Risk aversion was a theme that was very prevalent in the second quarter of 2010. World equity returns were particularly negative in May, with the MSCI EAFE (Europe, Australasia, Far East) Net Dividends Index declining by double-digits for both May and the quarter. The European debt crisis heightened investors' fears of slowing global growth and the possibility of a double-dip recession in some regions. The issues that European countries are facing have been brewing over time, with loose fiscal policy and deficit spending resulting in an inability to service government debt. One of the worst fiscal offenders in the European Union was Greece (whose sovereign debt was downgraded to junk status by Standard & Poor's), but Spain, Portugal and Italy also felt the pressure of carrying a heavy debt load. Stocks in y these countries were hard hit during the quarter. The market in Greece lost 40.4%, while Spain and Italy fell by approximately 20% and Portugal's market was down 16.7%. There was no safe harbor, as all markets represented in the Index lost value during the quarter. Singapore had the strongest performance, eking out a slight negative return of -0.1%. Strong growth in China and India was a plus for markets in Asia and the Pacific Rim. The Hong Kong market was down only 6.0%, while Japan was down 10.1%. In this turbulent environment, the Fund lagged slightly behind its MSCI EAFE (net dividends) benchmark for the quarter.

Portfolio Review

The Fund benefited from its underweight in Greece, Australia, Finland and France. However, as Japan sold off less than other countries, and the Index in general, our underweight in Japanese stocks detracted slightly from relative performance during the quarter. However, the Fund's Japanese holdings, especially in the industrials and consumer discretionary sectors, detracted slightly from relative performance. Stocks of some Japanese exporters, such as Honda Motor Company, Ltd. (1.2% of the Fund) and Nissan Motor Company, Ltd. (0.7%), pulled back as the Japanese yen strengthened, with investors concerned about the potential negative impact on the companies' expected earnings. All ten economic sectors of the MSCI EAFE Index had negative returns for the second quarter of 2010, driven by concerns about slowing global growth resulting from austerity measures recently announced by several governments. These governments are planning to implement austerity measures to put their fiscal houses in order after two years of government stimulus designed to rescue economies and institutions from the brink. The U.K. government announced such measures at the G20 meeting in Toronto in May, which included a package of tax increases and spending cuts. That announcement sent ripples throughout an already weakened Europe, and came at a time when the U.S. continues to press for further stimulus. The energy and financials sectors fell hardest, with declines of 22.5% and 17.0%, respectively. Defensive sectors experienced more moderate declines, with the consumer staples, telecommunications services and health care sectors falling by 7.4%, 9.4% and 9.6%, respectively. Security selection was strong in the Fund's financials sector, as the better capitalized insurance and financial institutions that are held in the Fund performed better than many of the companies in the sector that we chose not to own. As examples, the Fund held a position in Hong Kong-based Industrial & Commercial Bank of China (0.7%), which jumped 9.6% during the quarter, and in United Overseas Bank Ltd. (0.8%), based in Singapore, which was up 4.4% in an otherwise falling market. Other examples in the U.K. and Australia demonstrate how the strategy benefited from the relative value between peers. The Fund held a moderate overweight position in Australia and New Zealand Bank (0.8%), which fell by 19.8% during the quarter, but avoided owning Westpac Banking Corp., of Australia, which fell 27.9%. Similarly, the Fund held Standard Chartered PLC (1.5%), a U.K. commercial bank, which was down 10.0%, while avoiding institutions ranked lower in our selection process, such as Barclays PLC, which fell 25.7%. The relative strength from security selection in the financials sector, as well as the consumer discretionary sector, offset much of the headwinds from the industrials and energy sectors for the quarter.

Market Outlook