Market Overview
Equity markets were volatile throughout 2010’s second quarter, with initial strength giving way to acute weakness for much of the period. The Standard & Poor’s 500 Index returned -11.43%, including dividends in the quarter.

Fund Performance
The second quarter 2010 return for the fund was 10.20% (Class A Shares at NAV).

Performance data quoted represents past performance which is no guarantee of future results. Investment return and principal value will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Current performance may be lower or higher than what is stated. Other share classes may have experienced different returns than the share class presented. To view performance current to the most recent month-end and for after tax returns, click on Performance to the left.

Also click Performance on the left for standard fund performance.

The fund began the quarter conservatively positioned, with overall short exposure nearer the low end of the typical range of 70% to 100%. Short exposure was increased meaningfully early in the quarter as the Greek crisis jumped to other markets. With commodity-related equities under pressure, the fund’s natural resources long investment portfolio somewhat negatively impacted fund performance.

Positioning and Strategy
It is the portfolio managers’ view that the Greek debt crisis marked another critical inflection point for global financial markets. Importantly, markets began reassessing risks associated with structural debt issues in Europe and elsewhere. This backdrop of heightened uncertainty and renewed risk aversion was the catalyst for closing out an extraordinary period of ultra-loose U.S. financial conditions.

From the March 2009 lows to this past April’s trading highs, the Standard & Poor’s 500 Index had rallied more than 80%. The broader market was even stronger, with the Standard & Poor’s 400 Mid-cap and Russell 2000 Small Cap indexes more than doubling. The Morgan Stanley Retail Index almost tripled from previous lows, and the Standard & Poor’s Regional Bank Index surged 250%. It was a historic stock market rally and short squeeze — that ended abruptly during the quarter, as Greece’s debt crisis unleashed global contagion effects.

Since late 2008, unprecedented synchronized global policy stimulus fueled rallies throughout international risk assets. Investors and speculators enjoyed months of powerful reflationary dynamics, incited by policies designed specifically to boost global market liquidity, risk-taking, asset prices, and spending.

In particular, U.S. financial market and economic recoveries were powered by four extraordinary sources of “loose” finance. Over the seven quarters ended March 31, 2010, federal borrowings increased $3.27 TN, or 49%, to $9.97 trillion. During the same period, Federal Reserve assets expanded $1.39 TN, or 146%, to $2.39 trillion. Near-zero interest rates also contributed to ultra-loose financial conditions. From the January 2009 high, money market fund assets declined $1.10 trillion, as a rush for higher returns created an unprecedented wave of liquidity to inflate global markets.

The fourth key source of reflationary finance was less transparent: renewed risk embracement and re-leveraging by the hedge funds and global speculators. Marketplace liquidity was generated from securities leveraging, “carry trades,” and other sophisticated speculative activities. Prior to the Greek debt crisis, market perceptions held that global policymakers had things well under control; that aggressive fiscal and monetary stimulus ensured liquid markets and a sustainable global recovery. But as the Greek crisis spun out of control and contagion effects commenced, a radical reassessment of global prospects — and trading positions — was required.

The fund managers never backed away from their secular bearish thesis, viewing government-induced “loose” finance as destabilizing and unsustainable. Massive global fiscal and monetary stimulus worked to spawn bubbles and heightened systemic risk, without rectifying financial fragilities and economic imbalances. Their view remains that the U.S. economy is in the early stage of unavoidable adjustment and restructuring. The Greek crisis was a catalyst for market focus on structural debt issues, and, in the fund managers’ view, the U.S. faces very serious structural problems.

The fund was positioned defensively as 2010 began and maintained this posture to commence the second quarter. A more opportunistic stance was adopted as the Greek crisis expanded and financial conditions tightened. Short exposure was increased and the composition of this exposure was altered. Short positions in both individual companies and sectors were increased. Put options were also purchased to gain additional exposure to a market decline. The fund’s allocation to its long resources investments was reduced somewhat to the lower end of traditional long exposure.

It is the fund managers’ strategy to increase short exposure when financial conditions tighten and the environment for shorting turns more favorable. The managers believe renewed risk aversion, market tumult, faltering confidence and economic vulnerability have improved the risk versus reward backdrop for being short stocks, sectors and the overall equity market. During the second quarter of 2010, short exposure was boosted to the highest level since the fourth quarter of 2008.