Note 1. Organization
The Fund is registered as a
non-diversified,
closed-end
management
investment company under the Investment Company Act of 1940, as amended (the “1940 Act”). The Fund’s primary investment objective is total return, consisting of capital appreciation and current income.
Note 2. Significant Accounting Policies
The following is a summary of significant accounting policies followed by the Fund in the preparation of its financial statements. The preparation
of financial statements in conformity with accounting principals generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, and disclosure of
contingent assets and liabilities at the date of the financial statements and the reported amount of increases and decreases in net assets during the reporting period. Actual results could differ from those estimates and those differences could be
significant.
Security valuation procedures for the Fund, which include, nightly price
variance, as well as back-testing such as bi-weekly unchanged price, monthly secondary source and transaction analysis, have been approved by the Board of Trustees (the “Board” or the “Trustees”). All internally fair valued
securities are approved by a valuation committee (“Valuation Committee”) appointed by the Board. The Valuation Committee is comprised of the treasurer, assistant treasurer and two other appropriate investment professionals of the Virtus
Product Management team who previously have been identified to the Board. All internally fair valued securities are updated daily and reviewed in detail by the Valuation Committee monthly unless changes occur within the period. The Valuation
Committee reviews the validity of any model inputs and any changes to the model. Fair valuations are ratified by the Board at least quarterly.
The Fund utilizes a fair value hierarchy which prioritizes the inputs to valuation techniques used to measure fair value into three broad levels.
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Level 1 –
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quoted prices in active markets for identical securities
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Level 2 –
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prices determined using other significant observable inputs (including quoted prices for similar securities, interest rates, prepayment speeds, credit risk, etc.)
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Level 3 –
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prices determined using significant unobservable inputs (including the valuation committee’s own assumptions in determining the fair value of investments)
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A description of the valuation techniques applied to the Fund’s major categories of assets and liabilities measured at fair value on a
recurring basis is as follows:
Equity securities are valued at the official closing price (typically last sale) on the exchange on which the
securities are primarily traded, or if no closing price is available, at the last bid price and are categorized as Level 1 in the hierarchy. Restricted equity securities and private placements that are not widely traded, are illiquid or are
internally fair valued by the valuation committee, are generally categorized as Level 3 in the hierarchy.
31
VIRTUS TOTAL RETURN FUND
NOTES TO FINANCIAL STATEMENTS (Continued)
JUNE 30, 2013 (Unaudited)
Certain non-U.S. securities may be fair valued in cases where closing prices are not readily available or are deemed not reflective of readily
available market prices. For example, significant events (such as movement in the U.S. securities market, or other regional and local developments) may occur between the time that non-U.S. markets close (where the security is principally traded) and
the time that the Fund calculates its net asset value (“NAV”) (generally, 4 p.m. Eastern time the close of the New York Stock Exchange (“NYSE”)) that may impact the value of securities traded in these non-U.S. markets.
Debt securities, including restricted securities, are valued based on evaluated quotations received from independent pricing services or from
dealers who make markets in such securities. For most bond types, the pricing service utilizes matrix pricing that considers one or more of the following factors: yield or price of bonds of comparable quality, coupon, maturity, current cash flows,
type, and current day trade information, as well as dealer supplied prices. These valuations are generally categorized as Level 2 in the hierarchy. Structured Debt Instruments such as mortgage-backed and asset-backed securities may also incorporate
collateral analysis and utilize cash flow models for valuation and are generally categorized as Level 2 in the hierarchy. Pricing services do not provide pricing for all securities and therefore indicative bids from dealers are utilized which are
based on pricing models used by market makers in the security and are generally categorized as Level 2 in the hierarchy. Debt securities that are not widely traded, are illiquid, or are internally fair valued by the valuation committee are generally
categorized as Level 3 in the hierarchy.
Listed derivatives that are actively traded are valued based on quoted prices from the exchange
and are categorized as Level 1 in the hierarchy. Over the counter (“OTC”) derivative contracts, which include forward currency contracts and equity linked instruments, do not require material subjectivity as pricing inputs are observed
from actively quoted markets and are categorized as Level 2 in the hierarchy.
Investments in
open-end
mutual funds are valued at their closing NAV determined as of the close of regular trading on the NYSE each business day and are categorized as Level 1 in the hierarchy.
A summary of the inputs used to value the Fund’s major categories of assets and liabilities, which primarily include investments of the Fund,
by each major security type is disclosed at the end of the Schedule of Investments for the Fund. The inputs or methodologies used for valuing securities are not necessarily an indication of the risk associated with investing in those securities.
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B.
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Security Transactions and Investment Income
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Security transactions are recorded on the trade
date. Realized gains and losses from sales of securities are determined on the identified cost basis. Dividend income is recognized on the
ex-dividend
date or, in the case of certain foreign securities, as
soon as the Fund is notified. Interest income is recorded on the accrual basis. The Fund amortizes premiums and accretes discounts on securities using the effective interest method.
The Fund is treated as a separate taxable entity. It is the intention
of the Fund to comply with the requirements of Subchapter M of the Internal Revenue Code and to
32
VIRTUS TOTAL RETURN FUND
NOTES TO FINANCIAL STATEMENTS (Continued)
JUNE 30, 2013 (Unaudited)
distribute substantially all of its taxable income to its shareholders. Therefore, no provision for federal income taxes or excise taxes has been made.
The Fund may be subject to foreign taxes on income, gains on investments or currency repatriation, a portion of which may be recoverable. The Fund
will accrue such taxes and recoveries as applicable based upon current interpretations of the tax rules and regulations that exist in the markets in which it invests.
Management of the Fund has concluded that there are no significant uncertain tax positions that would require recognition in the financial
statements. As of June 30, 2013, the tax years that remain subject to examination by the major tax jurisdictions under the statute of limitations are from the year 2009 forward (with limited exceptions).
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D.
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Distributions to Shareholders
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Distributions are recorded by the Fund on the ex-dividend
date. Income and capital gain distributions are determined in accordance with income tax regulations, that may differ from accounting principles generally accepted in the United States of America. These differences may include the treatment of
non-taxable dividends, market premium and discount, non-deductible expenses, expiring capital loss carryovers, foreign currency gain or loss, operating losses and losses deferred due to wash sales. Permanent book and tax basis differences relating
to shareholder distributions will result in reclassifications to capital paid in on shares of beneficial interest.
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E.
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Foreign Currency Translation
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Non-U.S. investment securities and other assets and
liabilities denominated in foreign currencies are translated into U.S. dollar amounts at the foreign currency exchange rate effective at the end of the reporting period. Cost of investments is translated at the currency exchange rate effective at
the trade date. The gain or loss resulting from a change in currency exchange rates between the trade and settlement date of a portfolio transaction is treated as a gain or loss on foreign currency. Likewise, the gain or loss resulting from a change
in currency exchange rates between the date income is accrued and paid is treated as a gain or loss on foreign currency. The Fund does not isolate that portion of the results of operations arising from changes in foreign exchange rates on
investments from the fluctuations arising from changes in the market prices of securities held. Such fluctuations are included with the net realized and unrealized gain or loss on investments.
The preparation of financial statements in conformity with U.S. generally
accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates.
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G.
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When-issued Purchases and Forward Commitments (Delayed-Delivery)
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The Fund may engage in
when-issued or forward commitment transactions. Securities purchased on a when-issued or forward commitment basis are also known as delayed delivery transactions. Delayed delivery transactions involve a commitment by the Fund to purchase or sell a
security at a future date, ordinarily up to 90 days later. When-issued or forward commitments enable the Fund to lock in what is believed to be an
33
VIRTUS TOTAL RETURN FUND
NOTES TO FINANCIAL STATEMENTS (Continued)
JUNE 30, 2013 (Unaudited)
attractive price or yield on a particular security for a period of time, regardless of future changes in interest rates. The Fund records when-issued and delayed delivery securities on the trade
date. The Fund maintains collateral for the securities purchased. Securities purchased on a when-issued or delayed delivery basis begin earning interest on the settlement date.
The Fund may invest in direct debt instruments which are interests in
amounts owed by a corporate, governmental, or other borrower to lenders or lending syndicates. The Fund’s investments in loans may be in the form of participations in loans or assignments of all or a portion of loans from third parties. A loan
is often administered by a bank or other financial institution (the lender) that acts as agent for all holders. The agent administers the terms of the loan, as specified in the loan agreement. When investing in a loan participation, the Fund has the
right to receive payments of principal, interest and any fees to which it is entitled only from the lender selling the loan agreement and only upon receipt by the lender of payments from the borrower. The Fund generally has no right to enforce
compliance with the terms of the loan agreement with the borrower. As a result, the Fund may be subject to the credit risk of both the borrower and the lender that is selling the loan agreement. When the Fund purchases assignments from lenders it
acquires direct rights against the borrower on the loan. Direct indebtedness of emerging countries involves a risk that the government entities responsible for the repayment of the debt may be unable, or unwilling, to pay the principal and interest
when due. As of the date of this report, the Fund held only assignment loans.
Expenses incurred together by the Fund and other affiliated mutual funds are
allocated in proportion to the net assets of each such fund, except where allocation of direct expense to each fund or an alternative allocation method can be more appropriately used.
In addition to the net annual operating expenses that the Fund bears directly, the shareholders of the Fund indirectly bear the Fund’s
pro-rata expenses of any underlying mutual funds in which the Fund invests.
Note 3. Investment Advisory Fees and Related
Party Transactions
Virtus Investment Advisers, Inc. (the “Adviser”), an indirect wholly
owned subsidiary of Virtus Investment Partners, Inc. (“Virtus”), is the Adviser to the Fund. The Adviser manages the Fund’s investment program and general operations of the Fund, including oversight of the Fund’s subadvisers. As
compensation for its services to the Fund, the Adviser will receive a monthly fee at an annual rate of 0.85% of the Fund’s average daily managed assets which is defined as the average daily value of the total assets of the Fund minus the sum of
all accrued liabilities of the Fund (other than the aggregate amount of any outstanding borrowings or other indebtedness, constituting financial leverage).
34
VIRTUS TOTAL RETURN FUND
NOTES TO FINANCIAL STATEMENTS (Continued)
JUNE 30, 2013 (Unaudited)
The subadvisers manage the investments of the Fund, for which they are paid a
fee by the Adviser. DPIM, an indirect wholly-owned subsidiary of Virtus, is the subadviser for the Equity portfolio of the Fund, and Newfleet, an indirect wholly-owned subsidiary of Virtus, is the subadviser for the Fixed Income portfolio of the
Fund.
($ reported in thousands)
Effective January 1, 2013, VP Distributors LLC, the Fund’s former Administrator assigned its rights and obligations under the Administration
Agreement to Virtus Fund Services, LLC, an indirect wholly-owned subsidiary of Virtus.
For the period ended June 30, 2013, the Fund incurred
administration fees totaling $89 which are included in the Statement of Operations. A portion is paid to outside entities that also provide services to the Fund.
During the period, each Trustee who is not an interested person of the Fund or the
Adviser was paid a $20,000 annual retainer plus a $5,000 fee per Trustee for each meeting attended, together with the out-of-pocket costs relating to attendance at such meetings. The Audit Committee chairperson also receives an additional $5,000
retainer, the Nominating Committee chairperson receives an additional $2,000 retainer, and the Chairman of the Board receives an additional $20,000 in annual retainer. These fees are shared with another closed-end fund based on managed assets. Any
Trustee who is an interested person of the Fund or the Adviser, receives no remuneration from the Fund.
Note 4. Purchases
and Sales of Securities
($ reported in thousands)
Purchases and sales of securities (excluding U.S. Government and agency securities, and short term investments) during the period ended June 30,
2013, were as follows:
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Purchases
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$
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43,043
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Sales
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35,347
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There were no purchases and sales of long term U.S. Government and agency securities for the period ended
June 30, 2013:
Note 5. Indemnifications
Under the Fund’s organizational documents, its officers and Trustees are indemnified against certain liabilities arising out of the
performance of their duties to the Fund. Each Trustee has also entered into an indemnification agreement with the Fund. In addition, in the normal course of business, the Fund enters into contracts that provide a variety of indemnifications to other
parties. The Fund’s maximum exposure under these arrangements is unknown as this would involve future claims that may be made against the Fund and that have not occurred. However, the Fund has not had prior claims or losses pursuant to such
arrangements and expects the risk of loss to be remote.
35
VIRTUS TOTAL RETURN FUND
NOTES TO FINANCIAL STATEMENTS (Continued)
JUNE 30, 2013 (Unaudited)
Note 6. Capital Transactions
At June 30, 2013, the Fund had one class of common stock, par value $0.001 per share, of which unlimited shares are authorized and 27,466,109
shares are outstanding. Registered shareholders may elect to have all distributions paid by check mailed directly to the shareholder by Computershare as dividend paying agent. Pursuant to the Automatic Reinvestment and Cash Purchase Plan (the
“Plan”), shareholders not making such election will have all such amounts automatically reinvested by Computershare, as the Plan agent, in whole or fractional shares of the Fund, as the case may be. During the periods ended June 30, 2013
and December 31, 2012, there were no shares issued pursuant to the Plan.
On July 1, 2013, the Fund announced a distribution of $0.05 to
shareholders of record on July 11, 2013. This distribution has an ex-dividend date of July 9, 2013, and is payable on July 18, 2013.
Note 7. Credit Risk and Asset Concentrations
In countries with limited or developing markets, investments may present greater risks than in more developed markets and the prices of such
investments may be volatile. The consequences of political, social or economic changes in these markets may have disruptive effects on the market prices of these investments and the income they generate, as well as the Fund’s ability to
repatriate such amounts.
High-yield/high risk securities typically entail greater price volatility and/or principal and interest rate risk.
There is a greater chance that an issuer will not be able to make principal and interest payments on time. Analysis of the creditworthiness of issuers of high-yield securities may be complex, and as a result, it may be more difficult for the Adviser
and/or Subadviser to accurately predict risk.
The Fund may invest a high percentage of its assets in specific sectors of the market in its
pursuit of a greater investment return. Fluctuations in these sectors of concentration may have a greater impact on the Fund, positive or negative, than if the Fund did not concentrate its investments in such sectors.
Note 8. Borrowings
($ reported in thousands)
The
Fund has entered into a Credit Agreement (the “Agreement”) with a commercial bank (the “Bank”) that allows the Fund to borrow cash from the Bank, up to a limit of $55,000 which may be increased to $75,000 under certain
circumstances (“Commitment Amount”). Borrowings under the Agreement are collateralized by investments of the Fund. Interest is charged at LIBOR (London Interbank Offered Rate) plus an additional percentage rate on the amount borrowed.
Commitment fees are charged on the undrawn balance, if less than 50% of the Commitment Amount is outstanding as a loan to the Fund. Total commitment fees paid and accrued for the period ended June 30, 2013, were $1 and are included in interest
expense and fees on the Statement of Operations. The Agreement has a term of 364 days and is renewable by the Fund with the Bank’s consent. The Agreement can also be converted into a 364 day fixed term facility, one time at the Fund’s
option. The Bank has the ability to require repayment of outstanding borrowings under the Agreement upon certain circumstances such as an event of default. From January 1, 2013 – June 30, 2013, the average daily borrowings under the Agreement
and the weighted daily average interest
36
VIRTUS TOTAL RETURN FUND
NOTES TO FINANCIAL STATEMENTS (Continued)
JUNE 30, 2013 (Unaudited)
rate were $47,754 and 1.032%, respectively. At June 30, 2013, the amount of such outstanding borrowings was as follows:
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Outstanding
Borrowings
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Interest
Rate
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$50,500
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0.996%
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Note 9. Certain Provisions of the Declaration of Trust
The Fund’s Amended and Restated Declaration of Trust (“Declaration”) contains restrictions on the acquisitions and dispositions of
its shares. The restrictions on acquisitions and dispositions of the Fund’s shares are intended to preserve the benefit of the Fund’s capital loss carryforwards and certain other tax attributes for tax purposes.
The restrictions are designed to prevent an “ownership change”, as such term is defined in the Internal Revenue Code of 1986, as amended
(the “Code”). Section 382 of the Code imposes significant limitations on the ability of an entity classified as a corporation to use its capital loss carryforwards to offset income in circumstances where such entity has experienced an
“ownership change” and may also limit such an entity’s ability to use any built-in losses recognized within five years of any “ownership change.”
The restrictions in the Declaration generally prohibit any attempt to purchase or acquire in any manner whatsoever the Fund’s shares or any
option, warrant or other right to purchase or acquire shares, or any convertible securities (the “Shares”), if as a result of such purchase or acquisition of such Shares, any person or group becomes a greater than 4.99% shareholder (as
defined in the Code), which generally includes a person or group that beneficially owns 4.99% or more of the market value of the total outstanding shares, or the percentage of the Fund’s shares owned by a 4.99% shareholder (as defined in the
Code) would be increased. As a result of these restrictions, certain transfers of shares by existing 4.99% shareholders are prohibited. Any attempted transfer in violation of the foregoing restrictions will be void ab initio unless the transferor or
transferee obtains the written approval of the Board, which it may grant or deny in its sole and absolute discretion. The purported transferee will not be entitled to any rights of shareholders of the Fund with respect to the shares that are the
subject of the prohibited transfer, including the right to vote such shares and to receive dividends or distributions, whether liquidating or otherwise, in respect of such shares.
If the Board determines that a transfer would be prohibited, then, upon the Fund’s written demand, the purported transferee will transfer the
shares that are the subject of the prohibited transfer, or cause such shares to be transferred, to the Fund, which shall be deemed an agent for the limited purpose of consummating a sale of the share to a person who is not a 4.99% shareholder. The
proceeds of the sale of any such shares will be applied first to the Fund acting in its role as the agent for the sale of the prohibited shares, second, to the extent of any remaining proceeds, to reimburse the intended transferee for any payments
made to the transferor by such intended transferee for such shares, and the remainder, if any, to the original transferor.
37
VIRTUS TOTAL RETURN FUND
NOTES TO FINANCIAL STATEMENTS (Continued)
JUNE 30, 2013 (Unaudited)
Note 10. Federal Income Tax Information
($ reported in thousands)
At June
30, 2013, federal tax cost and aggregate gross unrealized appreciation (depreciation) of securities held by the Fund were as follows:
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Federal
Tax Cost
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Unrealized
Appreciation
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Unrealized
(Depreciation)
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Net Unrealized
Appreciation
(Depreciation)
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$162,105
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$14,132
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$(3,129)
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$11,003
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The Fund has capital loss carryovers which, may be used to offset future capital gains, as follows:
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Expiration
Year
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2016
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2017
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2018
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No Expiration
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Total
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$60,723
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$57,803
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$12,736
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$1,266
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$132,528
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Under the Regulated Investment Company Modernization Act of 2010 (the “Act”), net capital losses
recognized for tax years beginning after December 22, 2010 may be carried forward indefinitely, and their character is retained as short-term and/or long-term losses. As a transition rule, the Act requires that post-enactment net capital losses
be used before pre-enactment net capital losses.
The Fund may not realize the benefit of these losses to the extent the Fund does not realize
gains on investments prior to the expiration of the capital loss carryovers.
Note 11. Regulatory Exams
Federal and state regulatory authorities from time to time make inquiries and conduct examinations regarding compliance by Virtus and its
subsidiaries (collectively “the Company”) with securities and other laws and regulations affecting their registered products. There are currently no such matters which the Company believes will be material to these financial statements.