In 1999, the U.S. economy exhibited steady growth, benign inflation, a Federal budget surplus, as well as increases in employment and real incomes. In addition to these upbeat indicators, many businesses experienced another year of increased earnings and the stock market ended another year with double digit increases. However, unlike 1998, when the Fed decreased interest rates 50 basis points, in 1999 the Fed increased interest rates by 75 basis points to address liquidity issues and to head off any manifestations of inflation. 1999 also saw the resurgence of the Japanese economy (the Nikkei was up 124%) as well as most emerging markets.

The markets were volatile again in 1999, however, we did not witness another broad market correction such as the one that struck in October of 1998. The S&P 500 notched a fifth consecutive double digit gain in 1999 finishing the year up 21.03%. The FINRAAQ index broke every record imaginable on its way to an 85.6% finish and the Russell 2000 notched its best return in nearly two years finishing up 19.6%. The real story in the market, however, was the FINRAAQ index. In the last three months of 1999 technology stocks set a torrid pace. From October 18 through December 31, the FINRAAQ tacked on 1380 points, going from 2689.15 to 4069.13. The market for 1999 can best be summed up as: Technology, Technology, and Technology. The reason the Technology sector took top honors for performance can be summed up as: Earnings, Earnings, and Earnings. No other sector could boast such high quality earnings and solid fundamentals (Internet stocks excepted). The main reason behind the eye-popping performance of the technology sector is the build-out of the Internet. One could make a case that there are no technology companies that are not involved with the Internet in some fashion. We still believe the best way to play the Internet is to invest in those companies that are building the infrastructure of the Internet or whose products are an integral component in other company’s Internet infrastructure products. With that said, we cast a wary eye towards the consumer focused internet sector while at the same time we are watching with interest any company focused on business-to-business e-commerce, telecommunications, telecommunications semiconductors (IC’s), broadband, network storage, and other similar undercurrents.

The SM&R Growth Fund (Class T) was able to post a 24.49% return before sales charges (but after other expenses) in 1999 vs. the S&P 500 at 21.03%. An over weighted technology sector was the primary reason for the strong performance. When we refer to a sector as being over weighted, we are referring to the sector weighting relative to the S&P 500. Other sectors that contributed to the performance were Utilities, Transportation, and Energy. The fund is well diversified across all sectors and overweighs sectors by no more than twice the S&P 500 sector weights and under weights by no more than half the S&P 500 sector weights.

Although the Y2K problem initially appears to have been more hype than an actual problem, the real tests are still to come. January 30, 2000 represents the first real data crunching test of the year for business. Going forward, the end of each month and the end of each quarter represent potential data crunching problems for business primarily because this time the exercise will be live and not some sort of rigged test or experiment. The media misled the public and even some businesses into thinking that the real problems would occur exactly at midnight on December 31 when in actuality, the real threat would be present throughout the year. We will continue to monitor the situation carefully but don’t expect any major developments.

We continue to seek out undervalued companies undergoing positive changes in fundamentals and selling those issues that have hit their price targets or whose fundamentals do not warrant inclusion in our portfolio. Within the Technology sector we seek to identify those companies that possess a unique advantage within their niche or are considered to be the leader within their sub-sector. These processes have served the fund well over the last several years and should continue to do so going forward. Areas of the market that we will be watching closely in 2000 will be Healthcare, Financials, Capital Goods, Consumer Cyclicals, Technology, Telecommunications, and Utilities.

The SM&R Equity Income Fund’s objective is to provide current income, along with an opportunity for increased share price over time. The fund is guided by a strategy of investing in primarily the stocks of well-established companies with records of consistent and increasing dividend payments. In 1999, the fund (Class T) produced a return of (1.39)%, before sales charges (but after other expenses.) Over that same time frame, the fund’s peers, as measured by the Lipper Equity Income Fund Index, returned 4.19%. The fund has continued to surpass the goal of maintaining a dividend yield at least 50% greater than that of the market, as represented by the Standard & Poor’s 500 stock market index. The current dividend yield on the fund is 2.7% versus 1.2% for the S&P 500.

The fund’s performance suffered from its overweighed position in financial services relative to the S&P 500 financial sector weight. The poor performance of financial companies is a result of interest rates rising throughout 1999. We feel this is a short-term phenomenon and have strong convictions regarding the outlook for financial companies going forward—particularly the financial conglomerates, which offer a variety of services to consumers. The financial sector is also where investors can locate strong dividend yielding stocks. As such, the financial sector currently encompasses nearly one quarter of the fund’s holdings.

As 1999 wound down, it was clear to all market watchers that technology was the place to be invested. The Equity Income Fund currently invests a relatively small portion of its assets in the technology sector, as these companies typically need to reinvest their cash and therefore do not pay a dividend to shareholders. While we have concerns regarding what appears to be a "speculative bubble" in technology investing, we are looking to slightly increase our technology exposure in the fund when and if we see a pullback in the lofty levels this sector is currently exhibiting. While we will not deviate from our value style, nor our conservative philosophy, we believe we can afford to take on incremental levels of risk going forward as we have a strong enough portfolio yield to allow for some diversification into non-dividend paying stocks. We can assure you, though, that we will not follow in the footsteps of our competitors and raise our technology weighting to greater than the market, nor even a market weighting, as many of our so-called equity income fund competitors have done.

Going forward, we believe the market will remain in a relatively flat trading range over the next several quarters as the economic fundamentals which drive the equity markets harbor neither terribly worrisome nor exuberant information. We maintain a cautious tilt, however, as the market appears clearly overvalued by most historical measures. We believe inflation will tick upwards for the year 2000, and at a quicker rate than forecast by the Federal Reserve. The reasoning behind our forecast is that productivity can only offset wage inflation for so long. Currently, wage inflation, as measured by the Employment Cost Index, is growing at a faster rate than CPI. However, productivity is growing at the same rate as wages. There is nothing inflationary about wages growing as fast as productivity. We feel productivity will taper off after several quarters of strong showings and wage inflation will reveal itself in the CPI numbers. We also feel GDP growth will slow to around 3% and CPI will increase to around 3% in early 2000 as productivity slows.

Under our forecast environment, technology shares will likely come down off their recent highs, as investors will begin to doubt the growth assumptions underlying their lofty valuations. When this occurs, these same investors will likely seek solace in the shares of companies with stable, predictable earnings growth combined with the safety of dividends, such as energy, financials and consumer staples—all core sectors for the SM&R Equity Income Fund. While the fund has not lived up to even our expectations for 1999, we would remind our shareholders that the fund strives to maintain a strong dividend yield, holding a portfolio of value stocks, maintaining low turnover-which leads to low taxes, and stays true to its stated goal of conservative investments in stable, dividend paying companies with the potential for share price appreciation over time.

The SM&R Balanced Fund is the lowest risk fund in the SM&R Equity Funds. The fund strives to maintain the objective of providing reasonable current income and share price appreciation, while protecting the initial investment. The fund’s investment strategy is to use a balanced approach by investing in a combination of the high-yielding stock of well-known companies, as well as bonds and money market instruments. Throughout 1999, the fund’s conservative blend of about 60% stocks, 25% bonds and 15% money market instruments has served the fund well. The equity portion of the fund produced a total return (capital appreciation and dividend income) of approximately 21% while the bond portion of the fund returned approximately (1.0)%. Combined, the fund (Class T) produced a total return of 11.87% during 1999, before sales charges (but after other expenses.) As a comparison, the fund’s peers, as measured by the Lipper Balanced Fund Index returned 8.98% over the same period.

Within the fund, we continued our fixed income strategy of structuring maturities at the mid-term to long end of the yield curve. Within the equity portion of the fund, we utilize the same conservative and defensive stock selection disciplines used in the SM&R Equity Income and Growth Funds. The key is identifying stocks of superior companies and purchasing them at discounted valuations. During 1999, we noted particular strength from our equity holdings in the technology and energy sectors. The fund benefited from the nearly market weight of technology companies relative to the S&P 500. While this may appear to contradict our philosophy of conservative stewardship, we feel the balanced stock/bond approach allows us a little more latitude in sector allocation versus say, the Equity Income Fund. In other words, the stability of the fixed income portion allows us to increase the risk on the equity portion. Feel secure in knowing, however, that the fund will not go to excesses seen by other funds this year. We do not feel a market weight in technology projected unnecessary risk into the fund and it provided for strong overall fund performance during a year in which fixed income investing produced a negative return.

Balanced Fund investors were rewarded again in 1999 by their investment in the fund, with a fifth consecutive year of double-digit returns. Although the fund has not produced the spectacular returns witnessed by some equity funds over the last year or two, we have achieved our goal of providing consistently positive performance in the strong up market and believe the fund is well positioned should equity markets turn downward. The conservative and low risk balanced approach has enabled SM&R to provide upside potential while protecting the downside via this uniquely positioned fund.

Going forward, we believe the market will remain in a relatively flat trading range over the next several quarters as the economic fundamentals which drive the equity markets harbor neither terribly worrisome nor exuberant information. We maintain a cautious tilt however, as the market appears clearly overvalued by most historical measures. We believe inflation will tick upwards for the year 2000, and at a quicker rate than forecast by the Federal Reserve. The reasoning behind our forecast is that productivity can only offset wage inflation for so long. Currently wage inflation, as measured by the Employment Cost Index, is growing at a faster rate than CPI. However, productivity is growing at the same rate as wages. There is nothing inflationary about wages growing as fast as productivity. We feel productivity will taper off after several quarters of strong showings and wage inflation will reveal itself in the CPI numbers. We feel GDP growth will slow to around 3% and CPI will increase to around 3% in early 2000 as productivity slows.

Under our forecast environment, technology shares will likely come down off their recent highs, as investors will begin to doubt the growth assumptions underlying their lofty valuations. When this occurs, these same investors will likely seek solace in the shares of companies with stable, predictable earnings growth combined with the safety of dividends, such as energy, healthcare, and consumer staples—all core sectors for the SM&R Balanced Fund. This should provide upside for the equity portion of the fund, while the fixed income portion protects the overall portfolio value from sustained market corrections.

Bondholders experienced a breathtaking roller coaster ride over the past twelve months. Investors who turned to bonds for safety and security instead experienced volatility and uncertainty. Market volatility caused by economic problems in Asia and Russia caused the collapse of the hedge fund, Long Term Capital Management. As the hedge fund's losses mushroomed to over $4 billion, a consortium of 14 banks and brokerage firms negotiated a bailout plan. The demise of the little-known fund heightened concerns of a global liquidity crisis. This spurred the Federal Reserve into making three separate 25 basis point (or 1/4 percentage point) reductions in the Fed Funds rate, the rate banks charge each other for overnight borrowing. These events sparked a "flight to quality" as investors sold corporate bonds and shifted into U.S. Treasury Bonds. The yield on the 30-year Treasury bond subsequently declined to a three-decade low of 4.69% in October 1998.

Interest rates reversed course during 1999, however. The yield on the 30-year Treasury bond rose by 100 basis points or 1 percentage point. Economic data rather than stocks and emerging markets returned as the driving force behind movements in interest rates. The market sentiment on expected Federal Reserve interest rate action shifted from easing early in the year to tightening by late in the second quarter. Concerns that a global recession could hurt U.S. economic growth changed to worries that a global recovery could bring competition for the foreign capital that has supported U.S. Treasury markets.

As the difference in the yields between corporate bonds and Treasury securities increased, we took the opportunity to place approximately 35% of your portfolio in investment grade corporate issues. The diversification and a shorter weighted-average maturity of the fund enabled your fund (Class T) to achieve a return of (1.27)% since the beginning of 1999 versus a return of (1.51)% for the Lehman Government/Mortgage-Backed Securities Index.

With the rapid decline and subsequent rise in long-term bond interest rates over the past twelve months, investors who turned to short-term bonds found some protection from the market's volatility. During the fourth quarter 1998, investors concerns about a collapse of emerging markets and a liquidity crisis drove long-term Treasury bond yields to a three-decade low.

Interest rates reversed course in 1999, however, as economic data rather than stocks and emerging markets returned as the reason for movement in interest rates. The yield on the 30-year Treasury bond rose by 100 basis points (or 1 percentage point) as Federal Reserve interest rate policy shifted from easing to tightening. From September through November 1998, the Federal Reserve reduced the Fed Funds rate (the rate banks charge each other for overnight loans) by 150 basis points in order to avert a worldwide liquidity crisis. In 1999, however, concerns that a global recession could hurt U.S. economic growth changed to worries that a global recovery could bring competition for the foreign capital that has supported U.S. Treasury markets. In order to take a "preemptive strike" against a rise in inflation, the Federal Reserve increased the Fed Funds rate 100 basis points, effectively "taking back" two-thirds of the interest rate reductions of the fall.

The weighted-average maturity of 0.05 years at the beginning of 1999 provided a great deal of price stability for your fund during this rise in interest rates. Five percent of your portfolio's net assets were invested in the long bond (the 30-year U.S. Treasury bond) as yields topped 6.25%. Another 20 percent was invested in corporate bonds with maturities ranging from one to five years. These bonds represent a mix of sectors, including utility, financial and industrial. By the end the fiscal year, August 31, 1999, the fund's weighted-average maturity had lengthened to 1.46 years.

These changes enhanced the yield and return for your fund. The total return for the SM&R Primary Fund from the beginning of 1999 through August 31, 1999 was 3.0% versus 1.8% for the Lehman 1-3 year Government/Corporate Bond Index. Your fund also outpaced this index for the past 12 months, returning 4.8% versus 4.0% for the index.

Yields have climbed in all key sectors of the U.S. Fixed income markets in 1999. The 30-year U.S. Treasury bond represents the extreme case with yields up roughly 135 basis points from the lows reached in October 1998 after the Russian debt crisis caused a worldwide flight to quality. The increase in yields in other market sectors, including municipals, has not been nearly so dramatic since these yields declined much less than similar maturity Treasuries. Generally, municipal security yields are 80% to 90% of comparable Treasuries. However, during October 1998, investors could buy AAA-rated municipal securities at higher yields than Treasuries with the same maturity.

Municipal yields have risen 75 basis points, or 3/4 of 1%, since the beginning of 1999. The slope of the municipal yield curve has remained extremely steep, with 20-year municipals yielding roughly 210 basis points more than 1-year issues. In the Treasury market, the difference between 1-year and 30-year bond yields is only about 80 basis points.

Your fund continues to be conservatively managed, predominately invested in general obligation and essential service revenue bonds. The weighted-average quality rating and weighted-average maturity are approximately AA+ and 11 years, respectively. This investment style has enabled your fund (Class T) to produce a total return of 6.19% for the volatile interest rate environment over the last five years.