offsetting position in the underlying futures contract. For example, a writer of a 10-year U.S Treasury Note futures contract would be called covered if the
seller either owns cash market U.S. Treasury Notes or is long on the 10-year U.S. Treasury Note futures contract. The sellers risk in selling a covered call is limited as the obligation towards the buyer can be met either by the ownership of
the futures position or the cash security tied to the underlying futures contract.
Defensive investing
The fund may depart from its principal investment strategies in response to adverse market, economic or political conditions by taking temporary defensive positions,
including by investing in any type of money market instruments and short-term debt securities or holding cash without regard to any percentage limitations. Although the subadvisers have the ability to take defensive positions, they may choose
not to do so for a variety of reasons, even during volatile market conditions.
Other investments
The fund may also use other strategies and invest in other investments that are described, along with their risks, in the Statement of Additional Information
(SAI). However, the fund might not use all of the strategies and techniques or invest in all of the types of investments described in this Prospectus or in the SAI.
Percentage and other limitations
The
funds compliance with its investment limitations (other than the limitation on borrowing) and requirements described in this Prospectus is usually determined at the time of investment. If such a percentage limitation is complied with at the
time of an investment, any subsequent change resulting from a change in asset values or characteristics will not constitute a violation of that limitation.
Important information
The funds investment objective may be changed by the Board of Trustees (the Board) without
shareholder approval and on 60 days notice to shareholders. There is no assurance that the fund will meet its investment objective.
The fund will consider an
issuer to be a non-U.S. issuer if the issuer is a non-U.S. government (including any sub-division, agency or instrumentality of a non-U.S. government), a supranational entity or any other issuer (including corporate issuers) organized
under the laws of a country outside of the United States and having a principal place of business outside of the United States. The fund will consider all other issuers to be U.S. issuers.
The fund will consider the entity that issues the security backed by the pool of assets supporting a MBS or ABS to be the issuer for purposes of its
investment limitations set forth above.
The funds 80% investment policy may be changed by the Board without shareholder approval upon 60 days prior
notice to shareholders.
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The funds other investment strategies and policies may be changed from time to time without shareholder approval,
unless specifically stated otherwise in this Prospectus or in the SAI.
More on risks of investing in the fund
Following is more information on the principal risks summarized above and additional risks of investing in the fund.
Below are descriptions of the main factors that may play a role in shaping the funds overall risk profile. The descriptions appear in alphabetical order, not in
order of importance.
Asset-backed and mortgage-backed securities risk. MBS and ABS, like traditional fixed-income securities, are subject to credit, interest rate, prepayment and extension risks.
Small movements in interest rates (both increases and decreases) may quickly and significantly reduce the value of certain MBS. The funds investments in ABS are
subject to risks similar to those associated with mortgage-related securities, as well as additional risks associated with the nature of the assets and the servicing of those assets. These securities also are subject to the risk of default on the
underlying mortgage or assets, particularly during periods of economic downturn. The risk of loss due to default on private MBS and ABS is historically higher because neither the U.S. government nor an agency or instrumentality has guaranteed them.
Certain CMBS are issued in several classes with different levels of yield and credit protection. The funds investments in CMBS with several classes may be in the lower classes that have greater risks than the higher classes, including greater
interest rate, credit and prepayment risks. MBS and ABS are subject to heightened illiquidity risk and the liquidity of MBS and ABS may change over time.
MBS
may be either pass-through securities or CMOs. Pass-through securities represent a right to receive principal and interest payments collected on a pool of mortgages, which are passed through to security holders. CMOs are created by dividing the
principal and interest payments collected on a pool of mortgages into several revenue streams (tranches) with different priority rights to portions of the underlying mortgage payments. Certain CMO tranches may represent a right to receive interest
only (IOs), principal only (POs) or an amount that remains after floating-rate tranches are paid (an inverse floater). These securities are frequently referred to as mortgage derivatives and may be extremely
sensitive to changes in interest rates. Interest rates on inverse floaters, for example, vary inversely with a short-term floating rate (which may be reset periodically). Interest rates on inverse floaters will decrease when short-term rates
increase, and will increase when short-term rates decrease. These securities have the effect of providing a degree of investment leverage. In response to changes in market interest rates or other market conditions, the value of an inverse floater
may increase or decrease at a multiple of the increase or decrease in the value of the underlying securities. If the fund invests in CMO tranches (including CMO tranches issued by government agencies) and interest rates move in a manner not
anticipated by fund management, it is possible that the fund could lose all or substantially all of its investment. Certain MBS in which the fund may invest may also provide a degree of investment leverage, which could cause the fund to lose all or
substantially all of its investment.
The mortgage market in the United States has experienced difficulties that may adversely affect the performance and market
value of certain of the funds mortgage-related investments. Delinquencies and losses on mortgage loans (including subprime and second-lien mortgage loans) generally have increased and may continue to increase, and a decline in or flattening of
real-estate values (as has been experienced and may continue to be experienced in many housing markets) may exacerbate such delinquencies and losses. Also, a number of mortgage loan originators have experienced serious financial difficulties or
bankruptcy. Reduced investor demand for mortgage loans and mortgage-related securities and increased investor yield requirements have caused limited liquidity in the secondary market for mortgage-related securities, which can adversely affect the
market value of mortgage-related securities. It is possible that such limited liquidity in such secondary markets could continue or worsen.
ABS entail certain risks
not presented by MBS, including the risk that in certain states it may be difficult to perfect the liens securing the collateral backing certain asset-backed securities. In addition, certain ABS are based on loans that are unsecured, which means
that there is no collateral to seize if the underlying borrower defaults.
Asset class
risk. Securities or other assets in the funds portfolio may underperform in comparison to the general financial markets, a particular financial market or other asset classes. This may cause the fund to
underperform other investment vehicles that invest in different asset classes.
Assets under
management risk. From time to time a third party, LMPFA and/or affiliates of LMPFA or the fund may invest in the fund and hold its investment for a period of time in order to facilitate commencement of the
funds operations or to allow for the fund to achieve size or scale. There can be no assurance that any such entity will not redeem its investment, that it will not redeem at an inopportune time for the fund or that the size of the fund will be
maintained at a level necessary to enable the fund to remain viable. Such redemption may cause the fund to sell assets (or invest cash) at disadvantageous times or prices, increase or accelerate taxable gains or transaction costs and may negatively
affect the funds net asset value, market price, performance, or ability to satisfy redemptions in a timely manner.
Authorized Participant concentration risk. Only an Authorized Participant may engage in creation or redemption transactions directly with the fund.
Authorized Participants are broker-dealers that are permitted to create and redeem shares directly with the fund and who have entered into agreements with the funds distributor. The fund has a limited number of institutions that
act as Authorized Participants. To the extent that these institutions exit the business or are unable to process creation and/or redemption orders with respect to the fund and no other Authorized Participant steps forward to create or redeem, in
either of these cases, fund shares may trade at a premium or discount to net asset value and possibly face trading halts and/or delisting.
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Cash management and defensive investing risk. The value of the investments held by the fund for cash management or defensive investing purposes can fluctuate. Like other fixed income securities, they are subject to risk, including market, interest rate and credit
risk. If the fund holds cash uninvested, the cash will be subject to the credit risk of the depository institution holding the cash and the fund will not earn income on the cash. If a significant amount of the funds assets is used for cash
management or defensive investing purposes, the fund will be less likely to achieve its investment objective. Defensive investing may not work as intended and the value of an investment in the fund may still decline.
Cash transactions risk. Unlike many ETFs, the fund may effect its
creations and redemptions primarily for cash, rather than in-kind securities. Other more conventional ETFs generally are able to make in-kind redemptions and avoid realizing gains in connection with transactions designed to meet redemption requests.
Effecting all redemptions for cash may cause the fund to sell portfolio securities in order to obtain the cash needed to distribute redemption proceeds. Such dispositions may occur at an inopportune time resulting in potential losses to the fund and
involve transaction costs. If the fund recognizes a capital loss on these sales, the loss will offset capital gains, if any, which may reduce the amount of capital gain distributions from the fund. If the fund recognizes gain on these sales, this
generally will cause the fund to recognize gain it might not otherwise have recognized if it were to distribute portfolio securities in-kind or to recognize such gain sooner than would otherwise be required. The fund generally intends to distribute
these gains to shareholders to avoid being taxed on this gain at the fund level and otherwise comply with the special tax rules that apply to it. This strategy may cause shareholders to be subject to tax on gains they would not otherwise be subject
to, or at an earlier date than, if they had made an investment in a more conventional ETF.
In addition, cash transactions may have to be carried out over
several days if the securities market is relatively illiquid and may involve considerable brokerage fees and taxes. These brokerage fees and taxes, which will be higher than if the fund sold and redeemed its shares primarily in-kind, will generally
be passed on to purchasers and redeemers of Creation Units in the form of creation and redemption transaction fees. To the extent transaction and other costs associated with a redemption exceed the redemption fee, those transaction costs might be
borne by the funds remaining shareholders. In addition, these factors may result in wider spreads between the bid and the offered prices of the funds shares than for more conventional ETFs.
Collateralized debt obligations risk. In addition to the
typical risks associated with fixed-income securities and ABS, CDOs carry additional risks including, but not limited to: (i) the possibility that distributions from collateral securities will not be adequate to make interest or other payments;
(ii) the risk that the collateral may default or decline in value or be downgraded, if rated by a NRSRO; (iii) the fund may invest in tranches of CDOs that are subordinate to other tranches of the issuers securities; (iv) the
structure and complexity of the transaction and the legal documents could lead to disputes among investors regarding the characterization of proceeds and the entitlement to those proceeds; (v) the investment returns achieved by the fund could
be significantly different than those predicted by financial models; (vi) the lack of a readily available secondary market for CDOs; (vii) the risk of forced fire sale liquidation due to technical defaults such as coverage test
failures; and (viii) the CDOs manager may perform poorly. CDOs are subject to heightened illiquidity risk and the liquidity of CDOs may change over time.
Covered call risk. Covered call risk is the risk that the
fund, as issuer of the call option, will forgo any profit from increases in the market value of the underlying security or futures contract covering the call option above the sum of the premium and the strike price of the call but retain the risk of
loss if the underlying security or futures contract declines in value. The fund will have no control over the exercise of the option by the option holder and may lose the benefit from any capital appreciation on the underlying security or futures
contract. A number of factors may influence the option holders decision to exercise the option, including the value of the underlying security or futures contract, price volatility, dividend yield and interest rates. To the extent that these
factors increase the value of the call option, the option holder is more likely to exercise the option, which may negatively affect the fund.
Credit risk. The value of your investment in the fund could decline if the issuer of a security held by the fund or another obligor for that
security (such as a party offering credit enhancement) fails to pay, otherwise defaults, is perceived to be less creditworthy, becomes insolvent or files for bankruptcy. The value of your investment in the fund could also decline if the credit
rating of a security held by the fund is downgraded or the credit quality or value of any assets underlying the security declines. If the fund enters into financial contracts (such as certain derivatives, repurchase agreements, reverse repurchase
agreements, and when-issued, delayed delivery and forward commitment transactions), the fund will be subject to the credit risk presented by the counterparty. In addition, the fund may incur expenses in an effort to protect the funds
interests or to enforce its rights against an issuer, guarantor or counterparty or may be hindered or delayed in exercising those rights. Credit risk is broadly gauged by the credit ratings of the securities in which the fund invests. However,
ratings are only the opinions of the companies issuing them and are not guarantees as to quality. Securities rated in the lowest category of investment grade (Baa/BBB) may possess certain speculative characteristics. Credit risk is
typically greatest for the funds high yield debt securities, which are rated below the Baa/BBB categories or unrated securities of comparable quality (junk bonds).
The fund may invest in securities which are subordinated to more senior securities of the issuer, or which represent interests in pools of such subordinated securities.
The fund is more likely to suffer a credit loss on subordinated securities than on non-subordinated securities of the same issuer. If there is a default, bankruptcy or liquidation of the issuer, most subordinated securities are paid only if
sufficient assets remain after payment of the issuers non-subordinated securities. In addition, any recovery of interest or principal may take more time. As a result, even a perceived decline in creditworthiness of the issuer is likely to have
a greater adverse impact on subordinated securities.
Cybersecurity risk. Cybersecurity incidents, both intentional and unintentional, may allow an unauthorized party to gain access to fund assets, fund or customer data (including private shareholder information), or proprietary information,
cause the fund, the manager, the subadviser, Authorized Participants, the relevant listing exchange and/or their service providers (including, but not limited to, fund accountants, custodians, sub-custodians,
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transfer agents and financial intermediaries) to suffer data breaches, data corruption or loss of operational functionality or prevent fund investors from purchasing or redeeming shares or
receiving distributions. The fund, the manager, and the subadviser have limited ability to prevent or mitigate cybersecurity incidents affecting third party service providers, and such third party service providers may have limited indemnification
obligations to the fund or the manager. Cybersecurity incidents may result in financial losses to the fund and its shareholders, and substantial costs may be incurred in order to prevent any future cybersecurity incidents. Issuers of securities in
which the fund invests are also subject to cybersecurity risks, and the value of these securities could decline if the issuers experience cybersecurity incidents.
Derivatives risk. Derivatives involve special risks and costs and
may result in losses to the fund, even when used for hedging purposes. Using derivatives can increase losses and reduce opportunities for gains when market prices, interest rates, currencies, or the derivatives themselves behave in a way not
anticipated by the fund, especially in abnormal market conditions. Using derivatives also can have a leveraging effect which may increase investment losses and increase the funds volatility, which is the degree to which the funds share
price may fluctuate within a short time period. Certain derivatives have the potential for unlimited loss, regardless of the size of the initial investment. The other parties to certain derivatives transactions present the same types of credit risk
as issuers of fixed income securities.
The funds counterparty to a derivative transaction may not honor its obligations in respect to the
transaction. In certain cases, the fund may be hindered or delayed in exercising remedies against or closing out derivative instruments with a counterparty, which may result in additional losses.
Derivatives also tend to involve greater illiquidity risk and they may be difficult to value. The fund may be unable to terminate or sell its derivative positions. In
fact, many over-the-counter derivatives will not have liquidity except through the counterparty to the instrument. Derivatives are generally subject to the risks applicable to the assets, rates, indices or other indicators underlying the derivative.
The value of a derivative may fluctuate more than the underlying assets, rates, indices or other indicators to which it relates. Use of derivatives or similar instruments may have different tax consequences for the fund than an investment in the
underlying security, and those differences may affect the amount, timing and character of income distributed to shareholders. The funds use of derivatives may also increase the amount of taxes payable by shareholders. The U.S. government and
foreign governments are in the process of adopting and implementing regulations governing derivatives markets, including mandatory clearing of certain derivatives, margin, and reporting requirements. The ultimate impact of the regulations remains
unclear. Additional regulation of derivatives may make derivatives more costly, limit their availability or utility, otherwise adversely affect their performance or disrupt markets. The fund may be exposed to additional risks as a result of the
additional regulations. The extent and impact of the additional regulations are not yet fully known and may not be for some time.
Investments by the fund in
structured securities, a type of derivative, raise certain tax, legal, regulatory and accounting issues that may not be presented by direct investments in securities. These issues could be resolved in a manner that could hurt the performance of the
fund.
Swap agreements tend to shift the funds investment exposure from one type of investment to another. For example, the fund may enter into interest rate
swaps, which involve the exchange of interest payments by the fund with another party, such as an exchange of floating rate payments for fixed interest rate payments with respect to a notional amount of principal. If an interest rate swap intended
to be used as a hedge negates a favorable interest rate movement, the investment performance of the fund would be less than what it would have been if the fund had not entered into the interest rate swap.
Credit default swap contracts involve heightened risks and may result in losses to the fund. Credit default swaps may be illiquid and difficult to value. If the fund
buys a credit default swap, it will be subject to the risk that the credit default swap may expire worthless, as the credit default swap would only generate income in the event of a default on the underlying debt security or other specified event.
As a buyer, the fund would also be subject to credit risk relating to the sellers payment of its obligations in the event of a default (or similar event). If the fund sells a credit default swap, it will be exposed to the credit risk of the
issuer of the obligation to which the credit default swap relates. As a seller, the fund would also be subject to leverage risk, because it would be liable for the full notional amount of the swap in the event of a default (or similar event). The
fund would also be subject to the risk of loss on any securities segregated to cover the funds expenses under the swap.
The absence of a central exchange or
market for over-the-counter swap transactions may lead, in some instances, to difficulties in trading and valuation, especially in the event of market disruptions. Recent legislation requires certain swaps to be executed through a centralized
exchange or regulated facility and be cleared through a regulated clearinghouse. Although this clearing mechanism is generally expected to reduce counterparty credit risk, it may disrupt or limit the swap market and may not result in swaps being
easier to trade or value. As swaps become more standardized, the fund may not be able to enter into swaps that meet its investment needs. The fund also may not be able to find a clearinghouse willing to accept a swap for clearing. In a cleared swap,
a central clearing organization will be the counterparty to the transaction. The fund will assume the risk that the clearinghouse may be unable to perform its obligations.
The fund will be required to maintain its positions with a clearing organization through one or more clearing brokers. The clearing organization will require the fund to
post margin and the broker may require the fund to post additional margin to secure the funds obligations. The amount of margin required may change from time to time. In addition, cleared transactions may be more expensive to maintain than
over-the-counter transactions and may require the fund to deposit larger amounts of margin. The fund may not be able to recover margin amounts if the broker has financial difficulties. Also, the broker may require the fund to terminate a derivatives
position under certain circumstances. This may cause the fund to lose money. Futures are standardized, exchange-traded contracts that obligate a purchaser to take delivery, and a seller to make delivery, of a specific amount of an asset at a
specified future date at a specified price. The primary risks associated with the use of futures contracts are: (a) the imperfect correlation between the change in market value of the instruments held by the fund and the price of the futures
contract; (b) the possible lack of a
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liquid secondary market for a futures contract and the resulting inability to close a futures contract when desired; (c) losses caused by unanticipated market movements, which are
potentially unlimited; (d) the subadvisers inability to predict correctly the direction of securities prices, interest rates, currency exchange rates and other economic factors; and (e) the possibility that the counterparty will
default in the performance of its obligations.
An option is an agreement that, for a premium payment or fee, gives the option holder (the purchaser) the right but
not the obligation to buy (a call option) or sell (a put option) the underlying asset (or settle for cash in an amount based on an underlying asset, rate, or index) at a specified price (the exercise price) during
a period of time or on a specified date. The fund may write a call or put option where it (i) owns or is short the underlying security in the case of a call or put option, respectively (sometimes referred to as a covered option), or
(ii) does not own or is not short such security (sometimes referred to as a naked option). When the fund purchases an option, it may lose the total premium paid for it if the price of the underlying security or other assets
decreased, remained the same or failed to increase to a level at or beyond the exercise price (in the case of a call option) or increased, remained the same or failed to decrease to a level at or below the exercise price (in the case of a put
option). If a put or call option purchased by the fund were permitted to expire without being sold or exercised, its premium would represent a loss to the fund. To the extent that the fund writes or sells an option, in particular a naked option, if
the decline or increase in the underlying asset is significantly below or above the exercise price of the written option, the fund could experience a substantial loss.
Risks associated with the use of derivatives are magnified to the extent that an increased portion of the funds assets is committed to derivatives in general or
is invested in just one or a few types of derivatives.
Extension risk. When interest rates rise, repayments of fixed income securities, particularly asset- and mortgage- backed securities, may occur more slowly than anticipated, extending the effective duration of these fixed income
securities at below market interest rates and causing their market prices to decline more than they would have declined due to the rise in interest rates alone. This may cause the funds share price to be more volatile.
Foreign investments and emerging markets risk. The funds
investments in securities of foreign issuers or issuers with significant exposure to foreign markets involve additional risk as compared to investments in U.S. securities or issuers with predominantly domestic exposure, such as less liquid, less
regulated, less transparent and more volatile markets. The markets for some foreign securities are relatively new, and the rules and policies relating to these markets are not fully developed and may change. The value of the funds investments
may decline because of factors affecting the particular issuer as well as foreign markets and issuers generally, such as unfavorable or unsuccessful government actions, tariffs and tax disputes, reduction of government or central bank support,
inadequate accounting standards, lack of information and political, economic, financial or social instability. Foreign investments may also be adversely affected by U.S. government or international economic sanctions, which could eliminate the value
of an investment. To the extent the fund focuses its investments in a single country or only a few countries in a particular geographic region, economic, political, regulatory or other conditions affecting such country or region may have a greater
impact on fund performance relative to a more geographically diversified fund.
The value of the funds foreign investments may also be affected by
foreign tax laws, special U.S. tax considerations and restrictions on receiving the investment proceeds from a foreign country. Dividends or interest on, or proceeds from the sale or disposition of, foreign securities may be subject to non-U.S.
withholding or other taxes.
It may be difficult for the fund to pursue claims against a foreign issuer or other parties in the courts of a foreign country. Some
securities issued by non-U.S. governments or their subdivisions, agencies and instrumentalities may not be backed by the full faith and credit of such governments. Even where a security is backed by the full faith and credit of a government, it may
be difficult for the fund to pursue its rights against the government. In the past, some non-U.S. governments have defaulted on principal and interest payments. In certain foreign markets, settlement and clearance procedures may result in delays in
payment for or delivery of securities not typically associated with settlement and clearance of U.S. investments.
If the fund buys securities denominated in a
foreign currency, receives income in foreign currencies, or holds foreign currencies from time to time, the value of the funds assets, as measured in U.S. dollars, can be affected unfavorably by changes in exchange rates relative to the U.S.
dollar or other foreign currencies. Currency exchange rates can be volatile, and are affected by factors such as general economic conditions, the actions of the U.S. and foreign governments or central banks, the imposition of currency controls and
speculation. The fund may be unable or may choose not to hedge its foreign currency exposure.
In certain foreign markets, settlement and clearance of trades may
experience delays in payment for or delivery of securities not typically associated with settlement and clearance of U.S. investments. Settlement of trades in these markets can take longer than in other markets and the fund may not receive its
proceeds from the sale of certain securities for an extended period (possibly several weeks or even longer) due to, among other factors, low trading volumes and volatile prices. The custody or holding of securities, cash and other assets by local
banks, agents and depositories in securities markets outside the United States may entail additional risks. Governments or trade groups may compel local agents to hold securities in designated depositories that may not be subject to independent
evaluation. Local agents are held only to the standards of care of their local markets, and thus may be subject to limited or no government oversight. In extreme cases, the funds securities may be misappropriated or the fund may be unable to
sell its securities. In general, the less developed a countrys securities market is, the greater the likelihood of custody problems.
The risks of foreign
investments are heightened when investing in issuers in emerging market countries. Emerging market countries tend to have economic, political and legal systems that are less developed and are less stable than those of more developed countries. They
are often particularly sensitive to market movements because their market prices tend to reflect speculative expectations. Low trading volumes may result in a lack of liquidity and in extreme price volatility. Investors should be able to
tolerate sudden, sometimes substantial, fluctuations in the value of investments
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in emerging markets. Emerging market countries may have policies that restrict investment by foreigners or that prevent foreign investors from withdrawing their money at will.
Hedging risk. The decision as to whether and to what extent
the fund will engage in hedging transactions to hedge against such risks as credit risk, currency risk and interest rate risk will depend on a number of factors, including prevailing market conditions, the composition of the fund and the
availability of suitable transactions. Hedges are sometimes subject to imperfect matching between the derivative and the underlying asset or index; accordingly, there can be no assurance that the fund will engage in hedging transactions at any given
time or from time to time, even under volatile market environments, or that any such strategies, if used, will be successful. Hedging transactions involve costs and may reduce gains or result in losses.
High yield (junk) bonds risk. High yield bonds, often
called junk bonds, have a higher risk of issuer default or may be in default and are considered speculative. Changes in economic conditions or developments regarding the individual issuer are more likely to cause price volatility and
weaken the capacity of such securities to make principal and interest payments than is the case for higher grade debt securities. The value of lower-quality debt securities often fluctuates in response to company, political, or economic developments
and can decline significantly over short as well as long periods of time or during periods of general or regional economic difficulty. High yield bonds may also have lower liquidity as compared to higher-rated securities, which means the fund may
have difficulty selling them at times, and it may have to apply a greater degree of judgment in establishing a price for purposes of valuing fund shares. High yield bonds generally are issued by less creditworthy issuers. Issuers of high yield bonds
may have a larger amount of outstanding debt relative to their assets than issuers of investment grade bonds. In the event of an issuers bankruptcy, claims of other creditors may have priority over the claims of high yield bond holders,
leaving few or no assets available to repay high yield bond holders. The fund may incur expenses to the extent necessary to seek recovery upon default or to negotiate new terms with a defaulting issuer. High yield bonds frequently have
redemption features that permit an issuer to repurchase the security from the fund before it matures. If the issuer redeems high yield bonds, the fund may have to invest the proceeds in bonds with lower yields and may lose income.
Illiquidity risk. Illiquidity risk exists when particular
investments are impossible or difficult to sell and some assets that the fund wants to invest in may be impossible or difficult to purchase. Although most of the funds investments must be liquid at the time of investment, investments may
become illiquid after purchase by the fund, particularly during periods of market turmoil or due to adverse changes in the conditions of a particular issuer. Markets may become illiquid when, for instance, there are few, if any, interested buyers or
sellers or when dealers are unwilling or unable to make a market for certain securities. As a general matter, dealers recently have been less willing to make markets for fixed income securities. Recent federal banking regulations may also cause
certain dealers to reduce their inventories of certain securities, which may further decrease the ability to buy or sell such securities. When the fund holds illiquid investments, the portfolio may be harder to value, especially in changing markets,
and if the fund is forced to sell these investments to meet redemption requests or for other cash needs, the fund may suffer a loss. The fund may experience heavy redemptions that could cause the fund to liquidate its assets at inopportune times or
at a loss or depressed value, which could cause the value of your investment to decline. In addition, when there is illiquidity in the market for certain investments, the fund, due to limitations on illiquid investments, may be unable to achieve its
desired level of exposure to a certain sector, industry or issuer. The liquidity of certain assets, particularly of privately-issued and non-investment grade MBS, ABS and CDOs, may be difficult to ascertain and may change over time. Transactions in
less liquid or illiquid securities may entail transaction costs that are higher than those for transactions in liquid securities. Further, such securities, once sold, may not settle for an extended period (for example, several weeks or even longer).
The fund will not receive its sales proceeds until that time, which may constrain the funds ability to meet its obligations (including obligations to redeeming shareholders).
Investing in ETFs risk. Investing in securities issued by ETFs
involves risks similar to those of investing directly in the securities and other assets held by the ETF. Unlike shares of typical mutual funds, shares of ETFs are generally traded on an exchange throughout a trading day and bought and sold based on
market values and not at net asset value. For this reason, shares could trade at either a premium or discount to net asset value, which may be substantial during periods of market stress. The trading price of an index-based ETF is expected to (but
may not) closely track the net asset value of the ETF, and the fund will generally gain or lose value consistent with the performance of the ETFs portfolio securities. The fund will pay brokerage commissions in connection with the purchase and
sale of shares of ETFs. In addition, the fund will indirectly bear its pro rata share of the fees and expenses incurred by an ETF in which it invests, including advisory fees. These expenses are in addition to the advisory and other expenses that
the fund bears directly in connection with its own operations. An index-based ETF may not replicate exactly the performance of the benchmark index it seeks to track for a number of reasons, including transaction costs incurred by the ETF, the
temporary unavailability of certain index securities in the secondary market or discrepancies between the ETF and the index with respect to the weighting of securities or the number of securities held. Investments in ETFs are subject to the risk
that the listing exchange may halt trading of an ETFs shares, in which case the fund would be unable to sell its ETF shares unless and until trading is resumed.
Investment in loans risk. Investments in loans are generally
subject to the same risks as investments in other types of debt obligations, including, among others, credit risk, interest rate risk, prepayment risk, and extension risk. In addition, in many cases loans are subject to the risks associated with
below-investment grade securities. This means loans are often subject to significant credit risks, including a greater possibility that the borrower will be adversely affected by changes in market or economic conditions and may default or enter
bankruptcy. This risk of default will increase in the event of an economic downturn or a substantial increase in interest rates (which will increase the cost of the borrowers debt service). Transactions in loans may settle on a delayed basis.
As a result, the proceeds from the sale of a loan may not be available to make additional investments or to meet the funds redemption obligations. Because junior loans are unsecured and subordinated and thus lower in priority of payment to
senior loans, they are subject to the additional risk that the cash flow of the borrower and property securing the loan or debt, if any, may be insufficient to meet scheduled payments after giving effect to the senior secured obligations of the
borrower. This risk is generally higher for
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subordinated unsecured loans or debt, which are not backed by a security interest in any specific collateral. Junior loans generally have greater price volatility than senior loans and may have
lower liquidity as compared to senior loans. In addition, investments in loans may be difficult to value and may be illiquid. The secondary market for loans may be subject to irregular trading activity, wide bid/ask spreads, and extended trade
settlement periods, which may increase the expenses of the fund or cause the fund to be unable to realize the full value of its investment in the loan, resulting in a material decline in the funds net asset value. Opportunities to invest in
loans or certain types of loans, such as senior loans, may be limited. The limited availability of loans may be due to a number of reasons, including that direct lenders may allocate only a small number of loans to new investors, including the fund.
There also may be fewer loans made or available, particularly during economic downturns. There is also a possibility that originators will not be able to sell participations in junior loans, which would create greater credit risk exposure for the
holders of such loans. Bank loans may not be considered securities and therefore, the fund may not have the protections afforded by U.S. federal securities laws with respect to such investments.
Leverage risk. The value of your investment may be more volatile
if the fund borrows or uses derivatives or other investments that have a leveraging effect on the funds portfolio. Other risks also will be compounded. This is because leverage generally magnifies the effect of a change in the value of an
asset and creates a risk of loss of value on a larger pool of assets than the fund would otherwise have had. The fund may also have to sell assets at inopportune times to satisfy its obligations. The use of leverage is considered to be a speculative
investment practice and may result in the loss of a substantial amount, and possibly all, of the funds assets.
LIBOR risk. The funds investments, payment obligations, and financing terms may be based on floating rates, such as the London Interbank Offered
Rate, or LIBOR, which is the offered rate for short-term Eurodollar deposits between major international banks. Plans are underway to phase out the use of LIBOR by the end of 2021. There remains uncertainty regarding the nature of any
replacement rate and the impact of the transition from LIBOR on the funds transactions and the financial markets generally. As such, the potential effect of a transition away from LIBOR on the fund or the funds investments cannot yet be
determined.
Market and interest rate risk. The market
prices of the funds securities may go up or down, sometimes rapidly or unpredictably. If the market prices of the funds securities fall, the value of your investment in the fund will decline. The market price of a security may fall due
to general market conditions, such as real or perceived adverse economic or political conditions, tariffs and trade disruptions, inflation, changes in interest or currency rates, lack of liquidity in the bond markets or adverse investor sentiment.
Changes in market conditions will not typically have the same impact on all types of securities. The market price of a security may also fall due to specific conditions that affect a particular sector of the securities market or a particular issuer.
Your fund shares at any point in time may be worth less than what you invested, even after taking into account the reinvestment of fund dividends and distributions.
The market prices of securities may fluctuate significantly when interest rates change. When interest rates rise, the value of fixed income securities, and therefore the
value of your investment in the fund, generally goes down. Generally, the longer the maturity or duration of a fixed income security, the greater the impact of a rise in interest rates on the securitys market price. However, calculations of
duration and maturity may be based on estimates and may not reliably predict a securitys price sensitivity to changes in interest rates. Moreover, securities can change in value in response to other factors, such as credit risk. In addition,
different interest rate measures (such as short- and long-term interest rates and U.S. and non-U.S. interest rates), or interest rates on different types of securities or securities of different issuers, may not necessarily change in the same amount
or in the same direction. When interest rates go down, the funds yield will decline. Also, when interest rates decline, investments made by the fund may pay a lower interest rate, which would reduce the income received by the fund.
Market events risk. The market values of securities or other
assets will fluctuate, sometimes sharply and unpredictably, due to changes in general market conditions, overall economic trends or events, governmental actions or intervention, actions taken by the U.S. Federal Reserve or foreign central banks,
market disruptions caused by trade disputes or other factors, political developments, investor sentiment, the global and domestic effects of a pandemic, and other factors that may or may not be related to the issuer of the security or other asset.
Economies and financial markets throughout the world are increasingly interconnected. Economic, financial or political events, trading and tariff arrangements, public health events, terrorism, natural disasters and other circumstances in one country
or region could have profound impacts on global economies or markets. As a result, whether or not the fund invests in securities of issuers located in or with significant exposure to the countries directly affected, the value and liquidity of the
funds investments may be negatively affected.
The rapid and global spread of a highly contagious novel coronavirus respiratory disease, designated
COVID-19, first detected in China in December 2019, has resulted in extreme volatility in the financial markets and severe losses; reduced liquidity of many instruments; restrictions on international and, in some cases, local travel; significant
disruptions to business operations (including business closures); strained healthcare systems; disruptions to supply chains, consumer demand and employee availability; and widespread uncertainty regarding the duration and long-term effects of this
pandemic. Some sectors of the economy and individual issuers have experienced particularly large losses. In addition, the COVID-19 pandemic may result in a sustained economic downturn or a global recession, domestic and foreign political and social
instability, damage to diplomatic and international trade relations and increased volatility and/or decreased liquidity in the securities markets. The ultimate economic fallout from the pandemic, and the long-term impact on economies, markets,
industries and individual issuers, are not known. The U.S. government and the Federal Reserve, as well as certain foreign governments and central banks, are taking extraordinary actions to support local and global economies and the financial markets
in response to the COVID-19 pandemic, including by pushing interest rates to very low levels. This and other government intervention into the economy and financial markets to address the COVID-19 pandemic may not work as intended, particularly if
the efforts are perceived by investors as being unlikely to achieve the desired results. The COVID-19 pandemic could adversely affect the value and liquidity of the
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funds investments, impair the funds ability to satisfy redemption requests, and negatively impact the funds performance. In addition, the outbreak of COVID-19, and measures
taken to mitigate its effects, could result in disruptions to the services provided to the fund by its service providers.
Market
trading risk.
Absence of active market. Although shares of the fund are listed for trading
on one or more stock exchanges, there can be no assurance that an active trading market for such shares will develop or be maintained by market makers or Authorized Participants. Authorized Participants are not obligated to execute purchase or
redemption orders for Creation Units. In periods of market volatility, market makers and/or Authorized Participants may be less willing to transact in fund shares. The absence of an active market for the funds shares may contribute to the
funds shares trading at a premium or discount to net asset value.
Risk of secondary
listings. The funds shares may be listed or traded on U.S. and non-U.S. stock exchanges other than the U.S. stock exchange where the funds primary listing is maintained, and may otherwise be made available to non-U.S.
investors through funds or structured investment vehicles similar to depositary receipts. There can be no assurance that the funds shares will continue to trade on any such stock exchange or in any market or that the funds shares will
continue to meet the requirements for listing or trading on any exchange or in any market. The funds shares may be less actively traded in certain markets than in others, and investors are subject to the execution and settlement risks and
market standards of the market where they or their broker direct their trades for execution. Certain information available to investors who trade fund shares on a U.S. stock exchange during regular U.S. market hours may not be available to investors
who trade in other markets, which may result in secondary market prices in such markets being less efficient.
Secondary market trading risk. Shares of the fund may trade in the secondary market at times when the fund does not accept orders to purchase or redeem shares. At such times, shares may trade in
the secondary market with more significant premiums or discounts than might be experienced at times when the fund accepts purchase and redemption orders.
Secondary market trading in fund shares may be halted by a stock exchange because of market conditions or for other reasons. In addition, trading in fund shares on a
stock exchange or in any market may be subject to trading halts caused by extraordinary market volatility pursuant to circuit breaker rules on the stock exchange or market.
Shares of the fund, similar to shares of other issuers listed on a stock exchange, may be sold short and are therefore subject to the risk of increased volatility and
price decreases associated with being sold short.
Shares of the fund may trade at prices other than net asset
value. Shares of the fund trade on stock exchanges at prices at, above or below the funds most recent net asset value. The net asset value of the fund is calculated at the end of each business day and fluctuates with changes in the
market value of the funds holdings. The trading price of the funds shares fluctuates continuously throughout trading hours based on both market supply of and demand for fund shares and the underlying value of the funds portfolio
holdings or net asset value. As a result, the trading prices of the funds shares may deviate significantly from net asset value during periods of market volatility, including during periods of high redemption requests or other unusual market
conditions. ANY OF THESE FACTORS, AMONG OTHERS, MAY LEAD TO THE FUNDS SHARES TRADING AT A PREMIUM OR DISCOUNT TO NET ASSET VALUE. However, because shares can be created and redeemed in Creation Units at net asset value, the subadviser believes
that large discounts or premiums to the net asset value of the fund are not likely to be sustained over the long term (unlike shares of many closed-end funds, which frequently trade at appreciable discounts from, and sometimes at premiums to, their
net asset values). While the creation/redemption feature is designed to make it more likely that the funds shares normally will trade on stock exchanges at prices close to the funds next calculated net asset value, exchange prices are
not expected to correlate exactly with the funds net asset value due to timing reasons, supply and demand imbalances and other factors. In addition, disruptions to creations and redemptions, including disruptions at market makers, Authorized
Participants, or market participants, or during periods of significant market volatility, may result in trading prices for shares of the fund that differ significantly from its net asset value. Authorized Participants may be less willing to create
or redeem fund shares if there is a lack of an active market for such shares or its underlying investments, which may contribute to the funds shares trading at a discount to net asset value.
Costs of buying or selling fund shares. Buying or selling fund shares on an exchange involves two types of
costs that apply to all securities transactions. When buying or selling shares of the fund through a broker, you will likely incur a brokerage commission and other charges. In addition, you may incur the cost of the spread; that is, the
difference between what investors are willing to pay for fund shares (the bid price) and the price at which they are willing to sell fund shares (the ask price). There may also be regulatory and other charges that are
incurred as a result of trading activity. The spread varies over time for shares of the fund based on trading volume and market liquidity, and is generally narrower if the fund has more trading volume and market liquidity and wider if the fund has
less trading volume and market liquidity. In addition, increased market volatility may cause increased spreads. Because of the costs inherent in buying or selling fund shares, frequent trading may detract significantly from investment results and an
investment in fund shares may not be advisable for investors who anticipate regularly trading in fund shares.
Mortgage dollar rolls risk. Mortgage dollar rolls are transactions in which the fund sells mortgage-backed securities (MBS) to a dealer and
simultaneously agrees to repurchase similar securities in the future at a predetermined price. The funds mortgage dollar rolls could lose money if the price of the mortgage-backed securities sold falls below the agreed upon repurchase price,
or if the counterparty is unable to honor the agreement. If the counterparty files for bankruptcy or becomes insolvent, the funds right to repurchase securities may be limited. Mortgage dollar roll transactions may have a leveraging effect on
the fund, making the value of an investment in the fund more volatile, requiring the fund to liquidate portfolio securities when it may not be advantageous to do so and magnifying any change in the funds net asset value.
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National closed market trading risk. Where the underlying securities held by the fund trade on foreign exchanges that are closed when the securities exchange on which the funds shares trade is open, there are likely to be deviations between the current
price of such an underlying security (i.e., during the funds domestic trading day) and the last quoted price for the underlying security (i.e., the funds quote from the closed foreign market), which in turn could lead to a difference
between the price at which the fund has valued the security and the value of the underlying security. This could also result in premiums or discounts to the funds NAV that may be greater than those experienced by other ETFs.
Operational risk. Your ability to transact with the fund or
the valuation of your investment may be negatively impacted because of the operational risks arising from factors such as processing errors and human errors, inadequate or failed internal or external processes, failures in systems and technology,
changes in personnel, and errors caused by third party service providers or trading counterparties. It is not possible to identify all of the operational risks that may affect the fund or to develop processes and controls that completely eliminate
or mitigate the occurrence of such failures. The fund and its shareholders could be negatively impacted as a result.
Portfolio management risk. The value of your investment may decrease if the subadvisers judgment about the quality, relative yield, value or
market trends affecting a particular security, industry, sector or region, or about interest rates, is incorrect or does not produce the desired results, or if there are imperfections, errors or limitations in the models, tools and data used by the
subadviser. In addition, the funds investment strategies or policies may change from time to time. Those changes may not lead to the results intended by the subadviser and could have an adverse effect on the value or performance of the fund.
Furthermore, the implementation of the funds investment strategies is subject to a number of constraints, which could also adversely affect the funds value or performance.
Preferred stock risk. Preferred stock pay dividends at a
specified rate and generally have preference over common stock in the payment of dividends and the liquidation of the issuers assets, but are typically junior to the debt securities of the issuer in those same respects. Unlike interest
payments on debt securities, dividends on preferred stock are generally payable at the discretion of the issuers board of directors. Shareholders of preferred stock may suffer a loss of value if dividends are not paid. The market prices of
preferred stocks are subject to changes in interest rates and are more sensitive to changes in the issuers creditworthiness than are the prices of debt securities. Generally, under normal circumstances, preferred stock do not carry voting
rights. Preferred stock may trade less frequently and in a more limited volume and may be subject to more abrupt or erratic price movements than other securities.
Prepayment or call risk. Many fixed income securities give the
issuer the option to repay or call the security prior to its maturity date. Issuers often exercise this right when interest rates fall. Accordingly, if the fund holds a fixed income security subject to prepayment or call risk, it will not benefit
fully from the increase in value that other fixed income securities generally experience when interest rates fall. Upon prepayment of the security, the fund would also be forced to reinvest the proceeds at then current yields, which would be
lower than the yield of the security that was paid off. In addition, if the fund purchases a fixed income security at a premium (at a price that exceeds its stated par or principal value), the fund may lose the amount of the premium paid in the
event of prepayment.
Redemptions by affiliated funds and by other significant
investors. The fund may be an investment option for other Legg Mason, Inc. (Legg Mason) sponsored mutual funds and ETFs that are managed as funds of funds, unaffiliated mutual funds and
ETFs and other investors with substantial investments in the fund. As a result, from time to time, the fund may experience relatively large redemptions and could be required to liquidate its assets at inopportune times or at a loss or depressed
value, which could cause the value of your investment to decline.
Risk of investing in fewer
issuers. To the extent the fund invests its assets in a small number of issuers, or in issuers in related businesses or that are subject to related operating risks, the fund will be more susceptible to
negative events affecting those issuers.
Risks relating to inflation-indexed
securities. The value of inflation-indexed fixed income securities generally fluctuates in response to changes in real interest rates, which are in turn tied to the relationship between nominal interest rates
and the rate of inflation. Therefore, if inflation were to rise at a faster rate than nominal interest rates, real interest rates might decline, leading to an increase in value of inflation-indexed securities. In contrast, if nominal interest rates
increase at a faster rate than inflation, real interest rates might rise, leading to a decrease in value of inflation-indexed securities. The principal value of inflation-indexed securities declines in periods of deflation, and holders of such
securities may experience a loss. Although the holders of U.S. TIPS receive no less than the par value of the security at maturity, if the fund purchases U.S. TIPS in the secondary market whose principal values have been adjusted upward due to
inflation since issuance, it may experience a loss if there is a subsequent period of deflation. If inflation is lower than expected during the period the fund holds an inflation-indexed security, the fund may earn less on the security than on a
conventional bond.
Any increase in principal value caused by an increase in the index the inflation-indexed securities are tied to is taxable in the year the
increase occurs, even though the fund will not receive cash representing the increase at that time. As a result, the fund could be required at times to liquidate other investments, including when it is not advantageous to do so, in order to satisfy
the distribution requirements applicable to regulated investment companies under the Internal Revenue Code of 1986, as amended (the Code). See Taxes in the SAI.
If real interest rates rise (i.e., if interest rates rise for reasons other than inflation, for example, due to changes in currency exchange rates), the value of
inflation-indexed securities held by the fund will decline. Moreover, because the principal amount of inflation-indexed securities would be adjusted downward during a period of deflation, the fund will be subject to deflation risk with respect to
its investments in these securities. Inflation-indexed securities are tied to indices that are calculated based on rates of inflation for prior periods. There can be no assurance that such indices will accurately measure the actual rate of inflation
in the prices of goods and services.
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Sovereign debt risk. Sovereign government and supranational debt involve many of the risks of foreign and emerging markets investments as well as the risk of debt moratorium, repudiation or renegotiation and the fund may be unable to enforce
its rights against the issuers. Sovereign debt risk is increased for emerging market issuers.
Trading issues risk. Trading in shares of the fund on NASDAQ may be halted due to market conditions or for reasons that, in the view of NASDAQ, make
trading in shares inadvisable. In addition, trading in shares on NASDAQ is subject to trading halts caused by extraordinary market volatility pursuant to NASDAQs circuit breaker rules. There can be no assurance that the
requirements of NASDAQ necessary to maintain the listing of the fund will continue to be met or will remain unchanged.
U.S. government securities risk. Although the U.S. government guarantees principal and interest payments on securities issued by the U.S. government and
some of its agencies, such as securities issued by the Government National Mortgage Association, this guarantee does not apply to losses resulting from declines in the market value of these securities.
Valuation risk. Many factors may influence the price at which the
fund could sell any particular portfolio investment. The sales price may well differhigher or lowerfrom the funds last valuation, and such differences could be significant, particularly for illiquid securities and securities that
trade in relatively thin markets and/or markets that experience extreme volatility. If market conditions make it difficult to value some investments, the fund may value these investments using more subjective methods, such as fair value
methodologies. Valuation methodologies may be further impacted by technological issues and/or errors by pricing vendors or their personnel. Authorized Participants who purchase or redeem fund shares on days when the fund is holding fair-valued
securities may receive fewer or more shares, or lower or higher redemption proceeds, than they would have received if the fund had not fair-valued securities or had used a different valuation methodology. The value of non-U.S. securities, certain
fixed income securities and currencies, as applicable, may be materially affected by events after the close of the markets in which they are traded, but before the fund determines its net asset value. The funds ability to value its investments
may be impacted by technological issues and/or errors by pricing services or other third party service providers. The valuation of the funds investments involves subjective judgment.
Volatility risk. The value of the securities or other assets in
the funds portfolio may fluctuate, sometimes rapidly and unpredictably. The value of a security or other asset may fluctuate due to factors affecting markets generally or particular industries. The value of a security may also be more volatile
than the market as a whole. This volatility may affect the funds net asset value. Securities or other assets in the funds portfolio may be subject to price volatility and the prices may not be any less volatile than the market as a whole
and could be more volatile. Events or financial circumstances affecting individual securities or sectors may increase the volatility of the fund.
Warrants and rights risk. Warrants and rights can provide a greater potential for profit or loss than an equivalent investment in the underlying
security. Prices of warrants and rights do not necessarily move in tandem with the prices of the underlying securities and therefore, are highly volatile and speculative investments. They have no voting rights, pay no dividends and have no rights
with respect to the assets of the issuer other than a purchase option. If a warrant or right held by the fund is not exercised by the date of its expiration, the fund would lose the entire purchase price of the warrant or right.
Please note that there are other factors that could adversely affect your investment and that could prevent the fund from achieving its investment objective. More
information about risks appears in the SAI. Before investing, you should carefully consider the risks that you will assume.
Portfolio
holdings
On each business day, the fund will disclose on
www.leggmason.com/etfproducts (click on the name of the fund) the identities and quantities of the funds portfolio holdings and other
assets held by the fund that will form the basis for the funds calculation of its net asset value per share at the end of the business day. A description of the funds policies and procedures with respect to the disclosure of its
portfolio holdings is available in the SAI.
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More on fund management
Legg Mason Partners Fund Advisor, LLC (LMPFA or the manager) is the funds investment manager. LMPFA, with offices at 620 Eighth Avenue, New
York, New York 10018, also serves as the investment manager of other Legg Mason-sponsored funds. LMPFA provides administrative and certain oversight services to the fund. As of December 31, 2019, LMPFAs total assets under
management were approximately $202.1 billion.
Western Asset Management Company, LLC (Western Asset) provides the day-to-day portfolio management of the
fund as subadviser. Western Asset Management Company Limited (Western Asset London), Western Asset Management Company Pte. Ltd. (Western Asset Singapore) and Western Asset Management Company Ltd (Western Asset
Japan and, collectively with Western Asset London and Western Asset Singapore, the sub-subadvisers) serve as sub-subadvisers to the fund. References to the subadviser include the subadviser and each applicable
sub-subadviser.
Western Asset, established in 1971, has offices at 385 East Colorado Boulevard, Pasadena, California 91101 and 620 Eighth Avenue, New York,
New York 10018. Western Asset London was founded in 1984 and has offices at 10 Exchange Square, Primrose Street, London EC2A 2EN. Western Asset Japan was founded in 1991 and has offices at 36F Shin-Marunouchi Building, 5-1 Marunouchi
1-Chome Chiyoda-Ku, Tokyo 100-6536, Japan. Western Asset Singapore was established in 2000 and has offices at 1 George Street #23-01, Singapore 049145.
Western
Asset London, Western Asset Japan and Western Asset Singapore provide certain subadvisory services relating to currency transactions and investments in non-U.S. dollar-denominated securities and related foreign currency instruments. Western Asset
London generally manages global and non-U.S. dollar fixed income mandates, Western Asset Japan generally manages Japanese fixed income mandates, and Western Asset Singapore generally manages Asian (other than Japan) fixed income mandates. Each
office provides services relating to relevant portions of Western Assets broader portfolios as appropriate.
Western Asset London, Western Asset Japan and
Western Asset Singapore undertake investment-related activities including investment management, research and analysis, and securities settlement.
Western Asset
employs a team approach to investment management that utilizes relevant staff in multiple offices around the world. Expertise from Western Asset investment professionals in those offices add local sector investment experience as well as the ability
to trade in local markets. Although the investment professionals at Western Asset London, Western Asset Japan, and Western Asset Singapore are responsible for the management of the investments in their local sectors, Western Asset provides overall
supervision of their activities for the fund to maintain a cohesive investment management approach.
Western Asset, Western Asset London, Western Asset Japan and
Western Asset Singapore act as investment advisers to institutional accounts, such as corporate pension plans, mutual funds and endowment funds. As of December 31, 2019, the total assets under management of Western Asset and its supervised
affiliates, including Western Asset London, Western Asset Japan and Western Asset Singapore, were approximately $456.3 billion.
LMPFA pays Western Asset a
portion of the management fee that it receives from the fund. The fund does not pay any additional advisory or other fees for advisory services provided by Western Asset, Western Asset London, Western Asset Japan or Western Asset Singapore.
LMPFA, Western Asset, Western Asset London, Western Asset Japan and Western Asset Singapore are wholly-owned subsidiaries of Legg Mason. Legg Mason, whose principal
executive offices are at 100 International Drive, Baltimore, Maryland 21202, is a global asset management company. As of December 31, 2019, Legg Masons asset management operations, including Western Asset and its supervised affiliates,
had aggregate assets under management of approximately $803.5 billion.
On February 18, 2020, Franklin Resources and Legg Mason announced that they have entered
into a definitive agreement for Franklin Resources to acquire Legg Mason in an all-cash transaction. As part of this transaction, LMPFA and the subadviser(s), each currently a wholly owned subsidiary of Legg Mason, would become a wholly owned
subsidiary of Franklin Resources. The transaction is subject to approval by Legg Masons shareholders and customary closing conditions, including receipt of applicable regulatory approvals. Subject to such approvals and the satisfaction of the
other conditions, the transaction is expected to be consummated in the latter part of 2020. Under the 1940 Act, consummation of the transaction will result in the automatic termination of the management and subadvisory agreements. Therefore, the
funds Board of Trustees has approved new management and subadvisory agreements that will be presented to the shareholders of the fund for their approval. Additional informational materials will be mailed to shareholders.
Investment professionals
Primary
responsibility for the day-to-day portfolio management, development of investment strategy, oversight and coordination of the fund lies with the following investment professionals. The fund is managed by a broad team of investment professionals.
Senior members of the portfolio management team are responsible for the development of investment strategy and oversight for the fund and coordination of other relevant investment team members. They work together with the broader Western Asset
investment management team on portfolio structure, duration weighting and term structure decisions.
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Investment professional
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Title and Recent Biography
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Investment professional of the fund since
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S. Kenneth Leech
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Chief Investment Officer and has been employed by Western Asset as an investment professional for at least the past five years.
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2018
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John Bellows
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Portfolio Manager/Research Analyst and he has been employed by Western Asset as an investment professional for at least the past five years.
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2018
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Mark S. Lindbloom
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Portfolio Manager and has been employed by Western Asset as an investment professional for at least the past five years.
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2018
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Frederick R. Marki
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Portfolio Manager and has been employed by Western Asset as an investment professional for at least the past five years.
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2018
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Julien A. Scholnick
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Portfolio Manager and has been employed by Western Asset as an investment professional for at least the past five years.
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2018
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The SAI provides information about the compensation of the investment professionals, other accounts managed by the investment
professionals and any fund shares held by the investment professionals.
Management fee
Pursuant to the management agreement and subject to the general supervision of the Board, LMPFA provides or causes to be furnished all investment management,
supervisory, administrative and other services reasonably necessary for the operation of the fund, including certain distribution services (provided pursuant to a separate distribution agreement) and investment advisory services (provided pursuant
to separate subadvisory agreements) under a unitary fee structure. The fund is responsible for paying interest expenses, taxes, brokerage expenses, future 12b-1 fees (if any), acquired fund fees and expenses, extraordinary expenses and the
management fee payable to LMPFA under the management agreement.
The fund pays management fees at an annual rate as follows:
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Name of Fund
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Management Fee
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Western Asset Total Return ETF
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0.49% of average daily net assets
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For the fiscal year ended December 31, 2019, the fund paid LMPFA an effective management fee of 0.45% of the funds average
daily net assets for management services.
A discussion regarding the basis for the Boards approval of the funds management agreement and subadvisory
agreements is available in the funds Annual Report for the period ended December 31, 2019.
Expense limitation
The manager has agreed to waive fees and/or reimburse management fees so that the ratio of total annual fund operating expenses will not exceed 0.45%
(subject to the same exclusions as the management agreement). This arrangement cannot be terminated prior to May 1, 2021 without the Board of Trustees consent.
Additional information
The fund enters into
contractual arrangements with various parties, including, among others, the funds investment manager and the subadviser, who provide services to the fund. Shareholders are not parties to, or intended (or third-party) beneficiaries
of, those contractual arrangements.
This Prospectus and the SAI provide information concerning the fund that you should consider in determining whether to purchase
shares of the fund. The fund may make changes to this information from time to time. Neither this Prospectus nor the SAI is intended to give rise to any contract rights or other rights in any shareholder, other than rights conferred by federal or
state securities laws.
Distribution
Legg
Mason Investor Services, LLC (LMIS), 100 International Drive, Baltimore, Maryland 21202, serves as the distributor of Creation Units for the fund on an agency basis. LMIS does not maintain a secondary market in the funds shares.
LMIS has no role in determining the funds policies or the securities that are purchased or sold by the fund.
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The Board has adopted a distribution and service plan (Plan) pursuant to Rule 12b-1 under the Investment
Company Act of 1940, as amended (the 1940 Act). Under the Plan, the fund is authorized to pay distribution fees in connection with the sale and distribution of its shares and pay service fees in connection with the provision of ongoing
services to shareholders of the fund and the maintenance of shareholder accounts in an amount up to 0.25% of its average daily net assets each year. No Rule 12b-1 fees are currently paid by the fund, and there are no current plans to impose these
fees.
Additional payments
Legg
Mason or its affiliates make payments to broker-dealers, registered investment advisers, banks or other intermediaries (together, intermediaries) related to marketing activities and presentations, educational training programs,
conferences, the development of technology platforms and reporting systems, or their making shares of the fund available to their customers generally and in certain investment programs. Such payments, which may be significant to the intermediary,
are not made by the fund. Rather, such payments are made by Legg Mason or its affiliates from their own resources, which come directly or indirectly in part from fees paid by the fund. A financial intermediary may make decisions about which
investment options it recommends or makes available, or the level of services provided, to its customers based on the payments it is eligible to receive. Therefore, such payments to an intermediary create conflicts of interest between the
intermediary and its customers and may cause the intermediary to recommend the fund over another investment. More information regarding these payments is contained in the funds SAI. Please contact your salesperson or other investment
professional for more information regarding any such payments his or her firm may receive from Legg Mason or its affiliates.
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Shareholder information
Additional shareholder information, including how to buy and sell shares of the fund, is available free of charge by calling toll-free: 1-877-721-1926 or visiting our
website at www.leggmason.com/etfliterature.
Purchasing and selling shares
Shares of the fund may be acquired or redeemed directly from the fund only in Creation Units or multiples thereof, as discussed in the Creations and
redemptions section of this Prospectus. Only an Authorized Participant may engage in creation or redemption transactions directly with the fund. Once created, shares of the fund generally trade in the secondary market in amounts less than a
Creation Unit.
Shares of the fund are listed for trading on the secondary market on NASDAQ. Shares can be bought and sold throughout the trading day like other
publicly traded shares. There is no minimum investment. Although shares are generally purchased and sold in round lots of 100 shares, brokerage firms typically permit investors to purchase or sell shares in smaller odd lots
at no per-share price differential. The funds shares trade on NASDAQ as follows:
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Name of Fund
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Ticker Symbol
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Western Asset Total Return ETF
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WBND
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Share prices are reported in dollars and cents per share
Buying or selling fund shares on an exchange or other secondary market involves two types of costs that may apply to all securities transactions. When buying or selling
shares of the fund through a broker, you may incur a brokerage commission and other charges. The commission is frequently a fixed amount and may be a significant proportional cost for investors seeking to buy or sell small amounts of shares. In
addition, you may incur the cost of the spread, that is, any difference between the bid price and the ask price. The spread varies over time for shares of the fund based on the funds trading volume and market liquidity, and is
generally lower if the fund has high trading volume and market liquidity, and higher if the fund has little trading volume and market liquidity (which is often the case for funds that are newly launched or small in size). The funds spread may
also be impacted by the liquidity of the underlying securities held by the fund, particularly for newly launched or smaller funds or in instances of significant volatility of the underlying securities.
Authorized Participants may acquire shares directly from the fund and may tender their shares for redemption directly to the fund, at net asset value per share only in
Creation Units.
The funds primary listing exchange is NASDAQ. NASDAQ is open for trading Monday through Friday and is closed on weekends and the following
holidays: New Years Day, Martin Luther King, Jr. Day, Presidents Day, Good Friday, Memorial Day, Independence Day, Labor Day, Thanksgiving Day and Christmas Day.
Section 12(d)(1) of the 1940 Act restricts investments by investment companies in the securities of other investment companies. Registered investment companies are
permitted to invest in the fund beyond the limits set forth in Section 12(d)(1), subject to certain terms and conditions set forth in SEC rules or in an SEC exemptive order issued to the fund. In order for a registered investment company to
invest in shares of the fund beyond the limitations of Section 12(d)(1) pursuant to the exemptive relief obtained by the fund, the registered investment company (outside the Legg Mason fund family) must enter into an agreement with the fund.
Frequent purchases and redemptions of fund shares
The Board has evaluated the risks of frequent purchases and redemptions of fund shares (market timing) activities by the funds shareholders. The Board
noted that the funds shares can only be purchased and redeemed directly from the fund in Creation Units by Authorized Participants and that the vast majority of trading in the funds shares occurs on the secondary market. Because the
secondary market trades do not involve the fund directly, it is unlikely those trades would cause many of the harmful effects of market timing, including dilution, disruption of portfolio management, increases in the funds trading costs and
the realization of capital gains.
With respect to trades directly with the fund, to the extent effected in-kind, those trades do not cause any of the harmful
effects (as previously noted) that may result from frequent cash trades. To the extent that the fund permits or requires trades to be effected in whole or in part in cash, the Board noted that those trades could result in dilution to the fund and
increased transaction costs, which could negatively impact the funds ability to achieve its investment objective. However, the Board noted that direct trading by Authorized Participants is critical to ensuring that the funds shares trade
at or close to net asset value. The fund also employs fair valuation pricing to minimize potential dilution from market timing. The fund imposes transaction fees on in-kind purchases and redemptions of fund shares to cover the custodial and other
costs incurred by the fund in effecting in-kind trades. These fees may increase if an investor substitutes cash in part or in whole for securities, reflecting the fact that the funds trading costs increase in those circumstances. Given this
structure, the Board determined that it is not necessary to apply policies and procedures to the fund to detect and deter market timing.
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Book entry
Shares are held in book-entry form, which means that no stock certificates are issued. The Depository Trust Company (DTC) or its nominee is the record owner
of all outstanding shares of the fund and is recognized as the owner of all shares for all purposes.
Investors owning shares are beneficial owners as shown on the
records of DTC or its participants. DTC serves as the securities depository for all shares. Participants in DTC include securities brokers and dealers, banks, trust companies, clearing corporations and other institutions that directly or indirectly
maintain a custodial relationship with DTC. As a beneficial owner of shares, you are not entitled to receive physical delivery of stock certificates or to have shares registered in your name, and you are not considered a registered owner of shares.
Therefore, to exercise any right as an owner of shares, you must rely upon the procedures of DTC and its participants. These procedures are the same as those that apply to any other stocks that you hold in book entry or street name form.
Fund share trading prices
The trading
prices of the funds shares in the secondary market generally differ from the funds daily net asset value and are affected by market forces such as the supply of and demand for ETF shares and underlying securities held by the fund,
economic conditions and other factors. Information regarding the intraday value of shares of the fund, also known as the intra-day indicative value (IIV), is disseminated every 15 seconds throughout each trading day by the
national securities exchange on which the funds shares are listed or by market data vendors or other information providers. The IIV is based on the current market value of the securities and/or cash required to be deposited in exchange for a
Creation Unit but does not include a reduction for the fees, operating expenses or transaction costs incurred by the fund. The IIV does not necessarily reflect the precise composition of the current portfolio of securities held by the fund at a
particular point in time or the best possible valuation of the current portfolio. Therefore, the IIV should not be viewed as a real-time update of the funds net asset value, which is computed only once a day. The IIV is generally
determined by using both current market quotations and/or price quotations obtained from broker-dealers and other market intermediaries that may trade in the portfolio securities held by the fund. The quotations of certain fund holdings may not be
updated during U.S. trading hours if such holdings do not trade in the United States and thus may not reflect the current fair value of those securities. The fund is not involved in, or responsible for, the calculation or dissemination of the IIV
nor makes any representation or warranty as to its accuracy.
Calculation of net asset value
The funds net asset value per share is the value of its assets minus its liabilities divided by the number of shares outstanding.
The fund calculates its net asset value every day the New York Stock Exchange (the NYSE) is open. The fund generally values its securities and other assets
and calculates its net asset value as of the scheduled close of regular trading on the NYSE, normally at 4:00 p.m. (Eastern time). If the NYSE closes at a time other than the scheduled closing time, the fund will calculate its net asset value as of
the scheduled closing time. The NYSE is closed on certain holidays listed in the SAI.
Valuation of the funds securities and other assets is performed in
accordance with procedures approved by the Board. These procedures delegate most valuation functions to the manager, which generally uses independent third party pricing services approved by the Board. Under the procedures, assets are valued as
follows:
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Equity securities and certain derivative instruments that are traded on an exchange are valued at the closing price (which
may be reported at a different time than the time at which the funds NAV is calculated) or, if that price is unavailable or deemed by the manager not representative of market value, the last sale price. Where a security is traded on more than
one exchange (as is often the case overseas), the security is generally valued at the price on the exchange considered by the manager to be the primary exchange. In the case of securities not traded on an exchange, or if exchange prices are not
otherwise available, the prices are typically determined by independent third party pricing services that use a variety of techniques and methodologies.
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The valuations for fixed income securities and certain derivative instruments are typically the prices supplied by
independent third party pricing services, which may use market prices or broker/dealer quotations or a variety of fair valuation techniques and methodologies.
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The valuations of securities traded on foreign markets and certain fixed income securities will generally be based on
prices determined as of the earlier closing time of the markets on which they primarily trade, unless a significant event has occurred. When the fund holds securities or other assets that are denominated in a foreign currency, the fund will use the
currency exchange rates, generally determined as of 4:00 p.m. (London time). Foreign markets are open for trading on weekends and other days when the fund does not price its shares. Therefore, the value of the funds shares may change on days
when you will not be able to purchase or sell the funds shares.
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Investments in ETFs and closed-end funds listed on an exchange are valued at the closing sale or official closing price on
that exchange. Investments in open-end funds other than ETFs are valued at the net asset value per share of the class of the underlying fund held by the fund as determined on each business day.
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If independent third party pricing services are unable to supply prices for a portfolio investment, or if the prices
supplied are deemed by the manager to be unreliable, the market price may be determined by the manager using quotations from one or more broker/dealers. When such prices or quotations are not available, or when the manager believes that they are
unreliable, the manager may price securities using fair value procedures approved by the Board. These procedures permit, among other things, the use of a formula or other method that takes into consideration market indices, yield curves and other
specific adjustments to determine fair value. Fair value of a security is the amount, as determined by the manager in good faith, that the fund might reasonably expect to receive upon a current sale of the security. The fund may also
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Western Asset Total Return ETF
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31
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use fair value procedures if the manager determines that a significant event has occurred between the time at which a market price is determined and the time at which the funds net asset
value is calculated.
|
Many factors may influence the price at which the fund could sell any particular portfolio investment. The sales price may
well differhigher or lowerfrom the funds last valuation, and such differences could be significant, particularly for securities that trade in relatively thin markets and/or markets that experience extreme volatility. Moreover,
valuing securities using fair value methodologies involves greater reliance on judgment than valuing securities based on market quotations. A fund that uses fair value methodologies may value those securities higher or lower than another fund using
market quotations or its own fair value methodologies to price the same securities. There can be no assurance that a fund could obtain the value assigned to a security if it were to sell the security at approximately the time at which the fund
determines its net asset value.
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32
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Western Asset Total Return ETF
|
Dividends, other distributions and taxes
Dividends and other distributions
The fund pays
dividends from substantially all of its net investment income monthly. Shares will generally begin to earn dividends on the settlement date of purchase. The fund generally distributes capital gain, if any, once a year, typically in December. The
fund may pay additional distributions and dividends in order to avoid a federal tax.
Dividends and other distributions on shares of the fund are distributed on a
pro rata basis to beneficial owners of such shares. Dividend payments are made through DTC participants and indirect participants to beneficial owners then of record with proceeds received from the fund.
The Board reserves the right to revise the dividend policy or postpone the payment of dividends if warranted in the Boards judgment due to unusual circumstances.
Reinvestment of distributions
Distributions are paid by the fund in cash. No dividend reinvestment service is provided by the fund. Broker-dealers may make available the DTC book-entry Dividend
Reinvestment Service for use by beneficial owners of the fund for reinvestment of their dividend distributions. Beneficial owners should contact their broker to determine the availability and costs of the service and the details of participation
therein. Brokers may require beneficial owners to adhere to specific procedures and timetables. If this service is available and used, dividend distributions of both income and realized gains will be automatically reinvested in additional whole
shares of the fund purchased in the secondary market.
Taxes
The following discussion is very general, applies only to shareholders who are U.S. persons, and does not address shareholders subject to special rules, such as those
who hold fund shares through an IRA, 401(k) plan or other tax-advantaged account. Except as specifically noted, the discussion is limited to federal income tax matters, and does not address state, local, foreign or non-income taxes. Further
information regarding taxes, including certain federal income tax considerations relevant to non-U.S. persons, is included in the SAI. Because each shareholders circumstances are different and special tax rules may apply, you should consult
your tax adviser about federal, state, local and/or foreign tax considerations that may be relevant to your particular situation.
In general, selling shares and
receiving dividends and distributions are taxable events. Distributions attributable to short-term capital gains are taxable to you as ordinary income. Distributions attributable to qualified dividend income received by the fund, if any, may be
eligible to be taxed to noncorporate shareholders at the reduced rates applicable to long-term capital gain if certain requirements are satisfied. Distributions of net capital gain reported by the fund as capital gain dividends are taxable to you as
long-term capital gain regardless of how long you have owned your shares. Noncorporate shareholders ordinarily pay tax at reduced rates on long-term capital gain.
You may want to avoid buying shares when the fund is about to declare a dividend or capital gain distribution because it will be taxable to you even though it may
economically represent a return of a portion of your investment.
A Medicare contribution tax is imposed at the rate of 3.8% on all or a portion of net
investment income of U.S. individuals if their income exceeds specified thresholds, and on all or a portion of undistributed net investment income of certain estates and trusts. Net investment income generally includes for this purpose dividends and
capital gain distributions paid by the fund and gain on the redemption, sale or exchange of fund shares.
A dividend declared by the fund in October, November
or December and paid during January of the following year will, in certain circumstances, be treated as paid in December for tax purposes.
If the fund meets
certain requirements with respect to its holdings, it may elect to pass through to shareholders foreign taxes that it pays, in which case each shareholder will include the amount of such taxes in computing gross income, but will be
eligible to claim a credit or deduction for such taxes, subject to generally applicable limitations on such deductions and credits. If the fund does not so elect, the foreign taxes paid or withheld will nonetheless reduce the funds taxable
income. In addition, the funds investment in certain foreign securities, foreign currencies or foreign currency derivatives may affect the amount, timing, and character of fund distributions to shareholders.
Capital gain or loss realized upon a sale of fund shares is generally treated as a long-term gain or loss if the shares have been held for more than one year. Any
capital gain or loss realized upon a sale of fund shares held for one year or less is generally treated as short-term gain or loss, except that any capital loss on the sale of shares held for six months or less is treated as long-term capital loss
to the extent that capital gain dividends were paid with respect to such shares.
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Western Asset Total Return ETF
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33
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Creations and redemptions
Prior to trading in the secondary market, shares of the fund are created at NAV by market makers, large investors and institutions only in block-size
Creation Units or multiples thereof. The following table sets forth the number of shares of the fund that constitute a Creation Unit:
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Fund
|
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Creation unit size
|
Western Asset Total Return ETF
|
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100,000
|
Each creator or Authorized Participant enters into an authorized participant agreement with LMIS, the funds
distributor. Only an Authorized Participant may create or redeem Creation Units directly with the fund.
The fund generally only accepts cash to purchase
Creation Units. The purchaser must transfer cash in an amount equal to the value of the Creation Unit(s) purchased and the applicable transaction fee. However, a creation transaction, which is subject to acceptance by LMIS, may also take place when
an Authorized Participant deposits into the fund a designated portfolio of securities (including any portion of such securities for which cash may be substituted) and a specified amount of cash approximating the holdings of the fund in exchange for
a specified number of Creation Units (a Creation Basket). Except in limited circumstances, the composition of such portfolio will correspond pro rata to the positions in the funds portfolio.
Redemption proceeds will generally be paid in cash. However, shares may also be redeemed in Creation Units for a designated portfolio of securities (including any
portion of such securities for which cash may be substituted) held by the fund (Fund Securities) and a specified amount of cash. Except in limited circumstances, the composition of such portfolio will correspond pro rata to the positions
in the funds portfolio. Except when aggregated in Creation Units, shares are not redeemable by the fund.
The prices at which creations and
redemptions occur are based on the next calculation of net asset value after a creation or redemption order is received in an acceptable form under the authorized participant agreement.
In the event of a system failure or other interruption, including disruptions at market makers or Authorized Participants, orders to purchase or redeem Creation Units
either may not be executed according to the funds instructions or may not be executed at all, or the fund may not be able to place or change orders.
To the
extent the fund engages in in-kind transactions, the fund intends to comply with the U.S. federal securities laws in accepting securities for deposit and satisfying redemptions with redemption securities by, among other means, assuring that any
securities accepted for deposit and any securities used to satisfy redemption requests will be sold in transactions that would be exempt from registration under the Securities Act of 1933 (the 1933 Act). Further, an Authorized
Participant that is not a qualified institutional buyer, as such term is defined in Rule 144A under the 1933 Act, will not be able to receive restricted securities eligible for resale under Rule 144A.
Information about the procedures regarding creation and redemption of Creation Units (including the cut-off times for receipt of creation and redemption orders) is
included in the funds SAI.
Because new shares may be created and issued on an ongoing basis, at any point during the life of the fund a
distribution, as such term is used in the 1933 Act, may be occurring. Broker-dealers and other persons are cautioned that some activities on their part may, depending on the circumstances, result in their being deemed participants in a
distribution in a manner that could render them statutory underwriters subject to the prospectus delivery and liability provisions of the 1933 Act. Any determination of whether one is an underwriter must take into account all the relevant facts and
circumstances of each particular case.
Broker-dealers should also note that dealers who are not underwriters but are participating in a distribution (as
contrasted to ordinary secondary transactions), and thus dealing with shares that are part of an unsold allotment within the meaning of Section 4(a)(3)(C) of the 1933 Act, would be unable to take advantage of the prospectus delivery
exemption provided by Section 4(a)(3) of the 1933 Act. For delivery of prospectuses to exchange members, the prospectus delivery mechanism of Rule 153 under the 1933 Act is available only with respect to transactions on a national securities
exchange.
Costs associated with creations and
redemptions. Authorized Participants are charged standard creation and redemption transaction fees to offset transfer and other transaction costs associated with the issuance and redemption of Creation Units.
The standard creation and redemption transaction fees are set forth in the table below. The standard creation transaction fee is charged to the Authorized Participant on the day such Authorized Participant creates a Creation Unit, and is the same
regardless of the number of Creation Units purchased by the Authorized Participant on the applicable business day. Similarly, the standard redemption transaction fee is charged to the Authorized Participant on the day such Authorized Participant
redeems a Creation Unit, and is the same regardless of the number of Creation Units redeemed by the Authorized Participant on the applicable business day. Creations and redemptions for cash (when cash creations and redemptions (in whole or in part)
are available or specified) are also subject to an additional charge (as shown in the table below). This charge is intended to compensate for brokerage, tax, foreign exchange, execution, market impact and other costs and expenses related to cash
transactions. Investors who use the services of a broker or other financial intermediary to acquire or dispose of fund shares may pay fees for such services.
The following table shows, as of December 31, 2019 the approximate value of one Creation Unit of the fund, standard fees, the additional charge for creations and
the maximum additional charge for redemptions (as described above):
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34
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Western Asset Total Return ETF
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Approximate
Value of a
Creation Unit ($)
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|
Creation
Unit Size
|
|
Standard
Creation/
Redemption
Transaction
Fee ($)
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|
Additional
Charge for
Creations* (%)
|
|
Maximum
Additional Charge
for
Redemptions**
(%)
|
Western Asset Total Return ETF
|
|
2,688,000
|
|
100,000
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|
100
|
|
2.0
|
|
2.0
|
*
|
This amount, reflected as a percentage of the NAV per Creation Unit, generally will be equal to the costs and expenses
incurred by a fund in connection with such cash transactions and is not subject to a maximum limit.
|
**
|
As a percentage of the NAV per Creation Unit inclusive of the standard redemption transaction fee.
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Western Asset Total Return ETF
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35
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Financial highlights
The financial highlights table is intended to help you understand the performance of the fund for the past five years, unless otherwise noted. Total return represents
the rate that a shareholder would have earned (or lost) on a fund share assuming reinvestment of all dividends and distributions. Unless otherwise noted, this information has been audited by the funds independent registered public accounting
firm, PricewaterhouseCoopers LLP, whose report, along with the funds financial statements, is incorporated by reference into the funds SAI (see back cover) and is included in the funds annual report. The funds annual report
is available upon request by calling toll-free 1-877-721-1926.
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For a share of beneficial interest outstanding throughout each year ended December 31, unless otherwise noted:
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20191
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20181,2
|
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Net asset value, beginning of year
|
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$25.16
|
|
|
|
$25.00
|
|
|
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|
Income from operations:
|
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|
|
|
|
|
|
Net investment income
|
|
|
0.82
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|
|
0.20
|
|
Net realized and unrealized gain
|
|
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2.45
|
|
|
|
0.10
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|
Total income from operations
|
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3.27
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|
0.30
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|
|
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Less distributions from:
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|
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Net investment income
|
|
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(0.90)
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|
|
(0.14)
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Net realized gains
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(0.65)
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Total distributions
|
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(1.55)
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(0.14)
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Net asset value, end of year
|
|
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$26.88
|
|
|
|
$25.16
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Total return, based on NAV3
|
|
|
13.19
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%
|
|
|
1.19
|
%
|
|
|
|
Net assets, end of year (000s)
|
|
|
$107,525
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$25,162
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Ratios to average net assets:
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|
|
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Gross expenses4
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0.49
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%
|
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0.49
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%5
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Net expenses4
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0.45
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0.45
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5
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Net investment income
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|
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3.09
|
|
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3.33
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5
|
|
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Portfolio turnover rate6
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80
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%
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18
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%
|
1
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Per share amounts have been calculated using the average shares method.
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2
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For the period October 3, 2018 (inception date) to December 31, 2018.
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3
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Performance figures may reflect fee waivers and/or expense reimbursements. In the absence of fee waivers and/or expense
reimbursements, the total return would have been lower. The total return calculation assumes that distributions are reinvested at NAV. Past performance is no guarantee of future results. Total returns for periods of less than one year are not
annualized.
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4
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As a result of an expense limitation arrangement, the ratio of total annual fund operating expenses, other than interest
expenses, taxes, brokerage expenses, future 12b-1 fees (if any), acquired fund fees and expenses, extraordinary expenses and the management fee payable to LMPFA under the investment management agreement, to the average net assets did not exceed
0.45%. This expense limitation arrangement cannot be terminated prior to May 1, 2021 without the Board of Trustees consent.
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6
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Excluding mortgage dollar rolls transactions. If mortgage dollar roll transactions had been included, the portfolio
turnover rate would have been 285% and 97% for the year ended December 31, 2019 and the period ended December 31, 2018, respectively.
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36
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Western Asset Total Return ETF
|
Legg Mason Fixed Income
ETFs
Western Asset Total Return ETF
You may visit
www.leggmason.com/etfliterature for a free copy of a Prospectus, Statement of Additional Information (SAI) or an Annual or Semi-Annual Report.
Shareholder reports Additional information about the funds investments is available in the funds Annual and Semi-Annual Reports to
shareholders. In the funds Annual Report, you will find a discussion of the market conditions and investment strategies that significantly affected the funds performance during its last fiscal year. The independent registered public
accounting firms report and financial statements in the funds Annual Report are incorporated by reference into (are legally a part of) this Prospectus
(https://www.sec.gov/Archives/edgar/data/1645194/000119312520052248/d81782dncsr.htm).
The fund sends only one report to a household if more than one account has the same last name and same address. Contact your Service Agent or the fund if you do not
want this policy to apply to you.
Statement of additional information The SAI provides more detailed information about the fund and is incorporated by reference into (is legally a part of) this Prospectus.
You can make inquiries about the fund or obtain shareholder reports or the SAI (without charge) by contacting your Service Agent, by calling the fund at 1-877-721-1926,
or by writing to the fund at 100 First Stamford Place, Attn: Shareholder Services 5th Floor, Stamford, Connecticut 06902.
Reports and other information about the fund are available on the EDGAR Database on the Securities and Exchange Commissions Internet site at http://www.sec.gov. Copies of this information may be obtained for a duplicating fee by electronic request at the following E-mail address: publicinfo@sec.gov.
If someone makes a statement about the
fund that is not in this Prospectus, you should not rely upon that information. Neither the fund nor the distributor is offering to sell shares of the fund to any person to whom the fund may not lawfully sell its shares.
(Investment Company Act
file no. 811-23096)
ETFF411564ST 05/20
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Western Asset Total Return ETF
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37
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May 1, 2020
LEGG MASON ETF INVESTMENT TRUST
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Fund
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Exchange
|
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Ticker Symbol
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WESTERN ASSET TOTAL RETURN ETF (the Fund)
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NASDAQ
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WBND
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620 Eighth Avenue
New
York, New York 10018
1-877-721-1926
STATEMENT OF ADDITIONAL INFORMATION
This Statement of Additional Information (SAI) is not a prospectus and is meant to be read in conjunction with the Prospectus of the Fund,
dated May 1, 2020, as amended or supplemented from time to time, and is incorporated by reference in its entirety into the Prospectus.
Additional
information about the Funds investments is available in the Funds annual and semi-annual reports to shareholders. The annual report contains financial statements that are incorporated herein by reference ((https://www.sec.gov/Archives/edgar/data/1645194/000119312520052248/d81782dncsr.htm)). The Funds Prospectus and copies of the annual and
semi-annual reports may be obtained free of charge by writing the Fund at 100 First Stamford Place, Attn: Shareholder Services5th Floor, Stamford, Connecticut 06902, by calling the telephone number set forth above, by sending an e-mail request
to prospectus@leggmason.com or by visiting www.leggmason.com/etfliterature. Legg Mason Investor Services, LLC (LMIS or the Distributor), a wholly-owned broker/dealer subsidiary of Legg Mason, Inc., serves as the Funds
sole and exclusive distributor. The Fund only issues or redeems shares that have been aggregated into blocks of shares, called Creation Units, to authorized participants who have entered into agreements with the Funds distributor. The
following table sets forth the number of shares that constitute a Creation Unit for the Fund:
Creation Unit Size
100,000
THIS SAI IS NOT A PROSPECTUS AND IS
AUTHORIZED FOR DISTRIBUTION TO PROSPECTIVE INVESTORS ONLY IF PRECEDED OR ACCOMPANIED BY AN EFFECTIVE PROSPECTUS.
No person has been authorized
to give any information or to make any representations not contained in the Prospectus or this SAI in connection with the offering made by the Prospectus and, if given or made, such information or representations must not be relied upon as having
been authorized by the Fund or the Distributor. The Prospectus and this SAI do not constitute an offering by the Fund or by the Distributor in any jurisdiction in which such offering may not lawfully be made.
TABLE OF CONTENTS
GLOSSARY OF TERMS
Because the following is a combined glossary of terms used for all the Legg Mason Funds, certain terms below may not apply to your fund. Any terms
used but not defined herein have the meaning ascribed to them in the applicable Funds prospectus.
1933 Act means the Securities Act of 1933,
as amended.
1934 Act means the Securities Exchange Act of 1934, as amended.
1940 Act means the Investment Company Act of 1940, as amended.
1940 Act Vote means the vote of the lesser of (a) more than 50% of the outstanding shares of the Fund or (b) 67% or more of the shares of the Fund
present at a shareholders meeting if more than 50% of the outstanding shares of that Fund are represented at the meeting in person or by proxy.
Advisers Act means the Investment Advisers Act of 1940, as amended.
Authorized Participant means broker-dealers that are permitted to create and redeem shares directly with the Fund and who have entered into agreements with
the Funds Distributor.
Board means the Board of Trustees.
Cash Component means a deposit of a specified cash payment that is exchanged (with Deposit Securities, if any) for Creation Units of the Fund.
CEA means the Commodity Exchange Act, as amended.
CFTC
means the U.S. Commodity Futures Trading Commission.
Code means the Internal Revenue Code of 1986, as amended.
Creation Units means aggregations of a specified number of shares by which the Fund offers and issues.
Deposit Securities means the basket of securities and/or instruments exchanged (with the Cash Component, if any) for Creation Units of the Fund.
Distributor means the party that is responsible for the distribution or sale of the Funds shares. Legg Mason Investor Services, LLC (LMIS)
is the Funds distributor.
DTC means The Depository Trust Company, which is a limited-purpose trust company, which was created to hold securities
of participants of DTC (DTC Participants) and to facilitate the clearance and settlement of securities transactions among the DTC Participants in such securities through electronic book-entry changes in accounts of the DTC Participants,
thereby eliminating the need for physical movement of securities certificates.
Exchange means the applicable exchange on which shares of the Fund are
listed for trading on the secondary market as indicated on the front cover of this SAI.
FINRA means the Financial Industry Regulatory Authority, Inc.
Fund means the Fund or Funds listed on the cover of this SAI unless stated otherwise.
1
Fund Deposit means the minimum initial and subsequent investment amount for a Creation Unit of the Fund and
consists of the Deposit Securities and Cash Component.
Fundamental Investment Policy means an investment policy of the Fund that may be changed only by
a 1940 Act Vote. Only those policies expressly designated as such are fundamental investment policies. All other policies and restrictions may be changed by the Board without shareholder approval.
Independent Trustee means a Trustee of the Trust who is not an interested person (as defined in the 1940 Act) of the Trust.
IRAs means Individual Retirement Accounts.
IRS means
Internal Revenue Service.
IIV means the Funds intra-day indicative value.
Legg Mason means Legg Mason, Inc.
Legg Mason Funds means
the funds managed by Legg Mason Partners Fund Advisor, LLC or an affiliate.
Manager or LMPFA means Legg Mason Partners Fund Advisor, LLC.
NAV means net asset value.
NASDAQ means NASDAQ Stock
Market, LLC.
NRSROs means nationally recognized (or non-U.S.) statistical rating organizations, including, but not limited to, Moodys Investors
Service, Inc. (Moodys), Fitch Ratings and S&P Global Ratings (S&P).
NSCC means the National Securities Clearing
Corporation.
NYSE means the New York Stock Exchange.
Plan means the distribution and service plan adopted pursuant to Rule 12b-1 under the 1940 Act.
Prospectus means the prospectus of a Fund as referenced on the cover page of this SAI.
Redemption Securities means the securities that will be delivered in an in-kind transfer in a redemption.
SAI means this Statement of Additional Information.
SEC
means the U.S. Securities and Exchange Commission.
Subadviser means Western Asset Management Company, LLC, Western Asset Management Company Limited,
Western Asset Management Company Pte. Ltd. and Western Asset Management Company Ltd, as applicable, and as referred to in the Funds Prospectus and this SAI.
Transmittal Date means the date on which an order to create Creation Units or an order to redeem Creation Units is placed.
Trust means Legg Mason ETF Investment Trust.
Trustees
means the trustees of the Trust.
2
INVESTMENT POLICIES
Investment Objective and Strategies
The Fund is registered under the 1940 Act, as an open-end management investment company. The Funds Prospectus discusses the Funds
investment objective and strategies. The following is a summary of certain strategies and investment limitations of the Fund and supplements the description of the Funds investment strategies in its Prospectus. Additional information regarding
investment practices and risk factors with respect to the Fund may also be found below in the section entitled Investment Practices and Risk Factors.
Western Asset Total Return ETF
●
|
|
Investment objective. The Fund seeks to maximize total return, consistent with prudent investment management and liquidity
needs.
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●
|
|
The Fund is an actively managed ETF.
|
●
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|
Under normal market conditions, the Fund will seek its investment objective by investing at least 80% of its assets in a
portfolio comprised of fixed income securities, debt instruments, derivatives, equity securities of any type acquired in reorganizations of issuers of fixed income securities or debt instruments (work out securities), non-convertible
preferred securities, warrants, cash and cash equivalents, foreign currencies, and exchange-traded funds (ETFs) that provide exposure to these investments (Principal Investments). Debt instruments include loans and similar
debt instruments that are not characterized as securities under applicable case law.
|
●
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|
As part of its 80% policy, the Fund intends to invest in derivatives that (i) provide exposure to the Principal
Investments, (ii) are used to risk manage the Funds holdings, and/or (iii) are used to enhance returns, such as through covered call strategies. The risk management uses of derivatives will include managing
(i) investment-related risks, (ii) risks due to fluctuations in securities prices, interest rates, or currency exchanges rates, (iii) risks due to the credit-worthiness of an issuer, and (iv) the effective duration of the
Funds portfolio. The types of derivatives in which the Fund will invest include swaps and security-based swaps, futures and options on futures, currency forwards, and currency options and security options. As a result of the Funds use of
derivatives and to serve as collateral, the Fund may also hold significant amounts of U.S. Treasury securities, cash and cash equivalents and foreign currencies in which certain derivatives are denominated.
|
●
|
|
The types of fixed income securities in which the Fund may invest include corporate debt securities, U.S. and non-U.S.
government securities, asset-backed securities (ABS), mortgage-backed securities (MBS) (including commercial MBS (CMBS), residential MBS (RMBS) and non-agency collateralized mortgage obligations
(CMOs)), collateralized debt obligations (CDOs) and mortgage dollar rolls. The fixed income securities and debt instruments in which the Fund may invest may pay fixed, variable or floating rates of interest. The Fund will not
invest more than 20% of its portfolio in ABS and non-agency, non-government sponsored enterprise and privately-issued MBS or more than 10% of the Funds total assets in CDOs.
|
●
|
|
The Fund will also not invest more than 20% of its total assets in junior loans (e.g., debt instruments that are unsecured
and subordinated). Debt instruments are comprised primarily of the following: (i) U.S. or foreign loans made by banks and participations in such loans, loans made by commercial non-bank lenders and participations on such loans, loans made by
governmental entities and participations in such loans and/or other extensions of credit, such as guarantees made by any of the foregoing lenders; and (ii) U.S. or foreign loans on real estate secured by mortgages and participations in such
loans.
|
●
|
|
Although the Fund may invest in securities and debt instruments of any maturity, the Fund expects the normal range of the
Funds effective duration to be approximately 2 to 9 years. Effective duration seeks to measure the expected sensitivity of market price to changes in interest rates, taking into account the anticipated effects of structural complexities (for
example, some bonds can be prepaid by the issuer).
|
●
|
|
The Fund may invest up to 30% of its assets in below investment grade fixed income securities or debt instruments. For
these purposes, investment grade is defined as investments with a rating at the time of purchase in one of the four highest categories of at least one NRSRO (e.g., BBB- or higher or Baa3 or higher) or, if unrated, securities of
comparable quality at the time of purchase (as determined by the subadviser). Securities rated below investment grade (e.g., BB+ to D or Baa1 to C) or, if unrated, securities of comparable quality at the time of purchase (as determined by the
subadviser) are commonly known as junk bonds or high yield securities.
|
●
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The Fund may invest in securities issued by both U.S. and non-U.S. issuers (including issuers in emerging markets), but the
Fund will not invest more than 30% of its total assets in securities or debt instruments of non-U.S. issuers or more than 25% of its total assets directly in non-U.S. dollar denominated securities or debt instruments. For purposes of these
limitations only,
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derivatives, warrants and U.S.-listed ETFs that provide indirect exposure to the investments described above will not be counted by the Fund in calculating its holdings in non-U.S. issuers or in
non-U.S. dollar denominated securities or debt instruments.
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Fundamental and Non-Fundamental Investment Policies
General
The Fund has adopted the fundamental and
non-fundamental investment policies below for the protection of shareholders. Fundamental investment policies of the Fund may not be changed without a 1940 Act Vote. The Board may change non-fundamental investment policies at any time without
shareholder approval and upon notice to shareholders.
If any percentage restriction described below (other than the limitation on borrowing) is
complied with at the time of an investment, a later increase or decrease in the percentage resulting from a change in asset values or characteristics will not constitute a violation of such restriction, unless otherwise noted below.
The Funds investment objective is non-fundamental.
Fundamental Investment Policies
The Funds fundamental investment policies are as follows:
Borrowing. The Fund may not borrow money except as permitted by (i) the 1940 Act, or interpretations or modifications by the SEC, SEC staff
or other authority with appropriate jurisdiction, or (ii) exemptive or other relief or permission from the SEC, SEC staff or other authority.
Underwriting. The Fund may not engage in the business of underwriting the securities of other issuers except as permitted by (i) the 1940
Act, or interpretations or modifications by the SEC, SEC staff or other authority with appropriate jurisdiction, or (ii) exemptive or other relief or permission from the SEC, SEC staff or other authority.
Lending. The Fund may lend money or other assets to the extent permitted by (i) the 1940 Act, or interpretations or modifications by the SEC,
SEC staff or other authority with appropriate jurisdiction, or (ii) exemptive or other relief or permission from the SEC, SEC staff or other authority.
Senior Securities. The Fund may not issue senior securities except as permitted by (i) the 1940 Act, or interpretations or modifications by
the SEC, SEC staff or other authority with appropriate jurisdiction, or (ii) exemptive or other relief or permission from the SEC, SEC staff or other authority.
Real Estate. The Fund may not purchase or sell real estate except as permitted by (i) the 1940 Act, or interpretations or modifications by
the SEC, SEC staff or other authority with appropriate jurisdiction, or (ii) exemptive or other relief or permission from the SEC, SEC staff or other authority.
Commodities. The Fund may purchase or sell commodities or contracts related to commodities to the extent permitted by (i) the 1940 Act, or
interpretations or modifications by the SEC, SEC staff or other authority with appropriate jurisdiction, or (ii) exemptive or other relief or permission from the SEC, SEC staff or other authority.
Concentration. The Fund will not invest more than 25% of its total assets in the securities of one or more issuers conducting their principal
business activities in the same industry, except as permitted by exemptive relief or other relief or permission from the SEC, SEC staff or other authority with appropriate jurisdiction.
With respect to the fundamental policy relating to borrowing money set forth above, the 1940 Act permits a fund to borrow money in amounts of up to
one-third of the funds total assets from banks for any purpose, and to borrow up to 5% of the funds total assets from banks or other lenders for temporary purposes. (A funds total assets include the amounts being borrowed.) To
limit the risks attendant to borrowing, the 1940 Act requires a fund to maintain an asset coverage of at least 300% of the amount of its borrowings, provided that in the event that the funds asset coverage falls below 300%, the
fund is required to reduce the amount of its borrowings so that it meets the 300% asset coverage threshold within three days (not including Sundays and holidays). Asset coverage means the ratio that the value of a funds total assets (including
amounts borrowed), minus liabilities other than borrowings, bears to the aggregate amount of all borrowings. Certain trading practices
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and investments, such as reverse repurchase agreements, may be considered to be borrowings, and thus subject to the 1940 Act restrictions. Borrowing money to increase portfolio holdings is known
as leveraging. Borrowing, especially when used for leverage, may cause the value of the Funds shares to be more volatile than if the Fund did not borrow. This is because borrowing tends to magnify the effect of any increase or
decrease in the value of the Funds portfolio holdings. Borrowed money thus creates an opportunity for greater gains, but also greater losses. To repay borrowings, the Fund may have to sell securities at a time and at a price that is
unfavorable to the Fund. There also are costs associated with borrowing money, and these costs would offset and could eliminate the Funds net investment income in any given period. Currently, the Fund does not have any intention of borrowing
money for leverage. The policy above will be interpreted to permit the Fund to engage in trading practices and investments that may be considered to be borrowing to the extent permitted by the 1940 Act. Short-term credits necessary for the
settlement of securities transactions and arrangements with respect to securities lending will not be considered to be borrowings under the policy. Practices and investments that may involve leverage but are not considered to be borrowings are not
subject to the policy.
With respect to the fundamental policy relating to underwriting set forth above, the 1940 Act does not prohibit a fund from
engaging in the underwriting business or from underwriting the securities of other issuers; in fact, the 1940 Act permits a fund to have underwriting commitments of up to 25% of its assets under certain circumstances. Those circumstances currently
are that the amount of the funds underwriting commitments, when added to the value of the funds investments in issuers where the fund owns more than 10% of the outstanding voting securities of those issuers, cannot exceed the 25% cap. A
fund engaging in transactions involving the acquisition or disposition of portfolio securities may be considered to be an underwriter under the 1933 Act. Under the 1933 Act, an underwriter may be liable for material omissions or misstatements in an
issuers registration statement or prospectus. Securities purchased from an issuer and not registered for sale under the 1933 Act are considered restricted securities. There may be a limited market for these securities. If these securities are
registered under the 1933 Act, they may then be eligible for sale but participating in the sale may subject the seller to underwriter liability. These risks could apply to a fund investing in restricted securities. Although it is not believed that
the application of the 1933 Act provisions described above would cause the Fund to be engaged in the business of underwriting, the policy above will be interpreted not to prevent the Fund from engaging in transactions involving the acquisition or
disposition of portfolio securities, regardless of whether the Fund may be considered to be an underwriter under the 1933 Act.
With respect to the
fundamental policy relating to lending set forth above, the 1940 Act does not prohibit a fund from making loans; however, SEC staff interpretations currently prohibit funds from lending more than one-third of their total assets, except through the
purchase of debt obligations or the use of repurchase agreements. (A repurchase agreement is an agreement to purchase a security, coupled with an agreement to sell that security back to the original seller on an agreed-upon date at a price that
reflects current interest rates. The SEC frequently treats repurchase agreements as loans.) While lending securities may be a source of income to the Fund, as with other extensions of credit, there are risks of delay in recovery or even loss of
rights in the underlying securities should the borrower fail financially. However, loans would be made only when the Funds Subadvisers believe the income justifies the attendant risks. The Fund also will be permitted by this policy to make
loans of money, including to other funds. The Fund would have to obtain exemptive relief from the SEC to make loans to other funds. The policy above will be interpreted not to prevent the Fund from purchasing or investing in debt obligations and
loans. In addition, collateral arrangements with respect to options, forward currency and futures transactions and other derivative instruments, as well as delays in the settlement of securities transactions, will not be considered loans.
With respect to the fundamental policy relating to issuing senior securities set forth above, senior securities are defined as fund
obligations that have a priority over the funds shares with respect to the payment of dividends or the distribution of fund assets. The 1940 Act prohibits a fund from issuing senior securities, except that the fund may borrow money in amounts
of up to one-third of the funds total assets from banks for any purpose. A fund also may borrow up to 5% of the funds total assets from banks or other lenders for temporary purposes, and these borrowings are not considered senior
securities. The issuance of senior securities by a fund can increase the speculative character of the funds outstanding shares through leveraging. Leveraging of the Funds portfolio through the issuance of senior securities magnifies the
potential for gain or loss on monies, because even though the Funds net assets remain the same, the total risk to investors is increased to the extent of the Funds gross assets. The policy above will be interpreted not to prevent
collateral arrangements with respect to swaps, options, forward or futures contracts or other derivatives, or the posting of initial or variation margin.
With respect to the fundamental policy relating to real estate set forth above, the 1940 Act does not prohibit a fund from owning real estate; however, a
fund is limited in the amount of illiquid assets it may purchase. Investing in real estate may
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involve risks, including that real estate is generally considered illiquid and may be difficult to value and sell. Owners of real estate may be subject to various liabilities, including
environmental liabilities. To the extent that investments in real estate are considered illiquid, an SEC rule limits a funds purchases of illiquid securities to 15% of net assets. The policy above will be interpreted not to prevent the Fund
from investing in real estate-related companies, companies whose businesses consist in whole or in part of investing in real estate, instruments (like mortgages) that are secured by real estate or interests therein, or real estate investment trust
securities.
With respect to the fundamental policy relating to commodities set forth above, the 1940 Act does not prohibit a fund from owning
commodities, whether physical commodities and contracts related to physical commodities (such as oil or grains and related futures contracts), or financial commodities and contracts related to financial commodities (such as currencies and, possibly,
currency futures). However, a fund is limited in the amount of illiquid assets it may purchase. To the extent that investments in commodities are considered illiquid, an SEC rule limits a funds purchases of illiquid securities to 15% of net
assets. If the Fund were to invest in a physical commodity or a physical commodity-related instrument, the Fund would be subject to the additional risks of the particular physical commodity and its related market. The value of commodities and
commodity-related instruments may be extremely volatile and may be affected either directly or indirectly by a variety of factors. There also may be storage charges and risks of loss associated with physical commodities. The policy above will be
interpreted to permit investments in exchange traded funds that invest in physical and/or financial commodities.
With respect to the fundamental
policy relating to concentration set forth above, the 1940 Act does not define what constitutes concentration in an industry. The SEC staff has taken the position that investment of 25% or more of a funds total assets in one or
more issuers conducting their principal activities in the same industry or group of industries constitutes concentration. It is possible that interpretations of concentration could change in the future. A fund that invests a significant percentage
of its total assets in a single industry may be particularly susceptible to adverse events affecting that industry and may be more risky than a fund that does not concentrate in an industry. The policy above will be interpreted to refer to
concentration as that term may be interpreted from time to time. The policy also will be interpreted to permit investment without limit in the following: securities of the U.S. government and its agencies or instrumentalities; securities of state,
territory, possession or municipal governments and their authorities, agencies, instrumentalities or political subdivisions; and repurchase agreements collateralized by any such obligations. Accordingly, issuers of the foregoing securities will not
be considered to be members of any industry. Securities issued by a foreign government will be considered as an investment in a single industry for concentration purposes. The policy also will be interpreted to give broad authority to the fund as to
how to classify issuers within or among industries.
The Funds fundamental policies will be interpreted broadly. For example, the policies will
be interpreted to refer to the 1940 Act and the related rules as they are in effect from time to time, and to interpretations and modifications of or relating to the 1940 Act by the SEC and others as they are given from time to time. When a policy
provides that an investment practice may be conducted as permitted by the 1940 Act, the policy will be interpreted to mean either that the 1940 Act expressly permits the practice or that the 1940 Act does not prohibit the practice.
Diversification
The Fund is
currently classified as a diversified fund under the 1940 Act. This means that the Fund may not purchase securities of an issuer (other than obligations issued or guaranteed by the U.S. government, its agencies or instrumentalities) if, with respect
to 75% of its total assets, (a) more than 5% of the Funds total assets would be invested in securities of that issuer or (b) the Fund would hold more than 10% of the outstanding voting securities of that issuer. With respect to the
remaining 25% of its total assets, the Fund can invest more than 5% of its assets in one issuer. Under the 1940 Act, the Fund cannot change its classification from diversified to non-diversified without shareholder approval.
Non-Fundamental Investment Policies
The
following are some of the non-fundamental investment policies that the Fund currenly observes:
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The Fund may not invest in other registered open-end management investment companies and registered unit investment trusts
in reliance upon the provisions of subparagraphs (G) or (F) of Section 12(d)(1) of the 1940 Act. The foregoing investment policy does not restrict the Fund from (i) acquiring securities of other registered investment companies in
connection with a
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merger, consolidation, reorganization, or acquisition of assets, or (ii) purchasing the securities of registered investment companies, to the extent otherwise permissible under
Section 12(d)(1) of the 1940 Act.
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The Fund may not purchase or otherwise acquire any security if immediately after the acquisition the value of illiquid
securities held by the Fund would exceed 15% of the Funds net assets. The Fund monitors the portion of the Funds total assets that is invested in illiquid securities on an ongoing basis, not only at the time of investment in such
securities.
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Commodity Exchange Act Regulation- Exclusion from Commodity Pool Operator Definition
The Fund is operated by persons who have claimed an exclusion, granted to operators of registered investment companies like the Fund, from registration
as a commodity pool operator with respect to the Fund under the CEA and, therefore are not subject to registration or regulation with respect to the Fund under the CEA. As a result, the Fund is limited in its ability to trade instruments
subject to the CFTCs jurisdiction, including commodity futures (which include futures on broad-based securities indexes, interest rate futures and currency futures), options on commodity futures, and certain swaps or other investments, either
directly or indirectly through investments in other investment vehicles (collectively, Commodity Interests).
Under this exclusion, the
Fund must satisfy one of the following two trading limitations whenever it establishes a new Commodity Interest position: (1) the aggregate initial margin and premiums required to establish the Funds Commodity Interest positions does not
exceed 5% of the liquidation value of the Funds portfolio (after accounting for unrealized profits and unrealized losses on any such investments); or (2) the aggregate net notional value of the Funds Commodity Interests, determined
at the time the most recent position was established, does not exceed 100% of the liquidation value of the Funds portfolio (after accounting for unrealized profits and unrealized losses on any such positions). The Fund is not required to
consider its exposure to such instruments if they are held for bona fide hedging purposes, as such term is defined in the rules of the CFTC. In addition to meeting one of the foregoing trading limitations, the Fund may not be marketed as
a commodity pool or otherwise as a vehicle for trading in the markets for Commodity Interests.
If the Funds operators were to lose their
ability to claim this exclusion with respect to the Fund, such persons would be required to comply with certain CFTC rules regarding commodity pools that could impose additional regulatory requirements and compliance obligations.
INVESTMENT PRACTICES AND RISK FACTORS
In addition to the investment strategies and the risks described in the Funds Prospectus and in this SAI under Investment Objective and Strategies,
the Fund may employ other investment practices and may be subject to other risks, which are described below. The Fund may engage in the practices described below to the extent consistent with its investment objectives, strategies, policies and
restrictions. However, as with any investment or investment technique, even when the Funds Prospectus or this discussion indicates that the Fund may engage in an activity, the Fund may not actually do so for a variety of reasons. In addition,
new types of instruments and other securities may be developed and marketed from time to time. Consistent with its investment limitations, the Fund expects to invest in those new types of securities and instruments that its portfolio manager
believes may assist the Fund in achieving its investment objective.
This discussion is not intended to limit the Funds investment flexibility,
unless such a limitation is expressly stated, and therefore will be construed by the Fund as broadly as possible. Statements concerning what the Fund may do are not intended to limit any other activity.
Non-U.S. Securities
Investing in the securities of issuers
in any non-U.S. country, or in securities denominated in a non-U.S. currency, involves special risks and considerations not typically associated with investing in U.S. issuers or U.S. dollar denominated securities. These include risks resulting from
differences in accounting, auditing and financial reporting standards; lower liquidity than U.S. securities; the possibility of nationalization, expropriation or confiscatory taxation; adverse changes in investment or exchange control regulations
(which may include suspension of the ability to transfer currency out of a country); and political instability. In many cases, there is less publicly available information concerning non-U.S. issuers than is available concerning U.S. issuers.
Additionally, purchases and sales of non-U.S. securities and dividends and interest payable on those securities may be subject to non-U.S. taxes and tax withholding. Non-U.S. securities generally exhibit greater price volatility and a greater risk
of illiquidity.
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To the extent the Fund purchases securities denominated in a non-U.S. currency, a change in the value of
any such currency against the U.S. dollar will result in a change in the U.S. dollar value of the Funds assets and the Funds income available for distribution. In addition, the Fund is required to compute and distribute its income in
U.S. dollars. Therefore, if the exchange rate for a non-U.S. currency declines after the Funds income has been earned and translated into U.S. dollars (but before payment), the Fund could be required to liquidate portfolio securities to make
such distributions. Similarly, if an exchange rate declines between the time the Fund incurs expenses in U.S. dollars and the time such expenses are paid, the amount of such currency required to be converted into U.S. dollars in order to pay such
expenses in U.S. dollars will be greater than the equivalent amount in any such currency of such expenses at the time they were incurred.
The
relative performance of various countries securities markets historically has reflected wide variations relating to the unique characteristics of each countrys economy. Individual non-U.S. economies may differ favorably or unfavorably
from the U.S. economy in such respects as growth of gross domestic product, rate of inflation, capital reinvestment, resource self-sufficiency and balance of payments position. Bank deposit insurance, if any, may be subject to widely varying
regulations and limits in non-U.S. countries.
In general, non-U.S. securities purchased by the Fund may be listed on non-U.S. exchanges, traded
over-the-counter or purchased in private transactions. Transactions on non-U.S. exchanges are usually subject to mark-ups or commissions higher than negotiated commissions on U.S. transactions. There is less government supervision and regulation of
exchanges and brokers in many non-U.S. countries than in the United States. Additional costs associated with an investment in non-U.S. securities may include higher custodial fees than apply to domestic custodial arrangements and transaction costs
of non-U.S. currency conversions.
Certain of the foregoing risks may also apply to some extent to securities of U.S. issuers that are denominated in
non-U.S. currencies or that are traded in non-U.S. markets, or to securities of U.S. issuers having significant non-U.S. operations.
Foreign Securities
Economic, Political and Social Factors. Certain non-U.S. countries, including emerging markets, may be subject to a greater degree of
economic, political and social instability. Such instability may result from, among other things: (i) authoritarian governments or military involvement in political and economic decision making; (ii) popular unrest associated with demands
for improved economic, political and social conditions; (iii) internal insurgencies; (iv) hostile relations with neighboring countries; and (v) ethnic, religious and racial disaffection and conflict. Such economic, political and
social instability could significantly disrupt the financial markets in such countries and the ability of the issuers in such countries to repay their obligations. In addition, it may be difficult for the Fund to pursue claims against a foreign
issuer in the courts of a foreign country. Investing in emerging countries also involves the risk of expropriation, nationalization, confiscation of assets and property or the imposition of restrictions on foreign investments and on repatriation of
capital invested. In the event of such expropriation, nationalization or other confiscation in any emerging country, the Fund could lose its entire investment in that country. Certain emerging market countries restrict or control foreign investment
in their securities markets to varying degrees. These restrictions may limit the Funds investment in those markets and may increase the expenses of the Fund. In addition, the repatriation of both investment income and capital from certain
markets in the region is subject to restrictions such as the need for certain governmental consents. Even where there is no outright restriction on repatriation of capital, the mechanics of repatriation may affect certain aspects of the Funds
operation. Economies in individual non-U.S. countries may differ favorably or unfavorably from the U.S. economy in such respects as growth of gross domestic product, rates of inflation, currency valuation, capital reinvestment, resource
self-sufficiency and balance of payments positions. Many non-U.S. countries have experienced substantial, and in some cases extremely high, rates of inflation for many years. Inflation and rapid fluctuations in inflation rates have had, and may
continue to have, very negative effects on the economies and securities markets of certain emerging countries. Economies in emerging countries generally are dependent heavily upon international trade and, accordingly, have been and may continue to
be affected adversely 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 economies also have been, and may
continue to be, affected adversely and significantly by economic conditions in the countries with which they trade.
Sovereign Government
and Supranational Debt. The Fund may invest in all types of debt securities of governmental issuers in all countries, including emerging markets. These sovereign debt securities may include: debt securities issued or guaranteed by governments,
governmental agencies or instrumentalities and political subdivisions located in emerging market countries; debt securities issued by government owned, controlled or sponsored entities located in emerging market countries;
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interests in entities organized and operated for the purpose of restructuring the investment characteristics of instruments issued by any of the above issuers; Brady Bonds, which are debt
securities issued under the framework of the Brady Plan as a means for debtor nations to restructure their outstanding external indebtedness; participations in loans between emerging market governments and financial institutions; or debt securities
issued by supranational entities such as the World Bank. A supranational entity is a bank, commission or company established or financially supported by the national governments of one or more countries to promote reconstruction or development.
Sovereign debt is subject to risks in addition to those relating to non-U.S. investments generally. As a sovereign entity, the issuing government may be
immune from lawsuits in the event of its failure or refusal to pay the obligations when due. The debtors willingness or ability to repay in a timely manner may be affected by, among other factors, its cash flow situation, the extent of its
non-U.S. reserves, the availability of sufficient non-U.S. exchange on the date a payment is due, the relative size of the debt service burden to the economy as a whole, the sovereign debtors policy toward principal international lenders and
the political constraints to which the sovereign debtor may be subject. Sovereign debtors may also be dependent on disbursements or assistance from foreign governments or multinational agencies, the countrys access to trade and other
international credits, and the countrys balance of trade. Assistance may be dependent on a countrys implementation of austerity measures and reforms, which measures may limit or be perceived to limit economic growth and recovery. Some
sovereign debtors have rescheduled their debt payments, declared moratoria on payments or restructured their debt to effectively eliminate portions of it, and similar occurrences may happen in the future. There is no bankruptcy proceeding by which
sovereign debt on which governmental entities have defaulted may be collected in whole or in part.
Europe-Recent Events.
A number of countries in Europe have experienced severe economic and financial difficulties. Many non-governmental issuers, and even certain governments,
have defaulted on, or been forced to restructure, their debts; many other issuers have faced difficulties obtaining credit or refinancing existing obligations; financial institutions have in many cases required government or central bank support,
have needed to raise capital, and/or have been impaired in their ability to extend credit; and financial markets in Europe and elsewhere have experienced extreme volatility and declines in asset values and liquidity. These difficulties may continue,
worsen or spread within and outside of Europe. Responses to the financial problems by European governments, central banks and others, including austerity measures and reforms, may not work, 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 others of their debt could have
additional adverse effects on economies, financial markets and asset valuations around the world. In addition, on June 23, 2016, voters in the United Kingdom approved withdrawal from the European Union. Following a period of impasse within the
United Kingdoms Parliament, the Parliament approved the withdrawal of the United Kingdom from the European Union, which took place on January 31, 2020. Given the size and importance of the United Kingdoms economy, uncertainty about
its legal, political, and economic relationship with the remaining member states of the European Union may continue to be a source of instability. Moreover, other countries may seek to withdraw from the European Union and/or abandon the euro, the
common currency of the European Union. A number of countries in Europe have suffered terror attacks, and additional attacks may occur in the future. Ukraine has experienced ongoing military conflict; this conflict may expand and military attacks
could occur elsewhere in Europe. Europe has also been struggling with mass migration from the Middle East and Africa.
The ultimate effects of these
events and other socio-political or geopolitical issues are not known but could profoundly affect global economies and markets. Whether or not the Fund invests in securities of issuers located in Europe or with significant exposure to European
issuers or countries, these events could negatively affect the value and liquidity of the Funds investments.
Emerging Market
Issuers. The risks of non-U.S. investment, described above, are greater for investments in emerging market issuers, and such investments should therefore be considered speculative. Debt securities of governmental and other issuers in emerging
market countries will typically be rated below investment grade or be of comparable quality. For more information about lower-rated securities, see Fixed Income SecuritiesLower-Rated Securities below.
The Fund considers a country to be an emerging market country if, at the time of investment, it is represented in the J.P. Morgan Emerging Market Bond
Index Global or the J.P. Morgan Corporate Emerging Market Bond Index Broad or categorized by the World Bank in its annual categorization as middle- or low-income.
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Investors are strongly advised to consider carefully the special risks involved in emerging
markets, which are in addition to the usual risks of investing in developed markets around the world. Emerging market countries may experience substantial rates of inflation or deflation. Inflation, deflation and rapid fluctuations in such rates
have had, and may continue to have, very negative effects on the economies and securities markets of certain emerging market countries. While some emerging market countries have sought to develop a number of corrective mechanisms to reduce inflation
or deflation or mitigate their effects, inflation and deflation may continue to have significant effects both on emerging market countries and their securities markets. In addition, many of the currencies of emerging market countries have
experienced steady devaluations relative to the U.S. dollar, and major devaluations have occurred in certain countries.
Economies in emerging market
countries generally are heavily dependent upon international trade and, accordingly, have been and may continue to be affected adversely by economic conditions, trade barriers, exchange controls, managed adjustments in relative currency values and
other protectionist measures imposed or negotiated by the countries with which they trade.
Because of the high levels of non-U.S. dollar denominated
debt owed by many emerging market countries, fluctuating exchange rates can significantly affect the debt service obligations of those countries. This could, in turn, affect local interest rates, profit margins and exports, which are a major source
of non-U.S. exchange earnings. Hedging instruments may not be available with respect to investments in emerging market countries and, to the extent they are available, the ongoing and indeterminate nature of the foregoing risks (and the costs
associated with hedging transactions) would make it difficult to hedge effectively against such risks.
To the extent an emerging market country
faces a liquidity crisis with respect to its non-U.S. exchange reserves, it may increase restrictions on the outflow of any non-U.S. exchange. Repatriation is ultimately dependent on the ability of the Fund to liquidate its investments and convert
the local currency proceeds obtained from such liquidation into U.S. dollars. Where this conversion must be done through official channels (usually the central bank or certain authorized commercial banks), the ability to obtain U.S. dollars is
dependent on the supply of such U.S. dollars through those channels and, if available, upon the willingness of those channels to allocate those U.S. dollars to the Fund. In such a case, the Funds ability to obtain U.S. dollars may be adversely
affected by any increased restrictions imposed on the outflow of non-U.S. exchange. If the Fund is unable to repatriate any amounts due to exchange controls, it may be required to accept an obligation payable at some future date by the central bank
or other governmental entity of the jurisdiction involved. If such conversion can legally be done outside official channels, either directly or indirectly, the Funds ability to obtain U.S. dollars may not be affected as much by any increased
restrictions except to the extent of the price that may be required to be paid for the U.S. dollars.
Many emerging market countries have little
experience with the corporate form of business organization, and may not have well-developed corporation and business laws or concepts of fiduciary duty in the business context. The securities markets of emerging market countries are substantially
smaller, less developed, have lower liquidity and are more volatile than the securities markets of the U.S. and other more developed countries. Disclosure and regulatory standards in many respects are less stringent than in the U.S. and other major
markets. There also may be a lower level of monitoring and regulation of an emerging market countrys securities markets and the activities of investors in such markets; enforcement of existing regulations has been extremely limited. Also, any
change in the leadership or politics of emerging market countries, or the countries that exercise a significant influence over those countries, may halt the expansion of or reverse the liberalization of non-U.S. investment policies now occurring in
some emerging market countries and adversely affect existing investment opportunities.
Some emerging markets have different settlement and
clearance procedures, which, for example, may not call for delivery of a security to the Fund until well after the Fund has paid for such security. In certain markets there have been times when settlements have been unable to keep pace with the
volume of securities transactions, making it difficult to conduct such transactions. The inability of the Fund to make intended securities purchases due to settlement problems could cause the Fund to miss attractive investment opportunities.
Inability to dispose of a portfolio security caused by settlement problems could result either in losses to the Fund due to subsequent declines in value of the portfolio security or, if the Fund has entered into a contract to sell the security, in
possible liability to the purchaser.
The risk also exists that an emergency situation may arise in one or more emerging market countries as a result
of which trading of securities may cease or may be substantially curtailed and prices for the Funds portfolio securities in such markets may not be readily available.
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Depositary Receipts. American Depositary Receipts, or ADRs, are securities
issued by a U.S. depositary (usually a bank) and represent a specified quantity of underlying non-U.S. securities on deposit with a custodian bank as collateral. A non-U.S. issuer of the security underlying an ADR is generally not subject to the
same reporting requirements in the United States as a domestic issuer. Accordingly, the information available to a U.S. investor will be limited to the information the non-U.S. issuer is required to disclose in its own country and the market value
of an ADR may not reflect undisclosed material information concerning the issuer or the underlying security. ADRs may also be subject to exchange rate risks if the underlying securities are denominated in a non-U.S. currency. The Fund may also
invest in similar non-U.S. instruments issued by non-U.S. banks or trust companies such as European Depositary Receipts (EDRs) and Global Depositary Receipts (GDRs). EDRs are non-U.S. dollar denominated receipts similar to
ADRs, are issued and traded in Europe and are publicly traded on exchanges or over-the-counter in the United States. GDRs may be offered privately in the United States and also trade in public or private markets in other countries. For purposes of
its investment policies, the Fund will treat ADRs and similar instruments as equivalent to investment in the underlying securities.
Options, Futures
and Other Financial Instruments
General. The Fund may utilize futures, options (including options on credit default swaps), swaps
including interest rate and credit default swaps (including buying and selling credit default swaps), warrants, foreign currency futures, forwards and other derivative instruments (collectively, Financial Instruments). The Fund may use
Financial Instruments for any purpose, including as a substitute for other investments, to attempt to enhance its portfolios return or yield and to alter the investment characteristics of its portfolio (including to attempt to mitigate risk of
loss in some fashion, or hedge). Except as otherwise provided in the Prospectus, this SAI or by applicable law, the Fund may purchase and sell any type of Financial Instrument. The Fund may choose not to make use of derivatives for a
variety of reasons, and no assurance can be given that any derivatives strategy employed will be successful.
The U.S. government is in the
process of adopting and implementing regulations governing derivatives markets, including mandatory clearing of certain derivatives, margin and reporting requirements. The ultimate impact of the regulations remains unclear. Additional regulation of
derivatives may make them more costly, may limit their availability, may disrupt markets or may otherwise adversely affect their value or performance.
The use of Financial Instruments may be limited by applicable law and any applicable regulations of the SEC, the Commodity Futures Trading Commission
(the CFTC), or the exchanges on which some Financial Instruments may be traded. (Note, however, that some Financial Instruments that the Fund may use may not be listed on any exchange and may not be regulated by the SEC or the CFTC.) In
addition, the Funds ability to use Financial Instruments may be limited by tax considerations.
In addition to the instruments and strategies
discussed in this section, a Subadviser may discover additional opportunities in connection with Financial Instruments and other similar or related techniques. These opportunities may become available as a Subadviser develops new techniques, as
regulatory authorities broaden the range of permitted transactions and as new Financial Instruments or other techniques are developed. A Subadviser may utilize these opportunities and techniques to the extent that they are consistent with the
Funds investment objective and permitted by its investment limitations and applicable regulatory authorities. These opportunities and techniques may involve risks different from or in addition to those summarized herein.
This discussion is not intended to limit the Funds investment flexibility, unless such a limitation is expressly stated, and therefore will be
construed by the Fund as broadly as possible. Statements concerning what the Fund may do are not intended to limit any other activity. Also, as with any investment or investment technique, even when the Prospectus or this discussion indicates that
the Fund may engage in an activity, it may not actually do so for a variety of reasons, including cost considerations.
Summary of Certain
Risks. The use of Financial Instruments involves special considerations and risks, certain of which are summarized below, and may result in losses to the Fund. In general, the use of Financial Instruments may increase the volatility of the Fund
and may involve a small investment of cash relative to the magnitude of the risk or exposure assumed. Even a small investment in derivatives may magnify or otherwise increase investment losses to the Fund. As noted above, there can be no assurance
that any derivatives strategy will succeed.
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Financial Instruments are subject to the risk that the market value of the derivative itself or the market value of
underlying instruments will change in a way adverse to the Funds interest. Many Financial Instruments are complex, and successful use of them depends in part upon a Subadvisers ability to forecast correctly future market trends and other
financial or economic factors or the value of the underlying security, index, interest rate, currency or other instrument or measure. Even if a Subadvisers forecasts are correct, other factors may cause distortions or dislocations in the
markets that result in unsuccessful transactions. Financial Instruments may behave in unexpected ways, especially in abnormal or volatile market conditions.
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The Fund may be required to maintain assets as cover, maintain segregated accounts, post collateral or make
margin payments when it takes positions in Financial Instruments. Assets that are segregated or used as cover, margin or collateral may be required to be in the form of cash or liquid securities, and typically may not be sold while the position in
the Financial Instrument is open unless they are replaced with other appropriate assets. The Fund will cover the full notional amount of the credit default swaps written by the Fund. If markets move against the Funds position, the Fund may be
required to maintain or post additional assets and may have to dispose of existing investments to obtain assets acceptable as collateral or margin. This may prevent the Fund from pursuing its investment objective. Assets that are segregated or used
as cover, margin or collateral typically are invested, and these investments are subject to risk and may result in losses to the Fund. These losses may be substantial, and may be in addition to losses incurred by using the Financial Instrument in
question. If the Fund is unable to close out its positions, it may be required to continue to maintain such assets or accounts or make such payments until the positions expire or mature, and the Fund will continue to be subject to investment risk on
the assets. In addition, the Fund may not be able to recover the full amount of its margin from an intermediary if that intermediary were to experience financial difficulty. Segregation, cover, margin and collateral requirements may impair the
Funds ability to sell a portfolio security or make an investment at a time when it would otherwise be favorable to do so, or require the Fund to sell a portfolio security or close out a derivatives position at a disadvantageous time or price.
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The Funds ability to close out or unwind a position in a Financial Instrument prior to expiration or maturity depends
on the existence of a liquid 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. If there is no market or
the Fund is not successful in its negotiations, the Fund may not be able to sell or unwind the derivative position at a particular time or at an anticipated price. This may also be the case if the counterparty to the Financial Instrument becomes
insolvent. The Fund may be required to make delivery of portfolio securities or other assets underlying a Financial Instrument in order to close out a position or to sell portfolio securities or assets at a disadvantageous time or price in order to
obtain cash to close out the position. While the position remains open, the Fund continues to be subject to investment risk on the Financial Instrument. The Fund may or may not be able to take other actions or enter into other transactions,
including hedging transactions, to limit or reduce its exposure to the Financial Instrument.
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Certain Financial Instruments transactions may have a leveraging effect on the Fund, and adverse changes in the value of
the underlying security, index, interest rate, currency or other instrument or measure can result in losses substantially greater than the amount invested in the Financial Instrument itself. When the Fund engages in transactions that have a
leveraging effect, the value of the Fund is likely to be more volatile and all other risks also are likely to be compounded. This is because leverage generally magnifies the effect of any increase or decrease in the value of an asset and creates
investment risk with respect to a larger pool of assets than the Fund would otherwise have. Certain Financial Instruments have the potential for unlimited loss, regardless of the size of the initial investment.
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Many Financial Instruments may be difficult to value, which may result in increased payment requirements to counterparties
or a loss of value to the Fund.
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Illiquidity risk exists when a particular Financial Instrument is difficult to purchase or sell. If a derivative
transaction is particularly large or if the relevant market is illiquid, the Fund may be unable to initiate a transaction or liquidate a position at an advantageous time or price. Certain Financial Instruments, including certain over-the-counter
(OTC) options and swaps, may be considered illiquid and therefore subject to the Funds limitation on illiquid investments.
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In a hedging transaction there may be imperfect correlation, or even no correlation, between the identity, price or price
movements of a Financial Instrument and the identity, price or price movements of the investments being hedged. This lack of correlation may cause the hedge to be unsuccessful and may result in the Fund incurring substantial losses and/or not
achieving anticipated gains. Even if the strategy works as intended, the Fund might have been in a better position had it not attempted to hedge at all.
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Financial Instruments used for non-hedging purposes may result in losses which would not be offset by increases in the
value of portfolio holdings or declines in the cost of securities or other assets to be acquired. In the event that the Fund uses a Financial Instrument as an alternative to purchasing or selling other investments or in order to obtain desired
exposure to an index or market, the Fund will be exposed to the same risks as are incurred in purchasing or selling the other investments directly, as well as the risks of the transaction itself.
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Certain Financial Instruments involve the risk of loss resulting from the insolvency or bankruptcy of the counterparty or
the failure by the counterparty to make required payments or otherwise comply with the terms of the contract. In the event of default by a counterparty, the Fund may have contractual remedies pursuant to the agreements related to the transaction,
which may be limited by applicable law in the case of the counterpartys bankruptcy.
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Financial Instruments involve operational risk. There may be incomplete or erroneous documentation or inadequate collateral
or margin, or transactions may fail to settle. For Financial Instruments not guaranteed by an exchange or clearinghouse, the Fund may have only contractual remedies in the event of a counterparty default, and there may be delays, costs or
disagreements as to the meaning of contractual terms and litigation in enforcing those remedies.
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Certain Financial Instruments transactions, including certain options, swaps, forward contracts, and certain options on
foreign currencies, are entered into directly by the counterparties or through financial institutions acting as market makers (OTC derivatives), rather than being traded on exchanges or in markets registered with the CFTC or the SEC. Many of the
protections afforded to exchange participants will not be available to participants in OTC derivatives transactions. For example, OTC derivatives transactions are not subject to the guarantee of an exchange, and only OTC derivatives that are either
required to be cleared or submitted voluntarily for clearing to a clearinghouse will enjoy the protections that central clearing provides against default by the original counterparty to the trade. In an OTC derivatives transaction that is not
cleared, the Fund bears the risk of default by their counterparty. In a cleared derivatives transaction, the Fund is instead exposed to the risk of default of the clearinghouse and the risk of default of the broker through which it has entered into
the transaction. Information available on counterparty creditworthiness may be incomplete or outdated, thus reducing the ability to anticipate counterparty defaults.
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Financial Instruments transactions conducted outside the United States may not be conducted in the same manner as those
entered into on U.S. exchanges, and may be subject to different margin, exercise, settlement or expiration procedures. Many of the risks of OTC derivatives transactions are also applicable to Financial Instruments used outside the United States.
Financial Instruments used outside the United States also are subject to the risks affecting foreign securities, currencies and other instruments.
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Financial Instruments involving currency are subject to additional risks. Currency related transactions may be negatively
affected by government exchange controls, blockages, and manipulations. Exchange rates may be influenced by factors extrinsic to a countrys economy. Also, there is no systematic reporting of last sale information with respect to foreign
currencies. As a result, the information on which trading in currency derivatives is based may not be as complete as, and may be delayed beyond, comparable data for other transactions.
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Use of Financial Instruments involves transaction costs, which may be significant. Use of Financial Instruments also may
increase the amount of taxable income to shareholders.
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Hedging. Hedging strategies can be broadly categorized as
short hedges and long hedges. A short hedge is a purchase or sale of a Financial Instrument intended partially or fully to offset potential declines in the value of one or more investments held in the Funds portfolio.
Thus, in a short hedge the Fund takes a position in a Financial Instrument whose price is expected to move in the opposite direction of the price of the investment being hedged.
Conversely, a long hedge is a purchase or sale of a Financial Instrument intended partially or fully to offset potential increases in the acquisition
cost of one or more investments that the Fund intends to acquire. Thus, in a long hedge, the Fund takes a position in a Financial Instrument whose price is expected to move in the same direction as the price of the prospective investment being
hedged. A long hedge is sometimes referred to as an anticipatory hedge. In an anticipatory hedge transaction, the Fund does not own a corresponding security and, therefore, the transaction does not relate to a security the Fund owns. Rather, it
relates to a security that the Fund intends to acquire. If the Fund does not complete the hedge by purchasing the security it anticipated purchasing, the effect on the Funds portfolio is the same as if the transaction were entered into for
speculative purposes.
In hedging transactions, Financial Instruments on securities generally are used to attempt to hedge against price movements in
one or more particular securities positions that the Fund owns or intends to acquire. Financial Instruments on
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indices, in contrast, generally are used to attempt to hedge against price movements in market sectors in which the Fund has invested or expects to invest. Financial Instruments on debt
securities generally are used to hedge either individual securities or broad debt market sectors.
Risk of Government Regulation of
Derivatives. The regulation of derivatives transactions and funds that engage in such transactions is an evolving area of law and is subject to modification by government and judicial action. In 2019, the SEC re-proposed a new rule regarding
derivatives and their usage. It is impossible to fully predict the effects of new and existing legislation and regulation, but the effects could be substantial and adverse. Additional regulation could, among other things, make derivatives more
costly, limit their availability or utility, otherwise adversely affect their performance or disrupt markets. Such regulation may limit or prevent the Fund from using derivatives as part of its investment strategy and could ultimately prevent the
Fund from being able to achieve its investment goals. Limitations or restrictions applicable to the counterparties with which the Fund engages in derivative transactions could also prevent the Fund from using derivatives or affect pricing or other
factors relating to derivatives or may change the availability of certain investments.
The Dodd-Frank Wall Street Reform and Consumer Protection Act
(the Dodd-Frank Act) has caused broad changes to the OTC derivatives market and granted significant authority to the SEC and the CFTC to regulate OTC derivatives and market participants. Pursuant to such authority, rules have been
enacted that currently require clearing of many OTC derivatives transactions and may require clearing of additional OTC derivatives transactions in the future and that impose minimum margin and capital requirements for uncleared OTC derivatives
transactions. Similar regulations are being adopted in other jurisdictions around the world. The implementation of the clearing requirement has increased the costs of derivatives transactions since investors have to pay fees to clearing members and
are typically required to post more margin for cleared derivatives than had historically been the case. The costs of derivatives transactions are expected to increase further as clearing members raise their fees to cover the costs of additional
capital requirements and other regulatory changes. While the new rules and regulations and central clearing of some derivatives transactions are designed to reduce systemic risk (i.e., the risk that the interdependence of large derivatives dealers
could cause them to suffer liquidity, solvency or other challenges simultaneously), there is no assurance that they will achieve that result, and in the meantime, mandatory clearing of derivatives may expose the Fund to new kinds of costs and risks.
Additionally, new regulations may result in increased uncertainty about credit/counterparty risk and may limit the flexibility of the Fund to
protect its interests in the event of an insolvency of a derivatives counterparty. In the event of a counterpartys (or its affiliates) insolvency, the Funds ability to exercise remedies, such as the termination of transactions,
netting of obligations and realization on collateral, could be stayed or eliminated under the rules of the applicable exchange or clearing corporation or under new special resolution regimes adopted in the United States, the European Union and
various other jurisdictions. Such regimes provide government authorities with broad authority to intervene when a financial institution is experiencing financial difficulty. In particular, with respect to counterparties who are subject to such
proceedings in the European Union, the liabilities of such counterparties to the Fund could be reduced, eliminated, or converted to equity in such counterparties (sometimes referred to as a bail in).
Additional Risks of Financial Instruments Traded on Non-U.S. Exchanges. Financial Instruments may be traded on non-U.S. exchanges. Such
transactions may not be regulated as effectively as similar transactions in the United States, may not involve a clearing mechanism and related guarantees and are subject to the risk of governmental actions affecting trading in, or the price of,
non-U.S. securities. The value of such positions also could be adversely affected by (1) other complex non-U.S. political, legal and economic factors, (2) lesser availability than in the United States of data on which to make trading
decisions, (3) delays in the Funds ability to act upon economic events occurring in non-U.S. markets during non-business hours in the United States, (4) the imposition of different exercise and settlement terms and procedures and
margin requirements than in the United States and (5) lesser trading volume.
Options. A call option gives the purchaser the
right to buy, and obligates the writer to sell, the underlying instrument at the agreed-upon price during the option period. A put option gives the purchaser the right to sell, and obligates the writer to buy, the underlying instrument at the
agreed-upon price during the option period. Purchasers of options pay an amount, known as a premium, to the option writer in exchange for the right under the option contract. The Fund may purchase and sell both put options and call options on a
variety of underlying instruments, including, but not limited to, specific securities, securities indexes, commodities indexes, futures contracts and foreign currencies.
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The Fund can use both European-style or American-style options. A European-style option is only exercisable
immediately prior to its expiration. This is in contrast to American-style options, which are exercisable at any time prior to the expiration date of the option.
The Fund may purchase call options for any purpose. For example, a call option may be purchased by the Fund as a long hedge. Call options also may be
used as a means of participating in an anticipated price increase of an instrument on a more limited risk basis than would be possible if the instrument itself were purchased. In the event of a decline in the price of the underlying instrument, use
of this strategy would serve to limit the Funds potential loss to the option premium paid; conversely, if the market price of the underlying instrument increases above the exercise price and the Fund either sells or exercises the option, any
profit realized would be reduced by the premium.
The Fund may purchase put options for any purpose. For example, a put option may be purchased by
the Fund as a short hedge. The put option enables the Fund to sell the underlying instrument at the predetermined exercise price; thus the potential for loss to the Fund below the exercise price is limited to the option premium paid. If the market
price of the underlying instrument is higher than the exercise price of the put option, any profit the Fund realizes on the sale of the instrument would be reduced by the premium paid for the put option less any amount for which the put option may
be sold.
Writing put or call options can enable the Fund to enhance income or yield by reason of the premiums paid by the purchasers of such
options. However, the Fund may also suffer a loss as a result of writing options. For example, if the market price of the instrument underlying a put option declines to less than the exercise price of the option, minus the premium received, the Fund
would suffer a loss.
Writing call options can serve as a limited short hedge, because declines in the value of the hedged Instrument would be offset
to the extent of the premium received for writing the option. However, if the underlying instrument appreciates to a price higher than the exercise price of the call option, it can be expected that the option will be exercised and the Fund will be
obligated to sell the underlying instrument at less than its market value.
Writing put options can serve as a limited long hedge because increases
in the value of the hedged investment would be offset to the extent of the premium received for writing the option. However, if the underlying instrument depreciates to a price lower than the exercise price of the put option, it can be expected that
the put option will be exercised and the Fund will be obligated to purchase the underlying instrument at more than its market value.
The value of an
option position will reflect, among other things, the current market value of the underlying instrument, the time remaining until expiration, the relationship of the exercise price to the market price of the underlying instrument, the historical
price volatility of the underlying instrument and general market conditions.
The Fund may effectively terminate its right or obligation under an
option by entering into a closing transaction. For example, the 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, the 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 the Fund to realize profits or limit losses
on an option position prior to its exercise or expiration.
A type of put that the Fund may purchase is an optional delivery standby
commitment, which is entered into by parties selling debt securities to the Fund. An optional delivery standby commitment gives the Fund the right to sell the security back to the seller on specified terms. This right is provided as an
inducement to purchase the security.
Risks of Options. Options offer large amounts of leverage, which will result in the Funds net
asset value being more sensitive to changes in the value of the related instrument. The Fund may purchase or write both exchange-listed and OTC options. Exchange-listed 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-listed option transaction. In contrast, OTC options are contracts between the Fund and its counterparty (usually a securities dealer or a bank)
with no clearing organization guarantee. Thus, when the Fund purchases an OTC option, it relies on the counterparty from whom 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 the Fund as well as the loss of any expected benefit of the transaction.
The Funds ability to establish and close out positions in exchange-listed 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
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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 the 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, the Fund might be unable to close out an OTC option position at any time prior to its expiration, if at all.
If the Fund were unable to effect a closing transaction for an option it had purchased, due to the absence of a secondary market, the imposition of
price limits or otherwise, 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 the Fund could cause material losses because the Fund would be
unable to sell the investment used as cover for the written option until the option expires or is exercised.
Options have varying expiration dates.
The exercise price of the options may be below, equal to or above the current market value of the underlying instrument. Options purchased by the Fund that expire unexercised have no value, and the Fund will realize a loss in the amount of the
premium paid and any transaction costs. If an option written by the Fund expires unexercised, the Fund realizes a gain equal to the premium received at the time the option was written. Transaction costs must be included in these calculations.
Options on Indices. Puts and calls on indices are similar to puts and calls on other investments 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, futures contracts or other investments. When the 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 the 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 times a specified multiple (multiplier), which determines the total dollar value for each point of such difference. When the Fund buys a
call on an index, it pays a premium and has the same rights as to such call as are indicated above. When the 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 the
Funds exercise of the put, to deliver to the 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 the 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 the Fund to deliver to it an amount of cash equal to the difference between the
closing level of the index and exercise price times the multiplier if the closing level is less than the exercise price.
Risks of Options
on Indices. The risks of investment in options on indices may be greater than options on securities, commodities, futures contracts or other investments. Because index options are settled in cash, when the Fund writes a call on an index it
cannot provide in advance for its potential settlement obligations by acquiring and holding the underlying instrument. The Fund can offset some of the risk of writing a call index option by holding a diversified portfolio of instruments similar to
those on which the underlying index is based. However, the Fund cannot, as a practical matter, acquire and hold a portfolio containing exactly the same instruments as underlie the index and, as a result, bears a risk that the value of the instrument
held will vary from the value of the index.
Even if the Fund could assemble a portfolio that exactly reproduced the composition of the
underlying index, it still would not be fully covered from a risk standpoint because of the timing risk inherent in writing index options. When an index option is exercised, the amount of cash that the holder is entitled to receive is
determined by the difference between the exercise price and the closing index level on the date when the option is exercised. As with other kinds of options, the Fund as the call writer will not learn that the Fund has been assigned until the next
business day at the earliest. The time lag between exercise and notice of assignment poses no risk for the writer of a covered call on a specific underlying instrument, such as common stock, because there the writers obligation is to deliver
the underlying instrument, not to pay its value as of a fixed time in the past. So long as the writer already owns the underlying instrument, it can satisfy its settlement obligations by simply delivering it, and the risk that its value may have
declined since the exercise date is borne by the exercising holder. In contrast, even if the writer of an index call holds investments that exactly match the composition of the underlying index, it will not be able to satisfy its assignment
obligations by delivering those Instruments against payment of the exercise price. Instead, it will be required to pay cash in an amount based on the closing index value on the exercise date. By the time it learns that it has been assigned, the
index may have declined, with a corresponding decline in the value of its portfolio. This timing risk is an inherent limitation on the ability of index call writers to cover their risk exposure by holding instrument positions.
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If the 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 underlying index may subsequently change. If such a change causes the exercised option to fall out-of-the-money, the 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-listed 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 the Fund great flexibility to tailor the option to its needs, OTC options generally involve greater risk than exchange-listed options, which are guaranteed by the clearing organization of the exchanges
where they are traded.
Futures Contracts and Options on Futures Contracts. A financial futures contract sale creates an obligation by
the seller to deliver the type of Instrument called for in the contract in a specified delivery month for a stated price. A financial futures contract purchase creates an obligation by the purchaser to take delivery of the type of Instrument called
for in the contract in a specified delivery month at a stated price. The Fund may invest in single security futures contracts to the extent permitted by applicable law. Options on futures give the purchaser the right to assume a position in a
futures contract at the specified option exercise price at any time during the period of the option. The purchase of futures or call options on futures can serve as a long hedge, and the sale of futures or the purchase of put options on futures can
serve as a short hedge. Writing call options on futures contracts can serve as a limited short hedge, using a strategy similar to that used for writing call options on Instruments. Similarly, writing put options on futures contracts can serve as a
limited long hedge. Futures contracts and options on futures contracts can also be purchased and sold to attempt to enhance income or yield. To the extent permitted by applicable law, the Fund may also write call and put options on futures contracts
that are not covered. The Fund may invest in futures contracts and options thereon with respect to Instruments including, but not limited to, specific securities, securities indexes and currencies.
In addition, futures strategies can be used to manage the duration of the Funds fixed-income portfolio. If a Subadviser wishes to shorten the
duration of the Funds fixed-income portfolio, the Fund may sell a debt futures contract or a call option thereon, or purchase a put option on that futures contract. If a Subadviser wishes to lengthen the duration of the Funds
fixed-income portfolio, the Fund may buy a debt futures contract or a call option thereon, or sell a put option thereon.
Futures contracts may also
be used for non-hedging purposes, such as to simulate full investment in underlying instruments while retaining a cash balance for portfolio management purposes, as a substitute for direct investment in the underlying instrument, to facilitate
trading, to reduce transaction costs, or to seek higher investment returns when a futures contract or option is priced more attractively than the underlying instrument.
No price is paid upon entering into a futures contract. Instead, at the inception of a futures contract the Fund is required to deposit initial
margin. Margin must also be deposited when writing a call or put option on a futures contract, in accordance with applicable exchange rules. Unlike margin in securities transactions, initial margin on futures contracts does not represent a
borrowing, but rather is in the nature of a performance bond or good-faith deposit that is returned to the Fund at the termination of the transaction if all contractual obligations have been satisfied. Under certain circumstances, such as periods of
high volatility, the Fund may be required by an exchange to increase the level of its initial margin payment, and initial margin requirements might be increased generally in the future by regulatory action.
Subsequent variation margin payments are made to and from the futures broker daily as the value of the futures position varies, a process
known as marking-to-market. Variation margin does not involve borrowing, but rather represents a daily settlement of the Funds obligations to or from a futures broker. When the Fund purchases an option on a futures contract, the
premium paid plus transaction costs is all that is at risk. However, there may be circumstances when the purchase of an option on a futures contract would result in a loss to the Fund when the use of a futures contract would not, such as when there
is no movement in the value of the securities or currencies being hedged. In contrast, when the Fund purchases or sells a futures contract or writes a call or put option thereon, it is subject to daily variation margin calls that could be
substantial in the event of adverse price movements. If the Fund has insufficient cash to meet daily variation margin requirements, it might need to sell securities at a time when such sales are disadvantageous.
Although some futures and options on futures call for making or taking delivery of the underlying instrument, generally those contracts are closed out
prior to delivery by offsetting purchases or sales of matching futures or options (involving the same instrument and delivery month). If an offsetting purchase price is less than the original sale price, the Fund realizes a gain,
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or if it is more, the Fund realizes a loss. If an offsetting sale price is more than the original purchase price, the Fund realizes a gain, or if it is less, the Fund realizes a loss. The Fund
will also bear transaction costs for each contract, which will be included in these calculations. Positions in futures and options on futures 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 a futures contract or an option on a futures
contract can vary from the previous days 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 the Fund were unable to
liquidate a futures contract or an option on a futures position due to the absence of a liquid secondary market, the imposition of price limits or otherwise, it could incur substantial losses. The Fund would continue to be subject to market risk
with respect to the position. In addition, except in the case of purchased options, the Fund would continue to be required to make daily variation margin payments and might be required to maintain the position being hedged by the future or option or
to maintain cash or securities in a segregated account.
Risks of Futures Contracts and Options Thereon. The ordinary spreads between prices
in the cash and futures markets (including the options on futures market), 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 relationship 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. Due to the possibility of distortion, a correct forecast of general interest rate, currency exchange rate or stock market trends by a Subadviser may still not
result in a successful transaction. Of course, a Subadviser may be incorrect in its expectations as to the extent of various interest rate, currency exchange rate, stock market or other movements or the time span within which the movements take
place.
Index Futures. The risk of imperfect correlation between movements in the price of index futures and movements in the
price of the Financial Instruments that are the subject of the hedge increases as the composition of the Funds portfolio diverges from the Financial Instruments included in the applicable index. The price of the index futures may move more
than or less than the price of the Financial Instruments being hedged. If the price of the index futures moves less than the price of the Financial Instruments that are the subject of the hedge, the hedge will not be fully effective, but if the
price of the Financial Instruments being hedged has moved in an unfavorable direction, the Fund would be in a better position than if it had not hedged at all. If the price of the Financial Instruments being hedged has moved in a favorable
direction, this advantage will be partially offset by the futures contract. If the price of the futures contract moves more than the price of the underlying instruments, the Fund will experience either a loss or a gain on the futures contract that
will not be completely offset by movements in the price of the instruments that are the subject of the hedge. To compensate for the imperfect correlation of movements in the price of the instrument being hedged and movements in the price of the
index futures, the Fund may buy or sell index futures in a greater dollar amount than the dollar amount of the Financial Instruments being hedged if the historical volatility of the prices of such Financial Instruments being hedged is more than the
historical volatility of the prices of the Financial Instruments included in the index. It is also possible that, where the Fund has sold index futures contracts to hedge against decline in the market, the market may advance and the value of the
Financial Instruments held in the Fund may decline. If this occurred, the Fund would lose money on the futures contract and also experience a decline in value of its portfolio Financial Instruments. However, while this could occur for a very brief
period or to a very small degree, over time the value of a diversified portfolio of instruments will tend to move in the same direction as the market indices on which the futures contracts are based.
Where index futures are purchased to hedge against a possible increase in the price of Financial Instruments before the Fund is able to invest in them in
an orderly fashion, it is possible that the market may decline instead. If the Fund then concludes not to invest in them at that time because of concern as to possible further market decline or for other reasons, it will
18
realize a loss on the futures contract that is not offset by a reduction in the price of the Financial Instruments it had anticipated purchasing.
To the extent such instruments are permitted by applicable law, the Fund may invest in security futures. Such investments are expected to be subject to
risks similar to those of index future investing.
Non-U.S. Currency Hedging StrategiesSpecial Considerations. The Fund may engage in a
variety of non-U.S. currency exchange transactions to protect against uncertainty in the level of future exchange rates or to earn additional income. The Fund may use options and futures contracts relating to non-U.S. currencies as described above,
and swaps, indexed notes and forward currency contracts, as described below, to attempt to hedge against movements in the values of the non-U.S. currencies in which the Funds securities are denominated or to attempt to enhance income or yield.
Currency hedges can protect against price movements in a security that the Fund owns or intends to acquire that are attributable to changes in the value of the currency in which it is denominated. Such hedges do not, however, protect against price
movements in the securities that are attributable to other causes.
The Fund might seek to hedge against changes in the value of a particular
currency when no Financial Instruments on that currency are available or such Financial Instruments are more expensive than certain other Financial Instruments. In such cases, the Fund may seek to hedge against price movements in that currency by
entering into transactions using Financial Instruments on another currency or a basket of currencies, the value of which the Subadviser(s) believes will have a high degree of correlation to the value of the currency being hedged. The risk that
movements in the price of the Financial Instrument will not correlate perfectly with movements in the price of the currency subject to the hedging transaction is magnified when this strategy is used.
The value of Financial Instruments on non-U.S. currencies depends on the value of the underlying currency relative to the U.S. dollar. Because non-U.S.
currency transactions occurring in the interbank market might involve substantially larger amounts than those involved in the use of such Financial Instruments, the Fund could be disadvantaged by having to deal in the odd lot market (generally
consisting of transactions of less than $1 million) for the underlying non-U.S. currencies at prices that are less favorable than for round lots.
There is no systematic reporting of last sale information for non-U.S. currencies or any regulatory requirement that quotations available through dealers
or other market sources be firm or revised on a timely basis. Quotation information generally is representative of very large transactions in the interbank market and thus might not reflect odd-lot transactions where rates might be less favorable.
The interbank market in non-U.S. currencies is a global, round-the-clock market. To the extent the U.S. options or futures markets are closed while the markets for the underlying currencies remain open, significant price and rate movements might
take place in the underlying markets that cannot be reflected in the markets for the Financial Instruments until they reopen.
Settlement of hedging
transactions involving non-U.S. currencies might be required to take place within the country issuing the underlying currency. Thus, the Fund might be required to accept or make delivery of the underlying non-U.S. currency in accordance with any
U.S. or non-U.S. regulations regarding the maintenance of non-U.S. banking arrangements by U.S. residents and might be required to pay any fees, taxes and charges associated with such delivery assessed in the issuing country.
Options on non-U.S. currencies also have the other risks of using options inherent in options generally. See Risks of Options above.
Forward Currency Contracts. The Fund may enter into forward currency contracts to purchase or sell non-U.S. currencies for a fixed amount of U.S.
dollars or another non-U.S. currency. A forward currency contract involves an obligation to purchase or sell a specific currency at a future date, which may be any fixed number of days (term) from the date of the forward currency contract agreed
upon by the parties, at a price set at the time of the forward currency contract. These forward currency contracts are traded directly between currency traders (usually large commercial banks) and their customers. Forward currency contracts may be
used to attempt to hedge currency exposure or to enhance return or yield.
Such transactions may serve as long hedges; for example, the Fund
may purchase a forward currency contract to lock in the U.S. dollar price of a security denominated in a non-U.S. currency that the Fund intends to acquire. Forward currency contract transactions may also serve as short hedges; for example, the Fund
may sell a forward currency contract to lock in the U.S. dollar
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equivalent of the proceeds from the anticipated sale of a security, dividend or interest payment denominated in a non-U.S. currency.
The Fund may also use forward currency contracts to hedge against a decline in the value of existing investments denominated in non-U.S. currency. For
example, if the Fund owned securities denominated in Euros, it could enter into a forward currency contract to sell Euros in return for U.S. dollars to hedge against possible declines in the euros value. Such a hedge, sometimes referred
to as a position hedge, would tend to offset both positive and negative currency fluctuations, but would not offset changes in security values caused by other factors. The Fund could also hedge the position by selling another currency
expected to perform similarly to the euro. This type of hedge, sometimes referred to as a proxy hedge, could offer advantages in terms of cost, yield or efficiency, but generally would not hedge currency exposure as effectively as a
simple hedge into U.S. dollars. Proxy hedges may result in losses if the currency used to hedge does not perform similarly to the currency in which the hedged securities are denominated.
The cost to the Fund of engaging in forward currency contracts varies with factors such as the currency involved, the length of the contract period and
the market conditions then prevailing. Because forward currency contracts are usually entered into on a principal basis, no fees or commissions are involved. When the Fund enters into a forward currency contract, it relies on the counterparty to
make or take delivery of the underlying currency at the maturity of the contract. Failure by the counterparty to do so would result in the loss of any expected benefit of the transaction.
As is the case with futures contracts, parties to forward currency contracts can enter into offsetting closing transactions, similar to closing
transactions on futures contracts, by selling or purchasing, respectively, an instrument identical to the instrument purchased or sold. Secondary markets generally do not exist for forward currency contracts, with the result that closing
transactions generally can be made for forward currency contracts only by negotiating directly with the counterparty. Thus, there can be no assurance that the Fund will in fact be able to close out a forward currency contract at a favorable price
prior to maturity. In addition, in the event of insolvency of the counterparty, the Fund might be unable to close out a forward currency contract at any time prior to maturity, if at all. In either event, the Fund would continue to be subject to
market risk with respect to the position, and would continue to be required to maintain the required cover. The precise matching of forward currency contract amounts and the value of the securities involved generally will not be possible because the
value of such securities, measured in the non-U.S. currency, will change after the forward currency contract has been established. Thus, the Fund might need to purchase or sell non-U.S. currencies in the spot (cash) market to the extent such
non-U.S. currencies are not covered by forward currency contracts. The projection of short-term currency market movements is extremely difficult, and the successful execution of a short-term hedging strategy is highly uncertain. In addition,
although forward currency contracts limit the risk of loss due to a decline in the value of the hedged currencies, at the same time they limit any potential gain that might result should the value of the currencies increase.
Successful use of forward currency contracts depends on a Subadvisers skill in analyzing and predicting currency values. Forward currency contracts
may substantially change the Funds exposure to changes in currency exchange rates and could result in losses to the Fund if currencies do not perform as the Subadviser(s) anticipates. There is no assurance that a Subadvisers use of
forward currency contracts will be advantageous to the Fund or that the Subadviser will hedge at an appropriate time.
Combined Positions. The
Fund may purchase and write options in combination with each other, or in combination with other Financial Instruments, to adjust the risk and return characteristics of its overall position. For example, the 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.
Turnover. The Funds Financial Instrument activities may
affect its turnover rate and brokerage commission payments. For example, the exercise of calls or puts written by the Fund, and the sale or purchase of futures contracts, may cause it to sell or purchase related investments, thus increasing its
turnover rate. Once the Fund has received an exercise notice on an option it has written, it cannot effect a closing transaction in order to terminate its obligation under the option and must deliver or receive the underlying securities at the
exercise price. The exercise of puts purchased by the Fund may also cause the sale of related investments, also increasing turnover; although such exercise is within the Funds control, holding a protective put might cause it
20
to sell the related investments for reasons that would not exist in the absence of the put. The Fund will pay a brokerage commission each time it buys or sells a put or call or purchases or sells
a futures contract. Such commissions may be higher than those that would apply to direct purchases or sales.
Swaps, Caps, Floors and Collars.
The Fund may enter into swaps, caps, floors and collars to preserve a return or a spread on a particular investment or portion of its portfolio, to protect against any increase in the price of securities the Fund anticipates purchasing at a later
date or to attempt to enhance yield. A swap typically involves the exchange by the Fund with another party of their respective commitments to pay or receive cash flows, e.g., an exchange of floating rate payments for fixed-rate payments. The
purchase of a cap entitles the purchaser, to the extent that a specified index exceeds a predetermined value, to receive payments on a notional principal amount from the party selling the cap. The purchase of a floor entitles the purchaser, to the
extent that a specified index falls below a predetermined value, to receive payments on a notional principal amount from the party selling the floor. A collar combines elements of a cap and a floor. The Fund may engage in swap transactions,
including, but not limited to, swap agreements on interest rates, security indexes, specific securities, credit and event-linked swaps and currency exchange rates. Event-linked swaps are a form of event-linked investment exposure. Event-linked
exposure results in gains or losses that typically are contingent, or formulaically related to defined trigger events. Examples of trigger events include hurricanes, earthquakes, other weather-related phenomena, or statistics related to such events.
The occurrence of a trigger event causes a party to lose some or all of the amount invested in an event-linked swap. For example, if a trigger event occurs, the Fund may lose the swaps notional amount. Event-linked swaps are similar to
event-link bonds, which are commonly referred to as catastrophe bonds. If a trigger event occurs, the Fund may lose a portion of or its entire principal invested in an event-linked bond or notional amount on an event-linked swap. As
derivative instruments, event-linked swaps are subject to risks in addition to the risks of investing in event-linked bonds, including counterparty risk and leverage risk. The Fund may also enter into options on swap agreements.
Swap agreements, including caps, floors and collars, can be individually negotiated and structured to include exposure to a variety of different types of
investments or market factors. Depending on their structure, swap agreements may increase or decrease the overall volatility of the Funds investments and its share price and yield because, and to the extent, these agreements affect the
Funds exposure to long- or short-term interest rates (in the United States or abroad), non-U.S. currency values, mortgage-backed security values, corporate borrowing rates or other factors such as security prices, certain specified events,
index values or inflation rates. Swap agreements will tend to shift the Funds investment exposure from one type of investment to another. For example, if the Fund agrees to exchange payments in U.S. dollars for payments in non-U.S. currency,
the swap agreement would tend to decrease the Funds exposure to U.S. interest rates and increase its exposure to non-U.S. currency and interest rates. Caps and floors have an effect similar to buying or writing options.
If a counterpartys creditworthiness declines, the value of the agreement would be likely to decline, potentially resulting in losses. If a default
occurs by the other party to such transaction, the Fund will have contractual remedies pursuant to the agreements related to the transaction, which may be limited by applicable law in the case of a counterpartys insolvency.
Cleared Swaps. Recent legislation and implementing regulation require certain swaps to be cleared through a regulated clearinghouse. Although this
clearing mechanism is generally intended to reduce counterparty credit risk, it may disrupt or limit the swap market and may result in swaps being more difficult to trade or value. As swaps become more standardized, the Fund may not be able to enter
into swaps that meet its investment needs. The Fund also may not be able to find a clearinghouse willing to accept a swap for clearing. In a cleared swap, a central clearing organization will be the counterparty to the transaction. The Fund
will assume the risk that the clearinghouse may be unable to perform its obligations.
When the Fund enters into a cleared swap transaction, the Fund
is subject to the credit and counterparty risk of the clearinghouse and the clearing member through which it holds its cleared position. Credit/counterparty risk of market participants with respect to centrally cleared swaps is concentrated in a few
clearinghouses, and it is not clear how an insolvency proceeding of a clearinghouse would be conducted and what impact an insolvency of a clearinghouse would have on the financial system. A clearing member is obligated by contract and by applicable
regulation to segregate all funds received from customers with respect to cleared derivatives transactions from the clearing members proprietary assets. However, all funds and other property received by a clearing broker from its customers
generally are held by the clearing broker on a commingled basis in an omnibus account, and the clearing member may invest those funds in certain instruments permitted under the applicable regulations. The assets of the Fund might not be fully
protected in the event of the bankruptcy of the Funds clearing member, because the Fund would be limited to recovering only a pro rata share of all available funds segregated on
21
behalf of the clearing brokers customers for a relevant account class. Also, the clearing member is required to transfer to the clearing organization the amount of margin required by the
clearing organization for cleared derivatives, which amounts generally are held in an omnibus account at the clearing organization for all customers of the clearing member. Regulations promulgated by the CFTC require that the clearing member notify
the clearinghouse of the amount of initial margin provided by the clearing member to the clearing organization that is attributable to each customer. However, if the clearing member does not provide accurate reporting, the Fund is subject to the
risk that a clearing organization will use the Funds assets held in an omnibus account at the clearing organization to satisfy payment obligations of a defaulting customer of the clearing member to the clearing organization. In addition,
clearing members generally provide to the clearing organization the net amount of variation margin required for cleared swaps for all of its customers in the aggregate, rather than the gross amount of each customer. The Fund is therefore subject to
the risk that a clearing organization will not make variation margin payments owed to the Fund if another customer of the clearing member has suffered a loss and is in default, and the risk that the Fund will be required to provide additional
variation margin to the clearinghouse before the clearinghouse will move the Funds cleared derivatives transactions to another clearing member. In addition, if a clearing member does not comply with the applicable regulations or its agreement
with the Fund, or in the event of fraud or misappropriation of customer assets by a clearing member, the Fund could have only an unsecured creditor claim in an insolvency of the clearing member with respect to the margin held by the clearing member.
In some ways, centrally cleared swaps arrangements are less favorable to the Fund than OTC swaps arrangements. For example, the Fund may be required
to provide greater amounts of margin for cleared swaps than for OTC swaps. Also, in contrast to OTC swaps, following a period of notice to the Fund, a clearing member generally can require termination of existing cleared swaps at any time or
increases in margin requirements above the margin that the clearing member required at the beginning of a transaction. Clearinghouses also have broad rights to increase margin requirements for existing transactions or to terminate transactions at
any time. Any increase in margin requirements or termination by the clearing member or the clearinghouse could interfere with the ability of the Fund to pursue its investment strategy. Further, any increase in margin requirements by a clearing
member could also expose the Fund to greater credit risk of its clearing member, because margin for cleared swaps in excess of clearinghouse margin requirements typically is held by the clearing member. While the documentation in place between the
Fund and its clearing members generally provides that the clearing members will accept for clearing all transactions submitted for clearing that are within credit limits (specified in advance) for the Fund, the Fund is still subject to the risk that
no clearing member will be willing or able to clear a transaction. In those cases, the transaction might have to be terminated, and the Fund could lose some or all of the benefit of the transaction, including loss of an increase in the value of the
transaction and/or loss of hedging protection offered by the transaction. In addition, the documentation governing the relationship between the Fund and its clearing members is developed by the clearing members and generally is less favorable to the
Fund than typical OTC swap documentation. For example, this documentation generally includes a one-way indemnity by the Fund in favor of the clearing member, indemnifying the clearing member against losses it incurs in connection with acting as the
Funds clearing member, and the documentation typically does not give the Fund any rights to exercise remedies if the clearing member defaults or becomes insolvent.
Some types of cleared swaps are required to be executed on an exchange or on a swap execution facility (SEF). A SEF is a trading platform
where multiple market participants can execute swaps by accepting bids and offers made by multiple other participants in the platform. While this execution requirement is designed to increase transparency and liquidity in the cleared swap market,
trading on a SEF can create additional costs and risks for the Fund. For example, SEFs typically charge fees, and if the Fund executes swaps on a SEF through a broker intermediary, the intermediary may impose fees as well. Also, the Fund may
indemnify a SEF, or a broker intermediary who executes cleared swaps on a SEF on the Funds behalf, against any losses or costs that may be incurred as a result of the Funds transactions on the SEF.
The Fund may enter into swap transactions with certain counterparties pursuant to master netting agreements. A master netting agreement provides that all
swaps entered into between the Fund and that counterparty shall be regarded as parts of an integral agreement. If amounts are payable on a particular date in the same currency in respect of more than one swap transaction, the amount payable shall be
the net amount. In addition, the master netting agreement may provide that if one party defaults generally or on any swap, the counterparty can terminate all outstanding swaps with that party. As a result, to the extent the Fund enters into master
netting agreements with a counterparty, the Fund may be required to terminate a greater number of swap agreements than if it had not entered into such an agreement, which may result in losses to the Fund.
22
Interest Rate Swaps, Caps and Floors. Interest rate swaps are agreements between two parties to
exchange interest rate payment obligations. Typically, one partys obligation is based on a fixed interest rate while the other partys obligation is based on an interest rate that fluctuates with changes in a designated benchmark. An
interest rate cap transaction entitles the purchaser, to the extent that a specified index exceeds a predetermined value, to receive payments on a notional principal amount from the party selling the cap. An interest rate floor transaction entitles
the purchaser, to the extent that a specified index falls below a predetermined value, to receive payments on a notional principal amount from the party selling the floor. A collar combines elements of buying a cap and a floor. Caps and floors have
an effect similar to buying or writing options. Caps and floors typically have lower liquidity than swaps.
Options on Swaps
(Swaptions). A swaption is a contract that gives the counterparty the right, but not the obligation to enter into a new swap agreement or to shorten, extend, cancel or otherwise modify an existing swap agreement, at some designated
future time on specified terms. The Fund may write (sell) and purchase put and call swaptions. Swaptions are generally subject to the same risks involved in the use of options and swaps. Depending on the terms of the option agreement, the Fund will
generally incur a greater degree of risk when it writes a swaption than it will incur when it purchases a swaption. When the Fund purchases a swaption, only the amount of premium the Fund paid is at risk should the option expire unexercised.
However, when a Fund writes a swaption, upon exercise of the option the Fund will become obligated according to the terms of the underlying agreement, which may result in losses to the Fund in excess of the premium it received.
Credit Default Swaps and Related Investments. The Fund may enter into credit default swap contracts for investment purposes and to add leverage to
its investment portfolio. As the seller in a credit default swap contract, the Fund would be required to pay the par (or other agreed-upon) value of a debt-reference obligation to the counterparty in the event of a default by a third party on the
debt obligation. In return, the Fund would receive from the counterparty a periodic stream of payments over the term of the contract provided that no event of default has occurred. If no default occurs, the Fund would keep the stream of payments and
would have no payment obligations. As the seller, the Fund would effectively add leverage to its portfolio because, in addition to its net assets, the Fund would be subject to investment exposure on the swap. Credit default swap contracts involve
special risks and may result in losses to the Fund. Credit default swaps may in some cases be illiquid, and they increase credit risk since the Fund has exposure to both the issuer of the referenced obligation and the counterparty to the credit
default swap. As there is no central exchange or market for certain credit default swap transactions, they may be difficult to trade or value, especially in the event of market disruptions. It is possible that developments in the swap market,
including new or modified government regulation, could adversely affect the Funds ability to terminate existing credit default swap agreements or to realize amounts to be received under such agreements.
The Fund may also purchase credit default swap contracts to attempt to hedge against the risk of default of debt securities held in its portfolio, in
which case the Fund would function as the counterparty referenced in the preceding paragraph. This would involve the risk that the investment may expire worthless and would only generate income in the event of an actual default by the issuer of the
underlying obligation (or, as applicable, a credit downgrade or other indication of financial instability). It would also involve credit riskthat the seller may fail to satisfy its payment obligations to the Fund in the event of a default.
The Fund may invest in credit default swap index products that provide exposure to multiple credit default swaps. The Fund can either buy the index
(take on credit exposure) or sell the index (pass credit exposure to a counterparty). Such investments are subject to the associated risks with investments in credit default swaps discussed above.
Cover. Transactions using Financial Instruments, other than purchased options, and certain other transactions, such as reverse repurchase
agreements and certain forward commitments (e.g., forward roll transactions) expose the Fund to an obligation to another party. The Fund will comply with SEC guidelines regarding cover for these instruments and will, if the guidelines so require,
segregate on its books cash or liquid assets in the prescribed amount as determined daily. In some cases, (e.g., with respect to futures and forwards that are contractually required to cash-settle and most swaps), the Fund is permitted
under relevant guidance from the SEC or SEC staff to set aside assets with respect to an investment transaction in the amount of its net (marked-to-market) obligations thereunder, rather than the full notional amount of the transaction. The Fund
will cover the full notional amount of the credit default swaps written by the Fund. By setting aside assets equal only to its net obligations, the Fund will have the ability to engage to a greater extent in transactions in Financial Instruments,
which may increase the risks associated with such investments. Although this SAI describes certain permitted methods of segregating assets or otherwise covering such transactions for these purposes, such descriptions are not intended to
be comprehensive. The Fund may cover
23
such transactions using other methods currently or in the future permitted under the 1940 Act, the rules and regulations thereunder, or orders issued by the SEC thereunder. For these purposes,
interpretations and guidance provided by the SEC staff may be taken into account when deemed appropriate by the Fund.
Assets used as cover cannot be
sold while the position in the corresponding Financial Instrument is open, unless they are replaced with other appropriate assets. As a result, the commitment of a large portion of the Funds assets to cover in accounts could impede portfolio
management or the Funds ability to meet redemption requests or other current obligations.
Preferred Stocks and Convertible Securities
A preferred stock pays dividends at a specified rate and has preference over common stock in the payment of dividends and the liquidation of an
issuers assets but is junior to the debt securities of the issuer in those same respects. The market prices of preferred stocks are subject to changes in interest rates and are more sensitive to changes in an issuers creditworthiness
than are the prices of debt securities. Shareholders of preferred stock may suffer a loss of value if dividends are not paid. Under ordinary circumstances, preferred stock does not carry voting rights.
A convertible security is a bond, debenture, note, preferred stock or other security that may be converted into or exchanged for a prescribed amount of
common stock (or another equity security) of the same or a different issuer 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 the dividend
paid on preferred stock until the convertible security matures or is redeemed, converted or exchanged. Before conversion, convertible securities have characteristics similar to nonconvertible debt securities in that they ordinarily provide a stream
of income with generally higher yields than those of common stocks of the same or similar issuers.
Convertible securities are usually subordinated
to comparable-tier nonconvertible securities but rank senior to common stock in a corporations capital structure.
The value of a convertible
security is a function of (1) its yield in comparison with the yields of other securities of comparable maturity and quality that do not have a conversion privilege and (2) its worth, at market value, if converted into the underlying
common stock. A convertible security may be subject to redemption at the option of the issuer at a price established in the convertible securitys governing instrument. If a convertible security held by the Fund is called for redemption, the
Fund will be required to (1) permit the issuer to redeem the security, (2) convert it into the underlying common stock or (3) sell it to a third party. Any of these actions could have an adverse effect on the Funds ability to
achieve its investment objective.
Fixed Income Securities
The Fund may invest in a variety of fixed income securities. These securities share three principal risks: First, the level of interest income generated
by the Funds fixed income investments may decline due to a decrease in market interest rates. Thus, when fixed income securities mature or are sold, they may be replaced by lower-yielding investments. Second, their values fluctuate with
changes in interest rates. Thus, a decrease in interest rates will generally result in an increase in the value of the Funds fixed income investments. Conversely, during periods of rising interest rates, the value of the Funds fixed
income investments will generally decline. The magnitude of these fluctuations will generally be greater when the Funds duration or average maturity is longer. Changes in the value of portfolio securities will not affect interest income from
those securities, but will be reflected in the Funds net asset value. In addition, certain fixed income securities are subject to credit risk, which is the risk that an issuer of securities will be unable to pay principal and interest when
due, or that the value of the security will suffer because investors believe the issuer is unable to pay. The most common types of these instruments, and the associated risks, are described below. Subject to its investment policies and applicable
law, the Fund may invest in these and other instruments.
U.S. Government Obligations. U.S. Government securities include (1) U.S.
Treasury bills (maturity of one year or less), U.S. Treasury notes (maturity of one to ten years) and U.S. Treasury bonds (maturities generally greater than ten years); (2) obligations issued or guaranteed by U.S. Government agencies or
instrumentalities which are supported by any of the following: (a) the full faith and credit of the U.S. Government (such as GNMA certificates); (b) the right of the issuer to borrow an amount limited to a specific line of credit from the
U.S. Government (such as obligations of the Federal Home Loan Banks); (c) the discretionary authority of the U.S. Government to purchase certain obligations of agencies or instrumentalities (such as securities issued by the Federal National
Mortgage Association (Fannie Mae)); or (d) only the credit of the instrumentality (such as securities issued by the Federal Home Loan Mortgage Corporation (Freddie Mac)) and (3) obligations issued by
non-governmental entities (like financial institutions) that carry direct guarantees from U.S. government agencies as part of government initiatives in response to the market crisis or otherwise. In the case of obligations not backed by the full
faith and
24
credit of the United States, the Fund must look principally to the agency or instrumentality issuing or guaranteeing the obligation for ultimate repayment and may not be able to assert a claim
against the United States itself in the event the agency or instrumentality does not meet its commitments. Neither the U.S. Government nor any of its agencies or instrumentalities guarantees the market value of the securities they issue. Therefore,
the market value of such securities will fluctuate in response to changes in interest rates.
Variable and floating rate securities. Variable
and floating rate securities provide for a periodic adjustment in the interest rate paid on the obligations. The terms of such obligations provide that interest rates are adjusted periodically based upon an interest rate adjustment index as provided
in the respective obligations. The adjustment intervals may be regular, and range from daily up to annually, or may be event based, such as based on a change in the prime rate.
The Fund may invest in floating rate debt instruments (floaters) and engage in credit spread trades. The interest rate on a floater is a
variable rate which is tied to another interest rate, such as a corporate bond index or Treasury bill rate. The interest rate on a floater resets periodically, typically every six months. While, because of the interest rate reset feature, floaters
provide the Fund with a certain degree of protection against rising interest rates, the Fund will participate in any declines in interest rates as well. A credit spread trade is an investment position relating to a difference in the prices or
interest rates of two bonds or other securities or currencies, where the value of the investment position is determined by movements in the difference between the prices or interest rates, as the case may be, of the respective securities or
currencies.
The Fund may also invest in inverse floating rate debt instruments (inverse floaters). The interest rate on an inverse
floater resets in the opposite direction from the market rate of interest to which the inverse floater is indexed. An inverse floating rate security may exhibit greater price volatility than a fixed rate obligation of similar credit quality.
A floater may be considered to be leveraged to the extent that its interest rate varies by a magnitude that exceeds the magnitude of the change
in the index rate of interest. The higher degree of leverage inherent in some floaters is associated with greater volatility in their market values.
Variable and floating rate instruments may include variable amount master demand notes that permit the indebtedness thereunder to vary in addition to
providing for periodic adjustments in the interest rate. The absence of an active secondary market with respect to particular variable and floating rate instruments could make it difficult for the Fund to dispose of a variable or floating rate note
if the issuer defaulted on its payment obligation or during periods that the Fund is not entitled to exercise its demand rights, and the Fund could, for these or other reasons, suffer a loss with respect to such instruments. In determining
average-weighted portfolio maturity, an instrument will be deemed to have a maturity equal to either the period remaining until the next interest rate adjustment or the time the Fund can recover payment of principal as specified in the instrument,
depending on the type of instrument involved.
Inflation-Indexed Securities. Inflation indexed bonds are fixed income securities whose
principal value or coupon (interest payment) is periodically adjusted according to the rate of inflation. Two structures are common. The U.S. Treasury and some other issuers use a structure that accrues inflation into the principal value of the
bond. Most other issuers pay out the index-based accruals as part of a semiannual coupon. The Fund may also invest in inflation-indexed securities with other structures or characteristics as such securities become available in the market. It is
currently expected that other types of inflation-indexed securities would have characteristics similar to those described below.
U.S.
Treasury Inflation Protected Securities (U.S. TIPS) are fixed income securities issued by the U.S. Department of Treasury, the principal amounts of which are adjusted daily based upon changes in the rate of inflation (currently
represented by the non-seasonally adjusted Consumer Price Index for All Urban Consumers (CPI-U), calculated with a three-month lag). The U.S. Department of Treasury issues U.S. TIPS in maturities of five, ten and thirty years. U.S. TIPS
pay interest on a semi-annual basis, equal to a fixed percentage of the inflation-adjusted principal amount. The interest rate on these bonds is fixed at issuance, but over the life of the bond this interest may be paid on an increasing or
decreasing principal value that has been adjusted for inflation.
Repayment of the original bond principal upon maturity (as adjusted for inflation)
is guaranteed for U.S. TIPS, even during a period of deflation. However, because the principal amount of U.S. TIPS would be adjusted downward during a period of deflation, the Fund will be subject to deflation risk with respect to its investments in
these securities. In addition, the current market value of the bonds is not guaranteed, and will fluctuate. If the Fund purchases U.S. TIPS in the secondary market whose principal values have been adjusted upward due to inflation since issuance, the
Fund may experience a loss if there is a
25
subsequent period of deflation. The Fund may also invest in other inflation-related bonds which may or may not provide a guarantee of principal. If a guarantee of principal is not provided, the
adjusted principal value of the bond repaid at maturity may be less than the original principal amount.
The value of inflation-indexed bonds is
expected to fluctuate in response to changes in real interest rates, which are in turn tied to the relationship between nominal interest rates and the rate of inflation. Therefore, if inflation were to rise at a faster rate than nominal interest
rates, real interest rates might decline, leading to an increase in value of inflation indexed bonds. In contrast, if nominal interest rates increased at a faster rate than inflation, real interest rates might rise, leading to a decrease in value of
inflation indexed bonds. Although the principal value of these securities declines in periods of deflation, holders at maturity receive no less than par. If inflation is lower than expected during the period the Fund holds the security, the Fund may
earn less on the security than on a conventional bond. Any increase in principal value is taxable in the year the increase occurs, even though holders do not receive cash representing the increase at that time. As a result, the Fund investing in
inflation-indexed securities could be required at times to liquidate other investments, including when it is not advantageous to do so, in order to satisfy its distribution requirements as a regulated investment company and to eliminate any
fund-level income tax liability under the Code.
While these securities are expected to be protected from long-term inflationary trends,
short-term increases in inflation may lead to a decline in value. If interest rates rise due to reasons other than inflation (for example, due to changes in currency exchange rates), investors in these securities may not be protected to the extent
that the increase is not reflected in the bonds inflation measure.
The U.S. Treasury began issuing inflation-indexed bonds in 1997. Certain
non-U.S. governments, such as the United Kingdom, Canada and Australia, have a longer history of issuing inflation indexed bonds, and there may be a more liquid market in certain of these countries for these securities. The Fund may invest in
inflation-indexed securities issued in any country.
The periodic adjustment of U.S. TIPS is currently tied to the CPI-U, which is calculated by the
U.S. Department of Treasury. The CPI-U is a measurement of changes in the cost of living, made up of components such as housing, food, transportation and energy. Inflation-indexed bonds issued by a non-U.S. government are generally adjusted to
reflect a comparable inflation index, calculated by that government. There can no assurance that the CPI-U or any non-U.S. inflation index will accurately measure the real rate of inflation in the prices of goods and services. In addition, there can
be no assurance that the rate of inflation in a non-U.S. country will be correlated to the rate of inflation in the United States. The three-month lag in calculating the CPI-U for purposes of adjusting the principal value of U.S. TIPS may give rise
to risks under certain circumstances.
Mortgage-Related Securities. Mortgage-related securities represent an interest in a pool of mortgages
made by lenders such as commercial banks, savings and loan institutions, mortgage bankers and others. Mortgage-related securities may be issued by governmental, government-related or non-governmental entities, and provide regular payments which
consist of interest and, in most cases, principal. In contrast, other forms of debt securities normally provide for periodic payment of interest in fixed amounts with principal payments at maturity or specified call dates. In effect, payments on
mortgage-related securities are a pass-through of the payments made by the individual borrowers on their mortgage loans, net of any fees paid to the issuer or guarantor of such securities. Additional payments to holders of
mortgage-related securities are caused by repayments resulting from the sale of the underlying property, refinancing or foreclosure, net of fees or costs that may be incurred.
As prepayment rates of individual pools of mortgage loans vary widely, it is not possible to predict accurately the average life of a particular
security. Although mortgage-related securities are issued with stated maturities of up to forty years, unscheduled or early payments of principal and interest on the underlying mortgages may shorten considerably the securities effective
maturities. The volume of prepayments of principal on a pool of mortgages underlying a particular mortgage-related security will influence the yield of that security, and the principal returned to the Fund may be reinvested in instruments whose
yield may be higher or lower than that which might have been obtained had such prepayments not occurred. When interest rates are declining, such prepayments usually increase, and reinvestments of such principal prepayments will be at a lower rate
than that on the original mortgage-related security. An increase in mortgage prepayments could cause the Fund to incur a loss on a mortgage-related security that was purchased at a premium. On the other hand, a decrease in the rate of prepayments,
resulting from an increase in market interest rates or other causes, may extend the effective maturities of mortgage-related securities, increasing their sensitivity to changes in market interest rates and potentially increasing the volatility of
the Funds shares. The rate of prepayment may also be affected by general economic conditions, the location and age of the mortgages, and other social and demographic conditions. In determining the average maturity or duration of a
mortgage-related security, the Subadviser(s)
26
must apply certain assumptions and projections about the maturity and prepayment of such security; actual prepayment rates may differ. Because of prepayments, mortgage-related securities may have
less potential for capital appreciation during periods of declining interest rates than other securities of comparable maturities, although they may have a similar risk of decline in market value during periods of rising interest rates.
Pools often consist of whole mortgage loans or participations in loans. The majority of these loans are made to purchasers of one- to four-family homes.
The terms and characteristics of the mortgage instruments are generally uniform within a pool but may vary among pools. For example, in addition to fixed-rate, fixed-term mortgages, the Fund may purchase pools of variable-rate mortgages,
growing-equity mortgages, graduated-payment mortgages and other types.
All poolers apply standards for qualification to lending institutions that
originate mortgages for the pools. Poolers also establish credit standards and underwriting criteria for individual mortgages included in the pools. In addition, many mortgages included in pools are insured through private mortgage insurance
companies.
The average life of mortgage-related securities varies with the maturities and the nature of the underlying mortgage instruments. For
example, securities issued by the Government National Mortgage Association (GNMA) tend to have a longer average life than participation certificates (PCs) issued by the Federal Home Loan Mortgage Corporation
(FHLMC) because there is a tendency for the conventional and privately-insured mortgages underlying FHLMC PCs to repay at faster rates than the Federal Housing Administration and Veterans Administration loans underlying GNMAs. In
addition, the term of a security may be shortened by unscheduled or early payments of principal and interest on the underlying mortgages. The occurrence of mortgage prepayments is affected by factors including the level of interest rates, general
economic conditions, the location and age of the mortgage and other social and demographic conditions.
Yields on mortgage-related securities are
typically quoted based on the maturity of the underlying instruments and the associated average life assumption. Actual prepayment experience may cause the yield to differ from the yield expected on the basis of average life. Reinvestment of the
prepayments may occur at higher or lower interest rates than the original investment, thus affecting the yield of the Fund. The compounding effect from reinvestments of monthly payments received by the Fund will increase the yield to shareholders
compared to bonds that pay interest semi-annually.
Government Mortgage-Related Securities. GNMA is the principal federal government guarantor
of mortgage-related securities. GNMA is a wholly owned U.S. Government corporation within the Department of Housing and Urban Development. GNMA pass-through securities are considered to have a relatively low risk of default in that (1) the
underlying mortgage loan portfolio is comprised entirely of government-backed loans and (2) the timely payment of both principal and interest on the securities is guaranteed by the full faith and credit of the U.S. Government, regardless of
whether they have been collected. GNMA pass-through securities are, however, subject to the same interest rate risk as comparable debt securities. Therefore, the effective maturity and market value of the Funds GNMA securities can be expected
to fluctuate in response to changes in interest rate levels.
Residential mortgage loans are also pooled by Freddie Mac, a corporate
instrumentality of the U.S. Government. The mortgage loans in Freddie Macs portfolio are not government backed; Freddie Mac, not the U.S. Government, guarantees the timely payment of interest and ultimate collection of principal on Freddie Mac
securities. Freddie Mac also issues guaranteed mortgage certificates, on which it guarantees semiannual interest payments and a specified minimum annual payment of principal.
Fannie Mae is a government-sponsored corporation owned entirely by private stockholders. It is subject to general regulation by the Secretary of Housing
and Urban Development. Fannie Mae purchases residential mortgages from a list of approved seller/servicers, which include savings and loan associations, savings banks, commercial banks, credit unions and mortgage bankers. Pass-through securities
issued by Fannie Mae are guaranteed as to timely payment of principal and interest only by Fannie Mae, not the U.S. Government.
Although the U.S.
Government has recently provided financial support to Fannie Mae and Freddie Mac, which are currently being operated under the conservatorship of the Federal Housing Finance Agency, there can be no assurance that it will support these or other
government-sponsored enterprises in the future.
Under the Federal Housing Finance Agencys Single Security Initiative, Fannie Mae
and Freddie Mac have entered into a joint initiative to develop a common securitization platform for the issuance of Uniform Mortgage-Backed Securities
27
(UMBS), which would generally align the characteristics of Fannie Mae and Freddie Mac participation certificates. In June 2019 Fannie Mae and Freddie Mac are expected to begin
issuing UMBS in place of their current offerings of to be announced-eligible mortgage-backed securities. The effect of the issuance of UMBS on the market for mortgage-backed securities is uncertain.
Privately Issued Mortgage-Related Securities. Mortgage-related securities offered by private issuers include pass-through securities comprised of
pools of residential mortgage loans; mortgage-backed bonds which are considered to be debt obligations of the institution issuing the bonds and are collateralized by mortgage loans; and bonds and collateralized mortgage obligations
(CMOs) which are collateralized by mortgage-related securities issued by Freddie Mac, Fannie Mae or GNMA or by pools of mortgages.
CMOs are typically structured with classes or series that have different maturities and are generally retired in sequence. Each class of obligations
receives periodic interest payments according to the coupon rate on the obligations. However, all monthly principal payments and any prepayments from the collateral pool are generally paid first to the Class 1 holders. Thereafter, all
payments of principal are generally allocated to the next most senior class of obligations until that class of obligations has been fully repaid. Although full payoff of each class of obligations is contractually required by a certain date, any or
all classes of obligations may be paid off sooner than expected because of an increase in the payoff speed of the pool. Other allocation methods may be used. Payment of interest or principal on some classes or series of a CMO may be subject to
contingencies or some classes or series may bear some or all of the risk of default on the underlying mortgages.
Mortgage-related securities
created by non-governmental issuers generally offer a higher rate of interest than government and government-related securities because there are no direct or indirect government guarantees of payment in the former securities, resulting in higher
risks. Where privately issued securities are collateralized by securities issued by Freddie Mac, Fannie Mae or GNMA, the timely payment of interest and principal is supported by the government-related securities collateralizing such obligations. The
market for conventional pools is smaller and has lower liquidity than the market for the government and government-related mortgage pools.
Certain private mortgage pools are organized in such a way that the SEC staff considers them to be closed-end investment companies. The Funds
investment in such pools may be constrained by federal statute, which restricts investments in the shares of other investment companies. The private mortgage-related securities in which the Fund may invest include non-U.S. mortgage pass-through
securities (Non-U.S. Pass-Throughs), which are structurally similar to the pass-through instruments described above. Such securities are issued by originators of and investors in mortgage loans, including savings and loan associations,
mortgage bankers, commercial banks, investment bankers, specialized financial institutions and special purpose subsidiaries of the foregoing. Non-U.S. Pass-Throughs usually are backed by a pool of fixed rate or adjustable-rate mortgage loans.
Certain Non-U.S. Pass-Throughs in which the Fund invests typically are not guaranteed by an entity having the credit status of GNMA, but generally utilize various types of credit enhancement.
Asset-Backed Securities. ABS are securities, which may be issued by either a U.S. or foreign entity, that are collateralized by any type of
financial asset, such as a consumer-related loan (e.g., credit card receivables, student loans and automobile loans), a lease, or a secured or unsecured receivable. ABS exclude (1) securities collateralized by residential or commercial mortgage
loans, MBS, or other financial assets derivatives of MBS and (2) CDOs.
Such assets are generally securitized through the use of trusts
or special purpose corporations. Asset-backed securities are backed by a pool of assets representing the obligations often of a number of different parties. Certain of such securities may be illiquid.
The principal on asset-backed securities, like that on mortgage-backed securities, may be prepaid at any time. As a result, if such securities are
purchased at a premium, a prepayment rate that is faster than expected will reduce yield to maturity, while a prepayment rate that is slower than expected will have the opposite effect. Conversely, if the securities are purchased at a discount,
prepayments faster than expected will increase yield to maturity and prepayments slower than expected will decrease it. Accelerated prepayments also reduce the certainty of the yield because the Fund must reinvest the assets at the then-current
rates. Accelerated prepayments on securities purchased at a premium also impose a risk of loss of principal. On the other hand, a decrease in the rate of prepayments may extend the effective maturities of the securities, increasing their sensitivity
to changes in market interest rates and potentially increasing the volatility of the Funds shares. The rate of prepayment may also be affected by general economic conditions and other social and demographic conditions.
28
Each type of asset-backed security also entails unique risks depending on the type of assets
involved and the legal structure used. For example, credit card receivables are generally unsecured obligations of the credit card holder and the debtors are entitled to the protection of a number of state and federal consumer credit laws, many of
which give such debtors the right to set off certain amounts owed on the credit cards, thereby reducing the balance due. There have also been proposals to cap the interest rate that a credit card issuer may charge. In some transactions, the value of
the asset-backed security is dependent on the performance of a third party acting as credit enhancer or servicer. Furthermore, in some transactions (such as those involving the securitization of vehicle loans or leases) it may be administratively
burdensome to perfect the interest in the underlying collateral, and the underlying collateral may become damaged or stolen.
Most issuers of
automobile receivables permit the servicers to retain possession of the underlying obligations. If the servicer were to sell these obligations to another party, there is a risk that the purchaser would acquire an interest superior to that of the
holders of the related automobile receivables. In addition, because of the large number of vehicles involved in a typical issuance and technical requirements under state laws, the trustee for the holders of the automobile receivables may not have a
proper security interest in all of the obligations backing such receivables. Therefore, there is the possibility that recoveries on repossessed collateral may not, in some cases, be available to support payments on these securities. The market
experience in asset-backed securities is limited; therefore, the markets ability to sustain liquidity through all phases of the market cycle is not certain.
Municipal Obligations. Municipal obligations include obligations issued to obtain funds for various public purposes, including constructing a wide
range of public facilities, such as bridges, highways, housing, hospitals, mass transportation, schools and streets. Other public purposes for which municipal obligations may be issued include the refunding of outstanding obligations, the obtaining
of funds for general operating expenses and the making of loans to other public institutions and facilities. In addition, certain types of industrial development bonds (IDBs) and private activity bonds (PABs) are issued by or
on behalf of public authorities to finance various privately operated facilities, including certain pollution control facilities, convention or trade show facilities, and airport, mass transit, port or parking facilities.
Municipal obligations also include short-term tax anticipation notes, bond anticipation notes, revenue anticipation notes and other forms of short-term
debt obligations. Such notes may be issued with a short-term maturity in anticipation of the receipt of tax payments, the proceeds of bond placements or other revenues. Municipal obligations also include municipal lease obligations and certificates
of participation. Municipal lease obligations, which are issued by state and local governments to acquire land, equipment and facilities, typically are not fully backed by the municipalitys credit, and, if funds are not appropriated for the
following years lease payments, a lease may terminate, with the possibility of default on the lease obligation and significant loss to the Fund. Certificates of participation are participations in municipal lease obligations or installment
sales contracts. Each certificate represents a proportionate interest in or right to the payments made.
The two principal classifications of
municipal obligations are general obligation and revenue bonds. General obligation bonds are secured by the issuers pledge of its faith, credit and taxing power. Revenue bonds are payable only
from the revenues derived from a particular facility or class of facilities or from the proceeds of a special excise tax or other specific revenue source such as the corporate user of the facility being financed. IDBs and PABs are usually revenue
bonds and are not payable from the unrestricted revenues of the issuer. The credit quality of IDBs and PABs is usually directly related to the credit standing of the corporate user of the facilities.
The ability of state, county or local governments to meet their obligations will depend primarily on the availability of tax and other revenues to those
governments and on their fiscal conditions generally. The amounts of tax and other revenues available to governmental issuers may be affected from time to time by economic, political and demographic conditions within or outside of the particular
state. In addition, constitutional or statutory restrictions may limit a governments power to raise revenues or increase taxes.
The
availability of federal, state and local aid to issuers of municipal securities may also affect their ability to meet their obligations. Payments of principal and interest on revenue bonds will depend on the economic condition of the facility or
specific revenue source from whose revenues the payments will be made. The facilitys economic status, in turn, could be affected by economic, political and demographic conditions affecting the particular state.
Tender option bonds represent securities issued by a special purpose trust formed for the purpose of holding securities (typically municipal bonds or
other municipal securities) that are contributed to the trust by the Fund or another third party. The
29
trust typically issues two classes of securities: short-term floating rate interests (sometimes known as put bonds or puttable securities), which are generally sold to
third party investors (often money market funds), and residual interests (also referred to as inverse floaters), which are generally held by the entity that contributed securities to the trust. The short-term floating rate interests
typically have first priority on the cash flow from the municipal bonds or other securities held by the trust, and the remaining cash flow less certain expenses is paid to holders of the residual interests. Purchasers of short-term floating rate
interests issued by a tender option bond trust typically have the option, at periodic intervals or upon the occurrence of certain events, to tender their securities to the trust or a liquidity provider engaged by the trust and to receive the face
value thereof. Thus, the security holder would effectively hold a demand obligation that would ordinarily bear interest at the prevailing short-term tax-exempt rate. (See the discussion of Indexed Securities and Structured Notes, below.) Floating
rate interests issued by a tender option bond trust are subject to risks generally applicable to fixed income securities, as well as risks (including credit risk and illiquidity risk) relating to the underlying municipal securities held by the
trust.
Collateralized Debt Obligations. CDOs are comprised of collateralized bond obligations (CBOs) and collateralized loan
obligations (CLOs). CBOs are securities issued by a trust or other special purpose entity that are backed by a diversified pool of fixed income securities issued by U.S. or foreign governmental entities or fixed income securities issued
by U.S. or corporate issuers. CLOs are securities issued by a trust or other special purpose entity that are collateralized by a pool of loans by U.S. banks and participations in loans by U.S. banks that are unsecured or secured by collateral other
than real estate. Although certain CDOs may receive credit enhancement in the form of a senior-subordinate structure, over-collateralization or bond insurance, such enhancement may not always be present, and may fail to protect the Fund against the
risk of loss on default of the collateral. Certain CDOs may use derivatives contracts to create synthetic exposure to assets rather than holding such assets directly, which entails the risks of derivative instruments described elsewhere
in this SAI. CDOs may charge management fees and administrative expenses, which are in addition to those of the Fund.
For both CBOs and
CLOs, the cashflows from the SPE are split into two or more portions, called tranches, varying in risk and yield. The riskiest portion is the equity tranche, which bears the first loss from defaults from the bonds or loans in the SPE and
serves to protect the other, more senior tranches from default (though such protection is not complete). Since it is partially protected from defaults, a senior tranche from a CBO or CLO typically has higher ratings and lower yields than its
underlying securities, and may be rated investment grade. Despite the protection from the equity tranche, CBO or CLO tranches can experience substantial losses due to actual defaults, increased sensitivity to defaults due to collateral default and
disappearance of protecting tranches, market anticipation of defaults, as well as investor aversion to CBO or CLO securities as a class. Interest on certain tranches of a CDO may be paid in kind (paid in the form of obligations of the same type
rather than cash), which involves continued exposure to default risk with respect to such payments.
The risks of an investment in a CDO depend
largely on the type of the collateral securities and the class of the CDO in which the Fund invests. Normally, CBOs, CLOs and other CDOs are privately offered and sold, and thus, are not registered under the securities laws. As a result, investments
in CDOs may be characterized by the Fund as illiquid securities. However, an active dealer market may exist for CDOs, allowing a CDO to qualify for Rule 144A transactions. In addition to the normal risks associated with fixed income securities
discussed elsewhere in this SAI and the Prospectus (e.g., interest rate risk and credit risk), CDOs carry additional risks including, but not limited to: (i) the possibility that distributions from collateral securities will not be adequate to
make interest or other payments; (ii) the quality of the collateral may decline in value or default; (iii) the Fund may invest in tranches of CDOs that are subordinate to other tranches; (iv) the complex structure of the security may
not be fully understood at the time of investment and may produce disputes with the issuer or unexpected investment results; and (v) the CDOs manager may perform poorly or defalcate.
Corporate Debt Securities. The Fund may invest in debt securities (i.e., bonds, debentures, notes and other similar debt instruments) of domestic or
non-U.S. non-governmental issuers. Corporate debt securities may pay fixed or variable rates of interest, or interest at a rate contingent upon some other factor, such as the price of some commodity. These securities may include warrants, may be
convertible into preferred or common equity, or may be bought as part of a unit containing common stock.
Lower-Rated Securities.
Non-investment grade securities are described as speculative by Moodys Investors Service, Inc. (Moodys) and S&P Global Ratings (S&P) and may be subject to greater market fluctuations and
greater risk of loss of income or principal, including a greater possibility of default or bankruptcy of the issuer of such securities, than are more highly rated debt securities. Such securities are commonly referred to as junk bonds.
The Subadvisers seek to minimize the risks of
30
investing in all securities through diversification, in-depth credit analysis and attention to current developments in interest rates and market conditions and will monitor the ratings of
securities held by the Fund and the creditworthiness of their issuers. If the rating of a security in which the Fund has invested is downgraded or fails to meet criteria established by the manager or the Subadviser(s), the Fund will either dispose
of that security within a reasonable time or hold the security for so long as the Subadvisers determine appropriate, having due regard for market conditions, tax implications and other applicable factors.
A lower-rated debt security may be callable, i.e., subject to redemption at the option of the issuer at a price established in the
securitys governing instrument. If a debt security held by the Fund is called for redemption, the Fund will be required to permit the issuer to redeem the security or sell it to a third party. Either of these actions could have an adverse
effect on the Funds ability to achieve its investment objective because, for example, the Fund may be able to reinvest the proceeds only in securities with lower yields or may receive a price upon sale that is lower than it would have received
in the absence of the redemption. If the Fund experiences unexpected net redemptions, it may be forced to sell its higher-rated securities, resulting in a decline in the overall credit quality of the Funds investment portfolio and increasing
the exposure of the Fund to the risks of lower-rated securities.
At certain times in the past, the prices of many lower-rated securities
declined, indicating concerns that issuers of such securities might experience financial difficulties. At those times, the yields on lower-rated securities rose dramatically, reflecting 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 ratings of Moodys, S&P or other nationally recognized (or non-U.S.)
statistical rating organizations (NRSROs) represent the opinions of those agencies as to the quality of the debt securities that they rate. Such ratings are relative and subjective, and are not absolute standards of quality. Unrated debt
securities are not necessarily of lower quality than rated securities, but they may not be attractive to as many buyers. The Subadviser(s) will consider a securitys quality and credit rating when determining whether such security is an
appropriate investment. Subject to its investment objective, policies and applicable law, the Fund may purchase a security with the lowest rating.
The market for lower-rated securities may be thinner and less active than that for higher-rated securities, which can adversely affect the prices at
which these securities can be sold, and may make it difficult for the Fund to obtain market quotations daily. If market quotations are not available, these securities will be valued by a method that the Subadvisers or their affiliates (acting under
authority of the Board of Trustees) believe accurately reflects fair market value. Judgment may play a greater role in valuing lower-rated debt securities than is the case with respect to securities for which a broader range of dealer quotations and
last-sale information is available. 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.
Although the prices of lower-rated bonds are generally less sensitive to interest rate changes than are higher-rated bonds, the prices of lower-rated
bonds may be more sensitive to adverse economic changes and developments regarding the individual issuer. Although the market for lower-rated debt securities is not new, and the market has previously weathered economic downturns, there has been in
recent years a substantial increase in the use of such securities to Fund corporate acquisitions and restructurings. Accordingly, the past performance of the market for such securities may not be an accurate indication of its performance during
future economic downturns or periods of rising interest rates. When economic conditions appear to be deteriorating, medium- to lower-rated securities may decline in value due to heightened concern over credit quality, regardless of the prevailing
interest rates. Investors should carefully consider the relative risks of investing in high yield securities and understand that such securities are not generally meant for short-term investing.
Adverse economic developments can disrupt the market for lower-rated securities and severely affect the ability of issuers, especially highly leveraged
issuers, to service their debt obligations or to repay their obligations upon maturity, which may lead to a higher incidence of default on such securities. Lower-rated securities are especially affected by adverse changes in the industries in which
the issuers are engaged and by changes in the financial condition of the issuers. Highly leveraged issuers may also experience financial stress during periods of rising interest rates. In addition, the secondary market for lower-rated securities,
which is concentrated in relatively few market makers, may not be as liquid as the secondary market for more highly rated securities. As a result, the Fund could find it more difficult to sell these securities or may be able to sell the securities
only at prices lower than if such securities were widely traded.
Distressed Debt Securities. Distressed debt securities are debt
securities that are purchased in the secondary market and are the subject of bankruptcy proceedings or otherwise in default as to the repayment of principal and/or interest at the time
31
of acquisition by the Fund or are rated in the lower rating categories (Ca or lower by Moodys and CC or lower by S&P) or, if unrated, are in the judgment of the portfolio manager of
equivalent quality. Investment in distressed debt securities is speculative and involves significant risk. The risks associated with high yield securities are heightened when investing in distressed debt securities.
The Fund may make such investments when the portfolio manager believes it is reasonably likely that the issuer of the distressed debt securities will
make an exchange offer or will be the subject of a plan of reorganization pursuant to which the Fund will receive new securities (e.g., equity securities) and/or other assets. However, there can be no assurance that such an exchange offer will be
made or that such a plan of reorganization will be adopted. In addition, a significant period of time may pass between the time at which the Fund makes its investment in distressed debt securities and the time that any such exchange offer or plan of
reorganization is completed. During this period, it is unlikely that the Fund will receive any interest payments on the distressed debt securities, the Fund will be subject to significant uncertainty as to whether the exchange offer or plan will be
completed and the Fund may be required to bear extraordinary expenses to protect or recover its investment. Even if an exchange offer is made or a plan of reorganization is adopted with respect to the distressed debt securities held by the Fund,
there can be no assurance that the securities or other assets received by the Fund in connection with such exchange offer or plan of reorganization will not have a lower value or income potential than may have been anticipated when the investment
was made. Moreover, any securities received by the Fund upon completion of an exchange offer or plan of reorganization may be restricted as to resale. As a result of the Funds participation in negotiations with respect to any exchange offer or
plan of reorganization with respect to an issuer of distressed debt securities, the Fund may be restricted from disposing of such securities.
Stripped Mortgage-Backed Securities. Stripped mortgage-backed securities (SMBS) are derivative multi-class mortgage securities. SMBS
may be issued by agencies or instrumentalities of the U.S. Government, or by private originators of, or investors in, mortgage loans, including savings and loan associations, mortgage banks, commercial banks, investment banks and special purpose
entities of the foregoing.
SMBS are created by separating bonds into their principal and interest components and selling each piece
separately (commonly referred to as IOs and POs). The yield to maturity on an IO or PO class of stripped mortgage-backed securities is extremely sensitive not only to changes in prevailing interest rates but also to the rate of principal payments
(including prepayments) on the underlying assets. A rapid rate of principal prepayments may have a measurably adverse effect on the Funds yield to maturity to the extent it invests in IOs. If the assets underlying the IOs experience greater
than anticipated prepayments of principal, the Fund may fail to recoup fully its initial investment in these securities. Conversely, POs tend to increase in value if prepayments are greater than anticipated and decline if prepayments are slower than
anticipated. The secondary market for stripped securities may be more volatile and have lower liquidity than that for other securities, potentially limiting the Funds ability to buy or sell those securities at any particular time. Although
SMBS are purchased and sold by institutional investors through several investment banking firms acting as brokers or dealers, these securities were developed fairly recently. As a result, established trading markets have not yet developed and,
accordingly, these securities may be deemed illiquid.
Zero Coupon and Pay-In-Kind Securities. A zero coupon bond is a security that
makes no fixed interest payments but instead is sold at a discount from its face value. The bond is redeemed at its face value on the specified maturity date. Zero coupon bonds may be issued as such, or they may be created by a broker who strips the
coupons from a bond and separately sells the rights to receive principal and interest. The prices of zero coupon bonds tend to fluctuate more in response to changes in market interest rates than do the prices of interest-paying debt securities with
similar maturities. Zero coupon bonds generally accrue income prior to the receipt of cash payments. Since the Fund must distribute substantially all of its income to shareholders to qualify as a regulated investment company under federal income tax
law, to the extent that the Fund invests in zero coupon bonds, it may have to dispose of other securities, including at times when it may be disadvantageous to do so, to generate the cash necessary for the distribution of income attributable to its
zero coupon bonds. Pay-in-kind securities have characteristics similar to those of zero coupon securities, but interest on such securities may be paid in the form of obligations of the same type rather than cash.
Commercial Paper and Other Short-Term Investments
The Fund
may invest or hold cash or other short-term investments, including commercial paper. Commercial paper represents short-term unsecured promissory notes issued in bearer form by banks or bank holding companies, corporations and
32
finance companies. The Fund may purchase commercial paper issued pursuant to the private placement exemption in Section 4(a)(2) of the Securities Act of 1933. Section 4(a)(2) paper is
restricted as to disposition under federal securities laws in that any resale must similarly be made in an exempt transaction. The Fund may or may not regard such securities as illiquid, depending on the circumstances of each case.
The Fund may also invest in obligations (including certificates of deposit, demand and time deposits and bankers acceptances) of banks and savings
and loan institutions. While domestic bank deposits may be insured by an agency of the U.S. Government, the Fund would generally assume positions considerably in excess of the insurance limits.
Loans
Loans are negotiated and underwritten by a bank or
syndicate of banks and other institutional investors. The Fund may acquire an interest in loans through the primary market by acting as one of a group of lenders of a loan. The primary risk in an investment in loans is that the borrower may be
unable to meet its interest and/or principal payment obligations. The occurrence of such a default with regard to a loan in which the Fund had invested would have an adverse effect on the Funds net asset value. In addition, a sudden and
significant increase in market interest rates may cause a decline in the value of these investments and in the Funds net asset value. Other factors, such as rating downgrades, credit deterioration, or large downward movement in stock prices, a
disparity in supply and demand of certain securities or market conditions that reduce liquidity could reduce the value of loans, impairing the Funds net asset value. Loans may not be considered securities for certain purposes and
purchasers, such as the Fund, therefore may not be entitled to rely on the anti-fraud protections of the federal securities laws.
Loans in which the
Fund may invest may be collateralized or uncollateralized and senior or subordinate. Investments in uncollateralized and/or subordinate loans entail a greater risk of nonpayment than do investments in loans which hold a more senior position in the
borrowers capital structure or that are secured with collateral. In the case of collateralized senior loans, however, there is no assurance that sale of the collateral would raise enough cash to satisfy the borrowers payment obligation
or that the collateral can or will be liquidated. As a result, the Fund might not receive payments to which it is entitled and thereby may experience a decline in the value of its investment and its net asset value. In the event of bankruptcy,
liquidation may not occur and the court may not give lenders the full benefit of their senior positions. If the terms of a senior loan do not require the borrower to pledge additional collateral, the Fund will be exposed to the risk that the value
of the collateral will not at all times equal or exceed the amount of the borrowers obligations under the senior loans. To the extent that a senior loan is collateralized by stock in the borrower or its subsidiaries, such stock may lose all of
its value in the event of bankruptcy of the borrower.
The Fund may also acquire an interest in loans by purchasing participations
(Participations) in and/or assignments (Assignments) of portions of loans from third parties. By purchasing a Participation, the Fund acquires some or all of the interest of a bank or other lending institution in a loan to a
borrower. Participations typically will result in the Funds having a contractual relationship only with the lender and not the borrower. The Fund will have the right to receive payments or principal, interest and any fees to which it is
entitled only from the lender selling the Participation and only upon receipt by the lender of the payments from the borrower. In connection with purchasing Participations, the Fund generally will have no right to enforce compliance by the borrower
with the terms of the loan agreement relating to the loan, nor any rights of set-off against the borrower, and the Fund may not directly benefit from any collateral supporting the loan in which it has purchased the Participation. As a result, the
Fund will assume the credit risk of both the borrower and the lender that is selling the Participation.
When the Fund purchases Assignments from
lenders, the Fund will acquire direct rights against the borrower on the loan. However, since Assignments are arranged through private negotiations between potential assignees and assignors, the rights and obligations acquired by the Fund as the
purchaser of an Assignment may differ from, and be more limited than, those held by the lender from which the Fund is purchasing the Assignments. Certain of the Participations or Assignments acquired by the Fund may involve unfunded commitments of
the lenders or revolving credit facilities under which a borrower may from time to time borrow and repay amounts up to the maximum amount of the facility. In such cases, the Fund would have an obligation to advance its portion of such additional
borrowings upon the terms specified in the loan documentation.
The Fund may acquire loans of borrowers that are experiencing, or are more likely to
experience, financial difficulty, including loans of borrowers that have filed for bankruptcy protection. Although loans in which the Fund will invest generally will be secured by specific collateral, there can be no assurance that liquidation of
such collateral would satisfy the borrowers
33
obligation in the event of nonpayment of scheduled interest or principal, or that such collateral could be readily liquidated. In the event of bankruptcy of a borrower, the Fund could experience
delays or limitations with respect to its ability to realize the benefits of the collateral securing a senior loan.
In addition, the Fund may have
difficulty disposing of its investments in loans. The liquidity of such securities is limited and the Fund anticipates that such securities could be sold only to a limited number of institutional investors. The lack of a liquid secondary market
could have an adverse impact on the value of such securities and on the Funds ability to dispose of particular loans or Assignments or Participations when necessary to meet the Funds liquidity needs or in response to a specific economic
event, such as a deterioration in the creditworthiness of the borrower. The lack of a liquid secondary market for loans may also make it more difficult for the Fund to assign a value to those securities for purposes of valuing the Funds
investments and calculating its net asset value.
The issuer of a loan may offer to provide material, non-public information about the issuer to
investors, such as the Fund. The Subadvisers may avoid receiving this type of information about the issuer of a loan either held by or considered for investment by the Fund, because of prohibitions on trading in securities of issuers while in
possession of such information. The decision not to receive material, non-public information may place the Fund at a disadvantage, relative to other loan investors, in assessing a loan or the loans issuer.
Covenant Lite Loans
Loan agreements, which
set forth the terms of a loan and the obligations of the borrower and lender, contain certain covenants that mandate or prohibit certain borrower actions, including financial covenants that dictate certain minimum and maximum financial performance
levels. Covenants that require the borrower to maintain certain financial metrics during the life of the loan (such as maintaining certain levels of cash flow and limiting leverage) are known as maintenance covenants. These covenants are
included to permit the lender to monitor the performance of the borrower and declare an event of default if breached, allowing the lender to renegotiate the terms of the loan based upon the elevated risk levels or take other actions to help mitigate
losses. Covenant lite loans contain fewer maintenance covenants than traditional loans, or no maintenance covenants at all, and may not include terms that allow the lender to monitor the financial performance of the borrower and declare a default if
certain criteria are breached. This may expose the Fund to greater credit risk associated with the borrower and reduce the Funds ability to restructure a problematic loan and mitigate potential loss. As a result, the Funds exposure to
losses on such investments may be increased, especially during a downturn in the credit cycle.
Indexed Securities and Structured Notes
The values of indexed securities and structured notes are linked to currencies, other securities, interest rates, commodities, indices or other financial
indicators (reference instruments). These instruments differ from other types of debt securities in several respects. The interest rate or principal amount payable at maturity may vary based on changes in one or more specified reference
instruments, such as a floating interest rate compared with a fixed interest rate or the currency exchange rates between two currencies (neither of which need be the currency in which the instrument is denominated). An indexed security or structured
note may be positively or negatively indexed; that is, its value or interest rate may increase or decrease if the value of the reference instrument increases. Further, the change in the principal amount payable with respect to, or the interest rate
of, an indexed security or structured note may be a multiple of the percentage change (positive or negative) in the value of the underlying reference instrument(s). Investment in indexed securities and structured notes involves certain risks,
including the credit risk of the issuer and the normal risks of price changes in response to changes in interest rates. Further, in the case of certain indexed securities or structured notes, a decline in the reference instrument may cause the
interest rate to be reduced to zero, and any further declines in the reference instrument may then reduce the principal amount payable on maturity. Finally, these securities may have lower liquidity than other types of securities, and may be more
volatile than their underlying reference instruments.
When-Issued Securities and Forward Commitments
Securities may be purchased on a when-issued or to be announced or forward delivery basis. The payment obligation and
the interest rate that will be received on the when-issued securities are fixed at the time the buyer enters into the commitment although settlement, i.e., delivery of and payment for the securities, takes place at a later date. In a
to be announced transaction, the Fund commits to purchase securities for which all specific information is not known at the time of the trade.
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Securities purchased on a when-issued or forward delivery basis are subject to
changes in value based upon the markets perception of the creditworthiness of the issuer and changes, real or anticipated, in the level of interest rates. The value of these securities experiences appreciation when interest rates decline and
depreciation when interest rates rise. Purchasing securities on a when-issued or forward delivery basis can involve a risk that the yields available in the market on the settlement date may actually be higher or lower than
those obtained in the transaction itself. At the time the Fund enters into a when-issued or forward delivery commitment, the Fund will set aside cash or other appropriate liquid securities with a value at least equal to the
Funds obligation under the commitment. The Funds liquidity and ability to manage its assets might be affected when it sets aside cash or portfolio securities to cover such commitments.
An increase in the percentage of the Funds assets committed to the purchase of securities on a when-issued basis may increase the
volatility of its net asset value.
Restricted and Illiquid Securities
The Fund may invest up to 15% of its net assets in illiquid investments. An illiquid security is any security which the 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 security. To the extent required by applicable law and SEC guidance, the Fund will not
acquire an illiquid security if such acquisition would cause the aggregate value of illiquid securities to exceed 15% of the Funds net assets. If at any time the portfolio manager determines that the value of illiquid securities held by the
Fund exceeds 15% of the Funds net assets, the portfolio manager will take such steps as it considers appropriate to reduce the percentage as soon as reasonably practicable.
Restricted securities are securities subject to legal or contractual restrictions on their resale, such as private placements. Such restrictions might
prevent the sale of restricted securities at a time when the sale would otherwise be desirable. Under SEC regulations, certain restricted securities acquired through private placements can be traded freely among qualified purchasers. While
restricted securities are generally presumed to be illiquid, it may be determined that a particular restricted security is liquid. Investing in these restricted securities could have the effect of increasing the Funds illiquidity if qualified
purchasers become, for a time, uninterested in buying these securities.
Restricted securities may be sold only (1) pursuant to SEC Rule
144A or another exemption, (2) in privately negotiated transactions or (3) in public offerings with respect to which a registration statement is in effect under the 1933 Act. Rule 144A securities, although not registered in the U.S., may
be sold to qualified institutional buyers in accordance with Rule 144A under the 1933 Act. As noted above, the Fund may determine that some Rule 144A securities are liquid. Where registration is required, the Fund may be obligated to pay all or part
of the registration expenses and a considerable period may elapse between the time of the decision to sell and the time the Fund may be permitted to sell a restricted security under an effective registration statement. If, during such a period,
adverse market conditions were to develop, the Fund might obtain a less favorable price than prevailed when it decided to sell.
Illiquid securities
may be difficult to value, and the Fund may have difficulty disposing of such securities promptly. The Fund does not consider non-U.S. securities to be restricted if they can be freely sold in the principal markets in which they are traded, even if
they are not registered for sale in the U.S.
Liquidity Risk Management
Rule 22e-4 under the 1940 Act requires, among other things, that the Fund and other Legg Mason open-end funds establish a liquidity risk management
program (LRMP) that is reasonably designed to assess and manage liquidity risk. Rule 22e-4 defines liquidity risk as the risk that a fund could not meet requests to redeem shares issued by the fund without significant
dilution of the remaining investors interests in the fund. The Fund has implemented a LRMP to meet the relevant requirements. Additionally, the Board, including a majority of the Independent Trustees, approved the designation of the
Funds LRMP administrator to administer such program and will review no less frequently than annually a written report prepared by the LRMP administrator that addresses the operation of the LRMP and assesses its adequacy and effectiveness of
implementation. Among other things, the LRMP provides for the classification of each Fund investment as a highly liquid investment, moderately liquid investment, less liquid investment or illiquid
investment. The liquidity risk classifications of the Funds investments are determined after reasonable inquiry and taking into account relevant market, trading and investment-specific considerations. To the extent that a Fund investment
is deemed to be an illiquid investment or a less liquid investment, the Fund can expect to be exposed to greater liquidity risk. There is no guarantee the LRMP will be effective in its operations, and
35
complying with Rule 22e-4, including bearing related costs, could impact the Funds performance and its ability to achieve its investment objective.
Equity Securities
The Fund may directly or indirectly
invest its assets in equity securities. Among other risks, prices of equity securities generally fluctuate more than those of other securities. The Fund may experience a substantial or complete loss on an individual stock. These risks may affect a
single issuer, industry, or section of the economy or may affect the market as a whole.
Securities of Other Investment Companies
Investments in other investment companies may involve the payment of substantial premiums above the net asset value of such issuers portfolio
securities, and the total return on such investments will be reduced by the operating expenses and fees of such investment companies, including advisory fees. These fees would be in addition to any fees paid by the Fund. The Fund may invest in both
closed-end and open-end investment companies.
The Fund may invest, to the extent permitted by applicable law, all or some of its short-term cash
investments in a money market fund or similarly-managed pool advised by the manager or Subadviser that is not required to register with the SEC as an investment company. In connection with any such investments, the Fund, to the extent permitted by
the 1940 Act, may pay its share of expenses of a money market fund or other similarly-managed private fund in which it invests, which may result in the Fund bearing some additional expenses.
Reverse Repurchase Agreements and Forward Roll Transactions
A reverse repurchase agreement is a portfolio management technique in which the Fund temporarily transfers possession of a portfolio instrument to
another person, such as a financial institution or broker-dealer, in return for cash. At the same time, the Fund agrees to repurchase the instrument at an agreed upon time (normally within seven days) and price, including an interest payment. While
engaging in reverse repurchase agreements, the Fund will cover its commitment under these instruments with liquid assets or using other methods currently or in the future permitted under the 1940 Act, the rules and regulations thereunder, or orders
issued by the SEC thereunder. For these purposes, interpretations and guidance provided by the SEC staff may be taken into account when deemed appropriate by the Fund. Reverse repurchase agreements may expose the Fund to greater fluctuations in the
value of its assets and render the segregated assets unavailable for sale or other disposition. Reverse repurchase agreements have characteristics like borrowings.
The Fund may also enter into forward roll transactions in which the Fund sells a fixed income security for delivery in the current month and
simultaneously contracts to purchase substantially similar (same type, coupon and maturity) securities at an agreed upon future time. By engaging in the forward roll transaction the Fund forgoes principal and interest paid on the security that is
sold, but receives the difference between the current sales price and the forward price for the future purchase. The Fund would also be able to earn interest on the income that is received from the initial sale.
The obligation to purchase securities on a specified future date involves the risk that the market value of the securities that the Fund is obligated to
purchase may decline below the purchase price. In addition, in the event the other party to the transaction files for bankruptcy, becomes insolvent or defaults on its obligation, the Fund may be adversely affected.
Borrowing
The Fund may use borrowed money for any purpose
permitted by the 1940 Act. Borrowing by the Fund allows it to leverage its portfolio, which exposes it to certain risks. The value of an investment in the Fund will be more volatile and all other risks will tend to be compounded.
The 1940 Act requires the Fund to maintain asset coverage (that is, total assets less liabilities other than the borrowing and other senior securities)
of at least 300% of the amount borrowed, provided that in the event the Funds asset coverage falls below 300%, the Fund is required to reduce the amount of its borrowings so that it meets the 300% asset coverage threshold within three days (no
including Sundays and holidays). As a result, the Fund may be required to sell some of its holdings within three days to reduce the debt and restore the 300% asset coverage, even though it may be disadvantageous from an investment standpoint to sell
securities at that time. Borrowing may increase the effect on net asset value of any increase or decrease in the market value of the Fund. See Additional Information on page 54 for circumstances under which certain investment
transactions will not be deemed to be borrowings.
36
Money borrowed will be subject to interest costs, which may or may not be recovered by appreciation of the
securities purchased. The Fund also may be required to maintain minimum average balances in connection with such borrowing or to pay a commitment or other fee to maintain a line of credit; either of these requirements would increase the cost of
borrowing over the stated interest rate. The Fund may enter into reverse repurchase agreements and forward roll transactions as a method of borrowing.
Repurchase Agreements
Under the terms of a typical
repurchase agreement, the Fund would acquire one or more underlying debt obligations, frequently obligations issued by the U.S. government or its agencies or instrumentalities, for a relatively short period (typically overnight, although the term of
an agreement may be many months), subject to an obligation of the seller to repurchase, and the Fund to resell, the obligation at an agreed-upon time and price. The repurchase price is typically greater than the purchase price paid by the Fund,
thereby determining the Funds yield. A repurchase agreement is similar to, and may be treated as, a secured loan, where the Fund loans cash to the counterparty and the loan is secured by the purchased securities as collateral. All repurchase
agreements entered into by the Fund are required to be collateralized so that at all times during the term of a repurchase agreement, the value of the underlying securities is at least equal to the amount of the repurchase price. Also, the Fund or
its custodian is required to have control of the collateral, which the Subadviser believes will give the Fund a valid, perfected security interest in the collateral.
Repurchase agreements could involve certain risks in the event of default or insolvency of the other party, including possible delays or restrictions
upon the Funds ability to dispose of the underlying securities, the risk of a possible decline in the value of the underlying securities during the period in which the Fund seeks to assert its right to them, the risk of incurring expenses
associated with asserting those rights and the risk of losing all or part of the income from the agreement. If the Fund enters into a repurchase agreement involving securities the Fund could not purchase directly, and the counterparty defaults, the
Fund may become the holder of securities that it could not purchase. These repurchase agreements may be subject to greater risks. In addition, these repurchase agreements may be more likely to have a term to maturity of longer than seven days.
Repurchase agreements maturing in more than seven days are considered to be illiquid.
Duration
For the simplest fixed income securities,
duration indicates the average time at which the securitys cash flows are to be received. For simple fixed income securities with interest payments occurring prior to the payment of principal, duration is always less than maturity.
For example, a current coupon bullet bond with a maturity of 3.5 years (i.e., a bond that pays interest at regular intervals and that will have a single principal payment of the entire principal amount in 3.5 years) might have a duration
of approximately three years. In general, the lower the stated or coupon rate of interest of a fixed income security, the closer its duration will be to its final maturity; conversely, the higher the stated or coupon rate of interest of a fixed
income security, the shorter its duration will be compared to its final maturity.
Determining duration becomes more complex when fixed income
security features like floating or adjustable coupon payments, optionality (for example, the right of the issuer to prepay or call the security), and structuring (for example, the right of the holders of certain securities to receive priority as to
the issuers cash flows) are considered. The calculation of effective duration attempts to take into account optionality and other complex features. Generally, the longer the effective duration of a security, the greater will be the
expected change in the percentage price of the security with respect to a change in the securitys own yield. By way of illustration, a security with an effective duration of 3.5 years might normally be expected to go down in price by 35 basis
points (bps; 100 basis points = 1%) if its yield goes up by 10 bps, while another security with an effective duration of 4.0 years might normally be expected to go down in price by 40 bps if its yield goes up by 10 bps.
The assumptions that are made about a securitys features and options when calculating effective duration may prove to be incorrect. For example,
many mortgage pass-through securities may have stated final maturities of 30 years, but current prepayment rates, which can vary widely under different economic conditions, may have a large influence on the pass-through securitys response to
changes in yield. In these situations, a Subadviser may consider other analytical techniques that seek to incorporate the securitys additional features into the determination of its response to changes in its yield.
A security may change in price for a variety of reasons. For example, floating rate securities may have final maturities of ten or more years, but their
effective durations will tend to be very short. If there is an adverse credit event, or a perceived
37
change in the issuers creditworthiness, these securities could experience a far greater negative price movement than would be predicted by the change in the securitys yield in
relation to its effective duration.
As a result, investors should be aware that effective duration is not an exact measurement and may not reliably
predict a securitys price sensitivity to changes in yield or interest rates.
Portfolio Turnover
The length of time the Fund has held a particular security is not generally a consideration in investment decisions. A change in the securities held by
the Fund is known as portfolio turnover. As a result of the Funds investment policies, under certain market conditions the Funds portfolio turnover rate may be higher than that of other mutual funds. Portfolio turnover
generally involves some expense to the Fund, including brokerage commissions or dealer mark-ups and other transaction costs on the sale of securities and reinvestment in other securities. These transactions may result in realization of taxable
capital gains. Higher portfolio turnover rates, such as those above 100%, are likely to result in higher brokerage commissions or other transactions costs and could give rise to a greater amount of taxable capital gains.
Alternative Investment Strategies
At times the
Subadviser(s) may judge that conditions in the securities markets make pursuing the Funds investment strategy inconsistent with the best interests of its shareholders. At such times, the Subadviser(s) may temporarily use alternative
strategies, primarily designed to reduce fluctuations in the value of the Funds assets. In implementing these defensive strategies, the Fund may invest without limit in securities that the Subadviser(s) believes present less risk to the Fund,
including equity securities, debt and fixed income securities, preferred stocks, U.S. Government and agency obligations, cash or money market instruments, or in other securities the Subadviser considers consistent with such defensive strategies,
such as, but not limited to, options, futures, warrants or swaps. As a result of these strategies, the Fund may invest up to 100% of its assets in securities of U.S. issuers. During periods on which such strategies are used, the duration of the Fund
may diverge from the duration range disclosed in the Prospectus. It is impossible to predict when, or for how long, the Fund will use these alternative strategies. As a result of using these alternative strategies, the Fund may not achieve its
investment objective. Although the portfolio managers have the ability to take defensive positions, they may choose not to do so for a variety of reasons, even during volatile market conditions.
New Investment Products
New types of mortgage-backed and
asset-backed securities, derivative instruments, hedging instruments and other securities or instruments are developed and marketed from time to time. Consistent with its investment limitations, the Fund expects to invest in those new types of
securities and instruments that its Subadviser(s) believes may assist the Fund in achieving its investment objective.
Generally, the foregoing is
not intended to limit the Funds investment flexibility, unless such a limitation is expressly stated, and therefore will be construed by the Fund as broadly as possible. Statements concerning what the Fund may do are not intended to limit
other any activity. The Fund maintains the flexibility to use the investments described above for any purpose consistent with applicable law and any express limitations in the SAI or the Prospectus.
Investment Policies
Except for investment policies
designated as fundamental in the Prospectus or this SAI, the investment policies described in the Prospectus and in this SAI are not fundamental policies. Changes to fundamental investment policies require shareholder approval; the Trustees may
change any non-fundamental investment policy without shareholder approval.
Ratings of Debt Obligations
Moodys, S&P, Fitch and other NRSROs are private organizations that provide ratings of the credit quality of debt obligations. Bonds rated Baa3
or above by Moodys or BBB- or above by S&P and Fitch are considered investment-grade securities, bonds rated Baa are considered medium grade obligations subject to moderate credit risk and may possess certain speculative
characteristics, while bonds rated BBB are regarded as having adequate capacity to meet financial commitments. The Fund may consider these ratings in determining whether to purchase, sell or hold a security. Ratings are not absolute assurances of
quality. Consequently, securities with the same maturity, interest rate and rating may have different market prices. Credit rating agencies attempt to evaluate the safety of principal and interest payments and do not evaluate the risks of
fluctuations in market value. Also, credit rating agencies receive fees from rated issuers in connection with the issuance of ratings.
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Rating agencies may fail to make timely changes in credit ratings in response to subsequent events, so that
an issuers current financial condition may be better or worse than the rating indicates. Bonds rated lower than Baa3 by Moodys or BBB- by S&P or Fitch are considered below investment-grade quality and are obligations of issuers that
are considered predominantly speculative with respect to the issuers capacity to pay interest and repay principal according to the terms of the obligation and, therefore, carry greater investment risk, including the possibility of issuer
default and bankruptcy and increased market price volatility. Such securities are commonly referred to as junk bonds and are subject to a substantial degree of credit risk. Junk bonds are often issued by smaller, less creditworthy
companies or by highly leveraged (indebted) firms, which are generally less able than more financially stable firms to make scheduled payments of interest and principal. The risks posed by securities issued under such circumstances are substantial.
Bonds rated below investment-grade tend to be less marketable than higher-quality bonds because the market for them is less broad. The market for unrated bonds is even narrower.
Please see Appendix B of this SAI for a description of each rating category of Moodys, S&P and Fitch.
Investments by Other Funds and by Other Significant Investors
Certain investment companies, including those that are affiliated with the Fund because they are managed by the Manager or an affiliate of the Manager,
may invest in the Fund and may at times have substantial investments in the Fund. Other investors also may at times have substantial investments in the Fund.
From time to time, the Fund may experience relatively large redemptions or investments due to transactions in Fund shares by a Fund or other significant
investor. The effects of these transactions could adversely affect the Funds performance. In the event of such redemptions or investments, the Fund could be required to sell securities or to invest cash at a time when it is not advantageous to
do so. Such transactions may increase brokerage and/or other transaction costs of the Fund. A large redemption could cause the Funds expenses to increase and could result in the Fund becoming too small to be economically viable. Redemptions of
Fund shares could also accelerate the realization of taxable capital gains in the Fund if sales of securities result in capital gains. Although the ETF structure of the Fund should mitigate these risks to some degree, the impact of these
transactions may be significant when a Fund or other significant investor purchases, redeems, or owns a substantial portion of the Funds shares.
The manager and the Subadvisers may be subject to potential conflicts of interest in connection with investments in the Fund by an affiliated fund due to
their affiliation. Investments by an affiliated fund may give rise to conflicts in connection with the voting of Fund shares. The manager, the Subadvisers and/or their advisory affiliates intend to seek to address these potential conflicts of
interest in the best interests of the Funds shareholders, although there can be no assurance that such efforts will be successful. The manager and the Subadvisers will consider how to minimize potential adverse impacts of affiliated fund
investments, and, may take such actions as each deems appropriate to address potential adverse impacts.
Cybersecurity Risk
With the increased use of technologies such as mobile devices and Web-based or cloud applications, and the dependence on the Internet and
computer systems to conduct business, the Fund is susceptible to operational, information security and related risks. In general, cybersecurity incidents can result from deliberate attacks or unintentional events (arising from external or internal
sources) that may cause the Fund to lose proprietary information, suffer data corruption, physical damage to a computer or network system or lose operational capacity. Cybersecurity attacks include, but are not limited to, infection by malicious
software, such as malware or computer viruses or gaining unauthorized access to digital systems, networks or devices that are used to service the Funds operations (e.g., through hacking, phishing or malicious software
coding) or other means for purposes of misappropriating assets or sensitive information, corrupting data, or causing operational disruption. Cybersecurity attacks may also be carried out in a manner that does not require gaining unauthorized access,
such as causing denial-of-service attacks on the Funds websites (i.e., efforts to make network services unavailable to intended users). In addition, authorized persons could inadvertently or intentionally release confidential or proprietary
information stored on the Funds systems.
Cybersecurity incidents affecting the Funds Manager, the Subadviser, other service providers to
the Fund or its shareholders (including, but not limited to, Fund accountants, custodians, sub-custodians, transfer agents and financial intermediaries). Authorized Participants and/or the Exchange have the ability to cause disruptions and impact
business operations, potentially resulting in financial losses to both the Fund and its shareholders, interference with the Funds ability to calculate its net asset value, impediments to trading, the inability of Fund shareholders to transact
business and the Fund to
39
process transactions (including fulfillment of Fund share purchases and redemptions), violations of applicable privacy and other laws (including the release of private shareholder information)
and attendant breach notification and credit monitoring costs, regulatory fines, penalties, litigation costs, reputational damage, reimbursement or other compensation costs, forensic investigation and remediation costs, and/or additional compliance
costs. Similar adverse consequences could result from cybersecurity incidents affecting issuers of securities in which the Fund invests, counterparties with which the Fund engages in transactions, governmental and other regulatory authorities,
exchange and other financial market operators, banks, brokers, dealers, insurance companies and other financial institutions (including financial intermediaries and other service providers) and other parties. In addition, substantial costs may be
incurred in order to safeguard against and reduce the risk of any cybersecurity incidents in the future. In addition to administrative, technological and procedural safeguards, the Funds Manager and the Subadviser have established business
continuity plans in the event of, and risk management systems to prevent or reduce the impact of, such cybersecurity incidents. However, there are inherent limitations in such plans and systems, including the possibility that certain risks have not
been identified, as well as the rapid development of new threats. Furthermore, the Fund cannot control the cybersecurity plans and systems put in place by its service providers or any other third parties whose operations may affect the Fund and its
shareholders. The Fund and its shareholders could be negatively impacted as a result.
London Interbank Offered Rate (LIBOR) Replacement and
Other Reference Rates Risk
Many debt securities, derivatives, and other financial instruments, including some of the Funds investments,
utilize benchmark or reference rates such as LIBOR, European Interbank Offer Rate (EURIBOR), Sterling Overnight Interbank Average Rate (SONIA), and other similar types of reference rates for variable interest rate
calculations. Instruments in which the Fund invests may pay interest at floating rates based on LIBOR or other similar types of reference rates or may be subject to interest caps or floors based on such reference rates. The Fund and issuers of
instruments in which the Fund invests may also obtain financing at floating rates based on such reference rates. The elimination of a reference rate or any other changes or reforms to the determination or supervision of reference rates could have an
adverse impact on the market foror value ofany securities or payments linked to those reference rates.
The use of LIBOR came under
pressure following manipulation allegations in 2012. Despite increased regulation and other corrective actions since that time, concerns have arisen regarding its viability as a benchmark due largely to reduced activity in the financial markets that
it measures. In 2017, the U.K. Financial Conduct Authority announced that it will no longer encourage nor require banks to submit rates for the calculation of LIBOR after 2021. Such announcement indicates that the continuation of LIBOR cannot be
guaranteed after 2021. It is unclear whether LIBOR will continue to exist in its current or a modified form. Actions by regulators have resulted in the establishment of alternative reference rates to LIBOR in most major currencies. Based on the
recommendations of the New York Federal Reserves Alternative Reference Rate Committee (comprised of major derivative market participants and their regulators), the U.S. Federal Reserve began publishing a Secured Overnight Funding Rate
(SOFR) that is intended to replace U.S. Dollar LIBOR. Proposals for alternative reference rates for other currencies have also been announced or have already begun publication, such as SONIA in the United Kingdom.
Markets are slowly developing in response to these new rates, and transition planning is at a relatively early stage. Neither the effect of the
transition process nor its ultimate success is known. The transition process may lead to increased volatility and illiquidity in markets that currently rely on LIBOR to determine interest rates. The effect of any changes toor discontinuation
ofLIBOR on the Fund will vary depending on, among other things, provisions in individual contracts and whether, how, and when industry participants develop and adopt new reference rates and alternative reference rates for both legacy and new
products and instruments. Because the usefulness of LIBOR as a benchmark may deteriorate during the transition period, these effects could materialize prior to the end of 2021.
MANAGEMENT
Trustees and Officers
The business and affairs of the Fund are conducted by management under the supervision and subject to the direction of
its Board. The business address of each Trustee (including each Independent Trustee) is c/o Jane Trust, Legg Mason, 100 International Drive, 11th Floor, Baltimore, Maryland 21202. The tables below
provide information about each of the Trustees and officers of the Trust.
40
Independent Trustees#:
|
|
|
|
|
|
|
|
|
|
|
Name and
Year of Birth
|
|
Position(s) with Trust
|
|
Term of Office*
and Length of
Time Served**
|
|
Principal Occupation(s)
During
the Past Five Years
|
|
Number of
Funds in the
Legg
Mason
Funds
Complex
Overseen
by Trustee***
|
|
Other Board Memberships
Held by Trustee During the
Past Five Years
|
|
|
|
|
|
|
Paul R. Ades
Born 1940
|
|
Trustee
|
|
Since 1983
|
|
Paul R. Ades, PLLC (law firm) (since 2000)
|
|
44
|
|
None
|
Andrew L. Breech
Born 1952
|
|
Trustee
|
|
Since 1991
|
|
President, Dealer Operating Control Service, Inc. (automotive retail management) (since 1985)
|
|
44
|
|
None
|
Dwight B. Crane
Born
1937
|
|
Trustee
|
|
Since 1981
|
|
Professor Emeritus, Harvard Business School (since 2007); formerly, Professor, Harvard Business School (1969 to 2007); Independent Consultant (since 1969)
|
|
44
|
|
None
|
Althea L. Duersten
Born
1951
|
|
Trustee
|
|
Since 2014
|
|
Retired (since 2011); formerly, Chief Investment Officer, North America, JP Morgan Chase (investment bank) and member of JPMorgan Executive Committee (2007 to 2011)
|
|
44
|
|
Non-Executive Director, Rokos Capital Management LLP (since 2019)
|
Stephen R. Gross±
Born
1947
|
|
Trustee
|
|
Since 1986
|
|
Chairman Emeritus (since 2011) and formerly, Chairman, HLB Gross Collins, P.C. (accounting and consulting firm) (1979 to 2011); Executive Director of Business Builders Team, LLC (since 2005);
Principal, Gross Consulting Group, LLC (since 2011); CEO, Gross Capital Partners, LLC (since 2014); CEO, Trusted CFO Solutions, LLC (since 2011)
|
|
90
|
|
None
|
Susan M. Heilbron±
Born 1945
|
|
Trustee
|
|
Since 1991
|
|
Retired; formerly, President, Lacey & Heilbron (communications consulting) (1990 to 2002); General Counsel and Executive Vice President, The Trump Organization (1986 to 1990); Senior Vice
President, New York State Urban Development Corporation (1984 to 1986); Associate, Cravath, Swaine & Moore LLP (1980 to 1984 and 1977 to 1979)
|
|
90
|
|
Formerly, Director, Lincoln Savings Bank, FSB (1991 to 1994); Director, Trump Shuttle, Inc. (air transportation) (1989 to 1990);
Director, Alexanders Inc. (department store) (1987 to 1990)
|
Frank G. Hubbard
Born
1937
|
|
Trustee
|
|
Since 1993
|
|
President, Fealds, Inc. (business development) (since 2016); formerly, President, Avatar International Inc. (business development) (1998 to 2015)
|
|
44
|
|
None
|
Howard J. Johnson
Born
1938
|
|
Trustee and
Chairman of the Board
|
|
From 1981 to 1998 and since 2000 (Chairman of the Board since 2013)
|
|
Retired; formerly, Chief Executive Officer, Genesis Imaging LLC (technology company) (2003 to 2012)
|
|
44
|
|
None
|
Jerome H. Miller
Born
1938
|
|
Trustee
|
|
Since 1995
|
|
Retired; formerly, Vice Chairman, Shearson Lehman Hutton Inc. (1989 to 1992) and Senior Executive Vice President, E.F. Hutton Group Inc. (1986 to 1989)
|
|
44
|
|
None
|
41
|
|
|
|
|
|
|
|
|
|
|
Ken Miller
Born 1942
|
|
Trustee
|
|
Since 1983
|
|
Retired; formerly, President, Young Stuff Apparel Group, Inc. (apparel manufacturer), division of Li & Fung (1963 to 2012)
|
|
44
|
|
None
|
Thomas F. Schlafly
Born
1948
|
|
Trustee
|
|
Since 1983
|
|
Chairman, The Saint Louis Brewery, LLC (brewery) (since 2012); formerly, President, The Saint Louis Brewery, Inc. (1989 to 2012); Senior Counsel (since 2017) and formerly, Partner (2009 to
2016), Thompson Coburn LLP (law firm)
|
|
44
|
|
Director, Citizens
National Bank
of Greater St.
Louis (since
2006)
|
42
Interested Trustee and Officer:
|
|
|
|
|
|
|
|
|
|
|
Name and
Year of Birth
|
|
Position(s) with Trust
|
|
Term of Office*
and Length of
Time Served**
|
|
Principal Occupation(s)
During
the Past Five Years
|
|
Number of
Funds in the
Legg
Mason
Funds
Complex
Overseen
by Trustee***
|
|
Other Board Memberships
Held by Trustee During the
Past Five Years
|
|
|
|
|
|
|
Jane Trust, CFA
Born
1962
|
|
Trustee, President and
Chief Executive Officer
|
|
Since 2015
|
|
Senior Managing Director of Legg Mason & Co., LLC (Legg Mason & Co.) (since 2018); Managing Director of Legg Mason & Co. (2016 to 2018); Officer and/or Trustee/Director
of 145 funds associated with LMPFA or its affiliates (since 2015); President and Chief Executive Officer of LMPFA (since 2015); formerly, Senior Vice President of LMPFA (2015); Director of ClearBridge, LLC (formerly, Legg Mason Capital Management,
LLC) (2007 to 2014); Managing Director of Legg Mason Investment Counsel & Trust Co. (2000 to 2007)
|
|
135
|
|
None
|
#
|
Trustees who are not interested persons of the Trust within the meaning of Section 2(a)(19) of the 1940
Act.
|
*
|
Each Trustee serves until his or her respective successor has been duly elected and qualified or until his or her earlier
death, resignation, retirement or removal.
|
**
|
Indicates the earliest year in which the Trustee became a board member for a fund in the Legg Mason Funds complex.
|
***
|
Information is for the calendar year ended December 31, 2019, except as otherwise noted.
|
|
Ms. Trust is an interested person of the Trust, as defined in the 1940 Act, because of her position with
LMPFA and/or certain of its affiliates.
|
±
|
Mr. Gross and Ms. Heilbron were appointed to the Board effective February 6, 2019. Effective
January 1, 2020, Mr. Gross and Ms. Heilbron were no longer independent board members of the Legg Mason Partners Fixed Income Board. Information pertaining to the Number of Funds in the Legg Mason Funds Complex Overseen by Trustee for
each of Mr. Gross and Ms. Heilbron is as of December 31, 2019, prior to their departure from the Legg Mason Partners Fixed Income Board.
|
43
Additional Officers:
|
|
|
|
|
|
|
Name, Year of
Birth
and Address
|
|
Position(s) with Trust
|
|
Term of Office*
and Length of
Time Served**
|
|
Principal Occupation(s)
During the Past Five Years
|
|
|
|
|
Jenna Bailey
Born 1978
Legg Mason
100 First Stamford Place
5th Floor
Stamford, CT 06902
|
|
Identity Theft
Prevention Officer
|
|
Since 2015
|
|
Identity Theft Prevention Officer of certain funds associated with Legg Mason & Co. or its affiliates (since
2015); Compliance Officer of Legg Mason & Co. (since 2013); Assistant Vice President of Legg Mason & Co. (since 2011); formerly, Associate Compliance Officer of Legg Mason & Co. (2011 to 2013)
|
|
|
|
|
Ted P. Becker
Born 1951
Legg Mason
620 Eighth Avenue
49th Floor
New York, NY 10018
|
|
Chief Compliance
Officer
|
|
Since 2007
|
|
Director of Global Compliance at Legg Mason (since 2006); Chief Compliance Officer of LMPFA (since 2006);
Managing Director of Compliance of Legg Mason & Co. (since 2005); Chief Compliance Officer of certain funds associated with Legg Mason & Co. or its affiliates (since 2006)
|
|
|
|
|
Christopher Berarducci
Born
1974
Legg Mason
620 Eighth Avenue
49th Floor
New York, NY 10018
|
|
Treasurer and Principal Financial Officer
|
|
Since 2014 and 2019
|
|
Treasurer (since 2010) and Principal Financial Officer (since 2019) of certain funds associated with Legg Mason
& Co. or its affiliates; Director of Legg Mason & Co. (since 2015); formerly, Vice President of Legg Mason & Co. (2011 to 2015); Assistant Controller of certain funds associated with Legg Mason & Co. or its affiliates (prior to
2010)
|
|
|
|
|
Robert I. Frenkel
Born
1954
Legg Mason
100 First Stamford Place
6th Floor
Stamford, CT 06902
|
|
Secretary and
Chief Legal Officer
|
|
Since 2007
|
|
Vice President and Deputy General Counsel of Legg Mason, Inc. (since 2006); Managing Director and General
Counsel U.S. Mutual Funds for Legg Mason & Co. (since 2006) and Legg Mason & Co. predecessors (since 1994); Secretary and Chief Legal Officer of certain funds associated with Legg Mason & Co. or its affiliates (since 2006) and
Legg Mason & Co. predecessors (prior to 2006)
|
|
|
|
|
Jeanne Kelly
Born 1951
Legg Mason
620 Eighth Avenue
49th Floor
New York, NY 10018
|
|
Senior Vice President
|
|
Since 2007
|
|
Senior Vice President of certain funds associated with Legg Mason & Co. or its affiliates (since 2007); Senior Vice President of LMPFA (since 2006); President and Chief Executive Officer
of LM Asset Services, LLC (LMAS) and Legg Mason Fund Asset Management, Inc. (LMFAM) (formerly registered investment advisers) (since 2015); Managing Director of Legg Mason & Co. (since 2005) and Legg Mason & Co.
predecessors (prior to 2005); formerly, Senior Vice President of LMFAM (2013 to 2015)
|
|
|
|
|
Susan Kerr
Born 1949
Legg Mason
620 Eighth Avenue
49th Floor
New York, NY 10018
|
|
Chief Anti-Money
Laundering
Compliance
Officer
|
|
Since 2013
|
|
Assistant Vice President of Legg Mason & Co. and LMIS (since 2010); Chief Anti-Money Laundering Compliance Officer of certain mutual funds associated with Legg Mason & Co. or its
affiliates (since 2013) and Anti-Money Laundering Compliance Officer of LMIS (since 2012); Senior Compliance Officer of LMIS (since 2011); formerly, AML Consultant, DTCC (2010); AML Consultant, Rabobank Netherlands (2009); First Vice President,
Director of Marketing & Advertising Compliance and Manager of Communications Review Group at Citigroup Inc. (1996 to 2008)
|
44
|
|
|
|
|
|
|
Thomas C. Mandia
Born
1962
Legg Mason
100 First Stamford Place
6th Floor
Stamford, CT 06902
|
|
Assistant Secretary
|
|
Since 2007
|
|
Managing Director and Deputy General Counsel of Legg Mason & Co. (since 2005) and Legg Mason & Co. predecessors (prior to 2005); Secretary of LMPFA (since 2006); Assistant Secretary of
certain funds associated with Legg Mason & Co. or its affiliates (since 2006) and Legg Mason & Co. predecessors (prior to 2006); Secretary of LMAS (since 2002) and LMFAM (formerly registered investment advisers) (since 2013)
|
*
|
Each officer serves until his or her respective successor has been duly elected and qualified or until his or her earlier
death, resignation, retirement or removal.
|
**
|
Indicates the earliest year in which the officer took such office.
|
Qualifications of Trustees, Board Leadership Structure and Oversight and Standing Committees
The Independent Trustees were selected to join the Board based upon the following as to each Trustee: character and integrity; service as a board member
of predecessor funds and/or other funds in the Legg Mason Funds complex (except for Ms. Duersten with regard to funds incepted prior to April 1, 2014); willingness to serve and willingness and ability to commit the time necessary to
perform the duties of a Trustee; the fact that service as a Trustee would be consistent with the requirements of the Trusts retirement policies and the Trustees status as not being an interested person of the Fund, as defined
in the 1940 Act. Ms. Trust was selected to join the Board based upon her investment management and risk oversight experience as an executive and portfolio manager and leadership roles with Legg Mason and affiliated entities. The Board also
considered her character and integrity, her willingness to serve and willingness and ability to commit the time necessary to perform the duties of a Trustee, the fact that service as a Trustee would be consistent with requirements of the
Trusts retirement policies, and her status as a representative of Legg Mason. Independent Trustees constitute more than 75% of the Board. Mr. Johnson serves as Chairman of the Board and is an Independent Trustee. Ms. Trust is an
interested person of the Fund.
The Board believes that each Trustees experience, qualifications, attributes or skills on an individual
basis and in combination with those of the other Trustees lead to the conclusion that the Board possesses the requisite attributes and skills. The Board believes that the Trustees ability to review critically, evaluate, question and discuss
information provided to them, to interact effectively with the Manager, the Subadviser, other service providers, counsel and the independent registered public accounting firm, and to exercise effective business judgment in the performance of their
duties support this conclusion. In addition, the following specific experience, qualifications, attributes and/or skills apply to each Trustee.
Each Trustee, except for Ms. Trust and Ms. Duersten, has served as a board member of the Fund and/or other funds in the Legg Mason Funds
complex for at least eight years. Mr. Ades has substantial experience practicing law and advising clients with respect to various business transactions. Mr. Breech has substantial experience as the chief executive of a private corporation.
Mr. Crane has substantial experience as an economist, academic and business consultant. Ms. Duersten has substantial experience as a global investment and trading manager in capital markets across multiple asset classes, including as the
chief investment officer for the North American region of a major investment bank and service on its executive committee. Mr. Gross has a substantial accounting background and experience as an officer, trustee and board member of various
organizations. Ms. Heilbron has substantial legal background and experience, business and consulting experience, and experience as a board member of public companies. Mr. Hubbard has substantial experience in business development and was a
senior executive of an operating company. Mr. Johnson has substantial experience as the chief executive of an operating company and in the financial services industry, including as an actuary and pension consultant. Mr. Jerome Miller had
substantial experience as an executive in the asset management group of a major broker/dealer. Mr. Ken Miller has substantial experience as a senior executive of an operating company. Mr. Schlafly has substantial experience practicing law
and also serves as the non-executive Chairman of a private corporation and as director of a bank. Ms. Trust has been the Chief Executive Officer of the Trust and other funds in the fund complex since 2015 and has investment management and risk
oversight experience as an executive and portfolio manager and in leadership roles with Legg Mason and affiliated entities. References to the experience, qualifications, attributes and skills of Trustees are pursuant to requirements of the SEC, do
not constitute holding out of the Board or any Trustee as having any special expertise, and shall not impose any greater responsibility or liability on any such person or on the Board.
The Board has five standing Committees: the Audit Committee, the Contract Committee, the Performance Committee, the Governance Committee, and the
Compensation and Nominating Committee (which is a sub-committee of the Governance
45
Committee). Each Committee is chaired by an Independent Trustee. The Audit Committee and the Governance Committee are composed of all of the Independent Trustees. The Contract Committee is
composed of four Independent Trustees. The Performance Committee is composed of four Independent Trustees. The Compensation and Nominating Committee is composed of five Independent Trustees. Where deemed appropriate, the Board may constitute ad hoc
committees.
The Chairman of the Board and the chairs of the Audit and Performance Committees work with the Chief Executive Officer of the Trust to
set the agendas for Board and committee meetings. The Chairman of the Board also serves as a key point person for interaction between management and the other Independent Trustees. Through the committees the Independent Trustees consider and address
important matters involving the Fund, including those presenting conflicts or potential conflicts of interest for management. The Independent Trustees also regularly meet outside the presence of management and are advised by independent legal
counsel. The Board has determined that its committees help ensure that the Fund has effective and independent governance and oversight. The Board also has determined that its leadership structure, in which the Chairman of the Board is not affiliated
with Legg Mason, is appropriate. The Board also believes that its leadership structure facilitates the orderly and efficient flow of information between the Independent Trustees and management, including the Funds Subadviser.
The Audit Committee oversees the scope of the Funds audit, the Funds accounting and financial reporting policies and practices and its
internal controls. The Audit Committee assists the Board in fulfilling its responsibility for oversight of the integrity of the Funds accounting, auditing and financial reporting practices, the qualifications and independence of the
Funds independent registered public accounting firm and the Funds compliance with legal and regulatory requirements. The Audit Committee approves, and recommends to the Board for ratification, the selection, appointment, retention or
termination of the Funds independent registered public accounting firm and approves the compensation of the independent registered public accounting firm. The Audit Committee also approves all audit and permissible non-audit services provided
to the Fund by the independent registered public accounting firm and all permissible non-audit services provided by the Funds independent registered public accounting firm to its Manager and any affiliated service providers if the engagement
relates directly to the Funds operations and financial reporting. The Audit Committee has formed a sub-committee for purposes of reviewing shareholder reports as required under applicable listing standards.
The Contract Committee is charged with assisting the Board in requesting and evaluating such information from the Manager and the Subadviser as may
reasonably be necessary to evaluate the terms of the Funds investment management agreement, subadvisory arrangements and distribution arrangements.
The Performance Committee is charged with assisting the Board in carrying out its oversight responsibilities over the Fund and fund management with
respect to investment management, objectives, strategies, policies and procedures, performance and performance benchmarks, and the applicable risk management process.
The Governance Committee is charged with overseeing Board governance and related Trustee practices, including selecting and nominating persons for
election or appointment by the Board as Trustees of the Trust. The Governance Committee has formed the Compensation and Nominating Committee, the function of which is to recommend to the Board the appropriate compensation for serving as a Trustee on
the Board. In addition, the Compensation and Nominating Committee is responsible for, among other things, selecting and recommending candidates to fill vacancies on the Board. The Committee may consider nominees recommended by a shareholder. In
evaluating potential nominees, including any nominees recommended by shareholders, the Committee takes into consideration various factors, including, among any others it may deem relevant, character and integrity, business and professional
experience, and whether the committee believes the person has the ability to apply sound and independent business judgment and would act in the interest of the Fund and its shareholders. Shareholders who wish to recommend a nominee should send
recommendations to the Trusts Secretary that include all information relating to such person that is required to be disclosed in solicitations of proxies for the election of Trustees. A recommendation must be accompanied by a written consent
of the individual to stand for election if nominated by the Board and to serve if elected by the shareholders.
Service providers to the Fund,
primarily the Funds Manager, the Subadviser and, as appropriate, their affiliates, have responsibility for the day-to-day management of the Fund, which includes responsibility for risk management. As an integral part of its responsibility for
oversight of the Fund, the Board oversees risk management of the Funds investment program and business affairs. Oversight of the risk management process is part of the Boards general oversight of the Fund and its service providers. The
Board has emphasized to the Funds Manager and the Subadviser the importance of maintaining vigorous risk
46
management. The Board exercises oversight of the risk management process primarily through the Audit Committee and the Performance Committee, and through oversight by the Board itself.
The Fund is subject to a number of risks, including investment risk, counterparty risk, valuation risk, reputational risk, risk of operational failure or
lack of business continuity, and legal, compliance and regulatory risk. Risk management seeks to identify and address risks, i.e., events or circumstances that could have material adverse effects on the business, operations, shareholder services,
investment performance or reputation of the Fund. The Funds Manager and the Subadviser, the affiliates of the Manager and the Subadviser, or various service providers to the Fund employ a variety of processes, procedures and controls to
identify various of those possible events or circumstances, to lessen the probability of their occurrence and/or to mitigate the effects of such events or circumstances if they do occur. Different processes, procedures and controls are employed with
respect to different types of risks. Various personnel, including the Funds and the Managers Chief Compliance Officer and the Managers chief risk officer, as well as personnel of the Subadviser and other service providers, such as
the Funds independent registered public accounting firm, make periodic reports to the Audit Committee, the Performance Committee or to the Board with respect to various aspects of risk management, as well as events and circumstances that have
arisen and responses thereto. The Board recognizes that not all risks that may affect the Fund can be identified, that it may not be practical or cost-effective to eliminate or mitigate certain risks, that it may be necessary to bear certain risks
(such as investment-related risks) to achieve the Funds goals, and that the processes, procedures and controls employed to address certain risks may be limited in their effectiveness. Moreover, reports received by the Trustees as to risk
management matters are typically summaries of the relevant information. As a result of the foregoing and other factors, the Boards risk management oversight is subject to inherent limitations.
During the fiscal year ended December 31, 2019, the Board met 5 times, the Audit Committee met 4 times, the Audit Sub-committee met 2 times, the
Governance Committee met 4 times, the Performance Committee met 4 times, the Compensation and Nominating Committee met 1 time, and the Contract Committee met 1 time.
Trustee Ownership of Securities
The following tables show the dollar range of equity securities owned by the Trustees in the Fund and other investment companies in the Legg Mason Funds
complex overseen by the Trustees as of December 31, 2019.
|
|
|
|
|
Name of Trustee
|
|
Total Return ETF
|
|
Aggregate Dollar Range of Equity
Securities in All Registered
Investment
Companies in Legg
Mason Funds Complex Overseen by
Trustee ($)
|
Independent Trustees:
|
Paul R. Ades
|
|
None
|
|
Over 100,000
|
Andrew L. Breech
|
|
None
|
|
Over 100,000
|
Dwight B. Crane
|
|
None
|
|
Over 100,000
|
Althea L. Duersten
|
|
None
|
|
Over 100,000
|
Stephen R. Gross*
|
|
None
|
|
Over 100,000
|
Susan M. Heilbron*
|
|
None
|
|
None
|
Frank G. Hubbard
|
|
None
|
|
Over 100,000
|
Howard J. Johnson
|
|
None
|
|
Over 100,000
|
Jerome H. Miller
|
|
None
|
|
Over 100,000
|
Ken Miller
|
|
None
|
|
Over 100,000
|
Thomas F. Schlafly
|
|
None
|
|
Over 100,000
|
|
|
|
Interested Trustee:
|
|
|
|
|
Jane Trust
|
|
None
|
|
Over 100,000
|
47
As of December 31, 2019, none of the Independent Trustees or their immediate family members owned
beneficially or of record any securities of the Manager, the Subadviser, or the Distributor of the Fund, or of a person (other than a registered investment company) directly or indirectly controlling, controlled by or under common control with the
Manager, the Subadviser, or the Distributor of the Fund.
For serving as a Trustee of the Trust, each Independent Trustee receives an annual
retainer plus fees for attending each regularly scheduled meeting and special Board meeting they attend in person or by telephone. Each Independent Trustee is also reimbursed for all out-of-pocket expenses relating to attendance at such meetings.
Those Independent Trustees who serve in leadership positions of the Board or Board committees, and members of the Contract Committee, the Performance Committee, and the Compensation and Nominating Committee, receive additional compensation. The
Board reviews the level of Trustee compensation periodically and Trustee compensation may change from time to time. Ms. Trust, an interested person of the Fund, as defined in the 1940 Act, does not receive compensation from the Fund
for her service as Trustee. The Fund pays its pro rata share of the fees and expenses of the Trustees based upon asset size.
Officers of the Trust
receive no compensation from the Fund, although they may be reimbursed for reasonable out-of-pocket travel expenses for attending Board meetings.
Trustee Compensation
Information regarding compensation paid to the Trustees is shown below.
|
|
|
|
|
|
|
Name of Trustee
|
|
Total Return ETF
|
|
Total Pension
or
Retirement
Benefits Paid
as Part of Fund
Expenses*
($)
|
|
Total
Compensation
from Legg Mason
Funds Complex
Paid to
Trustee**
($)
|
Independent Trustees:
|
Paul R. Ades
|
|
191
|
|
None
|
|
331,000
|
Andrew L. Breech
|
|
199
|
|
None
|
|
346,000
|
Dwight B. Crane
|
|
207
|
|
None
|
|
361,000
|
Althea L. Duersten
|
|
191
|
|
None
|
|
331,000
|
Stephen R. Gross***
|
|
145
|
|
None
|
|
557,469
|
Susan M. Heilbron***
|
|
154
|
|
None
|
|
628,753
|
Frank G. Hubbard
|
|
191
|
|
None
|
|
331,000
|
Howard J. Johnson****
|
|
210
|
|
None
|
|
366,000
|
Jerome H. Miller
|
|
193
|
|
None
|
|
336,000
|
Ken Miller
|
|
193
|
|
None
|
|
336,000
|
Thomas F. Schlafly
|
|
191
|
|
None
|
|
331,000
|
|
|
|
|
Interested Trustee:
|
|
|
|
|
|
|
Jane Trust
|
|
None
|
|
None
|
|
None
|
*
|
Information is for the fiscal year ended December 31, 2019.
|
**
|
Information is for the calendar year ended December 31, 2019.
|
***
|
Mr. Gross and Ms. Heilbron were appointed to the Board effective February 6, 2019.
|
****
|
The total amount of deferred compensation accrued by the Trust (including earnings or depreciation in value of amounts
deferred) through December 31, 2019 for Mr. Howard J. Johnson is $162,156.
|
|
Ms. Trust is not compensated by the Trust for her services as a Trustee because of her affiliations with the Manager.
|
48
INVESTMENT MANAGEMENT AND OTHER SERVICE PROVIDER INFORMATION
Manager
The Manager, a limited
liability company organized under the laws of the State of Delaware, serves as investment manager to the Fund and provides administrative and certain oversight services to the Fund, pursuant to an investment management agreement (the
Management Agreement). The Manager has offices at 620 Eighth Avenue, New York, New York, 10018 and also serves as the investment manager of other Legg Mason Funds. The Manager is a wholly-owned subsidiary of Legg Mason, a Maryland
corporation. Legg Mason, whose principal executive offices are at 100 International Drive, Baltimore, Maryland 21202, is a global asset management company.
The Manager is responsible for managing the Fund consistent with the 1940 Act, the Code, the Funds investment objective, policies and restrictions
described in the Prospectus and this SAI and in accordance with any exemptive orders issued by the SEC applicable to the Fund and any SEC staff no-action letters applicable to the Fund. Pursuant to the Management Agreement and subject to the general
supervision of the Board, the Manager provides or causes to be furnished all investment management, supervisory, administrative and other services reasonably necessary for the operation of the fund, including: custodians; audit; portfolio
accounting; legal; transfer agency and registrar; securities lending; depository; accounting services; indicative optimized portfolio value calculation; printing costs; insurance; certain distribution services (provided pursuant to a separate
distribution agreement); and investment advisory services (provided pursuant to separate subadvisory agreements), under what is essentially an all-in fee or a unitary fee structure. The Fund bears other expenses which are not covered under the
Management Agreement that may vary and will affect the total level of expenses paid by the fund, such as taxes and governmental fees, transaction expenses, costs of borrowing money (including interest expenses), future 12b-1 fees (if any), acquired
fund fees and expenses and extraordinary expenses (such as litigation and indemnification expenses). The Manager may earn a profit on the fees charged under the Management Agreement and would benefit from any price decreases in third-party services
covered by the Management Agreement, including decreases resulting from an increase in net assets.
The Manager is permitted to enter into contracts
with subadvisers or subadministrators, subject to the Boards approval and to the extent permitted by any exemptive orders or SEC staff no action letters applicable to the Fund. The Manager has entered into subadvisory arrangements, as
described below.
The Management Agreement provides that the Manager, its affiliates performing services contemplated by the Management Agreement,
and the partners, shareholders, directors, officers and employees of the Manager and such affiliates, will not be liable for any error of judgment or mistake of law, for any loss arising out of any investment, or for any act or omission in the
execution of securities transactions for the fund, but the Manager is not protected against any liability to the Fund to which the Manager would be subject by reason of willful misfeasance, bad faith or gross negligence in the performance of its
duties or by reason of its reckless disregard of its obligations and duties under the Management Agreement.
After the initial term of two years, the
Management Agreement will continue in effect from year to year, provided its continuance is specifically approved at least annually with respect to the fund (a) by the Board or by a 1940 Act Vote, and (b) in either event, by a majority of
the Independent Trustees with such Independent Trustees casting votes in person at a meeting called for such purpose.
The Board or a majority of the
outstanding voting securities of the fund (as defined in the 1940 Act) may terminate the Management Agreement, without penalty, on not more than 60 days nor less than 30 days written notice to the Manager. The Manager may terminate the
Management Agreement, without penalty, upon not less than 90 days written notice to the Fund. The Management Agreement may be terminated immediately upon the mutual written consent of all parties to the Agreement. In addition, the Management
Agreement terminates automatically upon its assignment.
For its services under the Funds Management Agreement, the Manager receives an
investment management fee that is calculated daily and payable monthly according to the following schedule:
|
|
|
|
|
|
|
Investment Management Fee Rate
(% of Average Daily Net Assets)
|
|
|
49
The table below sets forth the management fees paid by the Fund to the Manager (waived/reimbursed amounts are in
parentheses), with respect to the fiscal periods indicated:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
For the Fiscal Period Ended
December 31,
|
|
|
|
Gross
Management
Fees ($)
|
|
|
|
Management Fees
Waived/Expenses
Reimbursed ($)
|
|
|
|
Net Management
Fees (After
Waivers/Expense
Reimbursements) ($)
|
2019
|
|
|
|
|
|
|
|
|
215,523
|
|
|
|
|
|
|
|
|
|
(17,594
|
)
|
|
|
|
|
|
|
|
|
197,929
|
|
2018
|
|
|
|
|
|
|
|
|
29,635
|
|
|
|
|
|
|
|
|
|
(2,419
|
)
|
|
|
|
|
|
|
|
|
27,216
|
|
Any expense limitation arrangements in place during the Funds past three fiscal periods can be found in the
Funds Prospectus in effect (as amended or supplemented from time to time) for such year.
Subadviser
Western Asset. Western Asset, a wholly owned subsidiary of Legg Mason, serves as subadviser to the Fund under a subadvisory agreement between
Western Asset and LMPFA (the Western Asset Subadvisory Agreement).
Under the Western Asset Subadvisory Agreement, Western Asset
is responsible, subject to the general supervision of the Board and the Manager, for the actual management of the Funds assets, including the responsibility for making decisions and placing orders to buy, sell or hold a particular security,
consistent with the investment objectives and policies described in the Prospectus and this SAI. Western Asset receives from the Manager for its services an advisory fee equal to 70% of the management fee paid to the Manager, net of (i) all
fees and expenses incurred by the Manager under the Management Agreement (including without limitation any subadvisory fee paid to another subadviser or sub-subadviser to the Fund) and (ii) expense waivers and reimbursements. In no event shall
the subadvisory fee be less than zero.
Under the Western Asset Subadvisory Agreement, Western Asset will not be liable for any error of judgment or
mistake of law or for any loss suffered by the Fund in connection with the performance of the Western Asset Subadvisory Agreement, except a loss resulting from willful misfeasance, bad faith or gross negligence on its part in the performance of its
duties or from reckless disregard by it of its obligations or duties thereunder.
Western Asset, established in 1971, has offices at 385 East
Colorado Boulevard, Pasadena, California 91101 and 620 Eighth Avenue, New York, New York 10018. Western Asset acts as investment adviser to institutional accounts, such as corporate pension plans, mutual funds and endowment funds.
Western Asset Management Company Limited (Western Asset Limited). Western Asset Limited, a wholly-owned subsidiary of Legg Mason,
serves as sub-subadviser to the Fund under a sub-subadvisory agreement between Western Asset and Western Asset Limited (the Western Asset Limited Sub-Subadvisory Agreement).
Under the Western Asset Limited Sub-Subadvisory Agreement, Western Asset Limited shall, as requested by Western Asset, regularly provide the Fund with
investment research, advice, management and supervision and shall furnish a continuous investment program for the Fund consistent with the investment objectives, restrictions and policies described in the Prospectus and this SAI. Western Asset
Limited receives from Western Asset 100% of the subadvisory fee paid by the Manager to Western Asset for the portion of the Funds assets allocated to Western Asset Limited by Western Asset from time to time.
Under the Western Asset Limited Sub-Subadvisory Agreement, Western Asset Limited will not be liable for any error of judgment or mistake of law or for
any loss suffered by the Fund in connection with the performance of the Western Asset Limited Sub-Subadvisory Agreement, except a loss resulting from willful misfeasance, bad faith or gross negligence on its part in the performance of its duties or
from reckless disregard by it of its obligations or duties thereunder.
50
The Western Asset Limited Sub-Subadvisory Agreement terminates automatically upon assignment and is
terminable at any time without penalty by vote of the Board, by vote of a majority of the Funds outstanding voting securities, or by Western Asset Limited, on not more than 60 days notice, and may be terminated immediately upon the
mutual written consent of the parties.
Western Asset Management Pte. Ltd. (Western Asset Singapore). Western Asset Singapore, a
wholly owned subsidiary of Legg Mason, serves as sub-subadviser to the Fund under a sub-subadvisory agreement between Western Asset and Western Asset Singapore (Western Asset Singapore Sub-Subadvisory Agreement).
Under the Western Asset Singapore Sub-Subadvisory Agreement, Western Asset Singapore shall, as requested by Western Asset, regularly provide the Fund
with investment research, advice, management and supervision and shall furnish a continuous investment program for the Fund consistent with the investment objectives, restrictions and policies described in the Prospectus and this SAI. Western Asset
Singapore receives from Western Asset 100% of the subadvisory fee paid by the Manager to Western Asset for the portion of the Funds assets allocated to Western Asset Singapore by Western Asset from time to time.
Under the Western Asset Singapore Sub-Subadvisory Agreement, Western Asset Singapore will not be liable for any error of judgment or mistake of law or
for any loss suffered by the Fund in connection with the performance of the Western Asset Singapore Sub-Subadvisory Agreement, except a loss resulting from willful misfeasance, bad faith or gross negligence on its part in the performance of its
duties or from reckless disregard by it of its obligations or duties thereunder.
Western Asset Company Ltd (Western Asset Japan).
Western Asset Japan, a wholly owned subsidiary of Legg Mason, serves as sub-subadviser to the Fund under a sub-subadvisory agreement between Western Asset and Western Asset Japan (the Western Asset Japan Sub-Subadvisory Agreement).
Under the Western Asset Japan Sub-Subadvisory Agreement, Western Asset Japan shall, as requested by Western Asset, regularly provide the
Fund with investment research, advice, management and supervision and shall furnish a continuous investment program for the Fund consistent with the investment objectives, restrictions and policies described in the Prospectus and this SAI. Western
Asset Japan receives from Western Asset 100% of the subadvisory fee paid by the Manager to Western Asset for the portion of the Funds assets allocated to Western Asset Japan by Western Asset from time to time.
Under the Western Asset Japan Sub-Subadvisory Agreement, Western Asset Japan will not be liable for any error of judgment or mistake of law or for any
loss suffered by the Fund in connection with the performance of the Western Asset Japan Sub-Subadvisory Agreement, except a loss resulting from willful misfeasance, bad faith or gross negligence on its part in the performance of its duties or from
reckless disregard by it of its obligations or duties thereunder.
Each of the Western Asset Advisory Agreement, Western Asset Limited
Sub-Subadvisory Agreement, Western Asset Singapore Sub-Subadvisory Agreement and Western Asset Japan Sub-Subadvisory Agreement (collectively, the Subadvisory Agreements) terminates automatically upon assignment and is terminable at any
time without penalty by vote of the Board, by vote of a majority of the Funds outstanding voting securities, or by the applicable Subadviser, on not more than 60 days notice, and may be terminated immediately upon the mutual written
consent of the parties.
Western Asset Limited, Western Asset Japan and Western Asset Singapore provide certain sub-subadvisory services relating to
currency transactions and investments in non-U.S. dollar-denominated securities and related foreign currency instruments. Western Asset Limited generally manages global and non-U.S. dollar fixed-income mandates, Western Asset Japan generally manages
Japanese fixed-income mandates and Western Asset Singapore generally manages Asian (other than Japan) fixed-income mandates. Each office provides services relating to relevant portions of Western Assets broader portfolios as appropriate.
Western Asset, Western Asset Japan and Western Asset Singapore undertake investment-related activities including investment management, research and
analysis, and securities settlement.
Expenses
In addition to amounts payable under the Management Agreement, the Fund is responsible for the following expenses: taxes and governmental fees; costs
(including brokerage commissions, transaction fees or charges, if any, or Acquired Fund Fees and Expenses as such term is defined in Form N-1A as the same may be amended from time to time) in connection with the
51
creation and redemption transactions of the Funds shares and purchases and sales of the Funds securities and other investments and losses in connection therewith; costs of borrowing
money, including interest expenses; and litigation expenses and any non-recurring or extraordinary expenses as may arise, including, without limitation, those relating to actions, suits or proceedings to which the fund is a party and any legal
obligation which the Fund may have to indemnify the Funds Trustees and officers with respect thereto.
Management may agree to implement an
expense cap, waive fees and/or reimburse operating expenses. Any such waived fees and/or reimbursed expenses are described in the Funds Prospectus. The expense caps and waived fees and/or reimbursed expenses do not cover extraordinary
expenses, such as (a) any expenses or charges related to litigation, derivative actions, demand related to litigation, regulatory or other government investigations and proceedings, for cause regulatory inspections and
indemnification or advancement of related expenses or costs, to the extent any such expenses are considered extraordinary expenses for the purposes of fee disclosure in Form N-1A as the same may be amended from time to time; (b) transaction
costs (such as brokerage commissions and dealer and underwriter spreads) and taxes; and (c) other extraordinary expenses as determined for the purposes of fee disclosure in Form N-1A, as the same may be amended from time to time. Without
limiting the foregoing, extraordinary expenses are generally those that are unusual or expected to recur only infrequently, and may include such expenses, by way of illustration, as (i) expenses of the reorganization, restructuring,
redomiciling or merger of the Fund or the acquisition of all or substantially all of the assets of another fund; (ii) expenses of holding, and soliciting proxies for, a meeting of shareholders of the Fund (except to the extent relating to
routine items such as the election of Trustees or the approval of the independent registered public accounting firm); and (iii) expenses of converting to a new custodian, transfer agent or other service provider, in each case to the extent any
such expenses are considered extraordinary expenses for the purposes of fee disclosure in Form N-1A as the same may be amended from time to time.
In
order to implement an expense limitation, the Manager will, as necessary, waive management fees or reimburse operating expenses. However, the Manager is permitted to recapture amounts waived or reimbursed by the manager to the Fund during the same
fiscal year if the Funds total annual fund operating expenses have fallen to a level below the expense limitation shown in the Funds Prospectus. In no case will the Manager recapture any amount that would result, on any particular
business day of the Fund, in the Funds total annual fund operating expenses exceeding such expense limitation or any lower limit then in effect.
Investment Professionals
Other Accounts Managed by the Investment Professionals
The table below identifies the investment professionals, the number of accounts (other than the Fund) for which the investment professionals have
day-to-day management responsibilities and the total assets in such accounts, within each of the following categories: registered investment companies, other pooled investment vehicles, and other accounts. For each category, the number of accounts
and total assets in the accounts where fees are based on performance are also indicated, as applicable. Unless noted otherwise, all information is provided as of December 31, 2019.
|
|
|
|
|
|
|
|
|
|
|
|
|
Investment
Professionals
|
|
|
|
Type of
Account
|
|
Number of
Accounts
Managed
|
|
Total
Assets
Managed
(Billions)
($)
|
|
Number of
Accounts Managed
for which Advisory
Fee is
Performance-
Based
|
|
Assets Managed for
which Advisory Fee is
Performance-Based
(Billions) ($)
|
|
|
|
|
|
|
|
Fred Marki
|
|
|
|
Registered Investment Companies
|
|
19
|
|
63.53
|
|
0
|
|
0
|
|
|
|
|
|
|
|
|
|
|
|
Other Pooled Investment Vehicles
|
|
20
|
|
14.76
|
|
0
|
|
0
|
|
|
|
|
|
|
|
|
|
|
|
Other Accounts
|
|
191
|
|
65.59
|
|
9
|
|
6.68
|
52
|
|
|
|
|
|
|
|
|
|
|
|
|
John Bellows
|
|
|
|
Registered Investment Companies
|
|
17
|
|
61.33
|
|
0
|
|
0
|
|
|
|
|
|
|
|
|
|
|
|
Other Pooled Investment Vehicles
|
|
16
|
|
12.10
|
|
0
|
|
0
|
|
|
|
|
|
|
|
|
|
|
|
Other Accounts
|
|
179
|
|
57.18
|
|
6
|
|
4.01
|
|
|
|
|
|
|
|
Julien Scholnick
|
|
|
|
Registered Investment Companies
|
|
15
|
|
60.64
|
|
0
|
|
0
|
|
|
|
|
|
|
|
|
|
|
|
Other Pooled Investment Vehicles
|
|
15
|
|
12.01
|
|
0
|
|
0
|
|
|
|
|
|
|
|
|
|
|
|
Other Accounts
|
|
171
|
|
55.59
|
|
6
|
|
4.01
|
|
|
|
|
|
|
|
Ken Leech
|
|
|
|
Registered Investment Companies
|
|
94
|
|
150.21
|
|
0
|
|
0
|
|
|
|
|
|
|
|
|
|
|
|
Other Pooled Investment Vehicles
|
|
227
|
|
80.98
|
|
11
|
|
2.20
|
|
|
|
|
|
|
|
|
|
|
|
Other Accounts
|
|
627
|
|
228.76
|
|
21
|
|
12.08
|
|
|
|
|
|
|
|
Mark Lindbloom
|
|
|
|
Registered Investment Companies
|
|
25
|
|
71.55
|
|
0
|
|
0
|
|
|
|
|
|
|
|
|
|
|
|
Other Pooled Investment Vehicles
|
|
19
|
|
14.14
|
|
0
|
|
0
|
|
|
|
|
|
|
|
|
|
|
|
Other Accounts
|
|
184
|
|
58.79
|
|
8
|
|
4.99
|
Conflicts of Interest
The Subadviser has adopted compliance policies and procedures to address a wide range of potential conflicts of interest that could directly impact
client portfolios. For example, potential conflicts of interest may arise in connection with the management of multiple portfolios (including portfolios managed in a personal capacity). These could include potential conflicts of interest related to
the knowledge and timing of a portfolios trades, investment opportunities and broker selection. Portfolio managers are privy to the size, timing, and possible market impact of a portfolios trades.
It is possible that an investment opportunity may be suitable for both a portfolio and other accounts managed by a portfolio manager, but may not be
available in sufficient quantities for both the portfolio and the other accounts to participate fully. Similarly, there may be limited opportunity to sell an investment held by a portfolio and another account. A conflict may arise where the
portfolio manager may have an incentive to treat an account preferentially as compared to a portfolio because the account pays a performance-based fee or the portfolio manager, the Subadviser or an affiliate has an interest in the account. The
Subadviser has adopted procedures for allocation of portfolio transactions and investment opportunities across multiple
53
client accounts on a fair and equitable basis over time. Eligible accounts that can participate in a trade generally share the same price on a pro-rata allocation basis, taking into account
differences based on factors such as cash availability, investment restrictions and guidelines, and portfolio composition versus strategy.
With
respect to securities transactions, the Subadviser determines which broker or dealer to use to execute each order, consistent with their duty to seek best execution of the transaction. However, with respect to certain other accounts (such as pooled
investment vehicles that are not registered investment companies and other accounts managed for organizations and individuals), the Subadviser may be limited by the client with respect to the selection of brokers or dealers or may be instructed to
direct trades through a particular broker or dealer. In these cases, trades for a portfolio in a particular security may be placed separately from, rather than aggregated with, such other accounts. Having separate transactions with respect to a
security may temporarily affect the market price of the security or the execution of the transaction, or both, to the possible detriment of a portfolio or the other account(s) involved. Additionally, the management of multiple portfolios and/or
other accounts may result in a portfolio manager devoting unequal time and attention to the management of each portfolio and/or other account. The Subadvisers team approach to portfolio management and block trading approach seeks to limit this
potential risk.
The Subadviser also maintains a gift and entertainment policy to address the potential for a business contact to give gifts or host
entertainment events that may influence the business judgment of an employee. Employees are permitted to retain gifts of only a nominal value and are required to make reimbursement for entertainment events above a certain value. All gifts (except
those of a de minimis value) and entertainment events that are given or sponsored by a business contact are required to be reported in a gift and entertainment log which is reviewed on a regular basis for possible issues.
Employees of the Subadviser have access to transactions and holdings information regarding client accounts and the Subadvisers overall trading
activities. This information represents a potential conflict of interest because employees may take advantage of this information as they trade in their personal accounts. Accordingly, the Subadviser maintains a Code of Ethics that is compliant with
Rule 17j-1 under the 1940 Act and Rule 204A-1 under the Advisers Act to address personal trading. In addition, the Code of Ethics seeks to establish broader principles of good conduct and fiduciary responsibility in all aspects of the
Subadvisers business. The Code of Ethics is administered by the Legal and Compliance Department and monitored through the Subadvisers compliance monitoring program.
The Subadviser may also face other potential conflicts of interest with respect to managing client assets, and the description above is not a complete
description of every conflict of interest that could be deemed to exist. The Subadviser also maintains a compliance monitoring program and engages independent auditors to conduct a SOC1/ISAE 3402 audit on an annual basis. These steps help to ensure
that potential conflicts of interest have been addressed.
Investment Professional Compensation
With respect to the compensation of the Funds investment professionals, the Subadvisers compensation system assigns each employee a total
compensation range, which is derived from annual market surveys that benchmark each role with its job function and peer universe. This method is designed to reward employees with total compensation reflective of the external market value of their
skills, experience and ability to produce desired results. Standard compensation includes competitive base salaries, generous employee benefits and a retirement plan.
In addition, the Subadvisers employees are eligible for bonuses. These are structured to closely align the interests of employees with those of the
Subadviser, and are determined by the professionals job function and pre-tax performance as measured by a formal review process. All bonuses are completely discretionary. The principal factor considered is an investment professionals
investment performance versus appropriate peer groups and benchmarks (e.g., a securities index and with respect to the Fund, the benchmark set forth in the Funds Prospectus to which the Funds average annual total returns are compared or,
if none, the benchmark set forth in the Funds annual report). Performance is reviewed on a 1, 3 and 5 year basis for compensationwith 3 and 5 years having a larger emphasis. The Subadviser may also measure an investment
professionals pre-tax investment performance against other benchmarks, as it determines appropriate. Because investment professionals are generally responsible for multiple accounts (including the Fund) with similar investment strategies, they
are generally compensated on the performance of the aggregate group of similar accounts, rather than a specific account. Other factors that may be considered when making bonus decisions include client service, business development, length of service
to the Subadviser, management or supervisory responsibilities, contributions to developing business strategy and overall contributions to the Subadvisers business.
54
Finally, in order to attract and retain top talent, all investment professionals are eligible for
additional incentives in recognition of outstanding performance. These are determined based upon the factors described above and include Legg Mason stock options and long-term incentives that vest over a set period of time past the award date.
Investment Professional Securities Ownership
The table below identifies ownership of equity securities of the Fund by the investment professionals responsible for the day-to-day management of the
Fund as of December 31, 2019.
|
|
|
Investment Professional
|
|
Dollar Range of Ownership of
Securities ($)
|
|
|
Fred Marki
|
|
None
|
John Bellows
|
|
None
|
Julien Scholnick
|
|
None
|
S. Kenneth Leech
|
|
None
|
Mark Lindbloom
|
|
None
|
Custodian and Transfer Agent
The Fund has entered into an agreement with The Bank of New York Mellon (BNY Mellon), 240 Greenwich Street, New York, New York 10286, to
serve as custodian of the Fund. BNY Mellon, among other things, maintains a custody account or accounts in the name of the Fund, receives and delivers all assets for the Fund upon purchase and upon sale or maturity, collects and receives all income
and other payments and distributions on account of the assets of the Fund and makes disbursements on behalf of the Fund. BNY Mellon neither determines the Funds investment policies nor decides which securities the Fund will buy or sell. For
its services, BNY Mellon receives a monthly fee based upon the daily average market value of securities held in custody and also receives securities transaction charges, including out-of-pocket expenses. The Fund may also periodically enter into
arrangements with other qualified custodians with respect to certain types of securities or other transactions such as repurchase agreements or derivatives transactions. BNY Mellon may also act as the Funds securities lending agent and in that
case would receive a share of the income generated by such activities.
The Trust has also entered into an agreement with BNY Mellon to serve as
transfer agent to the Fund. Under its transfer agency agreement with the Trust, BNY Mellon provides the following services with respect to the Fund: (i) performing and facilitating the performance of purchases and redemptions of Creation Units,
(ii) preparing and transmitting by means of DTCs book-entry system payments for dividends and distributions declared by the Fund on or with respect to fund shares, (iii) preparing and delivering reports, information and documents as
specified in the agreement, (iv) performing the customary services of a transfer agent and dividend disbursing agent, and (v) rendering certain other miscellaneous services as specified in the transfer agency agreement or as otherwise
agreed upon.
Fund Counsel
Morgan, Lewis & Bockius LLP, located at One Federal Street, Boston, Massachusetts 02110, serves as legal counsel to the Trust and the Fund.
Independent Registered Public Accounting Firm
PricewaterhouseCoopers LLP, 100 East Pratt Street, Suite 2600, Baltimore, Maryland 21202, serves as the Funds independent registered public
accounting firm.
EXCHANGE LISTING AND TRADING
A discussion of exchange listing and trading matters associated with an investment in the Fund is contained in the Shareholder information
section of the Prospectus. The discussion below supplements, and should be read in conjunction with, such section of the Prospectus.
55
The shares of the Fund are listed for trading on the Exchange. The shares trade on the Exchange at prices
that may differ to some degree from their NAV. There can be no assurance that the requirements of the Exchange necessary to maintain the listing of shares of the Fund will continue to be met.
The Exchange may, but is not required to, remove the shares of the Fund from listing subject to certain conditions, including if: (1) following the
initial twelve-month period beginning upon the commencement of trading of the Fund, there are fewer than 50 beneficial holders of the shares for 30 or more consecutive trading days; (2) the IIV of the Fund is no longer calculated or
available or the Funds disclosed portfolio is not made available to all market participants at the same time; (3) the Trust has failed to file any filings required by the SEC or the Exchange is aware that the Trust is not in compliance
with the conditions of any exemptive order or no-action relief granted by the SEC to the Trust with respect to the Fund; or (4) such other event shall occur or condition exists that, in the opinion of the Exchange, makes further dealings on the
Exchange inadvisable. In addition, the Exchange will remove the shares of the Fund from listing and trading upon termination of the Trust or the Fund.
As in the case of other publicly-traded securities, when you buy or sell shares through a broker, you will incur a brokerage commission determined by
that broker.
In order to provide additional information regarding the indicative value of shares of the Fund, the Exchange or a market data
vendor disseminates every 15 seconds through the facilities of the Consolidated Tape Association, or through other widely disseminated means, an updated IIV for the Fund as calculated by an information provider or market data vendor. The Trust is
not involved in or responsible for any aspect of the calculation or dissemination of the IIV and makes no representation or warranty as to the accuracy of the IIV.
The Funds IIV is based on a securities component and a cash component which comprises that days Fund Deposit (as defined below), as
disseminated prior to that Business Days (as defined below) commencement of trading. The IIV does not necessarily reflect the precise composition of the current portfolio of securities held by the Fund at a particular point in time or the best
possible valuation of the current portfolio. Therefore, the IIV should not be viewed as a real-time update of the Funds NAV, which is computed only once a day. The IIV does not include a reduction for the fees, operating expenses
or transaction costs incurred by the Fund. The IIV is generally determined by using both current market quotations and/or price quotations obtained from broker-dealers that may trade in the portfolio securities held by the Fund. The quotations of
fund holdings may not be updated during U.S. trading hours if such holdings do not trade in the United States and thus may not reflect the current fair value of those securities.
The cash component included in the IIV consists of estimated accrued interest, dividends and other income, less expenses. If applicable, the Funds
IIV reflects changes in currency exchange rates between the U.S. dollar and the applicable currency.
The Trust reserves the right to adjust the
share prices of the Fund in the future to maintain convenient trading ranges for investors. Any adjustments would be accomplished through stock splits or reverse stock splits, which would have no effect on the net assets of the Fund or an
investors equity interest in the Fund.
The base and trading currencies of the Fund are the U.S. dollar. The base currency is the currency in
which the Funds NAV per share is calculated and the trading currency is the currency in which shares of the Fund are listed and traded on the Exchange.
CONTINUOUS OFFERING
The method by which Creation Units are created and traded may raise certain issues under applicable securities laws. Because new Creation Units are
issued and sold by the fund on an ongoing basis, at any point a distribution, as such term is used in the 1933 Act, may occur. Broker-dealers and other persons are cautioned that some activities on their part may, depending on the
circumstances, result in their being deemed participants in a distribution in a manner that could render them statutory underwriters and subject them to the prospectus delivery requirement and liability provisions of the 1933 Act.
For example, a broker-dealer firm or its client may be deemed a statutory underwriter if it takes Creation Units after placing an order with the
distributor, breaks them down into constituent shares and sells such shares directly to customers or if it chooses to couple the creation of new shares with an active selling effort involving solicitation of secondary market demand for shares. A
determination of whether one is an underwriter for purposes of the 1933 Act must take into account all of the facts and
56
circumstances pertaining to the activities of the broker-dealer or its client in the particular case and the examples mentioned above should not be considered a complete description of all the
activities that could lead to a categorization as an underwriter.
Broker-dealer firms should also note that dealers who are not
underwriters but are effecting transactions in shares, whether or not participating in the distribution of shares, generally are required to deliver a prospectus. This is because the prospectus delivery exemption in Section 4(a)(3)
of the 1933 Act is not available in respect of such transactions as a result of Section 24(d) of the 1940 Act. Firms that incur a prospectus delivery obligation with respect to shares of the Fund are reminded that, pursuant to Rule 153 under
the 1933 Act, a prospectus delivery obligation under Section 5(b)(2) of the 1933 Act owed to an exchange member in connection with a sale on the Exchange generally is satisfied by the fact that the prospectus is available at the Exchange upon
request. The prospectus delivery mechanism provided in Rule 153 is available only with respect to transactions on an exchange.
BOOK ENTRY ONLY SYSTEM
DTC acts as securities depositary for the shares. Shares of the Fund are represented by securities registered in the
name of DTC or its nominee and deposited with, or on behalf of, DTC. Certificates will not be issued for shares.
DTC, a limited-purpose trust
company, was created to hold securities of participants of DTC (the DTC Participants) and to facilitate the clearance and settlement of securities transactions among the DTC Participants in such securities through electronic book-entry
changes in accounts of the DTC Participants, thereby eliminating the need for physical movement of securities certificates. DTC Participants include securities brokers and dealers, banks, trust companies, clearing corporations and certain other
organizations, some of whom (and/or their representatives) own DTC. More specifically, DTC is owned by a number of its DTC Participants and by the NYSE and FINRA. Access to the DTC system is also available to others such as banks, brokers, dealers
and trust companies that clear through or maintain a custodial relationship with a DTC Participant, either directly or indirectly (the Indirect Participants).
Beneficial ownership of shares is limited to DTC Participants, Indirect Participants and persons holding interests through DTC Participants and Indirect
Participants. Ownership of beneficial interests in shares (owners of such beneficial interests are referred to herein as beneficial owners) is shown on, and the transfer of ownership is effected only through, records maintained by DTC
(with respect to DTC Participants) and on the records of DTC Participants (with respect to Indirect Participants and beneficial owners that are not DTC Participants). Beneficial owners will receive from or through the DTC Participant a written
confirmation relating to their purchase of shares.
Conveyance of all notices, statements and other communications to beneficial owners is
effected as follows. Pursuant to the Depositary Agreement between the Trust and DTC, DTC is required to make available to the Trust upon request and for a fee to be charged to the Trust a listing of the share holdings of each DTC Participant. The
Trust shall inquire of each such DTC Participant as to the number of beneficial owners holding shares, directly or indirectly, through such DTC Participant. The Trust shall provide each such DTC Participant with copies of such notice, statement or
other communication, in such form, number and at such place as such DTC Participant may reasonably request, in order that such notice, statement or communication may be transmitted by such DTC Participant, directly or indirectly, to such beneficial
owners. In addition, the Trust shall pay to each such DTC Participant a fair and reasonable amount as reimbursement for the expenses attendant to such transmittal, all subject to applicable statutory and regulatory requirements.
Share distributions shall be made to DTC or its nominee, Cede & Co., as the registered holder of all shares. DTC or its nominee, upon receipt of
any such distributions, shall credit immediately DTC Participants accounts with payments in amounts proportionate to their respective beneficial interests in shares as shown on the records of DTC or its nominee. Payments by DTC Participants to
Indirect Participants and beneficial owners of shares held through such DTC Participants will be governed by standing instructions and customary practices, as is now the case with securities held for the accounts of customers in bearer form or
registered in a street name, and will be the responsibility of such DTC Participants.
The Trust has no responsibility or liability for
any aspects of the records relating to or notices to beneficial owners, or payments made on account of beneficial ownership interests in such shares, or for maintaining, supervising or reviewing any records relating to such beneficial ownership
interests or for any other aspect of the relationship between DTC and the DTC Participants or the relationship between such DTC Participants and the Indirect Participants and beneficial owners owning through such DTC Participants.
57
DTC may determine to discontinue providing its service with respect to the shares at any time by giving
reasonable notice to the Trust and discharging its responsibilities with respect thereto under applicable law.
Under such circumstances, the Trust
shall take action either to find a replacement for DTC to perform its functions at a comparable cost or, if such a replacement is unavailable, to issue and deliver printed certificates representing ownership of shares, unless the Trust makes other
arrangements with respect thereto satisfactory to the Exchange.
CREATIONS AND REDEMPTIONS
The Trust issues and sells shares of the Fund only in Creation Units on a continuous basis through the Distributor, without a sales load, at the NAV
next determined after receipt of an order in proper form as described in the Participant Agreement (as defined below), on any Business Day (as defined below) primarily in exchange for cash, or otherwise for Deposit Securities. The number of shares
comprising a Creation Unit is set forth in the chart below:
|
Creation Unit Size
|
100,000
|
In its discretion, the Manager reserves the right to increase or decrease the number of the Funds shares that
constitutes a Creation Unit. The Board reserves the right to declare a split or a consolidation in the number of shares outstanding of the Fund, and to make a corresponding change in the number of shares constituting a Creation Unit, in the event
that the per share price in the secondary market rises (or declines) to an amount that falls outside the range deemed desirable by the Board.
A
Business Day with respect to the Fund is each day the Trust is open, including any day that the Fund is required to be open under Section 22(e) of the 1940 Act, which excludes weekends and the following holidays (or the days on
which they are observed): New Years Day, Martin Luther King, Jr. Day, Presidents Day, Good Friday, Memorial Day, Independence Day, Labor Day, Thanksgiving Day and Christmas Day. Orders from Authorized Participants to create or redeem
Creation Units will only be accepted on a Business Day.
Fund Deposit
The consideration for purchase of Creation Units consists of Deposit Securities and/or cash. The Deposit Securities will correspond pro rata to the
positions in the Funds portfolio (including cash positions) except (a) in the case of bonds, for minor differences when it is impossible to break up bonds beyond certain minimum sizes needed for transfer and settlement; (b) for minor
differences when rounding is necessary to eliminate fractional shares or lots that are not tradeable round lots; or (c) To Be Announced (TBA) transactions, short positions, derivatives and other positions that cannot be transferred
in kind. If there is a difference between the NAV attributable to a Creation Unit and the aggregate market value of the Deposit Securities or Redemption Securities (as defined below) exchanged for the Creation Unit, the party conveying the
instruments with the lower value will pay to the other an amount in cash equal to that difference (the Cash Component). Together, the Deposit Securities and Cash Component constitute the Fund Deposit, which represents the
minimum initial and subsequent investment amount for a Creation Unit of the Fund. The Deposit Securities and the securities that will be delivered in an in-kind transfer in a redemption (Redemption Securities) will be identical.
Purchases and redemptions of Creation Units may be made in whole or in part on a cash basis, rather than in kind, solely under the following
circumstances: (a) to the extent there is a Cash Component, as described above; (b) if, on a given Business Day, the Fund announces before the open of trading that all purchases, all redemptions or all purchases and redemptions on that day
will be made entirely in cash; (c) if, upon receiving a purchase or redemption order from an Authorized Participant, the Fund determines to require the purchase or redemption, as applicable, to be made entirely in cash; (d) if, on a given
Business Day, the Fund requires all Authorized Participants purchasing or redeeming shares on that day to deposit or receive (as applicable) cash in lieu of some or all of the Deposit Securities or Redemption Securities, respectively, solely
because: (i) such instruments are not eligible for transfer either through the NSCC process or DTC process; or (ii) in the case of the Fund holding non-U.S. investments, such instruments are not eligible for trading due to local
trading restrictions, local restrictions on securities transfers or other similar circumstances; or (e) if the fund permits an Authorized Participant to deposit or receive (as applicable) cash in lieu of some or all of the Deposit Securities or
Redemption Securities, respectively, solely because: (i) such instruments are, in the case of the purchase of a Creation Unit, not available in sufficient quantity; (ii) such
58
instruments are not eligible for trading by an Authorized Participant or the investor on whose behalf the Authorized Participant is acting; or (iii) a holder of shares of the Fund holding
non-U.S. investments would be subject to unfavorable income tax treatment if the holder receives redemption proceeds in kind. A purchase or redemption of shares made in whole or in part on a cash basis in reliance on (e)(i) or (e)(ii) is known as a
Custom Order.
The Fund will cause to be published through the NSCC, on each Business Day, at or before 9:00 a.m., Eastern time, the
identity and the required number of each Deposit Security (if any) and the amount of the Cash Component (if any) to be included in the current Fund Deposit (based on information at the end of the previous Business Day).
Procedures for Creating Creation Units
To be eligible to place orders with the Distributor and to create a Creation Unit of the Fund, an entity must have executed an agreement with the
Distributor, subject to acceptance by the Transfer Agent, with respect to creations and redemptions of Creation Units (Participant Agreement) (discussed below). Each such entity must be either (i) a broker-dealer or other
participant in the clearing process through the Continuous Net Settlement System (the Clearing Process) of the NSCC, a clearing agency that is registered with the SEC; or (ii) a DTC Participant. Any entity that has executed a
Participant Agreement is referred to as an Authorized Participant. All shares of the Fund, however created, will be entered on the records of DTC in the name of its nominee for the account of a DTC Participant.
The date on which an order to create Creation Units (or an order to redeem Creation Units, as discussed below) is placed is referred to as the
Transmittal Date. Subject to the terms of the applicable Participant Agreement, all orders to create Creation Units of the fund must be received by the distributor within a one-hour window from 9:00 a.m. Eastern time to 10:00 a.m.
Eastern time in order to receive the NAV determined on the Transmittal Date.
Orders must be transmitted by an Authorized Participant by telephone or
other transmission method acceptable to the Distributor pursuant to procedures set forth in the Participant Agreement. Economic or market disruptions or changes, or telephone or other communication failure may impede the ability to reach the
Distributor or an Authorized Participant. The Fund reserves the absolute right to reject a purchase order (see Acceptance of Creation Orders).
All investor orders to create Creation Units shall be placed with an Authorized Participant in the form required by such Authorized Participant. In
addition, an Authorized Participant may request that an investor make certain representations or enter into agreements with respect to an order (to provide for payments of cash). Investors should be aware that their particular broker may not have
executed a Participant Agreement and, therefore, orders to create Creation Units of the Fund will have to be placed by the investors broker through an Authorized Participant. In such cases, there may be additional charges to such investor.
Creation Units may be created in advance of the receipt by the Fund of all or a portion of the Fund Deposit. In such cases, the Authorized
Participant will remain liable for the full deposit of the missing portion(s) of the Fund Deposit and will be required to post collateral with the Fund consisting of cash in an amount not less than 105% of the marked-to-market value of such missing
portion(s). The Fund may use such collateral to buy the missing portion(s) of the Fund Deposit at any time and will subject such Authorized Participant to liability for any shortfall between the cost to the Fund of purchasing such securities and the
value of such collateral. The Fund will have no liability for any such shortfall. The Fund will return any unused portion of the collateral to the Authorized Participant once the entire Fund Deposit has been properly received by the Distributor and
deposited into the Fund.
Orders for creation that are effected outside the Clearing Process are likely to require transmittal by the DTC Participant
earlier on the Transmittal Date than orders effected using the Clearing Process. Those persons placing orders outside the Clearing Process should ascertain the deadlines applicable to DTC and the Federal Reserve Bank wire system by contacting the
operations department of the broker or depository institution effectuating such transfer of Deposit Securities and Cash Component.
Subject to the
conditions that (i) a properly completed irrevocable purchase order has been submitted by the Authorized Participant (either on its own or another investors behalf) not later than the Closing Time on the Transmittal Date and
(ii) arrangements satisfactory to the Fund are in place for payment of the Cash Component and any other cash amounts which may be due, the Fund will accept the order, subject to its right (and the right of the Distributor and the Manager) to
reject any order not submitted in proper form. A Creation Unit of the Fund will not be issued until the transfer of good title to the Fund of the Deposit Securities and the payment of the Cash Component have been completed. Notwithstanding the
foregoing, to the
59
extent contemplated by a Participant Agreement, Creation Units will be issued to an Authorized Participant notwithstanding the fact that the corresponding Fund Deposits have not been received in
part or in whole, in reliance on the undertaking of such Authorized Participant to deliver the missing Deposit Securities as soon as possible, which undertaking shall be secured by such Authorized Participants delivery and maintenance of
collateral. The Participant Agreement will permit the Fund to use such collateral to buy the missing Deposit Securities at any time and will subject the Authorized Participant to liability for any shortfall between the cost to the Fund of purchasing
such securities and the value of the collateral. As of the date of this SAI, cash purchases will be required for securities traded in Brazil, Chile, Columbia, Egypt, India, Malaysia, and South Korea.
Placement of Creation Orders Outside the Clearing Process
Authorized Participants making payment for orders of Creation Units of shares of the Fund must have international trading capabilities and must effect
such transactions outside the NSCC Clearing Process. Once the Custodian has been notified of an order to purchase, it will provide such information to the relevant sub-custodian(s) of the Fund. The Custodian shall cause the
sub-custodian(s) of the Fund to maintain an account into which the Authorized Participant shall deliver, on behalf of itself or the party on whose behalf it is acting, the Fund Deposit. Deposit Securities must be maintained by the applicable local
sub-custodian(s). Following the notice of intention, an irrevocable order to purchase Creation Units, in the form required by the Fund, must be received by the Distributor, as principal underwriter, from an Authorized Participant on its own or
another investors behalf by the Closing Time on the Transmittal Date.
The Trust must also receive, on or before the contractual settlement
date, immediately available or same day funds estimated by the Custodian to be sufficient to pay the Cash Component next determined after receipt in proper form of the purchase order, together with the creation transaction fee described below.
Acceptance of Creation Orders
The Fund and the Distributor reserve the absolute right to reject or revoke acceptance of a creation order transmitted to it in respect to the Fund, for
example, if: (i) the order is not in proper form; (ii) the investor(s), upon obtaining the shares ordered, would own 80% or more of the currently outstanding shares of the Fund; (iii) acceptance of the Fund Deposit would have certain
adverse tax consequences to the Fund; (iv) acceptance of the Fund Deposit would, in the opinion of the Fund, be unlawful; (v) acceptance of the Fund Deposit would otherwise, in the discretion of the Fund or the Manager, have an adverse
effect on the Fund or the rights of beneficial owners of the Fund; or (vi) in the event that circumstances outside the control of the Fund make it for all practical purposes impossible to process creation orders. Examples of such circumstances
include acts of God; public service or utility problems such as fires, floods, extreme weather conditions and power outages resulting in telephone, facsimile and computer failures; market conditions or activities causing trading halts; systems
failures involving computer or other information systems affecting the Fund, the Manager, the Subadviser, the Custodian, the Distributor, DTC, NSCCs Continuous Net Settlement System, Federal Reserve, the Transfer Agent or any other participant
in the creation process, and other extraordinary events. The Distributor shall notify the Authorized Participant acting on behalf of the creator of a Creation Unit of its rejection of the order of such person. The Fund, the Transfer Agent and the
Distributor are under no duty, however, to give notification of any defects or irregularities in the delivery of Fund Deposits nor shall any of them incur any liability for the failure to give any such notification.
All questions as to the number of shares of Deposit Securities and the validity, form, eligibility, and acceptance for deposit of any securities to be
delivered and the amount and form of the Cash Component, as applicable, shall be determined by the Fund, and the Funds determination shall be final and binding.
Creation Transaction Fee
The
Fund imposes a creation transaction fee as listed in the table below on each creation transaction regardless of the number of Creation Units purchased in the transaction.
|
Creation Transaction Fee ($)
|
100.00
|
In the case of cash creations or where the Fund permits a creator to substitute cash in lieu of depositing a portion
of the Deposit Securities, the creator may be assessed an additional variable charge calculated as a percentage of the value of a
60
Creation Unit to compensate the Fund for the costs associated with purchasing the applicable securities. This additional variable charge is not subject to a maximum limit and may exceed 2% of the
value of a Creation Unit, for example, to the extent the costs borne by the Fund exceed such amount.
As a result, in order to seek to replicate
the in-kind creation order process, the Fund expects to purchase, in the secondary market or otherwise gain exposure to, the portfolio securities that could have been delivered as a result of an in-kind creation order pursuant to local law or market
convention, or for other reasons (Market Purchases). In such cases where the Fund makes Market Purchases, the Authorized Participant will reimburse the Fund for, among other things, any difference between the market value at which the
securities and/or financial instruments were purchased by the Fund and the cash in lieu amount (which amount, at the Managers discretion, may be capped), applicable registration fees, brokerage commissions and certain taxes. The Manager may
adjust the transaction fee to the extent the composition of the Deposit Securities changes or cash in lieu is added to the Cash Component to protect ongoing shareholders. Creators of Creation Units are responsible for the costs of transferring the
securities constituting the Deposit Securities to the account of the Fund.
Redemption of Creation Units
Shares may be redeemed only in Creation Units at their NAV next determined after receipt of a redemption request in proper form on a Business Day and
only through an Authorized Participant. Redemption orders for Creation Units in the Fund must be received by the Distributor within a one-hour window from 9:00 a.m. Eastern time to 10:00 a.m. Eastern time in order to receive the NAV determined on
the Transmittal Date.
The Fund will not redeem shares in amounts less than Creation Units (except the Fund may redeem shares in amounts less
than a Creation Unit in the event the Fund is being liquidated or for other extraordinary purposes, such as a merger). Beneficial owners must accumulate enough shares in the secondary market to constitute a Creation Unit in order to have such shares
redeemed by the Trust. However, only Authorized Participants can trade directly with the Fund. There can be no assurance that there will be sufficient liquidity in the public trading market at any time to permit assembly of a Creation Unit.
Authorized Participants should expect to incur brokerage and other costs in connection with assembling a sufficient number of shares to constitute a Creation Unit. All redemptions are subject to the procedures contained in the applicable Participant
Agreement.
The Fund is responsible for making available, through the NSCC, at or before 9:00 a.m. Eastern time on each Business Day, the identity of
the Funds Redemption Securities and/or an amount of cash that will be applicable to redemption requests received in proper form (as described below) on that day. The Redemption Securities will be identical to the Deposit Securities.
Redemptions of Creation Units may be made in whole or in part on a cash basis, rather than in kind, solely under the following circumstances: (a) to
the extent there is a Cash Component; (b) if, on a given Business Day, the Fund announces before the open of trading that all purchases, all redemptions or all purchases and redemptions on that day will be made entirely in cash; (c) if,
upon receiving a redemption order from an Authorized Participant, the Fund determines to require the redemption to be made entirely in cash; (d) if, on a given Business Day, the Fund requires all Authorized Participants redeeming shares on that
day to receive cash in lieu of some or all of the Redemption Securities, solely because: (i) such instruments are not eligible for transfer either through the NSCC or DTC; or (ii) in the case of the Fund holding non-U.S. investments, such
instruments are not eligible for trading due to local trading restrictions, local restrictions on securities transfers or other similar circumstances; or (e) if the Fund permits an Authorized Participant to receive cash in lieu of some or all
of the Redemption Securities solely because: (i) such instruments are not eligible for trading by an Authorized Participant or the investor on whose behalf the Authorized Participant is acting; or (ii) a holder of shares of the Fund
holding non-U.S. investments would be subject to unfavorable income tax treatment if the holder receives redemption proceeds in kind.
An Authorized
Participant, or a beneficial owner of shares for which it is acting, subject to a legal restriction with respect to a particular security included in the redemption of a Creation Unit may be paid an equivalent amount of cash. This would specifically
prohibit delivery of Redemption Securities that are not registered in reliance upon Rule 144A under the 1933 Act to a redeeming beneficial owner of shares that is not a qualified institutional buyer, as such term is defined under Rule
144A of the 1933 Act. The Authorized Participant may request the redeeming beneficial owner of the shares to complete an order form or to enter into agreements with respect to such matters as compensating cash payment.
The right of redemption may be suspended or the date of payment postponed with respect to the Fund: (i) for any period during which the Exchange is
closed (other than customary weekend and holiday closings); (ii) for any period during which trading on the Exchange is suspended or restricted; (iii) for any period during which an emergency exists as a result of which disposal of
61
the shares of the Fund or determination of the Funds NAV is not reasonably practicable; or (iv) in such other circumstances as permitted by the SEC.
Redemption Transaction Fee
The
Fund imposes a redemption transaction fee as listed in the table below on each redemption transaction regardless of the number of Creation Units being redeemed in the transaction.
|
Redemption Transaction
Fee
($)
|
100.00
|
An additional variable charge of up to 2.0% of the value of a Creation Unit for cash redemptions or partial cash
redemptions (when cash redemptions are permitted or required for the Fund) may also be imposed to compensate the Fund for the costs associated with selling the applicable securities.
In order to seek to replicate the in-kind redemption order process, the Fund expects to sell, in the secondary market, the portfolio securities or settle
any financial instruments that may not be permitted to be re-registered in the name of the Authorized Participant as a result of an in-kind redemption order pursuant to local law or market convention, or for other reasons (Market Sales).
In such cases where the Fund makes Market Sales, the Authorized Participant will reimburse the Fund for, among other things, any difference between the market value at which the securities and/or financial instruments were sold or settled by the
Fund and the cash in lieu amount (which amount, at the Managers discretion, may be capped), applicable registration fees, brokerage commissions and certain taxes (Transaction Costs). The Manager may adjust the transaction fee to
the extent the composition of the Redemption Securities changes or cash in lieu is added to the Cash Component to protect ongoing shareholders. In no event will fees charged by the Fund in connection with a redemption exceed 2% of the value of each
Creation Unit. Investors who use the services of a broker or other such intermediary may be charged a fee for such services. To the extent the Fund cannot recoup the amount of Transaction Costs incurred in connection with a redemption from the
redeeming shareholder because of the 2% cap or otherwise, those Transaction Costs will be borne by the Funds remaining shareholders and negatively affect the Funds performance.
Placement of Redemption Orders Outside the Clearing Process
Redemption orders for Creation Units must be received by the Distributor no later than the Closing Time on the Transmittal Date to receive the NAV next
determined after receipt of the order in proper form on the Transmittal Date.
Arrangements satisfactory to the Fund must be in place for the
Authorized Participant to transfer the Creation Units through DTC on or before the contractual settlement date. Redemptions of shares for Redemption Securities will be subject to compliance with applicable U.S. federal and state securities laws and
the Fund (whether or not it otherwise permits or requires cash redemptions) reserves the right to redeem Creation Units for cash to the extent that the Fund could not lawfully deliver specific Redemption Securities upon redemptions or could not do
so without first registering the Deposit Securities under such laws.
In connection with taking delivery of shares for Redemption Securities upon
redemption of Creation Units, a redeeming shareholder or entity acting on behalf of a redeeming shareholder must maintain appropriate custody arrangements with a qualified broker-dealer, bank or other custody providers in each jurisdiction in which
any of the Redemption Securities are customarily traded, to which account such Redemption Securities will be delivered. If neither the redeeming shareholder nor the entity acting on behalf of a redeeming shareholder has appropriate arrangements to
take delivery of the Redemption Securities in the applicable foreign jurisdiction and it is not possible to make other such arrangements, or if it is not possible to effect deliveries of the Redemption Securities in such jurisdictions, the Fund may,
in its discretion, exercise its option to redeem such shares in cash, and the redeeming shareholder will be required to receive its redemption proceeds in cash.
Regular Foreign Holidays
The
Fund may effect deliveries of Creation Units and portfolio securities on a basis other than the contractually settled date in order to accommodate local holiday schedules, to account for different treatment among foreign and U.S. markets of dividend
record dates and ex-dividend dates or under certain other circumstances. The ability of the Trust to effect in-kind
62
creations and redemptions by the contractually settled date is subject, among other things, to the condition that, within the time period from the date of the order to the date of delivery of the
securities, there are no days that are holidays in the applicable foreign market. For every occurrence of one or more intervening holidays in the applicable foreign market that are not holidays observed in the U.S. equity market, the redemption
settlement cycle may be extended by the number of such intervening holidays. In addition to holidays, other unforeseeable closings in a foreign market due to emergencies may also prevent the Trust from delivering securities within normal settlement
periods. The securities delivery cycles currently practicable for transferring portfolio securities to redeeming Authorized Participants, coupled with foreign market holiday schedules, will require a delivery process longer than seven calendar days
for the Fund, in certain circumstances. The holidays applicable to the Fund during such periods are listed below, as are instances where more than seven days will be needed to deliver redemption proceeds. Although certain holidays may occur on
different dates in subsequent years, the number of days required to deliver redemption proceeds in any given year is not expected to exceed the maximum number of days listed below for the funds. The proclamation of new holidays, the treatment by
market participants of certain days as informal holidays (e.g., days on which no or limited securities transactions occur, as a result of substantially shortened trading hours), the elimination of existing holidays, or changes in local
securities delivery practices, could affect the information set forth herein at some time in the future. Because the portfolio securities of the Fund may trade on days that the Exchange is closed or on days that are not Business Days for the funds,
Authorized Participants may not be able to redeem their shares of the Fund, or to purchase and sell shares of the funds on the Exchange, on days when the net asset values of the funds could be significantly affected by events in the relevant
non-U.S. markets.
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MARKET HOLIDAYS CALENDAR YEAR - 2020
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Argentina
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|
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January 01
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April 02
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June 15
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November 23
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February 24
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April 09
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July 09
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December 07
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February 25
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April 10
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July 10
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December 08
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March 23
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May 01
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August 17
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December 25
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March 24
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May 25
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October 12
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Australia
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|
|
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January 01
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April 13
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August 03
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December 24
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January 27
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April 14
|
|
August 12
|
|
December 25
|
March 02
|
|
April 27
|
|
September 28
|
|
December 28
|
March 09
|
|
May 04
|
|
October 02
|
|
December 31
|
April 10
|
|
June 01
|
|
October 05
|
|
|
April 12
|
|
June 08
|
|
November 03
|
|
|
|
|
|
|
|
|
|
Austria
|
|
|
|
|
|
|
January 01
|
|
May 21
|
|
October 26
|
|
|
January 06
|
|
June 01
|
|
December 08
|
|
|
April 13
|
|
June 11
|
|
December 25
|
|
|
May 01
|
|
September 24
|
|
|
|
|
|
|
|
|
|
|
|
63
|
|
|
|
|
|
|
Belgium
|
|
|
|
|
|
|
January 01
|
|
May 21
|
|
November 02
|
|
|
January 06
|
|
May 22
|
|
November 11
|
|
|
April 13
|
|
June 01
|
|
December 25
|
|
|
May 01
|
|
July 21
|
|
|
|
|
|
|
|
|
|
|
|
Brazil
|
|
|
|
|
|
|
January 01
|
|
April 21
|
|
September 07
|
|
November 20
|
February 24
|
|
May 01
|
|
October 12
|
|
December 25
|
February 25
|
|
June 11
|
|
October 30
|
|
|
April 10
|
|
July 09
|
|
November 02
|
|
|
|
|
|
|
|
|
|
Canada
|
|
|
|
|
|
|
January 01
|
|
April 20
|
|
July 09
|
|
October 12
|
February 17
|
|
May 18
|
|
July 13
|
|
November 11
|
March 16
|
|
June 22
|
|
August 03
|
|
December 25
|
April 10
|
|
June 24
|
|
August 17
|
|
December 28
|
April 13
|
|
July 01
|
|
September 07
|
|
|
|
|
|
|
|
|
|
Chile
|
|
|
|
|
|
|
January 01
|
|
June 29
|
|
November 02
|
|
|
April 10
|
|
July 16
|
|
December 08
|
|
|
May 01
|
|
September 18
|
|
December 25
|
|
|
May 21
|
|
October 12
|
|
|
|
|
|
|
|
|
|
|
|
China
|
|
|
|
|
|
|
January 01
|
|
January 30
|
|
June 25
|
|
October 06
|
January 24
|
|
April 06
|
|
June 26
|
|
October 07
|
January 27
|
|
May 01
|
|
October 01
|
|
October 08
|
January 28
|
|
May 04
|
|
October 02
|
|
|
January 29
|
|
May 05
|
|
October 05
|
|
|
|
|
|
|
|
|
|
Colombia
|
|
|
|
|
|
|
January 01
|
|
May 01
|
|
July 20
|
|
November 16
|
64
|
|
|
|
|
|
|
January 06
|
|
May 25
|
|
August 07
|
|
December 08
|
March 23
|
|
June 15
|
|
August 17
|
|
December 25
|
April 09
|
|
June 22
|
|
October 12
|
|
|
April 10
|
|
June 29
|
|
November 02
|
|
|
|
|
|
|
|
|
|
Czech Republic
|
|
|
|
|
|
|
January 01
|
|
May 08
|
|
October 28
|
|
|
April 10
|
|
July 06
|
|
November 17
|
|
|
April 13
|
|
August 21
|
|
December 24
|
|
|
May 01
|
|
September 28
|
|
December 25
|
|
|
|
|
|
|
|
|
|
Denmark
|
|
|
|
|
|
|
January 01
|
|
May 01
|
|
June 01
|
|
December 31
|
April 09
|
|
May 08
|
|
June 05
|
|
|
April 10
|
|
May 21
|
|
December 24
|
|
|
April 13
|
|
May 22
|
|
December 25
|
|
|
|
|
|
|
|
|
|
Egypt
|
|
|
|
|
|
|
January 01
|
|
April 25
|
|
May 27
|
|
August 03
|
January 07
|
|
May 24
|
|
June 30
|
|
August 20
|
April 19
|
|
May 25
|
|
July 23
|
|
October 06
|
April 20
|
|
May 26
|
|
August 02
|
|
October 29
|
|
|
|
|
|
|
|
|
|
The Egyptian Market is closed on Fridays
|
|
|
|
|
|
|
|
|
|
Finland
|
|
|
|
|
|
|
January 01
|
|
May 01
|
|
December 25
|
|
|
January 06
|
|
May 21
|
|
|
|
|
April 10
|
|
June 19
|
|
|
|
|
April 13
|
|
December 24
|
|
|
|
|
|
|
|
|
|
|
|
France
|
|
|
|
|
|
|
January 01
|
|
May 08
|
|
June 21
|
|
|
April 10
|
|
May 21
|
|
July 14
|
|
|
65
|
|
|
|
|
|
|
April 13
|
|
June 01
|
|
November 11
|
|
|
May 01
|
|
June 07
|
|
December 25
|
|
|
|
|
|
|
|
|
|
Germany
|
|
|
|
|
|
|
January 01
|
|
April 13
|
|
June 01
|
|
|
January 06
|
|
May 01
|
|
June 11
|
|
|
February 24
|
|
May 08
|
|
November 18
|
|
|
April 10
|
|
May 21
|
|
December 25
|
|
|
|
|
|
|
|
|
|
Greece
|
|
|
|
|
|
|
January 01
|
|
April 17
|
|
October 28
|
|
|
January 06
|
|
April 20
|
|
December 25
|
|
|
March 02
|
|
May 01
|
|
|
|
|
March 25
|
|
June 08
|
|
|
|
|
|
|
|
|
|
|
|
Hong Kong
|
|
|
|
|
|
|
January 01
|
|
April 30
|
|
October 01
|
|
|
January 27
|
|
May 01
|
|
October 02
|
|
|
April 10
|
|
June 25
|
|
December 25
|
|
|
April 13
|
|
July 01
|
|
December 28
|
|
|
|
|
|
|
|
|
|
Hungary
|
|
|
|
|
|
|
January 01
|
|
June 01
|
|
December 25
|
|
|
April 10
|
|
August 20
|
|
|
|
|
April 13
|
|
August 21
|
|
|
|
|
May 01
|
|
October 23
|
|
|
|
|
|
|
|
|
|
|
|
Indonesia
|
|
|
|
|
|
|
January 01
|
|
May 21
|
|
June 01
|
|
December 24
|
March 25
|
|
May 22
|
|
July 31
|
|
December 25
|
April 10
|
|
May 25
|
|
August 17
|
|
|
May 01
|
|
May 26
|
|
August 20
|
|
|
May 07
|
|
May 27
|
|
October 29
|
|
|
|
|
|
|
|
|
|
66
|
|
|
|
|
|
|
Ireland
|
|
|
|
|
|
|
January 01
|
|
May 04
|
|
December 25
|
|
|
March 17
|
|
June 01
|
|
December 28
|
|
|
April 10
|
|
August 03
|
|
December 29
|
|
|
April 13
|
|
October 26
|
|
|
|
|
|
|
|
|
|
|
|
Israel
|
|
|
|
|
|
|
March 02
|
|
April 15
|
|
September 20
|
|
|
March 10
|
|
April 28
|
|
September 28
|
|
|
March 11
|
|
April 29
|
|
|
|
|
April 09
|
|
July 30
|
|
|
|
|
|
|
|
|
|
|
|
|
|
The Israeli Market is closed on Fridays
|
|
|
|
|
|
|
|
Italy
|
|
|
|
|
|
|
January 01
|
|
April 28
|
|
June 29
|
|
December 08
|
January 06
|
|
May 01
|
|
July 15
|
|
December 25
|
March 19
|
|
June 02
|
|
November 02
|
|
|
April 13
|
|
June 24
|
|
December 07
|
|
|
|
|
|
|
|
|
|
Japan
|
|
|
|
|
|
|
January 01
|
|
April 29
|
|
July 24
|
|
September 22
|
January 13
|
|
May 04
|
|
August 10
|
|
November 03
|
February 11
|
|
May 05
|
|
August 13
|
|
November 23
|
February 24
|
|
May 06
|
|
August 14
|
|
|
March 20
|
|
July 23
|
|
September 21
|
|
|
|
|
|
|
|
|
|
Malaysia
|
|
|
|
|
|
|
January 01
|
|
May 01
|
|
July 22
|
|
October 29
|
January 14
|
|
May 07
|
|
July 30
|
|
November 06
|
January 27
|
|
May 25
|
|
July 31
|
|
November 11
|
March 04
|
|
May 26
|
|
August 20
|
|
November 12
|
March 23
|
|
June 01
|
|
August 31
|
|
December 11
|
April 10
|
|
June 02
|
|
September 16
|
|
December 24
|
67
|
|
|
|
|
|
|
April 15
|
|
July 07
|
|
September 24
|
|
December 25
|
April 24
|
|
July 17
|
|
October 09
|
|
|
|
|
|
|
|
|
|
Mexico
|
|
|
|
|
|
|
January 01
|
|
April 10
|
|
October 12
|
|
|
February 03
|
|
May 01
|
|
November 02
|
|
|
March 16
|
|
May 05
|
|
November 16
|
|
|
April 09
|
|
September 16
|
|
December 25
|
|
|
|
|
|
|
|
|
|
Netherlands
|
|
|
|
|
|
|
January 01
|
|
May 04
|
|
December 25
|
|
|
April 10
|
|
May 05
|
|
|
|
|
April 13
|
|
May 21
|
|
|
|
|
April 27
|
|
June 01
|
|
|
|
|
|
|
|
|
|
|
|
New Zealand
|
|
|
|
|
|
|
January 01
|
|
February 06
|
|
April 14
|
|
October 26
|
January 02
|
|
March 09
|
|
April 27
|
|
November 13
|
January 20
|
|
March 23
|
|
June 01
|
|
November 30
|
January 27
|
|
April 10
|
|
September 28
|
|
December 25
|
February 03
|
|
April 13
|
|
October 23
|
|
|
|
|
|
|
|
|
|
Norway
|
|
|
|
|
|
|
January 01
|
|
May 01
|
|
December 25
|
|
|
April 09
|
|
May 21
|
|
|
|
|
April 10
|
|
June 01
|
|
|
|
|
April 13
|
|
December 24
|
|
|
|
|
|
|
|
|
|
|
|
Peru
|
|
|
|
|
|
|
January 01
|
|
June 24
|
|
July 29
|
|
December 25
|
April 09
|
|
June 29
|
|
October 08
|
|
December 31
|
April 10
|
|
July 27
|
|
October 09
|
|
|
May 01
|
|
July 28
|
|
December 08
|
|
|
|
|
|
|
|
|
|
68
|
|
|
|
|
|
|
Philippines
|
|
|
|
|
|
|
January 01
|
|
May 01
|
|
August 31
|
|
December 25
|
February 25
|
|
June 12
|
|
November 02
|
|
December 30
|
March 16
|
|
June 24
|
|
November 30
|
|
December 31
|
April 09
|
|
July 31
|
|
December 08
|
|
|
April 10
|
|
August 21
|
|
December 24
|
|
|
|
|
|
|
|
|
|
Poland
|
|
|
|
|
|
|
January 01
|
|
May 26
|
|
December 25
|
|
|
January 06
|
|
June 11
|
|
|
|
|
April 13
|
|
June 23
|
|
|
|
|
May 01
|
|
November 11
|
|
|
|
|
|
|
|
|
|
|
|
Portugal
|
|
|
|
|
|
|
January 01
|
|
May 01
|
|
October 05
|
|
|
February 25
|
|
June 10
|
|
December 01
|
|
|
March 19
|
|
June 11
|
|
December 08
|
|
|
April 10
|
|
June 24
|
|
December 25
|
|
|
|
|
|
|
|
|
|
Qatar
|
|
|
|
|
|
|
February 11
|
|
May 26
|
|
August 02
|
|
|
March 01
|
|
May 27
|
|
August 03
|
|
|
March 24
|
|
May 28
|
|
August 04
|
|
|
March 25
|
|
July 30
|
|
|
|
|
|
|
|
|
|
|
|
|
|
The Qatar Market is closed on Fridays
|
|
|
|
|
|
|
|
Russia
|
|
|
|
|
|
|
January 01
|
|
January 07
|
|
May 01
|
|
June 12
|
January 02
|
|
January 08
|
|
May 04
|
|
November 04
|
January 03
|
|
February 24
|
|
May 05
|
|
|
January 06
|
|
March 09
|
|
May 11
|
|
|
|
|
|
|
|
|
|
Singapore
|
|
|
|
|
|
|
69
|
|
|
|
|
|
|
January 01
|
|
May 07
|
|
December 25
|
|
|
January 27
|
|
May 25
|
|
|
|
|
April 10
|
|
July 31
|
|
|
|
|
May 01
|
|
August 10
|
|
|
|
|
|
|
|
|
|
|
|
South Africa
|
|
|
|
|
|
|
January 01
|
|
May 01
|
|
December 16
|
|
|
April 10
|
|
June 16
|
|
December 25
|
|
|
April 13
|
|
August 10
|
|
December 28
|
|
|
April 27
|
|
September 24
|
|
|
|
|
|
|
|
|
|
|
|
South Korea
|
|
|
|
|
|
|
January 01
|
|
May 01
|
|
October 01
|
|
|
January 24
|
|
May 05
|
|
October 02
|
|
|
April 15
|
|
July 17
|
|
October 09
|
|
|
April 30
|
|
September 30
|
|
December 25
|
|
|
|
|
|
|
|
|
|
Sweden
|
|
|
|
|
|
|
January 01
|
|
April 30
|
|
June 19
|
|
|
January 06
|
|
May 01
|
|
December 24
|
|
|
April 10
|
|
May 21
|
|
December 25
|
|
|
April 13
|
|
May 22
|
|
December 31
|
|
|
|
|
|
|
|
|
|
Switzerland
|
|
|
|
|
|
|
January 01
|
|
April 13
|
|
June 23
|
|
December 08
|
January 02
|
|
April 20
|
|
June 29
|
|
December 25
|
January 06
|
|
May 01
|
|
September 10
|
|
December 31
|
March 19
|
|
May 21
|
|
September 14
|
|
|
April 02
|
|
June 01
|
|
September 21
|
|
|
April 10
|
|
June 11
|
|
September 25
|
|
|
|
|
|
|
|
|
|
Taiwan
|
|
|
|
|
|
|
January 01
|
|
January 28
|
|
April 03
|
|
October 01
|
January 23
|
|
January 29
|
|
May 01
|
|
October 02
|
70
|
|
|
|
|
|
|
January 24
|
|
February 28
|
|
June 25
|
|
October 09
|
January 27
|
|
April 02
|
|
June 26
|
|
|
|
|
|
|
|
|
|
Thailand
|
|
|
|
|
|
|
January 01
|
|
April 15
|
|
June 03
|
|
October 13
|
February 10
|
|
May 01
|
|
July 06
|
|
October 23
|
April 06
|
|
May 04
|
|
July 07
|
|
December 07
|
April 13
|
|
May 06
|
|
July 28
|
|
December 10
|
April 14
|
|
May 21
|
|
August 12
|
|
December 31
|
|
|
|
|
|
|
|
Turkey
|
|
|
|
|
|
|
January 01
|
|
May 25
|
|
July 31
|
|
|
April 23
|
|
May 26
|
|
August 03
|
|
|
May 01
|
|
May 27
|
|
October 29
|
|
|
May 19
|
|
July 15
|
|
|
|
|
|
|
|
|
|
|
|
United Arab Emirates
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January 01
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May 26
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October 29
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March 22
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July 30
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December 01
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May 24
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August 02
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December 02
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May 25
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August 23
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December 03
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The UAE Market is closed on Fridays
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United Kingdom
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January 01
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April 13
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July 13
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November 30
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January 02
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April 23
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August 03
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December 25
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March 17
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May 08
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August 31
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December 28
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April 10
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May 25
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November 05
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MARKET HOLIDAYS CALENDAR YEAR - 2021
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Argentina
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January 01
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April 01
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June 21
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November 22
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February 15
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April 02
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July 09
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December 08
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February 16
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May 25
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August 16
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71
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March 24
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June 17
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October 12
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Australia
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January 01
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April 06
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August 02
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December 24
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January 26
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April 26
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August 11
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December 27
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March 01
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May 03
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September 27
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December 28
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March 08
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May 31
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October 01
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December 31
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April 02
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June 07
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October 04
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April 05
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June 14
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November 02
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Austria
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January 01
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May 24
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November 01
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January 06
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June 03
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November 15
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April 05
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September 24
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December 08
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May 13
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October 26
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Belgium
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January 01
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May 14
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November 02
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January 06
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May 24
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November 11
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April 05
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July 21
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November 15
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May 13
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November 01
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December 06
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Brazil
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January 01
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April 21
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October 12
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February 15
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June 03
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October 29
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February 17
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July 09
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November 02
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April 02
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September 07
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November 15
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Canada
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January 01
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April 26
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July 09
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October 11
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February 15
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May 24
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July 12
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November 11
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March 15
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June 21
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August 02
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December 31
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April 02
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June 24
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August 16
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April 05
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July 01
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September 06
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Chile
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January 01
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July 16
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December 08
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April 02
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October 12
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May 21
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October 31
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July 05
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November 01
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72
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China
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January 01
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February 17
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September 21
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October 07
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February 11
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March 08
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October 01
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October 15
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February 12
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April 05
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October 04
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February 15
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May 03
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October 05
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February 16
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June 14
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October 06
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Colombia
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January 01
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April 02
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June 29
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November 01
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January 11
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May 13
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July 20
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November 15
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March 22
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June 03
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August 16
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December 08
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April 01
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June 14
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October 12
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Czech Republic
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January 01
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July 06
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December 24
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April 02
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September 28
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April 05
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October 28
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July 05
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November 17
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Denmark
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January 01
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April 30
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December 24
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April 01
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May 13
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December 31
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April 02
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May 14
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April 05
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May 24
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Egypt
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January 07
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May 02
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July 20
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October 06
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January 25
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May 03
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July 21
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October 19
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April 25
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May 13
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July 22
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June 30
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August 10
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The Egyptian Market is closed on Fridays
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Finland
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January 01
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May 13
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January 06
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June 25
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April 02
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December 06
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April 05
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December 24
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France
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January 01
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May 24
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73
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April 02
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July 14
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April 05
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November 01
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May 13
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Germany
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January 01
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April 02
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June 03
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November 17
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January 06
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April 05
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September 20
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March 04
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May 13
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October 31
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March 08
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May 24
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November 01
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Greece
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January 01
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April 30
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January 06
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May 03
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March 15
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May 24
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March 25
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October 28
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Hong Kong
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January 01
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April 05
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September 21
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February 12
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May 19
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October 01
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February 15
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June 14
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October 15
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April 02
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July 01
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December 27
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Hungary
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January 01
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May 24
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December 27
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March 15
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August 20
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April 02
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November 01
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April 05
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December 24
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Indonesia
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January 01
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May 13
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July 20
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February 12
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May 14
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August 10
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March 11
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May 26
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August 17
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April 02
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June 01
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October 19
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Ireland
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January 01
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May 03
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December 29
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March 17
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June 07
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April 02
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August 02
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April 05
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October 25
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Israel
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March 28
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July 18
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September 29
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74
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May 09
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September 07
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November 29
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May 10
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September 08
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May 17
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September 21
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The Israeli Market is closed on Fridays
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Italy
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January 01
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April 28
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July 15
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December 06
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January 06
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June 02
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October 04
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December 07
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March 19
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June 24
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November 01
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December 08
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April 05
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June 29
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November 02
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Japan
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January 01
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April 29
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July 19
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September 22
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January 11
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May 03
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August 11
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October 11
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February 11
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May 04
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August 13
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November 03
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February 23
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May 05
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September 20
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November 23
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Malaysia
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January 01
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April 13
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June 01
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September 14
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January 14
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April 15
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June 02
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September 16
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January 28
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April 26
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July 07
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October 11
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February 01
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April 30
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July 20
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October 19
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February 12
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May 07
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July 21
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November 04
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March 04
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May 13
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July 22
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November 05
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March 11
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May 14
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July 30
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November 11
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March 23
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May 26
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August 10
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November 12
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April 02
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May 31
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August 31
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December 24
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Mexico
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January 01
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April 02
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October 12
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February 03
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May 05
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November 02
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March 15
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May 10
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November 16
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April 01
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September 16
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Netherlands
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January 01
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April 27
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May 24
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April 02
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May 04
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April 05
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May 05
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May 13
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New Zealand
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75
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January 01
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March 08
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April 26
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November 01
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January 04
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March 22
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June 01
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November 12
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January 25
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April 02
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September 27
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November 29
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February 01
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April 05
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October 22
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December 27
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February 08
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April 06
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October 25
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December 28
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Norway
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January 01
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May 01
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November 14
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April 01
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May 13
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December 24
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April 02
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May 17
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April 05
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May 24
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Peru
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January 01
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June 29
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October 08
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April 01
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July 28
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November 01
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April 02
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July 29
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December 08
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June 24
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August 30
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Philippines
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January 01
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April 02
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August 30
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December 30
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February 12
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April 09
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November 01
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December 31
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February 25
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May 13
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November 30
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March 16
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June 24
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December 08
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April 01
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July 20
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December 24
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Poland
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January 01
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May 26
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November 11
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January 06
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June 03
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April 05
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June 23
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May 03
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November 01
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Portugal
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January 01
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May 10
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November 01
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February 16
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June 03
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December 01
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March 19
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June 10
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December 08
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April 02
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June 24
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Qatar
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February 09
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May 13
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March 07
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July 20
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May 11
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July 21
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May 12
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July 22
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76
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The Qatar Market is closed on Fridays
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Russia
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January 01
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January 07
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November 04
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January 04
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February 23
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January 05
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March 08
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January 06
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May 03
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Singapore
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January 01
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May 26
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February 12
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July 20
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April 02
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August 09
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May 13
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November 04
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South Africa
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January 01
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April 27
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December 16
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March 22
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June 16
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December 27
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April 02
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August 09
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April 05
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September 24
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South Korea
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January 01
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May 05
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September 22
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February 11
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May 19
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February 12
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September 20
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March 01
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September 21
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Sweden
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January 01
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April 30
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December 24
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January 06
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May 13
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December 31
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April 02
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May 14
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April 05
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June 25
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Switzerland
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January 01
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April 02
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June 03
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September 20
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January 06
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April 05
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June 23
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November 01
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March 01
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April 19
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June 29
|
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December 08
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March 19
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May 13
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September 09
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December 31
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April 01
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May 24
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September 13
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Taiwan
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January 01
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March 01
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October 11
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77
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February 11
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|
April 05
|
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October 15
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February 12
|
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June 14
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February 15
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September 21
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|
|
|
Thailand
|
|
|
|
|
|
|
January 01
|
|
April 14
|
|
July 28
|
|
December 06
|
February 12
|
|
April 15
|
|
August 12
|
|
December 08
|
April 06
|
|
May 26
|
|
October 13
|
|
December 10
|
April 13
|
|
June 09
|
|
October 25
|
|
December 31
|
|
|
|
|
|
|
|
Turkey
|
|
|
|
|
|
|
January 01
|
|
May 14
|
|
July 21
|
|
October 28
|
April 23
|
|
May 19
|
|
July 22
|
|
|
May 12
|
|
July 15
|
|
July 23
|
|
|
May 13
|
|
July 20
|
|
August 30
|
|
|
|
|
|
|
|
|
|
United Arab Emirates
|
|
|
|
|
|
|
January 01
|
|
May 13
|
|
August 10
|
|
|
March 11
|
|
July 19
|
|
October 19
|
|
|
May 11
|
|
July 20
|
|
November 30
|
|
|
May 12
|
|
July 21
|
|
December 02
|
|
|
|
|
|
|
|
|
|
|
|
The UAE Market is closed on Fridays
|
|
|
|
|
|
|
|
|
|
United Kingdom
|
|
|
|
|
|
|
January 01
|
|
April 05
|
|
August 02
|
|
December 28
|
January 04
|
|
April 23
|
|
August 30
|
|
December 29
|
March 01
|
|
May 03
|
|
November 05
|
|
|
March 17
|
|
May 31
|
|
November 30
|
|
|
April 02
|
|
July 12
|
|
December 27
|
|
|
Redemptions. The longest redemption cycle for the Fund is a function of the longest redemption cycle among the
countries whose securities comprise the Fund. In the calendar years 2020 and 2021, the dates of regular holidays affecting the following securities markets present the worst case (longest) redemption cycle* for the Fund as follows:
SETTLEMENT PERIODS GREATER THAN SEVEN DAYS FOR YEAR 2020
78
|
|
|
|
|
|
|
Country
|
|
Beginning of Settlement Period
|
|
End of Settlement Period
|
|
Number of
Days in
Settlement
Period
|
China
|
|
1/24/20
|
|
1/30/20
|
|
7
|
China
|
|
10/1/20
|
|
10/8/20
|
|
8
|
Taiwan
|
|
1/23/20
|
|
1/29/20
|
|
7
|
SETTLEMENT PERIODS GREATER THAN SEVEN DAYS FOR YEAR 2021
|
|
|
|
|
|
|
Country
|
|
Beginning of Settlement Period
|
|
End of Settlement Period
|
|
Number of
Days in
Settlement
Period
|
China
|
|
2/11/21
|
|
2/17/21
|
|
7
|
China
|
|
10/1/21
|
|
10/7/21
|
|
7
|
DETERMINATION OF NET ASSET VALUE
The net asset value per share of the Fund is calculated on each day, Monday through Friday, except days on which the NYSE is closed. As of the date of
this SAI, the NYSE is normally open for trading every weekday except in the event of an emergency or for the following holidays (or the days on which they are observed): New Years Day, Martin Luther King, Jr. Day, Presidents Day, Good
Friday, Memorial Day, Independence Day, Labor Day, Thanksgiving Day and Christmas Day. Please see the Prospectus for a description of the procedures used by the Fund in valuing its assets.
PORTFOLIO TRANSACTIONS AND BROKERAGE
Portfolio Transactions
Pursuant
to the Subadvisory Agreement and subject to the general supervision of the Board and in accordance with the Funds investment objectives and strategies, the Subadviser is responsible for the execution of the Funds portfolio transactions
with respect to assets allocated to the Subadviser. The Subadviser is authorized to place orders pursuant to its investment determinations for the Fund either directly with the issuer or with any broker or dealer, foreign currency dealer, futures
commission merchant or others selected by it.
In certain instances, there may be securities that are suitable as an investment for the Fund as well
as for one or more of the other clients of the Subadviser. Investment decisions for the Fund and for the Subadvisers other clients are made with a view to achieving their respective investment objectives. It may develop that a particular
security is bought or sold for only one client even though it might be held by, or bought or sold for, other clients. Likewise, a particular security may be bought for one or more clients when one or more clients are selling the same security. Some
simultaneous transactions are inevitable when several clients receive investment advice from the same investment adviser, particularly when the same security is suitable for the investment objectives of more than one client. When two or more clients
are simultaneously engaged in the purchase or sale of the same security, the securities are allocated among clients in a manner believed to be equitable to each. It is recognized that in some cases this system could adversely affect the price of or
the size of the position obtainable in a security for the Fund. When purchases or sales of the same security for the Fund and for other portfolios managed by the Subadviser occur contemporaneously, the purchase or sale orders may be aggregated in
order to obtain any price advantages available to large volume purchases or sales.
79
Transactions on stock exchanges and other agency transactions involve the payment of negotiated brokerage
commissions by the Fund. Transactions in foreign securities often involve the payment of brokerage commissions that may be higher than those in the United States. Fixed income securities are generally traded on a net basis (i.e., without a
commission) through dealers acting as principal for their own account and not as brokers. This means that a dealer makes a market for securities by offering to buy at one price and selling the security at a slightly higher price. The difference
between the prices is known as a spread. Other portfolio transactions may be executed through brokers acting as agents and the Fund will pay a spread or commission in connection with such transactions. The cost of securities purchased
from underwriters includes an underwriting commission, concession or a net price. The Fund may also purchase securities directly from the issuer. The aggregate brokerage commissions paid by the Fund for the three most recent fiscal years or periods,
as applicable, are set forth below under Aggregate Brokerage Commissions Paid.
Brokerage and Research Services
The general policy of the Subadviser in selecting brokers and dealers is to obtain the best results achievable in the context of a number of factors
which are considered both in relation to individual trades and broader trading patterns. The Fund may not always pay the lowest commission or spread available. Rather, in placing orders on behalf of the Fund, the Subadviser also takes into account
other factors bearing on the overall quality of execution, such as size of the order, difficulty of execution, the reliability of the broker/dealer, the competitiveness of the price and the commission, the research services received and whether the
broker/dealer commits its own capital.
In connection with the selection of such brokers or dealers and the placing of such orders, subject to
applicable law, brokers or dealers may be selected who also provide brokerage and research services (as those terms are defined in Section 28(e) of the 1934 Act) to the Fund and/or the other accounts over which the Subadviser or its affiliates
exercise investment discretion. The Subadviser is authorized to pay a broker or dealer that provides such brokerage and research services a commission for executing a portfolio transaction for the Fund which is in excess of the amount of commission
another broker or dealer would have charged for effecting that transaction if the Subadviser determines in good faith that such amount of commission is reasonable in relation to the value of the brokerage and research services provided by such
broker or dealer. Investment research services include information and analysis on particular companies and industries as well as market or economic trends and portfolio strategy, market quotations for portfolio evaluations, analytical software and
similar products and services. If a research service also assists the Subadviser in a non-research capacity (such as bookkeeping or other administrative functions), then only the percentage or component that provides assistance to the Subadviser in
the investment decision making process may be paid in commission dollars. This determination may be viewed in terms of either that particular transaction or the overall responsibilities that the Subadviser and its affiliates have with respect to
accounts over which they exercise investment discretion. The Subadviser may also have arrangements with brokers pursuant to which such brokers provide research services to the Subadviser in exchange for a certain volume of brokerage transactions to
be executed by such brokers. While the payment of higher commissions increases the Funds costs, the Subadviser does not believe that the receipt of such brokerage and research services significantly reduces its expenses as Subadviser.
Arrangements for the receipt of research services from brokers (so-called soft dollar arrangements) may create conflicts of interest. Although the Subadviser is authorized to use soft dollar arrangements in order to obtain research
services, it is not required to do so, and the Subadviser may not be able or may choose not to use soft dollar arrangements because of regulatory restrictions, operational considerations or for other reasons.
Research services furnished to the Subadviser by brokers that effect securities transactions for the Fund may be used by the Subadviser in servicing
other investment companies and accounts which the Subadviser manages. Similarly, research services furnished to the Subadviser by brokers that effect securities transactions for other investment companies and accounts which the Subadviser manages
may be used by the Subadviser in servicing the Fund. Not all of these research services are used by the Subadviser in managing any particular account, including the Fund.
Firms that provide research and brokerage services to the Subadviser may also promote the sale of the Fund or other pooled investment vehicles advised by
the Subadviser, and the Subadviser and/or its affiliates may separately compensate them for doing so. Such brokerage business is placed on the basis of brokerage and research services provided by the firm and is not based on any sales of the Fund or
other pooled investment vehicles advised by the Subadviser.
The Fund contemplates that, consistent with the policy of obtaining the best net
results, brokerage transactions may be conducted through affiliated broker/dealers, as defined in the 1940 Act. The Funds Board has adopted procedures in
80
accordance with Rule 17e-1 under the 1940 Act to ensure that all brokerage commissions paid to such affiliates are reasonable and fair in the context of the market in which such affiliates
operate. For the three most recent fiscal periods (as applicable), the Fund did not pay any brokerage commission to its affiliates.
Securities of Regular Broker/Dealers
As of December 31, 2019, the value of the Funds holdings of the securities of its regular broker/dealers (as defined in Rule 10b-1 under the
1940 Act) were as follows:
|
|
|
|
|
Broker/Dealer
|
|
Type of Security
Owned D=Debt
E=Equity
|
|
Market Value (000s)
($)
|
Bank of America Corp
|
|
D
|
|
1,388
|
Goldman Sachs & Co.
|
|
D
|
|
1,333
|
Wells Fargo & Co
|
|
D
|
|
1,063
|
Citigroup Inc
|
|
D
|
|
981
|
JPMorgan Chase & Co.
|
|
D
|
|
716
|
Morgan Stanley
|
|
D
|
|
475
|
Barclays Plc
|
|
D
|
|
223
|
Aggregate Brokerage Commissions Paid
The table below shows the aggregate brokerage commissions paid by the Fund during the periods indicated.
|
|
|
For the Fiscal Period Ended
December 31,
|
|
Aggregate Brokerage Commissions Paid ($)
|
2019
|
|
23,635
|
2018
|
|
3,885
|
2017
|
|
0
|
For the fiscal period ended December 31, 2019, the Fund did not direct any brokerage transactions related to research
services and did not pay any brokerage commissions related to research services.
Portfolio Turnover
For reporting purposes, the Funds portfolio turnover rate is calculated by dividing the lesser of purchases or sales of portfolio securities for
the fiscal year by the monthly average of the value of the portfolio securities owned by the Fund during the fiscal year. In determining such portfolio turnover, all securities whose maturities at the time of acquisition were one year or less are
excluded. A 100% portfolio turnover rate would occur, for example, if all of the securities in the Funds investment portfolio (other than short-term money market securities) were replaced once during the fiscal year.
In the event that portfolio turnover increases, this increase necessarily results in correspondingly greater transaction costs which must be paid by the
Fund. To the extent the portfolio trading results in recognition of net short-term capital gains, shareholders will be taxed on distributions of such gains at ordinary tax rates (except shareholders who invest through IRAs and other retirement plans
which are not taxed currently on accumulations in their accounts).
Portfolio turnover will not be a limiting factor should the Subadviser deem it
advisable to purchase or sell securities.
|
|
|
For the Fiscal Period Ended 2019 (%)
|
|
For the Fiscal Period Ended 2018
(%)
|
80
|
|
18
|
81
SHARE OWNERSHIP
Principal Shareholders
DTC
is the securities depository for the shares of the Trust, and shares of the Fund are registered in the name of DTC or its nominee. Although the Fund does not have information concerning the beneficial ownership of shares held in the names of DTC
participants, as of April 2, 2020, the name and percentage ownership of each DTC participant that owned of record 5% or more of the outstanding shares of the Fund were as follows:
|
|
|
|
|
Name and Address
|
|
|
|
Percent of Fund (%)
|
|
|
|
|
|
Reliance Trust Company fbo MassMutual
P.O. Box 28004
Atlanta, GA 30358
|
|
|
|
25.83
|
TD Ameritrade Clearing Inc.
Suzanne Brodd
200 S. 108th Ave.
Omaha, NE 68154
|
|
|
|
13.95
|
Charles Schwab & Co. Inc.
Christina Young
2423 E. Lincoln Drive
Phoenix. AZ 85016
|
|
|
|
13.95
|
JP Morgan Securities, LLC/JPMC
John Fay
500 Stanton Christiana Road, OPS 4
3rd Floor
Newark, DE 19713
|
|
|
|
12.56
|
As of April 2, 2020, the Trustees and officers of the Trust, as a group, owned less than 1% of the
outstanding shares of the Fund.
DISTRIBUTOR
Legg Mason Investor Services, LLC, a wholly-owned broker/dealer subsidiary of Legg Mason, located at 100 International Drive, Baltimore, Maryland 21202,
serves as the sole and exclusive distributor of the Fund pursuant to a written agreement (the Distribution Agreement).
Shares of the
Fund are continuously offered by the Distributor only in Creation Units, as described in the Funds Prospectus and above in the Creations and Redemptions section of this SAI. Fund shares in amounts less than Creation Units are
generally not distributed by the Distributor or its agent. The Distributor or its agent will arrange for the delivery of the Funds Prospectus and, upon request, this SAI to persons purchasing Creation Units and will maintain records of both
orders placed with it or its agents and confirmations of acceptance furnished by it or its agents. The Distributor is a broker-dealer registered under the 1934 Act, and a member of the FINRA. The Distributor is also licensed as a broker-dealer in
all fifty U.S. states as well as in Puerto Rico, the U.S. Virgin Islands and the District of Columbia.
The Distribution Agreement is renewable from
year to year with respect to the Fund if approved (a) by the Board or by a vote of a majority of the Funds outstanding voting securities, and (b) by the affirmative vote of a majority of Trustees who are not parties to such agreement
or interested persons of any party by votes cast in person at a meeting called for such purpose.
The Distribution Agreement is terminable with
respect to the Fund without penalty by the Board or by vote of a majority of the outstanding voting securities of the Fund, or by the Distributor, on not less than 60 days written notice to the other party (unless the notice period is waived
by mutual consent). The Distribution Agreement will automatically and immediately terminate in the event of its assignment.
82
Legg Mason or its affiliates may, from time to time and from their own resources, pay, defray or absorb
costs relating to distribution, including payments out of their own resources to the distributor, or to otherwise promote the sale of shares.
Legg
Mason and/or its affiliates pay certain broker-dealers, registered investment advisers, banks and other financial intermediaries (Intermediaries) for certain activities related to the Fund or exchange-traded products in general. Legg
Mason and/or its affiliates make these payments from their own assets and not from the assets of the Fund. Although a portion of Legg Masons revenue comes directly or indirectly in part from fees paid by the Fund, these payments do not
increase the price paid by investors for the purchase of shares of, or the cost of owning, the Fund. Legg Mason and/or its affiliates make payments for Intermediaries participation in activities that are designed to make registered
representatives, other professionals and individual investors more knowledgeable about exchange-traded products, including the Fund, or for other activities, such as participation in marketing activities and presentations, educational training
programs, conferences, the development of technology platforms and reporting systems (Education Costs). Legg Mason and/or its affiliates also make payments to Intermediaries for certain printing, publishing and mailing costs associated
with the Fund or materials relating to exchange-traded products in general (Publishing Costs). In addition, Legg Mason and/or its affiliates make payments to Intermediaries that make shares of the Fund available to their clients, develop
new products that feature the Fund or otherwise promote the Fund. Legg Mason and/or its affiliates may also reimburse expenses or make payments from their own assets to Intermediaries or other persons in consideration of services or other activities
that Legg Mason and/or its affiliates believe may benefit the exchange-traded products business or facilitate investment in the Fund.
Payments to an
Intermediary may be significant to the Intermediary, and amounts that Intermediaries pay to your salesperson or other investment professional may also be significant for your salesperson or other investment professional. Because an Intermediary may
make decisions about which investment options it will recommend or make available to its clients or what services to provide for various products based on payments it receives or is eligible to receive, such payments may create conflicts of interest
between the Intermediary and its clients and these financial incentives may cause the Intermediary to recommend the Fund over other investments. The same conflicts of interest and financial incentives exist with respect to your salesperson or other
investment professional if he or she receives similar payments from his or her Intermediary firm.
Legg Mason and/or its affiliates make
Education Costs and Publishing Costs payments to other Intermediaries based on any number of metrics. For example, Legg Mason and/or its affiliates may make payments at year-end or other intervals in a fixed amount, an amount based upon an
Intermediarys services at defined levels or an amount based on the Intermediarys net sales of one or more funds in a year or other period, any of which arrangements may include an agreed-upon minimum or maximum payment, or any
combination of the foregoing. Please contact your salesperson or other investment professional for more information regarding any such payments his or her Intermediary firm may receive. Any payments made by Legg Mason and/or its affiliates to an
Intermediary create an incentive for an Intermediary to encourage customers to buy shares of the Fund.
In addition, Legg Mason and/or its
affiliates at times enter into other contractual arrangements with Intermediaries that Legg Mason and/or its affiliates believe may benefit the ETF business or facilitate investment in Legg Mason-sponsored ETFs. Such agreements at times include
payments by Legg Mason and/or its affiliates to such Intermediaries for data collection and provision, technology support, platform enhancement, or co-marketing and cross-promotional efforts. Payments made pursuant to such arrangements can vary in
any year and can be different for different Intermediaries. In certain cases, the payments described in the preceding sentence may be subject to certain minimum payment levels. Such payments will not be asset- or revenue-based.
The Fund may participate in certain market maker incentive programs of a national securities exchange in which an affiliate of the Fund would pay a fee
to the exchange used for the purpose of incentivizing one or more market makers in the securities of the Fund to enhance the liquidity and quality of the secondary market of securities of the Fund. The fee would then be credited by the exchange to
one or more market makers that meet or exceed liquidity and market quality standards with respect to the securities of the Fund. Each market maker incentive program is subject to approval from the SEC. Any such fee payments made to an exchange will
be made by an affiliate of the Fund solely for the benefit of the Fund and will not be paid from any Fund assets. Other funds managed by Legg Mason participate in such programs.
83
Services and Distribution Plan
The Board has adopted a services and distribution plan (the 12b-1 Plan) pursuant to Rule 12b-1 under the 1940 Act. Under the 12b-1 Plan, the
Fund is authorized to pay distribution fees in connection with the sale and distribution of its shares and pay service fees in connection with the provision of ongoing services to shareholders and the maintenance of shareholder accounts in an amount
up to 0.25% of its average daily net assets each year.
No Rule 12b-1 fees are currently paid by the Fund, and there are no current plans to
impose these fees. However, in the event Rule 12b-1 fees are charged in the future, because these fees would be paid out of the Funds assets on an ongoing basis, these fees would increase the cost of your investment in the Fund. By purchasing
shares subject to distribution fees and service fees, you might pay more over time than you would by purchasing shares with other types of sales charge arrangements. Long-term shareholders may pay more than the economic equivalent of the maximum
front-end sales charge permitted by the rules of FINRA. The net income attributable to shares will be reduced by the amount of distribution fees and service fees and other expenses of the Fund.
PROXY VOTING GUIDELINES AND PROCEDURES
The Manager delegates to the Subadviser the responsibility for voting proxies for the Fund through its contracts with the Subadviser. The Subadviser may
use its own proxy voting policies and procedures to vote proxies of the Fund if the Funds Board reviews and approves the use of those policies and procedures. Accordingly, the Manager does not expect to have proxy-voting responsibility for the
Fund.
Should the Manager become responsible for voting proxies for any reason, such as the inability of the Subadviser to provide investment
advisory services, the Manager shall utilize the proxy voting guidelines established by the most recent Subadviser to vote proxies until a new Subadviser is retained and the use of its proxy voting policies and procedures is authorized by the Board.
In the case of a material conflict between the interests of the Manager (or its affiliates if such conflict is known to persons responsible for voting at the Manager) and any fund, the Board of Directors of the Manager shall consider how to address
the conflict and/or how to vote the proxies. The Manager shall maintain records of all proxy votes in accordance with applicable securities laws and regulations.
The Manager shall be responsible for gathering relevant documents and records related to proxy voting from the Subadviser and providing them to the Fund
as required for the Fund to comply with applicable rules under the 1940 Act. The Manager shall also be responsible for coordinating the provision of information to the Board with regard to the proxy voting policies and procedures of the Subadviser,
including the actual proxy voting policies and procedures of the Subadviser, changes to such policies and procedures, and reports on the administration of such policies and procedures.
The Subadvisers proxy voting policies and procedures govern in determining how proxies relating to the Funds portfolio securities are voted.
A copy of the proxy voting policies and procedures is attached as Appendix A to this SAI. Information regarding how the Fund voted proxies (if any) relating to portfolio securities during the most recent twelve month period ended June 30 is
available without charge (1) by calling 1-877-721-1926, (2) on www.leggmason.com/etfliterature (click on the name of the Fund) and (3) on the SECs website at http://www.sec.gov.
DISCLOSURE OF PORTFOLIO HOLDINGS
On each Business Day, before the commencement of trading in its shares on the Exchange, the Fund will disclose on www.leggmason.com/etfproducts (click
on the name of the Fund) the identities and quantities of the Funds portfolio holdings that will form the basis for the Funds calculation of NAV per share at the end of the Business Day. The Manager, the Subadviser, and the Fund will not
disclose information concerning the identities and quantities of the portfolio securities held by the Fund before such information is publicly disclosed and is available to the entire investing public. Personnel of such entities with knowledge about
the composition of a Fund Deposit will be prohibited from disclosing such information to any other person, except as authorized in the course of their employment, until such information is made public. The Trust has executed confidentiality
agreements with its service providers who are provided information about the Fund Deposit. These agreements include a prohibition on trading while the service provider is in possession of confidential information.
84
THE TRUST
The certificate of trust to establish the Trust was filed with the State Department of Assessments and Taxation of Maryland on June 8, 2015. The
Fund is a series of the Trust. The Trusts name was changed from Legg Mason ETF Equity Trust to Legg Mason ETF Investment Trust effective on February 15, 2017.
The Trust is a Maryland statutory trust. A Maryland statutory trust is an unincorporated business association that is established under, and governed by,
Maryland law. Maryland law provides a statutory framework for the powers, duties, rights and obligations of the Trustees and shareholders of a statutory trust, while the more specific powers, duties, rights and obligations of the Trustees and the
shareholders are determined by the trustees as set forth in a trusts declaration of trust. The Trusts Declaration of Trust (the Declaration) provides that by becoming a shareholder of the Fund, each shareholder shall be
expressly held to have agreed to be bound by the provisions of the Declaration and any other governing instrument of the Trust, such as the by-laws of the Trust, which contain additional rules governing the conduct of the business of the Trust.
Some of the more significant provisions of the Declaration are summarized below. The following summary is qualified in its entirety by reference to the
applicable provisions of the Declaration.
Shareholder Voting
Under the Declaration, the Trustees have broad authority to direct the business and affairs of the Trust. The Declaration provides for shareholder voting
as required by the 1940 Act or other applicable laws but otherwise permits, consistent with Maryland law, actions by the Trustees without seeking the consent of shareholders. For example, the Trustees are empowered to amend the Declaration or
authorize the merger or consolidation of the Trust into another trust or entity, reorganize the Trust or any series or class into another trust or entity or a series or class of another entity, sell all or substantially all of the assets of the
Trust or any series or class to another entity, or a series or class of another entity, terminate the Trust or any series or class, or adopt or amend the by-laws of the Trust, in each case without shareholder approval if the 1940 Act would not
require such approval.
The Fund is not required to hold an annual meeting of shareholders, but the Fund will call special meetings of shareholders
whenever required by the 1940 Act or by the terms of the Declaration. The Declaration provides for dollar-weighted voting which means that a shareholders voting power is determined, not by the number of shares he or she owns, but
by the dollar value of those shares determined on the record date. All shareholders of record of all series and classes of the Trust vote together, except where required by the 1940 Act to vote separately by series or by class, or when the Trustees
have determined that a matter affects only the interests of one or more series or classes of shares. There is no cumulative voting on any matter submitted to a vote of the shareholders.
Election and Removal of Trustees
The Declaration provides
that the Trustees may establish the number of Trustees and that vacancies on the Board may be filled by the remaining Trustees, except when election of Trustees by the shareholders is required under the 1940 Act. When a vote of shareholders is
required to elect Trustees, the Declaration provides that such Trustees shall be elected by a plurality of votes cast by shareholders at a meeting at which a quorum is present. The Declaration also provides that a mandatory retirement age may be set
by action of two-thirds of the Trustees and that Trustees may be removed, with or without cause, by a vote of shareholders holding two-thirds of the voting power of the Trust, or by a vote of two-thirds of the remaining Trustees. The provisions of
the Declaration relating to the election and removal of Trustees may not be amended without the approval of two-thirds of the Trustees.
Amendments to the
Declaration
The Trustees are authorized to amend the Declaration without the vote of shareholders, but no amendment may be made that impairs the
exemption from personal liability granted in the Declaration to persons who are or have been shareholders, Trustees, officers or, employees of the Trust or that limits the rights to indemnification, advancement of expenses or insurance provided in
the Declaration with respect to actions or omissions of persons entitled to indemnification, advancement of expenses or insurance under the Declaration prior to the amendment.
85
Issuance and Redemption of Shares
The Fund may issue an unlimited number of shares for such consideration and on such terms as the Trustees may determine. All shares offered pursuant to
the Prospectus of the Fund, when issued, will be fully paid and non-assessable. Shareholders are not entitled to any appraisal rights with respect to their shares and, except as the Trustees may determine, shall have no preemptive, conversion,
exchange or similar rights. The Fund may involuntarily redeem a shareholders shares upon certain conditions as may be determined by the Trustees, including, for example, if the shareholder fails to provide the Fund with identification required
by law, or if the Fund is unable to verify the information received from the shareholder. Additionally, as discussed below, shares may be redeemed in connection with the closing of small accounts.
Notwithstanding anything to the contrary, the Trustees may in their sole discretion determine that shares of any series or class shall be issued and
redeemed only in aggregations of such number of shares and at such time as may be determined by, or determined pursuant to procedures or methods prescribed or approved by, the Trustees from time to time with respect to any series or class. The
number of shares comprising an aggregation for purposes of issuance or redemption with respect to any series or class are referred to as a Creation Unit and, collectively, as Creation Units (or such other term as the Trustees
shall determine) The Trustees shall have the power, in connection with the issuance of any Creation Unit, to charge such transaction fees or other fees as the Trustees shall determine. In addition, the Trustees may, from time to time in their sole
discretion, determine to change the number of shares constituting a Creation Unit. If the Trustees determine to issue shares of any series or class in Creation Units, then only shares of such series or class comprising a Creation Unit shall be
redeemable by the Trust with respect to any applicable series or class. Unless the Trustees otherwise shall determine, there shall be no redemption of any partial or fractional Creation Unit.
Disclosure of Shareholder Holdings
The Declaration
specifically requires shareholders, upon demand, to disclose to the Fund such information with respect to their ownership of shares of the Fund, whether direct or indirect, as the Trustees may deem necessary in order to comply with various laws or
regulations or for such other purpose as the Trustees may decide. The Fund may disclose such ownership information if required by law or regulation, or as the Trustees otherwise decide.
Small Accounts
The Declaration provides that the Fund may
close out a shareholders account by redeeming all of the shares in the account if the account falls below a minimum account size (which may vary by class) that may be set by the Trustees from time to time. Alternately, the Declaration permits
the Fund to assess a fee for small accounts (which may vary by class) and redeem shares in the account to cover such fees, or convert the shares into another share class that is geared to smaller accounts.
Series and Classes
The Declaration provides that the
Trustees may establish series and classes in addition to those currently established and that the Trustees may determine the rights and preferences, limitations and restrictions, including qualifications for ownership, conversion and exchange
features, minimum purchase and account size, expenses and charges, and other features of the series and classes. The Trustees may change any of those features, terminate any series or class, combine series with other series in the Trust, combine one
or more classes of a series with another class in that series or convert the shares of one class into shares of another class.
Each share of the
Fund, as a series of the Trust, represents an interest in the Fund only and not in the assets of any other series of the Trust.
Shareholder, Trustee and
Officer Liability
The Declaration provides that shareholders are not personally liable for the obligations of the Fund and requires the Fund to
indemnify a shareholder against any loss or expense claimed solely because of the shareholders being or having been a shareholder. The Fund will assume the defense of any claim against a shareholder for personal liability at the request of the
shareholder. The Declaration further provides that a Trustee acting in his or her capacity as a Trustee is not personally liable to any person, other than the Trust or its shareholders, in connection with the affairs of the Trust. Each Trustee is
required to perform his or her duties in good faith and in a manner he or she believes to be in the best interests of the Trust. All actions and
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omissions of Trustees are presumed to be in accordance with the foregoing standard of performance, and any person alleging the contrary has the burden of proving that allegation.
The Declaration limits a Trustees liability to the Trust or any shareholder to the fullest extent permitted under current Maryland law by providing
that a Trustee is liable to the Trust or its shareholders for monetary damages only (a) to the extent that it is proved that he or she actually received an improper benefit or profit in money, property, or services or (b) to the extent
that a judgment or other final adjudication adverse to the Trustee is entered in a proceeding based on a finding in the proceeding that the Trustees action, or failure to act, was the result of active and deliberate dishonesty and was material
to the cause of action adjudicated in the proceeding. The Declaration requires the Trust to indemnify any persons who are or who have been Trustees, officers or employees of the Trust to the fullest extent permitted by law against liability and
expenses in connection with any claim or proceeding in which he or she is involved by virtue of having been a Trustee, officer or employee. Subject to applicable federal law, expenses related to the defense against any claim to which indemnification
may apply shall be advanced by the Trust upon receipt of an undertaking by or on behalf of the recipient of those expenses to repay the advanced amount if it is ultimately found that he or she is not entitled to indemnification. In making any
determination as to whether a person has engaged in conduct for which indemnification is not available, or as to whether there is reason to believe that such person ultimately will be found entitled to indemnification, such person shall be afforded
a rebuttable presumption that he or she did not engage in conduct for which indemnification is not available.
The Declaration provides that any
Trustee who serves as chair of the Board, a member or chair of a committee of the Board, lead independent Trustee, audit committee financial expert, or in any other similar capacity will not be subject to any greater standard of care or liability
because of such position.
Derivative Actions
The
Declaration provides a detailed process for the bringing of derivative actions by shareholders in order to permit legitimate inquiries and claims while avoiding the time, expense, distraction, and other harm that can be caused to the Fund or its
shareholders as a result of spurious shareholder demands and derivative actions. Prior to bringing a derivative action, a demand by no fewer than three unrelated shareholders must be made on the Trustees. The Declaration details information,
certifications, undertakings and acknowledgements that must be included in the demand. The Trustees are not required to consider a demand that is not submitted in accordance with the requirements contained in the Declaration. The Declaration also
requires that, in order to bring a derivative action, the complaining shareholders must be joined in the action by shareholders owning, at the time of the alleged wrongdoing, at the time of demand, and at the time the action is commenced, shares
representing at least 5% of the voting power of the affected funds. The Trustees have a period of 90 days, which may be extended for an additional period not to exceed 60 days, to consider the demand. If a majority of the Trustees who are considered
independent for the purposes of considering the demand determine that a suit should be maintained, then the Trust will commence the suit and the suit will proceed directly and not derivatively. If a majority of the independent Trustees determines
that maintaining the suit would not be in the best interests of the Fund, the Trustees are required to reject the demand and the complaining shareholders may not proceed with the derivative action unless the shareholders are able to sustain the
burden of proof to a court that the decision of the Trustees not to pursue the requested action was not consistent with the standard of performance required of the Trustees in performing their duties. If a demand is rejected, the complaining
shareholders will be responsible for the costs and expenses (including attorneys fees) incurred by the Trust in connection with the consideration of the demand, if, in the judgment of the independent Trustees, the demand was made without
reasonable cause or for an improper purpose. If a derivative action is brought in violation of the Declaration, the shareholders bringing the action may be responsible for the Funds costs, including attorneys fees.
The Declaration further provides that the Fund shall be responsible for payment of attorneys fees and legal expenses incurred by a complaining
shareholder only if required by law, and any attorneys fees that the Fund is obligated to pay shall be calculated using reasonable hourly rates. The Declaration also requires that actions by shareholders against the Trust or the Fund be
brought only in the U.S. District Court for the District of Maryland (Baltimore Division), or if such action may not be brought in that court, then such action shall be brought in the Circuit Court for Baltimore City and that the right to jury trial
be waived to the fullest extent permitted by law.
The Declaration further provides that no provision of the Declaration will be effective to require
a waiver of compliance with any provision of the 1933 Act, the 1934 Act or the 1940 Act, or of any valid rule, regulation or order of the Commission thereunder.
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TAXES
The following is a summary of certain material U.S. federal (and, where noted, state and local) income tax considerations affecting the Fund and its
shareholders. This discussion is very general and does not address all the potential U.S. federal income tax consequences that may be applicable to the Fund or to all categories of investors, some of which may be subject to special tax rules. This
summary is based upon the Code, its legislative history, Treasury regulations (including temporary and proposed regulations), published rulings, and court decisions, each as of the date of this SAI and all of which are subject to change, possibly
with retroactive effect, which could affect the continuing accuracy of this discussion. This discussion assumes that each shareholder holds its shares of the Fund as capital assets for U.S. federal income tax purposes. Current and prospective
shareholders are urged to consult their own tax advisers with respect to the specific federal, state, local, and foreign tax consequences of investing in the Fund.
Tax reform legislation commonly known as the Tax Cuts and Jobs Act (the Tax Act) was enacted on December 22, 2017. The Tax Act makes
significant changes to the U.S. federal income tax rules for individuals and corporations, generally effective for taxable years beginning after December 31, 2017. Most of the changes applicable to individuals are temporary and, without further
legislation, will not apply after 2025. The application of certain provisions of the Tax Act is uncertain, and the changes to the Code that the Tax Act enacted may have direct or indirect effects on the Fund, its investments, or its shareholders
that cannot be predicted. In addition, legislative, regulatory, or administrative changes to, or in respect of the application of, the Tax Act could be enacted or promulgated at any time, either prospectively or with retroactive effect. Prospective
investors should consult their tax advisers regarding the implications of the Tax Act on their investment in the Fund.
Tax Treatment of Creations and
Redemptions of Creation Units
An Authorized Participant who exchanges Deposit Securities for Creation Units generally will recognize a gain
or a loss. The gain or loss will be equal to the difference between the market value of the Creation Units at the time and the sum of the exchangers aggregate basis in the Deposit Securities surrendered plus the amount of cash paid for such
Creation Units. A person who redeems Creation Units will generally recognize a gain or loss equal to the difference between the exchangers basis in the Creation Units and the sum of the aggregate market value of any securities received plus
the amount of any cash received for such Creation Units. The IRS, however, may assert that a loss realized upon an exchange of securities for Creation Units cannot be deducted currently under the rules governing wash sales, or on the
basis that there has been no significant change in economic position.
Any gain or loss realized upon a creation of Creation Units will be treated as
capital gain or loss if the Authorized Participant holds the Deposit Securities exchanged therefor as capital assets, and otherwise will be ordinary income or loss. Similarly, any gain or loss realized upon a redemption of Creation Units will be
treated as capital gain or loss if the Authorized Participant holds the shares of the Fund comprising the Creation Units as capital assets, and otherwise will be ordinary income or loss. Any capital gain or loss realized upon the creation of
Creation Units will generally be treated as long-term capital gain or loss if the Deposit Securities exchanged for such Creation Units have been held for more than one year, and otherwise will be short-term capital gain or loss. Any capital gain or
loss realized upon the redemption of Creation Units will generally be treated as long-term capital gain or loss if the shares of the Fund comprising the Creation Units have been held for more than one year, and otherwise, will generally be
short-term capital gain or loss. Any capital loss realized upon a redemption of Creation Units held for 6 months or less will be treated as a long-term capital loss to the extent of any amounts treated as distributions to the applicable
Authorized Participant of long-term capital gains with respect to the Creation Units (including any amounts credited to the Authorized Participant as undistributed capital gains).
The Fund has the right to reject an order for Creation Units if the purchaser (or a group of purchasers) would, upon obtaining the shares of the Fund so
ordered, own 80% or more of the outstanding shares of the Fund and if, pursuant to section 351 of the Code, the Fund would have a basis in any Deposit Securities different from the market value of such securities on the date of deposit. The Fund
also has the right to require information necessary to determine beneficial share ownership for purposes of the 80% determination. If the Fund does issue Creation Units to a purchaser (or a group of purchasers) that would, upon obtaining the shares
of the Fund so ordered, own 80% or more of the outstanding shares of the Fund, the purchaser (or a group of purchasers) may not recognize gain or loss upon the exchange of securities for Creation Units.
Persons purchasing or redeeming Creation Units should consult their own tax advisors with respect to the tax treatment of any creation or redemption
transaction.
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Tax Treatment of the Fund
The Fund has elected to be treated, and intends to qualify each year, as a regulated investment company under Subchapter M of the
Code. To qualify as such, the Fund must, among other things: (a) derive at least 90% of its gross income in each taxable year from dividends, interest, payments with respect to certain securities loans, gains from the sale or other disposition
of stock, securities or foreign currencies, other income (including, but not limited to, gains from options, futures, or forward contracts) derived with respect to its business of investing in such stock, securities or currencies, and net income
derived from interests in qualified publicly traded partnerships (i.e., partnerships (x) the interests in which are traded on an established securities market or are readily tradable on a secondary market or the
substantial equivalent thereof, and (y) that derive less than 90% of their income from sources described in this subparagraph (a) other than qualified publicly traded partnerships); and (b) diversify its holdings so that, at the end
of each quarter of the Funds taxable year, (i) at least 50% of the market value of the Funds assets consists of cash, securities of other regulated investment companies, U.S. government securities, and other securities, with such
other securities limited, in respect of any one issuer, to an amount not greater than 5% of the value of the Funds assets and not more than 10% of the outstanding voting securities of such issuer and (ii) not more than 25% of the value of
the Funds assets is invested, including through corporations in which the Fund owns a 20% or larger voting stock interest, (x) in the securities (other than U.S. government securities or securities of other regulated investment companies)
of any one issuer, (y) in the securities (other than the securities of other regulated investment companies) of any two or more issuers that the Fund controls and that are treated as engaged in the same, similar, or related trades or
businesses, or (z) in the securities of one or more qualified publicly traded partnerships, which generally include master limited partnerships.
In general, for purposes of the 90% gross income test described above, income derived from a partnership will be treated as qualifying income only to the
extent such income is attributable to items of income of the partnership which would be qualifying income if realized directly by the Fund. However, 100% of the net income derived from an interest in a qualified publicly traded partnership will be
treated as qualifying income. In general, qualified publicly traded partnerships will be treated as partnerships for U.S. federal income tax purposes because they meet a passive income requirement under the Code. In addition, although in general the
passive loss rules of the Code do not apply to regulated investment companies, such rules do apply to a regulated investment company with respect to items attributable to interests in qualified publicly traded partnerships. The Funds
investments in partnerships, if any, including in qualified publicly traded partnerships, may result in the Fund being subject to state, local, or foreign income, franchise, or withholding tax liabilities.
For purposes of the diversification test described above, the term outstanding voting securities of such issuer will include the equity
securities of a qualified publicly traded partnership. Also, for purposes of the diversification test, the identification of the issuer (or, in some cases, issuers) of a particular Fund investment can depend on the terms and conditions of that
investment. In some cases, identification of the issuer (or issuers) is uncertain under current law, and an adverse determination or future guidance by the IRS with respect to issuer identification for a particular type of investment may adversely
affect the Funds ability to meet the diversification test.
As a regulated investment company, the Fund will not be subject to U.S.
federal income tax on the portion of its taxable investment income and capital gains that it distributes to its shareholders, provided that it satisfies a minimum distribution requirement. To satisfy the minimum distribution requirement, the Fund
must distribute to its shareholders at least the sum of (i) 90% of its investment company taxable income (i.e., generally, its taxable income other than the excess of its net long-term
capital gain over its net short-term capital loss, plus or minus certain other adjustments, and calculated without regard to the deduction for dividends paid), and (ii) 90% of its net tax-exempt income for the taxable year. The Fund will be subject to income tax at the regular corporate tax rate on any taxable income or gains that it does not distribute to its shareholders.
If, for any taxable year, the Fund were to fail to qualify as a regulated investment company under the Code or were to fail to meet the distribution
requirement, it would be taxed in the same manner as an ordinary corporation, and distributions to its shareholders would not be deductible by the Fund in computing its taxable income. In addition, in the event of a failure to qualify, the
Funds distributions, including any distributions of net tax-exempt income and net long-term capital gains, would be taxable to shareholders as ordinary dividend
income for U.S. federal income tax purposes to the extent of the Funds current and accumulated earnings and profits. However, such dividends would be eligible, subject to any generally applicable limitations, (i) to be treated as
qualified dividend income in the case of shareholders taxed as individuals and (ii) for the dividends-received deduction in the case of corporate shareholders. Moreover, if the Fund were to fail to
qualify as a regulated investment company in any year, it would be required to pay out its earnings and profits accumulated in that year in order to qualify again as a regulated investment company. If the Fund were to fail to meet the income,
diversification, or distribution test described above,
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the Fund could in some cases cure such failure, including by paying Fund-level tax, paying interest, making additional distributions, or disposing of certain assets. In particular, if in the
first instance, the Fund does not satisfy the diversification test as of a particular quarter end, it will have up to 30 days after that quarter end to adjust its holdings in order to comply with the test retroactively. Portfolio transactions
executed by the Fund in order to comply with the diversification test will increase the Funds portfolio turnover and trading costs and may increase the amount of taxes payable by shareholders to the extent any capital gains are realized as a
result of such transactions. If the Fund were to fail to qualify as a regulated investment company for a period greater than two taxable years, the Fund would generally be required to recognize any net
built-in gains with respect to certain of its assets upon a disposition of such assets within five years of qualifying as a regulated investment company in a subsequent year.
If the Fund were to fail to distribute in a calendar year at least the sum of (i) 98% of its ordinary income for that year and
(ii) 98.2% of its capital gain net income (i.e., the excess of all gains from sales or exchanges of capital assets over the losses from such sales or exchanges) for the one-year period ending October 31 of that year (or
November 30 or December 31 of that year if the Fund is permitted to elect and so elects) it would be subject to a 4% nondeductible excise tax. For this purpose, however, any ordinary income or capital gain net income that is retained by
the Fund and subject to corporate income tax will be considered to have been distributed by year end. In addition, the minimum amounts that must be distributed in any year to avoid the excise tax will be increased or decreased to reflect any
underdistribution or overdistribution, as the case may be, from the previous year. For purposes of the required excise tax distribution, a regulated investment companys ordinary gains and losses from the sale, exchange or other taxable
disposition of property that would otherwise be taken into account after October 31 of a calendar year (or November 30 of that year if the regulated investment company makes the election described above) generally are treated as arising on
January 1 of the following calendar year; in the case of a Fund with a December 31 year end that makes the election described above, no such gains or losses will be so treated. The Fund anticipates that it will pay such dividends and will
make such distributions as are necessary to avoid the application of this excise tax, but there can be no assurance that it will be able to do so. In determining its net capital gain (i.e., net realized
long-term capital gains in excess of net realized short-term capital losses, including any capital loss carryforwards), its taxable income, and its earnings and profits,
a regulated investment company generally is permitted to elect to treat part or all of any post-October capital loss (defined as any net capital loss attributable to the portion of the taxable year after
October 31, or if there is no such loss, the net long-term capital loss or net short-term capital loss attributable to such portion of the taxable year), or late-year ordinary loss (generally, the sum of its (i) net ordinary loss from the sale, exchange or other taxable disposition of property, attributable to the portion of the taxable year after October 31
and its (ii) other net ordinary loss attributable to the portion of the taxable year after December 31) as if incurred in the succeeding taxable year.
Tax Treatment of the Funds Investments
The
Funds transactions in zero coupon securities, foreign currencies, forward contracts, options, and futures contracts (including options and futures contracts on foreign currencies), if any, will be subject to special provisions of the Code
(including provisions relating to hedging transactions and straddles) that, among other things, may affect the character of gains and losses realized by the Fund (i.e., may affect whether gains or losses are ordinary
or capital), accelerate recognition of income to the Fund, and defer Fund losses. These rules could therefore affect the character, amount, and timing of distributions to shareholders. These provisions also (a) will require the Fund to
mark to market certain types of the positions in its portfolio (i.e., require the Fund to treat all unrealized gains and losses with respect to those positions as though they were realized at the end of each year) and (b) may
cause the Fund to recognize income prior to or without receiving cash with which to pay dividends or make distributions in amounts necessary to satisfy the distribution requirements for avoiding income and excise taxes. In order to distribute this
income and avoid a tax at the Fund level, the Fund might be required to sell portfolio securities that it might otherwise have continued to hold, potentially resulting in additional taxable gain or loss.
As a result of entering into swap contracts, if any, the Fund may make or receive periodic net payments. The Fund may also make or receive a payment when
a swap is terminated prior to maturity through an assignment of the swap or other closing transaction. Periodic net payments will generally constitute ordinary income or deductions, while termination of a swap will generally result in capital gain
or loss (which will be a long-term capital gain or loss if the Fund has been a party to the swap for more than one year). With respect to certain types of swaps, the Fund may be required to recognize currently
income or loss with respect to future payments on such swaps or may elect under certain circumstances to mark such swaps to market annually for tax purposes as ordinary income or loss.
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Any investments by the Fund in so-called section 1256
contracts, such as regulated futures contracts, most foreign currency forward contracts traded in the interbank market, and options on most stock indexes, are subject to special tax rules. Any section 1256 contracts held by the Fund at the end
of its taxable year (and, for purposes of the 4% excise tax, on certain later dates as prescribed under the Code) are required to be marked to their market value, and any unrealized gain or loss on those positions will be included in the Funds
income as if each position had been sold for its fair market value at the end of the taxable year. The resulting gain or loss will be combined with any gain or loss realized by the Fund from positions in section 1256 contracts closed during the
taxable year. Provided such positions were held as capital assets and were neither part of a hedging transaction nor part of a straddle, 60% of the resulting net gain or loss will be treated as
long-term capital gain or loss, and 40% of such net gain or loss will be treated as short-term capital gain or loss, regardless of the period of time the positions were
actually held by the Fund.
In general, option premiums received by the Fund are not immediately included in the income of the Fund. Instead, the
premiums are recognized when the option contract expires, the option is exercised by the holder, or the Fund transfers or otherwise terminates the option (e.g., through a closing transaction). If a call option written by the Fund is exercised and
the Fund sells or delivers the underlying security, the Fund generally will recognize capital gain or loss equal to (a) sum of the strike price and the option premium received by the Fund minus (b) the Funds basis in the security.
Such gain or loss generally will be short-term or long-term depending upon the holding period of the underlying security. If securities are purchased by the Fund pursuant to the exercise of a put option written by it, the Fund generally will
subtract the premium received for purposes of computing its cost basis in the securities purchased. Gain or loss arising in respect of a termination of the Funds obligation under an option other than through the exercise of the option will be
short-term gain or loss depending on whether the premium income received by the Fund is greater or less than the amount paid by the Fund (if any) in terminating the transaction. Thus, for example, if an option written by the Fund expires
unexercised, the Fund generally will recognize short-term gain equal to the premium received.
In general, gain or loss on a short sale is recognized
when the Fund closes the sale by delivering the borrowed property to the lender, not when the borrowed property is sold. Gain or loss from a short sale is generally considered as capital gain or loss to the extent that the property used to close the
short sale constitutes a capital asset in the Funds hands. Except with respect to certain situations where the property used by the Fund to close a short sale has a long-term holding period on the date
of the short sale, special rules generally treat the gains on short sales as short-term capital gains. These rules may also terminate the running of the holding period of substantially identical
property held by the Fund. Moreover, a loss on a short sale will be treated as a long-term capital loss if, on the date of the short sale, substantially identical property has been held by
the Fund for more than one year. In general, the Fund will not be permitted to deduct payments made to reimburse the lender of securities for dividends paid on borrowed stock if the short sale is closed on or before the 45th day after the short sale
is entered into.
The Fund may purchase debt obligations with original issue discount (OID), market discount, or acquisition discount.
Some debt obligations with a fixed maturity date of more than one year from the date of issuance (and all zero-coupon debt obligations with a fixed maturity date of more than one year from the date of
issuance) will be treated as debt obligations that are issued with OID. Generally, the amount of the OID is treated as interest income and is included in taxable income (and is accordingly required to be distributed by the Fund) over the term of the
debt security, even though payment of that amount is not received until a later time, usually when the debt security matures. Periodic adjustments for inflation in the principal value of inflation-indexed
bonds also may be treated as OID that is includible in the Funds gross income on a current basis.
Some debt obligations with a fixed maturity
date of more than one year from the date of issuance in the secondary market may be treated as having market discount. Very generally, market discount is the excess of the stated redemption price of a debt obligation (or in the case of
an obligation issued with OID, its revised issue price) over the purchase price of such obligation. Under the Code, (i) generally, any gain recognized on the disposition of, and any partial payment of principal on, a debt security
having market discount is treated as ordinary income to the extent the gain, or principal payment, does not exceed the accrued market discount on such debt security, (ii) alternatively, the Fund may elect to accrue market discount
currently, in which case the Fund will be required to include the accrued market discount in the Funds income (as ordinary income) and thus distribute it over the term of the debt security, even though payment of that amount is not received
until a later time, upon partial of full repayment or disposition of the debt security, and (iii) the rate at which the market discount accrues, and thus is included in the Funds income, will depend upon which of the permitted accrual
methods the Fund elects.
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Some debt obligations with a fixed maturity date of one year or less from the date of issuance that are
acquired by the Fund may be treated as having OID or, in certain cases, acquisition discount (very generally, the excess of the stated redemption price over the purchase price). The Fund will be required to include the OID or acquisition
discount in income (as ordinary income) and thus distribute it over the term of the debt security, even though payment of that amount is not received until a later time, upon partial or full repayment or disposition of the debt security. The rate at
which OID or acquisition discount accrues, and thus is included in the Funds income, will depend upon which of the permitted accrual methods the Fund elects.
Because the OID, market discount, or acquisition discount earned by the Fund in a taxable year may exceed the total amount of cash interest the Fund
receives from the relevant debt obligations, the Fund may have to dispose of one or more of its investments, including at a time when it is not advantageous to do so, and use the proceeds thereof to make distributions in amounts necessary to satisfy
the distribution requirements. The Fund may realize capital gains or losses from such dispositions, which would increase or decrease the Funds investment company taxable income and/or net capital gain.
In addition, payment-in-kind securities held by the Fund, if any, will
give rise to income which is required to be distributed and is taxable even though the Fund receives no interest payment in cash on the security during the year.
Very generally, where the Fund purchases a bond at a price that exceeds the redemption price at maturity (i.e., a premium), the premium is
amortizable over the remaining term of the bond. In the case of a taxable bond, if the Fund makes an election applicable to all such bonds it purchases, which election is irrevocable without consent of the IRS, the Fund reduces the current taxable
income from the bond by the amortized premium and reduces its tax basis in the bond by the amount of such offset; upon the disposition or maturity of such bonds acquired on or after January 4, 2013, the Fund is permitted to deduct any remaining
premium allocable to a prior period. In the case of a tax-exempt bond, tax rules require the Fund to reduce its tax basis by the amount of amortized premium.
The Fund may invest in debt obligations that are in the lowest rating categories or are unrated, including debt obligations of issuers not currently
paying interest or that are in default. Investments in debt obligations that are at risk of or in default present special tax issues for the Fund. Tax rules are not entirely clear about issues such as when the Fund may cease to accrue interest, OID
or market discount, when and to what extent deductions may be taken for bad debts or worthless securities, and how payments received on obligations in default should be allocated between principal and income. These and other related issues will be
addressed by the Fund when, as, and if it invests in such securities, in order to seek to ensure that it distributes sufficient income to preserve its eligibility for treatment as a regulated investment company and does not become subject to U.S.
federal income or excise tax.
A portion of the interest paid or accrued on high yield obligations may not (and interest paid on debt obligations, if
any, that are considered for tax purposes to be payable in the equity of the issuer or a related party will not) be deductible to the issuer. If a portion of the interest paid or accrued on certain high yield discount obligations is not deductible
by the issuer, that portion will be treated as a dividend for purposes of the corporate dividends-received deduction. In such cases, if the issuer of the high yield discount obligations is a domestic
corporation, dividend payments by the Fund may be eligible for the dividends-received deduction to the extent of the deemed dividend portion of such accrued interest.
The Fund may be required to treat amounts as taxable income or gain, subject to the distribution requirements referred to above, even though no
corresponding amounts of cash are received concurrently, as a result of (1) mark-to-market rules, constructive sale rules or rules applicable to passive foreign
investment companies (PFICs), to partnerships or trusts in which the Fund invests or to certain options, futures, or forward contracts, or appreciated financial positions, (2) the inability to obtain cash distributions
or other amounts due to currency controls or restrictions on repatriation imposed by a foreign country with respect to the Funds investments (including through depositary receipts) in issuers in such country, or (3) tax rules applicable
to debt obligations acquired with OID, including zero-coupon or deferred payment bonds and pay-in-kind debt obligations, or to
market discount if the Fund elects to accrue such market discount currently. In order to distribute this income and avoid a tax on the Fund, the Fund might be required to liquidate portfolio securities that it might otherwise have continued to hold,
potentially resulting in additional taxable gain or loss. The Fund might also meet the distribution requirements by borrowing the necessary cash, thereby incurring interest expenses.
Foreign Investments
Dividends, interest or other income
(including, in some cases, capital gains) received by the Fund from investments in foreign securities may be subject to withholding and other taxes imposed by foreign countries. Even if the Fund is entitled to seek
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a refund in respect of such taxes, it may choose not to. Tax conventions between certain countries and the United States may reduce or eliminate such taxes in some cases. The Fund does not expect
to be eligible to elect to pass foreign taxes through to its shareholders, who therefore will not be entitled to credits or deductions on their own tax returns for foreign taxes paid by the Fund. Foreign taxes paid by the Fund may reduce the return
from the Funds investments.
Under certain circumstances, if the Fund receives a refund of foreign taxes paid in respect of a prior year, the
value of Fund shares could be affected or any foreign tax credits or deductions passed through to shareholders in respect of the Funds foreign taxes for the current year could be reduced.
Under Section 988 of the Code, gains or losses attributable to fluctuations in exchange rates between the time the Fund accrues income or
receivables or expenses or other liabilities denominated in a foreign currency and the time the Fund actually collects such income or pays such liabilities are generally treated as ordinary income or ordinary loss. Similarly, gains or losses on
foreign currency, foreign currency forward contracts, certain foreign currency options or futures contracts and the disposition of debt securities denominated in foreign currency, to the extent attributable to fluctuations in exchange rates between
the acquisition and disposition dates, are also treated as ordinary income or loss unless the Fund were to elect otherwise.
Passive Foreign
Investment Companies. If the Fund purchases equity interests (including certain interests treated as equity interests) in foreign entities treated as PFICs for U.S. federal income tax purposes, and does not timely make certain elections, it may
be subject to U.S. federal income tax on a portion of any excess distribution or gain from the disposition of such shares even if such income is distributed as a taxable dividend by the Fund to its shareholders. Additional charges in the
nature of interest may be imposed on the Fund in respect of deferred taxes arising from such distributions or gains.
In general, a PFIC
is any foreign corporation in which (i) 75% or more of the gross income for the taxable year is passive income, or (ii) the average percentage of the assets (generally by value, but by adjusted tax basis in certain cases) that produce, or
are held for the production of, passive income is at least 50%. Generally, passive income for this purpose means dividends, interest (including income equivalent to interest), royalties, rents, annuities, the excess of gains over losses from certain
property transactions and commodities transactions, income from certain notional principal contracts, and foreign currency gains. Passive income for this purpose does not include certain types of passive income excepted by the Code and other
guidance.
If the Fund were to invest in a PFIC and timely elect to treat the PFIC as a qualified electing fund under the Code for the
first year of its holding period in the PFIC stock, in lieu of the foregoing requirements, the Fund would generally be required to include in income each year a portion of the ordinary earnings and net capital gains of the qualified electing fund,
even if not distributed to the Fund, and such amounts would be subject to the 90% and excise tax distribution requirements described above. In order to distribute this income and avoid a tax at the Fund level, the Fund might be required to liquidate
portfolio securities that it might otherwise have continued to hold, potentially resulting in additional taxable gain or loss. In order to make the qualified electing fund election, the Fund would be required to obtain certain annual
information from the PFICs in which it invests, which may be difficult or impossible to obtain. Dividends paid by PFICs will not be eligible to be treated as qualified dividend income.
If the Fund were to invest in a PFIC and make a mark-to-market election,
the Fund would be treated as if it had sold and repurchased its stock in that PFIC at the end of each year. In such case, the Fund would report any such gains as ordinary income and would deduct any such losses as ordinary losses to the extent of
previously recognized gains. Such an election must be made separately for each PFIC owned by the Fund and, once made, would be effective for all subsequent taxable years of the Fund, unless revoked with the consent of the IRS. By making the
election, the Fund could potentially ameliorate the adverse tax consequences with respect to its ownership of shares in a PFIC, but in any particular year might be required to recognize income in excess of the distributions it receives from PFICs
and its proceeds from dispositions of PFIC stock. The Fund might have to distribute such excess income and gain to satisfy the 90% distribution requirement and to avoid imposition of the 4% excise tax. In order to distribute this income and avoid a
tax at the Fund level, the Fund might be required to liquidate portfolio securities that it might otherwise have continued to hold, potentially resulting in additional taxable gain or loss.
Capital Loss Carryforwards
As of December 31,
2019, the Fund had no unused capital loss carryforwards.
93
Taxation of U.S. Shareholders
Dividends and Distributions. Dividends and other distributions by the Fund are generally treated under the Code as received by the shareholders at
the time the dividend or distribution is made. However, if any dividend or distribution is declared by the Fund in October, November, or December of any calendar year and payable to shareholders of record on a specified date in such a month but is
actually paid during the following January, such dividend or distribution will be deemed to have been received by each shareholder on December 31 of the year in which the dividend was declared.
The Fund intends to distribute annually to its shareholders substantially all of its investment company taxable income (determined without regard to the dividends-paid deduction), and any net capital gain. However, if the Fund retains for investment an amount equal to all or a portion of its net capital gain, it will be subject to a corporate tax on the amount
retained. In that event, the Fund may designate such retained amounts as undistributed capital gains in a notice to its shareholders who (a) will be required to include in income for U.S. federal income tax purposes, as long-term capital gains, their proportionate shares of the undistributed amount, (b) will be entitled to credit their proportionate shares of the income tax paid by the Fund on the undistributed amount against
their U.S. federal income tax liabilities, if any, and to claim refunds to the extent their credits exceed their liabilities, if any, and (c) will be entitled to increase their tax basis, for U.S. federal income tax purposes, in their shares by
an amount equal to their share of the excess of the amount of undistributed net capital gain included in their income over the income paid by the Fund on the undistributed amount. Organizations or persons not subject to U.S. federal income tax on
such capital gains will be entitled to a refund of their pro rata share of such taxes paid by the Fund upon timely filing appropriate returns or claims for refund with the IRS.
Distributions of net investment income and of net realized short-term capital gains, whether paid in cash or in
shares, are taxable to a U.S. shareholder as ordinary income or, if certain conditions are met, as qualified dividend income, taxable to individual and certain other non-corporate shareholders at
the rates applicable to long-term capital gain. Distributions of net capital gain, if any, that the Fund reports as capital gain dividends are taxable as long-term capital gains, whether paid in cash or in
shares, and regardless of how long a shareholder has held shares of the Fund.
In general, dividends may be reported by the Fund as qualified
dividend income if they are attributable to qualified dividend income received by the Fund. Qualified dividend income generally means dividend income received from the Funds investments in common and preferred stock of U.S. corporations and
stock of certain qualified foreign corporations, provided that certain holding period and other requirements are met by both the Fund and the shareholders. If 95% or more of the Funds gross income (calculated without taking into account net
capital gain derived from sales or other dispositions of stock or securities) consists of qualified dividend income, the Fund may report all distributions of such income as qualified dividend income.
A foreign corporation is treated as a qualified foreign corporation for this purpose if it is incorporated in a possession of the United States or it is
eligible for the benefits of certain income tax treaties with the United States and meets certain additional requirements. Certain foreign corporations that are not otherwise qualified foreign corporations will be treated as qualified foreign
corporations with respect to dividends paid by them if the stock with respect to which the dividends are paid is readily tradable on an established securities market in the United States. PFICs are not qualified foreign corporations for this
purpose.
A dividend that is attributable to qualified dividend income of the Fund that is paid by the Fund to a shareholder will not be taxable as
qualified dividend income to such shareholder (1) if the dividend is received with respect to any share of the Fund held for fewer than 61 days during the 121-day period beginning on the date which is 60
days before the date on which such share became ex-dividend with respect to such dividend, (2) to the extent that the shareholder is under an obligation (whether pursuant to a short sale or otherwise) to
make related payments with respect to positions in substantially similar or related property, or (3) if the shareholder elects to have the dividend treated as investment income for purposes of the limitation on deductibility of investment
interest. The ex-dividend date is the date on which the owner of the share at the commencement of such date is entitled to receive the next issued dividend payment for such share even if the share
is sold by the owner on that date or thereafter.
Certain dividends received by the Fund from U.S. corporations (generally, dividends received by the
Fund in respect of any share of stock (1) with a tax holding period of at least 46 days during the 91-day period beginning on the date that is 45 days before the date on which the stock becomes ex-dividend as to that dividend and (2) that is held in an unleveraged position) and distributed and appropriately so reported by the Fund may be eligible for the
dividends-received deduction generally available to corporations under the Code. Certain preferred stock must have a holding period of at least 91 days during the
181-day period
94
beginning on the date that is 90 days before the date on which the stock becomes ex-dividend as to that dividend in order to be eligible. Capital gain
dividends distributed to the Fund from other regulated investment companies are not eligible for the dividends-received deduction. In order to qualify for the deduction, corporate shareholders must meet the
minimum holding period requirement stated above with respect to their Fund shares, taking into account any holding period reductions from certain hedging or other transactions or positions that diminish their risk of loss with respect to their Fund
shares, and, if they borrow to acquire or otherwise incur debt attributable to Fund shares, they may be denied a portion of the dividends-received deduction with respect to those shares. Any corporate
shareholder should consult its tax adviser regarding the possibility that its tax basis in its shares may be reduced, for U.S. federal income tax purposes, by reason of extraordinary dividends received with respect to the shares and, to
the extent such basis would be reduced below zero, current recognition of income may be required.
The Fund does not anticipate that a
significant portion of its dividends paid will qualify for the dividends-received deduction or be treated as qualified dividend income.
Dividends and distributions from the Fund will generally be taken into account in determining a shareholders net investment income for
purposes of the Medicare contribution tax applicable to certain individuals, estates and trusts.
Certain
tax-exempt educational institutions will be subject to a 1.4% tax on net investment income. For these purposes, certain dividends and capital gain distributions, and certain gains from the disposition of Fund
shares (among other categories of income), are generally taken into account in computing a shareholders net investment income.
Distributions
in excess of the Funds current and accumulated earnings and profits will, as to each shareholder, be treated as a tax-free return of capital to the extent of the shareholders basis in his or her
shares of the Fund, and as a capital gain thereafter (if the shareholder holds his or her shares of the Fund as capital assets). One or more of the Funds distributions during the year may include such a return of capital distribution. Each
shareholder who receives distributions in the form of additional shares will be treated for U.S. federal income tax purposes as if receiving a distribution in an amount equal to the amount of money that the shareholder would have received if he or
she had instead elected to receive cash distributions. The shareholders aggregate tax basis in shares of the Fund will be increased by such amount.
Investors considering buying shares just prior to a dividend or capital gain distribution should be aware that, although the price of shares purchased at
that time may reflect the amount of the forthcoming distribution, such dividend or distribution may nevertheless be taxable to them.
If Fund
shares are held through a qualified retirement plan entitled to tax-advantaged treatment for federal income tax purposes, distributions will generally not be taxable currently. Special tax rules apply to such retirement plans. You should consult
your tax adviser regarding the tax treatment of distributions (which may include amounts attributable to Fund distributions) which may be taxable when distributed from the retirement plan.
Sale, Exchange or Redemption of Shares. Upon the sale or exchange of his or her shares, a shareholder will generally recognize a taxable gain or
loss equal to the difference between the amount realized and his or her basis in the shares. A redemption of Creation Units by the Fund will be treated as a sale for this purpose. Such gain or loss will be treated as capital gain or loss if the
shares are capital assets in the shareholders hands, and will be long-term capital gain or loss if the shareholder held such shares for more than one year and
short-term capital gain or loss if the shareholder held such shares for one year or less. Any loss realized on a sale or exchange will be disallowed to the extent the shares disposed of are replaced, including
by reinvesting dividends or capital gains distributions in the Fund, within a 61-day period beginning 30 days before and ending 30 days after the disposition of the shares. In such a case, the basis of the
shares acquired will be increased to reflect the disallowed loss. Any loss realized by a shareholder on the sale of Fund shares held by the shareholder for six months or less will be treated for U.S. federal income tax purposes as a long-term capital loss to the extent of any distributions or deemed distributions of long-term capital gains received by the shareholder (including amounts credited to the
shareholder as undistributed capital gains) with respect to such shares during that six-month period.
If a shareholder recognizes a
loss with respect to the Funds shares of $2 million or more for an individual shareholder or $10 million or more for a corporate shareholder (or certain greater amounts over a combination of years), the shareholder must file with the IRS a
disclosure statement on IRS Form 8886. Direct shareholders of portfolio securities are in many cases excepted from this reporting requirement, but under current guidance, shareholders of a regulated investment company are not excepted. The fact that
a loss is so reportable does not affect the legal determination of whether the taxpayers treatment of the loss is proper.
95
Basis Reporting. The Fund, or, in the case of a shareholder holding shares through a broker, the
broker, will report to the IRS the amount of proceeds that a shareholder receives from a redemption, sale or exchange of Fund shares. The Fund or broker will also report the shareholders basis in those shares and the character of any gain or
loss that the shareholder realizes on the redemption, sale or exchange (i.e., short-term or long-term), and certain related tax information. Contact the broker through
whom you purchased your Fund shares to obtain information with respect to the available cost basis reporting methods and elections for your account.
Backup Withholding. The Fund may be required in certain circumstances to apply backup withholding on dividends, distributions and redemption
proceeds payable to non-corporate shareholders who fail to provide the Fund with their correct taxpayer identification numbers or to make required certifications, or who have been notified by the IRS that they
are subject to backup withholding. Certain shareholders are exempt from backup withholding. Backup withholding is not an additional tax and any amount withheld may be credited against a shareholders U.S. federal income tax liability.
Notices. Shareholders will receive, if appropriate, various written notices after the close of the Funds taxable year
regarding the U.S. federal income tax status of certain dividends, distributions and redemption proceeds that were paid (or that are treated as having been paid) by the Fund to its shareholders during the preceding taxable year. In certain cases,
the Fund may be required to amend the tax information reported to you with respect to a particular year. In this event, you may be required to file amended U.S. federal income or other tax returns with respect to such amended information and, if
applicable, to pay additional taxes (including potentially interest and penalties) or to seek a tax refund and may incur other related costs.
Other
Taxes
Dividends, distributions and sale and redemption proceeds may also be subject to additional state, local and foreign taxes depending
on each shareholders particular situation. Generally, shareholders will have to pay state or local taxes on Fund dividends and other distributions, although distributions derived from interest on U.S. government obligations (but not
distributions of gain from the sale of such obligations) may be exempt from certain state and local taxes.
Taxation of Non-U.S. Shareholders
Ordinary dividends and certain other payments made by the Fund to non-U.S. shareholders are generally subject to
federal withholding tax at a 30% rate (or such lower rate as may be determined in accordance with any applicable treaty). In order to obtain a reduced rate of withholding, a non-U.S. shareholder will be
required to provide an IRS Form W-8BEN or similar form certifying its entitlement to benefits under a treaty. The withholding tax does not apply to regular dividends paid to a
non-U.S. shareholder who provides an IRS Form W-8ECI, certifying that the dividends are effectively connected with the non-U.S.
shareholders conduct of a trade or business within the United States. Instead, the effectively connected dividends will be subject to regular U.S. federal income tax as if the non-U.S. shareholder were a
U.S. shareholder. A non-U.S. corporation receiving effectively connected dividends may also be subject to additional branch profits tax imposed at a rate of 30% (or a lower treaty rate). A non-U.S. shareholder who fails to provide an IRS Form W-8BEN or other applicable form may be subject to backup withholding at the appropriate rate. Backup withholding will not
be applied to payments that have already been subject to the 30% withholding tax.
The 30% withholding tax generally will not apply to distributions
of the excess of net long-term capital gains over net short-term capital losses or to redemption proceeds. The 30% withholding tax also will not apply to dividends that
the Fund reports as (a) interest-related dividends, to the extent such dividends are derived from the Funds qualified net interest income, or
(b) short-term capital gain dividends, to the extent such dividends are derived from the Funds qualified short-term gain. Qualified net
interest income is the Funds net income derived from U.S.-source interest and OID, subject to certain exceptions and limitations. Qualified short-term
gain generally means the excess of the net short-term capital gain of the Fund for the taxable year over its net long-term capital loss, if any. In the case of
shares held through an intermediary, the intermediary may withhold even if the Fund reports a payment as an interest-related dividend or a short-term capital gain
dividend. Non-U.S. shareholders should contact their intermediaries with respect to the application of these rules to their accounts.
A non-U.S. shareholder is not, in general, subject to U.S. federal income tax on gains (and is not allowed a deduction for losses) realized on the sale
of shares of the Fund unless (i) such gain is effectively connected with the conduct of a trade or business carried on by the non-U.S. shareholder within the United States, (ii) in the case of a non-U.S. shareholder that is an individual,
the holder is present in the United States for a period or periods aggregating 183 days or more during the year of the
96
sale and certain other conditions are met or (iii) the special rules relating to gain attributable to the sale or exchange of United States real property interests (as defined
below, USRPIs) apply to the non-U.S. shareholders sale of shares of the Fund.
Special rules would apply if the Fund were a
qualified investment entity (QIE) because it is either a United States real property holding corporation (USRPHC) or would be a USRPHC but for the operation of certain exceptions to the definition of USRPIs
described below. Very generally, a USRPHC is a domestic corporation that holds USRPIs the fair market value of which equals or exceeds 50% of the sum of the fair market values of the corporations USRPIs, interests in real property located
outside the United States, and other trade or business assets. USRPIs are generally defined as any interest in U.S. real property and any interest (other than solely as a creditor) in a USRPHC or, very generally, an entity that has been a USRPHC in
the last five years. A regulated investment company that holds, directly or indirectly, significant interests in real estate investment trusts (REITs) may be a USRPHC. Interests in domestically controlled QIEs, including REITs and
regulated investment companies that are QIEs, not-greater-than-10% interests in publicly traded classes of stock in REITs and
not-greater-than-5% interests in publicly traded classes of stock in regulated investment companies generally are not USRPIs, but
these exceptions do not apply for purposes of determining whether the Fund is a QIE. If an interest in the Fund were a USRPI, the Fund or applicable withholding agent would be required to withhold U.S. tax on the proceeds of a share redemption or
sale by a greater-than-5% non-U.S. shareholder, in which case such non-U.S. shareholder generally would also be required to file U.S. federal income tax returns and pay
any additional taxes due in connection with the redemption or sale.
If the Fund were a QIE, under a special look through
rule, any distributions by the Fund to a non-U.S. shareholder (including, in certain cases, distributions made by the Fund in redemption of its shares) attributable directly or indirectly to (i) distributions received by the Fund from a
lower-tier regulated investment company or REIT that the Fund is required to treat as USRPI gain in its hands and (ii) gains realized on the disposition of USRPIs by the Fund would retain their character as gains realized from USRPIs in the
hands of the Funds non-U.S. shareholders and would be subject to U.S. tax withholding. In addition, such distributions could result in the non-U.S. shareholder being required to file a U.S. federal
income tax return and pay tax on the distributions at regular U.S. federal income tax rates. The consequences to a non-U.S. shareholder, including the rate of such withholding and character of such distributions (e.g., as ordinary income or
USRPI gain), would vary depending upon the extent of the non-U.S. shareholders current and past ownership of the Fund.
Under
legislation commonly known as FATCA, the Fund is required to withhold 30% of certain ordinary dividends it pays to shareholders that fail to meet prescribed information reporting or certification requirements. In general, no such
withholding will be required with respect to a U.S. person or non-U.S. individual that timely provides the certifications required by the Fund or its agent on a valid IRS Form
W-9 or applicable IRS Form W-8, respectively. Shareholders potentially subject to withholding include foreign financial institutions (FFIs), such as non-U.S. investment funds, and non-financial foreign entities (NFFEs). To avoid withholding under FATCA, an FFI generally must enter into an information sharing
agreement with the IRS in which it agrees to report certain identifying information (including name, address, and taxpayer identification number) with respect to its U.S. account holders (which, in the case of an entity shareholder, may include its
direct and indirect U.S. owners), and an NFFE generally must identify and provide other required information to the Fund or other withholding agent regarding its U.S. owners, if any. Such non-U.S. shareholders
also may fall into certain exempt, excepted or deemed compliant categories as established by regulations and other guidance. A non-U.S. shareholder in a country that has entered into an intergovernmental
agreement with the U.S. to implement FATCA will be exempt from FATCA withholding provided that the shareholder and the applicable foreign government comply with the terms of such agreement.
A non-U.S. entity that invests in the Fund will need to provide the Fund with documentation properly certifying
the entitys status under FATCA in order to avoid FATCA withholding.
Non-U.S. investors should consult
their own tax advisers regarding the impact of these requirements on their investment in the Fund.
CODES OF ETHICS
Pursuant to Rule 17j-1 under the 1940 Act, the Fund, the Manager, the Subadviser and the Distributor each has adopted a code of ethics that
permits its personnel to invest in securities for their own accounts, including securities that may be purchased or held by the Fund. All personal securities transactions by employees must adhere to the requirements of the codes of ethics. Copies of
the codes
97
of ethics applicable to personnel of the Fund, the Manager, the Subadviser, the Distributor and the Independent Trustees are on file with the SEC.
FINANCIAL STATEMENTS
The Funds Annual Report to shareholders for the fiscal period ended December 31, 2019, contains the Funds audited financial statements,
accompanying notes and the report of PricewaterhouseCoopers LLP, an independent registered public accounting firm, all of which are incorporated by reference into this SAI
((https://www.sec.gov/Archives/edgar/data/1645194/000119312520052248/d81782dncsr.htm)). These audited financial statements are available
free of charge upon request by calling the Fund at 1-877-721-1926.
98
Appendix B
Credit Ratings
DESCRIPTION OF RATINGS
The ratings of Moodys Investors Service, Inc., S&P Global Ratings and Fitch Ratings represent their opinions as to the quality of
various debt obligations. It should be emphasized, however, that ratings are not absolute standards of quality. Consequently, debt obligations with the same maturity, coupon and rating may have different yields while debt obligations of the same
maturity and coupon with different ratings may have the same yield. As described by the rating agencies, ratings are generally given to securities at the time of issuances. While the rating agencies may from time to time revise such ratings, they
undertake no obligation to do so.
Moodys Investors Service, Inc. Global Rating Scales
Ratings assigned on Moodys global long-term and short- term rating scales are forward-looking opinions of the relative credit risks of financial
obligations issued by non-financial corporates, financial institutions, structured finance vehicles, project finance vehicles, and public sector entities. Moodys defines credit risk as the risk that an entity may not meet its contractual
financial obligations as they come due and any estimated financial loss in the event of default or impairment. The contractual financial obligations1 addressed by Moodys ratings are those
that call for, without regard to enforceability, the payment of an ascertainable amount, which may vary based upon standard sources of variation (e.g., floating interest rates), by an ascertainable date. Moodys rating addresses the
issuers ability to obtain cash sufficient to service the obligation, and its willingness to pay.2 Moodys ratings do not address non-standard sources of variation in the amount of the
principal obligation (e.g., equity indexed), absent an express statement to the contrary in a press release accompanying an initial rating.3 Long-term ratings are assigned to issuers or
obligations with an original maturity of one year or more and reflect both on the likelihood of a default or impairment on contractual financial obligations and the expected financial loss suffered in the event of default or impairment. Short-term
ratings are assigned to obligations with an original maturity of thirteen months or less and reflect both on the likelihood of a default or impairment on contractual financial obligations and the expected financial loss suffered in the event of
default or impairment.4, 5
Moodys issues ratings at the issuer level and instrument level
on both the long- term scale and the short-term scale. Typically, ratings are made publicly available although private and unpublished ratings may also be assigned.6
Moodys differentiates structured finance ratings from fundamental ratings (i.e., ratings on nonfinancial corporate, financial institution, and
public sector entities) on the global long-term scale by adding (sf ) to all structured finance ratings.7 The addition of (sf ) to structured finance ratings should eliminate any presumption that
such ratings and fundamental ratings at the same letter grade level will behave the same.
1
|
In the case of impairments, there can be a financial loss even when contractual obligations are met.
|
2
|
In some cases the relevant credit risk relates to a third party, in addition to, or instead of the issuer. Examples
include credit-linked notes and guaranteed obligations.
|
3
|
Because the number of possible features or structures is limited only by the creativity of issuers, Moodys cannot
comprehensively catalogue all the types of non-standard variation affecting financial obligations, but examples include indexed values, equity values and cash flows, prepayment penalties, and an obligation to pay an amount that is not ascertainable
at the inception of the transaction.
|
4
|
For certain structured finance, preferred stock and hybrid securities in which payment default events are either not
defined or do not match investors expectations for timely payment, long-term and short-term ratings reflect the likelihood of impairment and financial loss in the event of impairment.
|
5
|
Supranational institutions and central banks that hold sovereign debt or extend sovereign loans, such as the IMF or the
European Central Bank, may not always be treated similarly to other investors and lenders with similar credit exposures. Long-term and short-term ratings assigned to obligations held by both supranational institutions and central banks, as well as
other investors, reflect only the credit risks faced by other investors unless specifically noted otherwise.
|
6
|
For information on how to obtain a Moodys credit rating, including private and unpublished credit ratings, please
see Moodys Investors Service Products.
|
7
|
Like other global scale ratings, (sf) ratings reflect both the likelihood of a default and the expected loss suffered in
the event of default. Ratings are assigned based on a rating committees assessment of a securitys expected loss rate (default probability multiplied by expected loss severity), and may be subject to the constraint that the final expected
loss rating assigned would not be more than a certain number of notches, typically three to five notches, above the rating that would be assigned based on an assessment of default probability alone. The magnitude of this constraint may vary with the
level of the rating, the seasoning of the transaction, and the uncertainty around the assessments of expected loss and probability of default.
|
B-1
The (sf) indicator for structured finance security ratings indicates that otherwise similarly rated
structured finance and fundamental securities may have different risk characteristics. Through its current methodologies, however, Moodys aspires to achieve broad expected equivalence in structured finance and fundamental rating performance
when measured over a long period of time.
Description of Moodys Investors Service, Inc.s Global Long-Term Obligation Ratings:
AaaObligations rated Aaa are judged to be of the highest quality, subject to the lowest level of credit risk.
AaObligations rated Aa are judged to be of high quality and are subject to very low credit risk.
AObligations rated A are judged to be upper-medium grade and are subject to low credit risk.
BaaObligations rated Baa are judged to be medium-grade and subject to moderate credit risk and as such may possess certain speculative
characteristics.
BaObligations rated Ba are judged to be speculative and are subject to substantial credit risk.
BObligations rated B are considered speculative and are subject to high credit risk.
CaaObligations rated Caa are judged to be speculative of poor standing and are subject to very high credit risk.
CaObligations rated Ca are highly speculative and are likely in, or very near, default, with some prospect of recovery of principal and
interest.
CObligations rated C are the lowest rated and are typically in default, with little prospect for recovery of principal or
interest.
Note: Moodys appends numerical modifiers 1, 2, and 3 to each generic rating classification from Aa through
Caa. The modifier 1 indicates that the obligation ranks in the higher end of its generic rating category; the modifier 2 indicates a mid-range ranking; and the modifier 3 indicates a ranking in the lower end of that generic rating category.
Additionally, a (hyb) indicator is appended to all ratings of hybrid securities issued by banks, insurers, finance companies, and securities firms.*
By their terms, hybrid securities allow for the omission of scheduled dividends, interest, or principal payments, which can potentially result in
impairment if such an omission occurs. Hybrid securities may also be subject to contractually allowable write-downs of principal that could result in impairment. Together with the hybrid indicator, the long-term obligation rating assigned to a
hybrid security is an expression of the relative credit risk associated with that security.
Description of Moodys Investors Service, Inc.s
Global Short-Term Obligation Ratings:
P-1Issuers (or supporting institutions) rated Prime-1 have a superior ability to repay
short-term debt obligations.
P-2Issuers (or supporting institutions) rated Prime-2 have a strong ability to repay short-term debt
obligations.
P-3Issuers (or supporting institutions) rated Prime-3 have an acceptable ability to repay short-term obligations.
NPIssuers (or supporting institutions) rated Not Prime do not fall within any of the Prime rating categories.
Description of Moodys Investors Service, Inc.s US Municipal Ratings:
U.S. Municipal Short-Term Obligation Ratings:
While the
global short-term prime rating scale is applied to US municipal tax-exempt commercial paper, these programs are typically backed by external letters of credit or liquidity facilities and their short-term prime ratings usually map to the
long-term rating of the enhancing bank or financial institution and not to the municipalitys rating. Other short-term municipal obligations, which generally have different funding sources for repayment, are rated using two additional
short-term rating scales (i.e., the MIG and VMIG scales discussed below).
The Municipal Investment Grade (MIG) scale is used to rate
US municipal bond anticipation notes of up to five years maturity. Municipal notes rated on the MIG scale may be secured by either pledged revenues or proceeds of a take-out financing received prior to note maturity. MIG ratings expire at the
maturity of the obligation, and the issuers long-term rating is only one consideration in assigning the MIG rating. MIG ratings are divided into three levelsMIG 1 through MIG 3while speculative grade short-term obligations are
designated SG.
B-2
MIG 1This designation denotes superior credit quality. Excellent protection is afforded by
established cash flows, highly reliable liquidity support, or demonstrated broad-based access to the market for refinancing.
MIG
2This designation denotes strong credit quality. Margins of protection are ample, although not as large as in the preceding group.
MIG 3This designation denotes acceptable credit quality. Liquidity and cash-flow protection may be narrow, and market access for refinancing
is likely to be less well-established.
SGThis designation denotes speculative-grade credit quality. Debt instruments in this
category may lack sufficient margins of protection.
Demand Obligation Ratings:
In the case of variable rate demand obligations (VRDOs), a two-component rating is assigned: a long or short-term debt rating and a demand
obligation rating. The first element represents Moodys evaluation of risk associated with scheduled principal and interest payments. The second element represents Moodys evaluation of risk associated with the ability to receive purchase
price upon demand (demand feature). The second element uses a rating from a variation of the MIG scale called the Variable Municipal Investment Grade (VMIG) scale. VMIG ratings of demand obligations with unconditional
liquidity support are mapped from the short-term debt rating (or counterparty assessment) of the support provider, or the underlying obligor in the absence of third party liquidity support, with VMIG 1 corresponding to P-1, VMIG 2 to P-2, VMIG 3 to
P-3 and SG to not prime. For example, the VMIG rating for an industrial revenue bond with Company XYZ as the underlying obligor would normally have the same numerical modifier as Company XYZs prime rating. Transitions of VMIG ratings of demand
obligations with conditional liquidity support, as shown in the diagram below, differ from transitions on the Prime scale to reflect the risk that external liquidity support will terminate if the issuers long-term rating drops below investment
grade.
VMIG 1This designation denotes superior credit quality. Excellent protection is afforded by the superior short-term credit
strength of the liquidity provider and structural and legal protections that ensure the timely payment of purchase price upon demand.
VMIG
2This designation denotes strong credit quality. Good protection is afforded by the strong short- term credit strength of the liquidity provider and structural and legal protections that ensure the timely payment of purchase price upon
demand.
VMIG 3This designation denotes acceptable credit quality. Adequate protection is afforded by the satisfactory short-term
credit strength of the liquidity provider and structural and legal protections that ensure the timely payment of purchase price upon demand.
SGThis designation denotes speculative-grade credit quality. Demand features rated in this category may be supported by a liquidity provider
that does not have an investment grade short-term rating or may lack the structural and/or legal protections necessary to ensure the timely payment of purchase price upon demand.
Description of Moodys Investors Service, Inc.s National Long-Term Scale Ratings:
Moodys long-term National Scale Ratings (NSRs) are opinions of the relative creditworthiness of issuers and financial obligations within a
particular country. NSRs are not designed to be compared among countries; rather, they address relative credit risk within a given country. Moodys assigns national scale ratings in certain local capital markets in which investors have found
the global rating scale provides inadequate differentiation among credits or is inconsistent with a rating scale already in common use in the country.
In each
specific country, the last two characters of the rating indicate the country in which the issuer is located (e.g., Aaa.br for Brazil).
Long-Term NSR Scale
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Aaa.n
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Issuers or issues rated Aaa.n demonstrate the strongest creditworthiness relative to other domestic issuers.
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Aa.n
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Issuers or issues rated Aa.n demonstrate very strong creditworthiness relative to other domestic issuers.
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B-3
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A.n
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Issuers or issues rated A.n present above-average creditworthiness relative to other domestic issuers.
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Baa.n
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Issuers or issues rated Baa.n represent average creditworthiness relative to other domestic issuers.
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Ba.n
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Issuers or issues rated Ba.n demonstrate below-average creditworthiness relative to other domestic issuers.
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B.n
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Issuers or issues rated B.n demonstrate weak creditworthiness relative to other domestic issuers.
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Caa.n
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Issuers or issues rated Caa.n demonstrate very weak creditworthiness relative to other domestic issuers.
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Ca.n
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Issuers or issues rated Ca.n demonstrate extremely weak creditworthiness relative to other domestic issuers.
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C.n
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Issuers or issues rated C.n demonstrate the weakest creditworthiness relative to other domestic issuers.
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Note: Moodys appends numerical modifiers 1, 2, and 3 to each generic rating classification from Aa through Caa.
The modifier 1 indicates that the obligation ranks in the higher end of its generic rating category; the modifier 2 indicates a mid-range ranking; and the modifier 3 indicates a ranking in the lower end of that generic rating category. National
scale long-term ratings of D.ar and E.ar may also be applied to Argentine obligations.
Description of S&P Global Ratings Long-Term Issue
Credit Ratings:
Long-Term Issue Credit Ratings are based, in varying degrees, on S&P Global Ratings analysis of the following
considerations:
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The likelihood of paymentthe capacity and willingness of the obligor to meet its financial commitments on an
obligation in accordance with the terms of the obligation;
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The nature and provisions of the financial obligation, and the promise we impute; and
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The protection afforded by, and relative position of, the financial obligation in the event of a bankruptcy,
reorganization, or other arrangement under the laws of bankruptcy and other laws affecting creditors rights.
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An issue rating
is an assessment of default risk, but may incorporate an assessment of relative seniority or ultimate recovery in the event of default. Junior obligations are typically rated lower than senior obligations, to reflect lower priority in bankruptcy, as
noted above. (Such differentiation may apply when an entity has both senior and subordinated obligations, secured and unsecured obligations, or operating company and holding company obligations.)
AAAAn obligation rated AAA has the highest rating assigned by S&P Global Ratings. The obligors capacity to meet its
financial commitments on the obligation is extremely strong.
AAAn obligation rated AA differs from the highest-rated
obligations only to a small degree. The obligors capacity to meet its financial commitments on the obligation is very strong.
AAn obligation rated A is somewhat more susceptible to the adverse effects of changes in circumstances and economic conditions
than obligations in higher-rated categories. However, the obligors capacity to meet its financial commitments on the obligation is still strong.
BBBAn obligation rated BBB exhibits adequate protection parameters. However, adverse economic conditions or changing
circumstances are more likely to weaken the obligors capacity of the obligor to meet its financial commitments on the obligation.
BB, B, CCC, CC, and CObligations rated BB, B, CCC, CC, and C are regarded as
having significant speculative characteristics. BB indicates the least degree of speculation and C the highest. While such obligations will likely have some quality and protective characteristics, these may be outweighed by
large uncertainties or major exposure to adverse conditions.
BBAn obligation rated BB is less vulnerable to
nonpayment than other speculative issues. However, it faces major ongoing uncertainties or exposure to adverse business, financial, or economic conditions that could lead to the obligors inadequate capacity to meet its financial commitments on
the obligation.
B-4
BAn obligation rated B is more vulnerable to nonpayment than obligations rated
BB, but the obligor currently has the capacity to meet its financial commitments on the obligation. Adverse business, financial, or economic conditions will likely impair the obligors capacity or willingness to meet its financial
commitments on the obligation.
CCCAn obligation rated CCC is currently vulnerable to nonpayment, and is dependent upon
favorable business, financial, and economic conditions for the obligor to meet its financial commitments on the obligation. In the event of adverse business, financial, or economic conditions, the obligor is not likely to have the capacity to meet
its financial commitments on the obligation.
CCAn obligation rated CC is currently highly vulnerable to nonpayment.
The CC rating is used when a default has not yet occurred, but S&P Global Ratings expects default to be a virtual certainty, regardless of the
anticipated time to default.
CAn obligation rated C is currently highly vulnerable to nonpayment, and the obligation is
expected to have lower relative seniority or lower ultimate recovery compared with obligations that are rated higher.
DAn
obligation rated D is in default or in breach of an imputed promise. For non-hybrid capital instruments, the D rating category is used when payments on an obligation are not made on the date due, unless S&P Global Ratings
believes that such payments will be made within five business days in the absence of a stated grace period or within the earlier of the stated grace period or 30 calendar days. The D rating also will be used upon the filing of a
bankruptcy petition or the taking of similar action and where default on an obligation is a virtual certainty, for example due to automatic stay provisions. An obligations rating is lowered to D if it is subject to a distressed
exchange offer.
Ratings from AA to CCC may be modified by the addition of a plus (+) or minus (-) sign to show
relative standing within the rating categories.
Description of S&P Global Ratings Short-Term Issue Credit Ratings:
A-1A short-term obligation rated A-1 is rated in the highest category by S&P Global Ratings. The obligors capacity to
meet its financial commitments on the obligation is strong. Within this category, certain obligations are designated with a plus sign (+). This indicates that the obligors capacity to meet its financial commitments on these obligations is
extremely strong.
A-2A short-term obligation rated A-2 is somewhat more susceptible to the adverse effects of
changes in circumstances and economic conditions than obligations in higher rating categories. However, the obligors capacity to meet its financial commitments on the obligation is satisfactory.
A-3A short-term obligation rated A-3 exhibits adequate protection parameters. However, adverse economic conditions or changing
circumstances are more likely to weaken an obligors capacity to meet its financial commitments on the obligation.
BA
short-term obligation rated B is regarded as vulnerable and has significant speculative characteristics. The obligor currently has the capacity to meet its financial commitments; however, it faces major ongoing uncertainties that could
lead to the obligors inadequate capacity to meet its financial commitments.
CA short-term obligation rated C
is currently vulnerable to nonpayment and is dependent on favorable business, financial, and economic conditions for the obligor to meet its financial commitments on the obligation.
DA short-term obligation rated D is in default or in breach of an imputed promise. For non-hybrid capital instruments, the
D rating category is used when payments on an obligation are not made on the date due, unless S&P Global Ratings believes that such payments will be made within any stated grace period.
However, any stated grace period longer than five business days will be treated as five business days. The D rating also will be used upon the filing of a
bankruptcy petition or the taking of a similar action and where default on an obligation is a virtual certainty, for example due to automatic stay provisions. An obligations rating is lowered to D if it is subject to a distressed
exchange offer.
B-5
Description of S&P Global Ratings Municipal Short-Term Note Ratings:
An S&P Global Ratings U.S. municipal note rating reflects S&P Global Ratings opinion about the liquidity factors and market access risks unique
to the notes. Notes due in three years or less will likely receive a note rating. Notes with an original maturity of more than three years will most likely receive a long-term debt rating. In determining which type of rating, if any, to assign,
S&P Global Ratings analysis will review the following considerations:
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Amortization schedulethe larger the final maturity relative to other maturities, the more likely it will be treated
as a note; and
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Source of paymentthe more dependent the issue is on the market for its refinancing, the more likely it will be
treated as a note.
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SP-1Strong capacity to pay principal and interest. An issue determined to possess a very strong
capacity to pay debt service is given a plus (+) designation.
SP-2Satisfactory capacity to pay principal and interest, with some
vulnerability to adverse financial and economic changes over the term of the notes.
SP-3Speculative capacity to pay principal
and interest.
DD is assigned upon failure to pay the note when due, completion of a distressed exchange offer, or the
filing of a bankruptcy petition or the taking of similar action and where default on an obligation is a virtual certainty, for example due to automatic stay provisions.
Long-Term Issuer Credit Ratings
AAA An obligor
rated AAA has extremely strong capacity to meet its financial commitments. AAA is the highest issuer credit rating assigned by S&P Global Ratings.
AA An obligor rated AA has very strong capacity to meet its financial commitments. It differs from the highest-rated obligors only to
a small degree.
A An obligor rated A has strong capacity to meet its financial commitments but is somewhat more
susceptible to the adverse effects of changes in circumstances and economic conditions than obligors in higher-rated categories.
BBB
An obligor rated BBB has adequate capacity to meet its financial commitments. However, adverse economic conditions or changing circumstances are more likely to weaken the obligors capacity to meet its financial commitments.
BB, B, CCC, and CC Obligors rated BB, B, CCC, and CC are regarded as having significant
speculative characteristics. BB indicates the least degree of speculation and CC the highest. While such obligors will likely have some quality and protective characteristics, these may be outweighed by large uncertainties or
major exposure to adverse conditions.
BB An obligor rated BB is less vulnerable in the near term than other lower-rated
obligors. However, it faces major ongoing uncertainties and exposure to adverse business, financial, or economic conditions that could lead to the obligors inadequate capacity to meet its financial commitments.
B An obligor rated B is more vulnerable than the obligors rated BB, but the obligor currently has the capacity to meet its
financial commitments. Adverse business, financial, or economic conditions will likely impair the obligors capacity or willingness to meet its financial commitments.
CCC An obligor rated CCC is currently vulnerable and is dependent upon favorable business, financial, and economic conditions to meet
its financial commitments.
CC An obligor rated CC is currently highly vulnerable. The CC rating is used when a
default has not yet occurred but S&P Global Ratings expects default to be a virtual certainty, regardless of the anticipated time to default.
SD and D An obligor is rated SD (selective default) or D if S&P Global Ratings considers there to be a default on one
or more of its financial obligations, whether long- or short-term, including rated and unrated obligations but excluding hybrid instruments classified as regulatory capital or in nonpayment according to terms. A D rating is assigned when
S&P Global Ratings believes that the default will be a general default and that the obligor will fail to pay all or substantially all of its
B-6
obligations as they come due. An SD rating is assigned when S&P Global Ratings believes that the obligor has selectively defaulted on a specific issue or class of obligations but
it will continue to meet its payment obligations on other issues or classes of obligations in a timely manner. A rating on an obligor is lowered to D or SD if it is conducting a distressed exchange offer.
*Ratings from AA to CCC may be modified by the addition of a plus (+) or minus (-) sign to show relative standing within the
rating categories.
Short-Term Issuer Credit Ratings
A-1 An obligor rated A-1 has strong capacity to meet its financial commitments. It is rated in the highest category by S&P Global
Ratings. Within this category, certain obligors are designated with a plus sign (+). This indicates that the obligors capacity to meet its financial commitments is extremely strong.
A-2 An obligor rated A-2 has satisfactory capacity to meet its financial commitments. However, it is somewhat more susceptible to the
adverse effects of changes in circumstances and economic conditions than obligors in the highest rating category.
A-3 An obligor rated
A-3 has adequate capacity to meet its financial obligations. However, adverse economic conditions or changing circumstances are more likely to weaken the obligors capacity to meet its financial commitments.
B An obligor rated B is regarded as vulnerable and has significant speculative characteristics. The obligor currently has the capacity
to meet its financial commitments; however, it faces major ongoing uncertainties that could lead to the obligors inadequate capacity to meet its financial commitments.
C An obligor rated C is currently vulnerable to nonpayment that would result in an SD or D issuer rating and
is dependent upon favorable business, financial, and economic conditions to meet its financial commitments.
SD and D An obligor is
rated SD (selective default) or D if S&P Global Ratings considers there to be a default on one or more of its financial obligations, whether long- or short-term, including rated and unrated obligations but excluding
hybrid instruments classified as regulatory capital or in nonpayment according to terms. A D rating is assigned when S&P Global Ratings believes that the default will be a general default and that the obligor will fail to pay all or
substantially all of its obligations as they come due. An SD rating is assigned when S&P Global Ratings believes that the obligor has selectively defaulted on a specific issue or class of obligations but it will continue to meet its
payment obligations on other issues or classes of obligations in a timely manner. A rating on an obligor is lowered to D or SD if it is conducting a distressed exchange offer.
Description of S&P Global Ratings Dual Ratings:
Dual ratings may be assigned to debt issues that have a put option or demand feature. The first component of the rating addresses the likelihood of
repayment of principal and interest as due, and the second component of the rating addresses only the demand feature. The first component of the rating can relate to either a short-term or long-term transaction and accordingly use either short-term
or long-term rating symbols. The second component of the rating relates to the put option and is assigned a short-term rating symbol (for example, AAA/A-1+ or A-1+/A-1). With U.S. municipal short-term demand debt, the U.S.
municipal short-term note rating symbols are used for the first component of the rating (for example, SP-1+/A-1+).
Description of S&P Global
Ratings Active Qualifiers (Currently applied and/or outstanding):
S&P Global Ratings uses the following qualifiers that limit the
scope of a rating. The structure of the transaction can require the use of a qualifier such as a p qualifier, which indicates the rating addresses the principal portion of the obligation only. A qualifier appears as a suffix and is part
of the rating.
Federal deposit insurance limit: L qualifier. Ratings qualified with L apply only to amounts invested
up to federal deposit insurance limits.
Principal: p qualifier. This suffix is used for issues in which the credit
factors, the terms, or both, that determine the likelihood of receipt of payment of principal are different from the credit factors, terms or both that determine the likelihood of receipt of interest on the obligation. The p suffix
indicates that the rating addresses the principal portion of the obligation only and that the interest is not rated.
Preliminary ratings:
prelim qualifier. Preliminary ratings, with the prelim suffix, may be assigned to obligors or obligations, including financial programs, in the circumstances described below. Assignment of a final rating is conditional on
the
B-7
receipt by S&P Global Ratings of appropriate documentation. S&P Global Ratings reserves the right not to issue a final rating. Moreover, if a final rating is issued, it may differ from
the preliminary rating.
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Preliminary ratings may be assigned to obligations, most commonly structured and project finance issues, pending receipt
of final documentation and legal opinions.
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Preliminary ratings may be assigned to obligations that will likely be issued upon the obligors emergence from
bankruptcy or similar reorganization, based on late-stage reorganization plans, documentation and discussions with the obligor.
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Preliminary ratings may also be assigned to the obligors. These ratings consider the anticipated general credit quality of the reorganized or
post-bankruptcy issuer as well as attributes of the anticipated obligation(s).
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Preliminary ratings may be assigned to entities that are being formed or that are in the process of being independently
established when, in S&P Global Ratings opinion, documentation is close to final. Preliminary ratings may also be assigned to the obligations of these entities.
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Preliminary ratings may be assigned when a previously unrated entity is undergoing a well-formulated restructuring,
recapitalization, significant financing or other transformative event, generally at the point that investor or lender commitments are invited. The preliminary rating may be assigned to the entity and to its proposed obligation(s). These preliminary
ratings consider the anticipated general credit quality of the obligor, as well as attributes of the anticipated obligation(s), assuming successful completion of the transformative event. Should the transformative event not occur, S&P Global
Ratings would likely withdraw these preliminary ratings.
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A preliminary recovery rating may be assigned to an obligation that has a preliminary issue credit rating.
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Termination structures: t qualifier. This symbol indicates termination structures that are designed to honor
their contracts to full maturity or, should certain events occur, to terminate and cash settle all their contracts before their final maturity date.
Counterparty instrument rating: cir qualifier. This symbol indicates a counterparty instrument rating (CIR), which is a
forward-looking opinion about the creditworthiness of an issuer in a securitization structure with respect to a specific financial obligation to a counterparty (including interest rate swaps, currency swaps, and liquidity facilities). The CIR is
determined on an ultimate payment basis; these opinions do not take into account timeliness of payment.
Description of Fitch Ratings Corporate
Finance Long-Term Obligation Ratings:
Ratings of individual securities or financial obligations of a corporate issuer address relative
vulnerability to default on an ordinal scale. In addition, for financial obligations in corporate finance, a measure of recovery given default on that liability is also included in the rating assessment. This notably applies to covered bonds
ratings, which incorporate both an indication of the probability of default and of the recovery given a default of this debt instrument. On the contrary, ratings of debtor-in-possession (DIP) obligations incorporate the expectation of full
repayment.
The relationship between the issuer scale and obligation scale assumes a generic historical average recovery. Individual obligations
can be assigned ratings, higher, lower, or the same as the entitys issuer rating or Issuer Default Rating (IDR), based on their relative ranking, relative vulnerability to default or based on explicit Recovery Ratings.
As a result, individual obligations of entities, such as corporations, are assigned ratings higher, lower, or the same as that entitys issuer
rating or IDR, except DIP obligation ratings that are not based off an IDR. At the lower end of the ratings scale, Fitch publishes explicit Recovery Ratings in many cases to complement issuer and obligation ratings.
AAA: Highest credit quality. AAA ratings denote the lowest expectation of credit risk. They are assigned only in cases of
exceptionally strong capacity for payment of financial commitments. This capacity is highly unlikely to be adversely affected by foreseeable events.
AA: Very high credit quality. AA ratings denote expectations of very low credit risk. They indicate very strong capacity for payment
of financial commitments. This capacity is not significantly vulnerable to foreseeable events.
B-8
A: High credit quality. A ratings denote expectations of low credit risk. The capacity
for payment of financial commitments is considered strong. This capacity may, nevertheless, be more vulnerable to adverse business or economic conditions than is the case for higher ratings.
BBB: Good credit quality. BBB ratings indicate that expectations of credit risk are currently low. The capacity for payment of
financial commitments is considered adequate but adverse business or economic conditions are more likely to impair this capacity.
BB:
Speculative. BB ratings indicate an elevated vulnerability to credit risk, particularly in the event of adverse changes in business or economic conditions over time; however, business or financial alternatives may be available to allow
financial commitments to be met.
B: Highly speculative. B ratings indicate that material credit risk is present.
CCC: Substantial credit risk. CCC ratings indicate that substantial credit risk is present.
CC: Very high levels of credit risk. CC ratings indicate very high levels of credit risk.
C: Exceptionally high levels of credit risk. C indicates exceptionally high levels of credit risk.
Defaulted obligations typically are not assigned RD or D ratings, but are instead rated in the CCC to C
rating categories, depending upon their recovery prospects and other relevant characteristics. This approach better aligns obligations that have comparable overall expected loss but varying vulnerability to default and loss.
The ratings of corporate finance obligations are linked to Issuer Default Ratings (or sometimes Viability Ratings for banks) by i) recovery expectations,
including as often indicated by Recovery Ratings assigned in the case of low speculative grade issuers and ii) for banks an assessment of non-performance risk relative to the risk captured in the Issuer Default Rating or Viability Rating (e.g. in
respect of certain hybrid securities).
For performing obligations, the obligation rating represents the risk of default and takes into account the
effect of expected recoveries on the credit risk should a default occur.
If the obligation rating is higher than the rating of the issuer, this
indicates above average recovery expectations in the event of default. If the obligations rating is lower than the rating of the issuer, this indicates low expected recoveries should default occur.
Ratings in the categories of CCC, CC and C can also relate to obligations or issuers that are in default. In this
case, the rating does not opine on default risk but reflects the recovery expectation only.
Description of Fitch Ratings Issuer Default Ratings:
Rated entities in a number of sectors, including financial and non-financial corporations, sovereigns, insurance companies and certain sectors
within public finance, are generally assigned Issuer Default Ratings (IDRs). IDRs are also assigned to certain entities or enterprises in global infrastructure, project finance and public finance. IDRs opine on an entitys relative
vulnerability to default (including by way of a distressed debt exchange) on financial obligations. The threshold default risk addressed by the IDR is generally that of the financial obligations whose non-payment would best reflect the uncured
failure of that entity. As such, IDRs also address relative vulnerability to bankruptcy, administrative receivership or similar concepts.
In
aggregate, IDRs provide an ordinal ranking of issuers based on the agencys view of their relative vulnerability to default, rather than a prediction of a specific percentage likelihood of default.
AAA: Highest credit quality. AAA ratings denote the lowest expectation of default risk. They are assigned only in cases of
exceptionally strong capacity for payment of financial commitments. This capacity is highly unlikely to be adversely affected by foreseeable events.
AA: Very high credit quality. AA ratings denote expectations of very low default risk. They indicate very strong capacity for payment
of financial commitments. This capacity is not significantly vulnerable to foreseeable events.
B-9
A: High credit quality. A ratings denote expectations of low default risk. The
capacity for payment of financial commitments is considered strong. This capacity may, nevertheless, be more vulnerable to adverse business or economic conditions than is the case for higher ratings.
BBB: Good credit quality. BBB ratings indicate that expectations of default risk are currently low. The capacity for payment of
financial commitments is considered adequate but adverse business or economic conditions are more likely to impair this capacity.
BB:
Speculative. BB ratings indicate an elevated vulnerability to default risk, particularly in the event of adverse changes in business or economic conditions over time; however, business or financial alternatives may be available to allow
financial commitments to be met.
B: Highly speculative. B ratings indicate that material default risk is present, but a
limited margin of safety remains. Financial commitments are currently being met; however, capacity for continued payment is vulnerable to deterioration in the business and economic environment.
CCC: Substantial credit risk. Default is a real possibility.
CC: Very high levels of credit risk. Default of some kind appears probable.
C: Near default. A default or default-like process has begun, or the issuer is in a standstill, or for a closed funding vehicle, payment capacity
is irrevocably impaired.
Description of Fitch Ratings Structured Finance Long-Term Obligation Ratings:
Ratings of public finance obligations and ratings of infrastructure and project finance obligations on the long-term scale consider the obligations
relative vulnerability to default. These ratings are typically assigned to an individual security, instrument or tranche in a transaction. In limited cases in U.S. public finance, where Chapter 9 of the Bankruptcy Code provides reliably superior
prospects for ultimate recover to local government obligations that benefit from a statutory lien on revenues, Fitch reflects this in a security rating with limited notching above the IDR. Recover expectations can also be reflected in a security
rating in the U.S. during the pendency of a bankruptcy proceeding under the Code if there is sufficient visibility on potential recover prospects.
AAA: Highest
credit quality.
AAA ratings denote the lowest expectation of default risk. They are assigned only in cases of exceptionally
strong capacity for payment of financial commitments. This capacity is highly unlikely to be adversely affected by foreseeable events.
AA: Very high credit
quality.
AA ratings denote expectations of very low default risk. They indicate very strong capacity for payment of financial
commitments. This capacity is not significantly vulnerable to foreseeable events.
A: High credit quality.
A ratings denote expectations of low default risk. The capacity for payment of financial commitments is considered strong. This capacity may,
nevertheless, be more vulnerable to adverse business or economic conditions than is the case for higher ratings.
BBB: Good credit quality.
BBB ratings indicate that expectations of default risk are currently low. The capacity for payment of financial commitments is considered
adequate, but adverse business or economic conditions are more likely to impair this capacity.
BB: Speculative.
BB ratings indicate an elevated vulnerability to default risk, particularly in the event of adverse changes in business or economic
conditions over time.
B: Highly speculative.
B-10
B ratings indicate that material default risk is present, but a limited margin of safety
remains. Financial commitments are currently being met; however, capacity for continued payment is vulnerable to deterioration in the business and economic environment.
CCC: Substantial credit risk.
Default is a real
possibility.
CC: Very high levels of credit risk.
Default of some kind appears probable.
C: Exceptionally high
levels of credit risk.
Default appears imminent or inevitable.
D: Default.
Indicates a default. Default generally is
defined as one of the following:
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Failure to make payment of principal and/or interest under the contractual terms of the rated obligations;
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b.
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bankruptcy filings, administration, receivership, liquidation or other winding-up or cessation of the business of an
issuer/obligor; or
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c.
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distressed exchange of an obligation, where creditors were offered securities with diminished structural or economic
terms compared with the existing obligations to avoid a probable payment default.
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Description of Fitch Ratings Country Ceilings
Ratings:
Country Ceilings are expressed using the symbols of the long-term issuer primary credit rating scale and relate to sovereign
jurisdictions also rated by Fitch on the Issuer Default Rating (IDR) scale. They reflect the agencys judgment regarding the risk of capital and exchange controls being imposed by the sovereign authorities that would prevent or materially
impede the private sectors ability to convert local currency into foreign currency and transfer to non-resident creditors transfer and convertibility (T&C) risk. They are not ratings but expressions of a cap for the foreign currency
issuer ratings of most, but not all, issuers in a given country. Given the close correlation between sovereign credit and T&C risks, the Country Ceiling may exhibit a greater degree of volatility than would normally be expected when it lies
above the sovereign Foreign Currency Rating.
Description of Fitch Ratings Public Finance and Global Infrastructure Long-Term Obligation Ratings:
Ratings of public finance obligations and ratings of infrastructure and project finance obligations on the long-term scale, including the
financial obligations of sovereigns, consider the obligations relative vulnerability to default. These ratings are typically assigned to an individual security, instrument or tranche in a transaction. In limited cases in U.S. public finance,
where Chapter 9 of the Bankruptcy Code provides reliably superior prospects for ultimate recover to local government obligations that benefit from a statutory lien on revenues, Fitch reflects this in a security rating with limited notching above the
IDR. Recover expectations can also be reflected in a security rating in the U.S. during the pendency of a bankruptcy proceeding under the Code if there is sufficient visibility on potential recovery prospects.
Ratings of structured finance obligations on the long-term scale consider the obligations relative vulnerability to default. These ratings are
typically assigned to an individual security or tranche in a transaction and not to an issuer.
AAA: Highest credit quality. AAA
ratings denote the lowest expectation of default risk. They are assigned only in cases of exceptionally strong capacity for payment of financial commitments. This capacity is highly unlikely to be adversely affected by foreseeable events.
AA: Very high credit quality. AA ratings denote expectations of very low default risk. They indicate very strong
capacity for payment of financial commitments. This capacity is not significantly vulnerable to foreseeable events.
A: High credit
quality. A ratings denote expectations of low default risk. The capacity for payment of financial commitments is considered strong. This capacity may, nevertheless, be more vulnerable to adverse business or economic conditions than is
the case for higher ratings.
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BBB: Good credit quality. BBB ratings indicate that expectations of default risk are
currently low. The capacity for payment of financial commitments is considered adequate but adverse business or economic conditions are more likely to impair this capacity.
BB: Speculative. BB ratings indicate an elevated vulnerability to default risk, particularly in the event of adverse changes in
business or economic conditions over time.
B: Highly speculative. B ratings indicate that material default risk is
present, but a limited margin of safety remains. Financial commitments are currently being met; however, capacity for continued payment is vulnerable to deterioration in the business and economic environment.
CCC: Substantial credit risk. Default is a real possibility.
CC: Very high levels of credit risk. Default of some kind appears probable.
C: Exceptionally high levels of credit risk. Default appears imminent or inevitable.
D: Default. Indicates a default. Default generally is defined as one of the following:
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failure to make payment of principal and/or interest under the contractual terms of the rated obligation;
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(b)
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bankruptcy filings, administration, receivership, liquidation or other winding-up or cessation of the business of an
issuer/obligor where payment default on an obligation is a virtual certainty; or
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(c)
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distressed exchange of an obligation, where creditors were offered securities with diminished structural or economic
terms compared with the existing obligation to avoid a probable payment default.
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Notes: In U.S. public finance, obligations may be
pre-refunded, where funds sufficient to meet the requirements of the respective obligations are placed in an escrow account. When obligation ratings are maintained based on the escrowed funds and their structural elements, the ratings carry the
suffix pre (e.g. AAApre, AA+pre).
Structured Finance Defaults
Imminent default, categorized under C, typically refers to the occasion where a payment default has been intimated by the issuer and is all
but inevitable. This may, for example, be where an issuer has missed a scheduled payment but (as is typical) has a grace period during which it may cure the payment default. Another alternative would be where an issuer has formally announced a
distressed debt exchange, but the date of the exchange still lies several days or weeks in the immediate future.
Additionally, in structured finance
transactions, where analysis indicates that an instrument is irrevocably impaired such that it is not expected to pay interest and/or principal in full in accordance with the terms of the obligations documentation during the life of the
transaction, but where no payment default in accordance with the terms of the documentation is imminent, the obligation will typically be rated in the C category.
Structured Finance Write-downs
Where an
instrument has experienced an involuntary and, in the agencys opinion, irreversible write-down of principal (i.e. other than through amortization, and resulting in a loss to the investor), a credit rating of D will be assigned to
the instrument. Where the agency believes the write-down may prove to be temporary (and the loss may be written up again in future if and when performance improves), then a credit rating of C will typically be assigned. Should the
write-down then later be reversed, the credit rating will be raised to an appropriate level for that instrument. Should the write-down later be deemed as irreversible, the credit rating will be lowered to D.
Notes:
In the case of structured finance, while the
ratings do not address the loss severity given default of the rated liability, loss severity assumptions on the underlying assets are nonetheless typically included as part of the analysis. Loss severity assumptions are used to derive pool cash
flows available to service the rated liability.
The suffix sf denotes an issue that is a structured finance transaction.
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Description of Fitch Ratings Short-Term Ratings Assigned to Issuers and Obligations:
A short-term issuer or obligation rating is based in all cases on the short-term vulnerability to default of the rated entity and relates to the capacity
to meet financial obligations in accordance with the documentation governing the relevant obligation. Short-term deposit ratings may be adjusted for loss severity. Short-Term Ratings are assigned to obligations whose initial maturity is viewed as
short term based on market convention. Typically, this means up to 13 months for corporate, sovereign, and structured obligations, and up to 36 months for obligations in U.S. public finance markets.
F1: Highest Short-Term Credit Quality. Indicates the strongest intrinsic capacity for timely payment of financial commitments; may have an added
+ to denote any exceptionally strong credit feature.
F2: Good Short-Term Credit Quality. Good intrinsic capacity for timely
payment of financial commitments.
F3: Fair Short-Term Credit Quality. The intrinsic capacity for timely payment of financial commitments is
adequate.
B: Speculative Short-Term Credit Quality. Minimal capacity for timely payment of financial commitments, plus heightened
vulnerability to near term adverse changes in financial and economic conditions.
C: High Short-Term Default Risk. Default is a real
possibility.
RD: Restricted Default. Indicates an entity that has defaulted on one or more of its financial commitments, although it
continues to meet other financial obligations. Typically applicable to entity ratings only.
D: Default. Indicates a broad-based default event
for an entity, or the default of a short-term obligation.
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