Large Cap Value Fund

Investors’ concerns over corporate governance and accounting irregularities weighed heavily on the market during the second quarter. This was a quarter in which the market fell sharply and provided no place to hide. Traditional defensive groups such as pharmaceuticals, tobacco, telecommunications and electric utilities, all did poorly in the month of June. Amidst these difficulties, the economy showed signs of improvement, primarily driven by the resilient consumer market. Even in a nervous economic environment, consumers continued to buy homes, autos and other goods during the period.

The American AAdvantage Large Cap Value Fund Institutional Class returned -8.4%, outperforming the S&P 500/BARRA Value Index return of -10.6% and ahead of the Lipper Multi - Cap Value Index return of -10.5%. For complete fund performance, click here.

Favorable security selection was the primary driver of outperformance over the benchmark. Decisions in the consumer discretionary sector, like overweighting Fortune Brands (up 13.9%) and Wendy’s International (up 14.0%), while not holding AOL Time Warner (down 37.8%) and Walt Disney (down 18.1%), contributed a total of 1.6% to the Fund’s relative return in this sector. Performance was also driven by stock selection within the financial sector through underweightings in Citigroup (down 21.4%), American International (down 5.4%), and Merrill Lynch & Co. (down 26.6%). Also during the period, the Fund’s overweighting in utilities detracted from relative returns as this sector was down 19.9% for the quarter.

The Fund’s advisers believe the economic environment is favorable for value investors, but remain cautious given signs that the economic recovery is proceeding at a slow pace. Consequently, they believe that a meaningful advance in profits and stock prices will develop more slowly than investors have been anticipating. While all the noise about corporate governance, accounting scandals and terrorist threats has certainly been a factor, the Fund’s advisers believe the stock market is primarily reflecting the disappointing pace of economic recovery. However, the current weakness in the market has provided the Fund’s advisers an opportunity to purchase quality companies with attractive valuations. This market should reward disciplined investors who carefully evaluate companies and pay close attention to true fundamental valuations.

Small Cap Value Fund

The current economic recovery is proving to be very different from previous recoveries in that the U.S. stock market has remained fairly weak. Relentless reports of questionable accounting practices, capped by WorldCom’s record earnings restatement in June, have battered investors’ trust in corporate management. For the quarter and the year, large cap growth stocks fell the farthest while small value stocks held up relatively well. Investors are recognizing that value companies have not faced the intense pressure to expand earnings to keep pace with their growth counterparts and therefore, are less likely to have improperly reported earnings.

The American AAdvantage Small Cap Value Fund Institutional Class returned -2.9% for the quarter, slightly trailing the Russell 2000 Value Index return of -2.1%, but well ahead of the Lipper Small Cap Value Index return of -4.1%. In this difficult environment, the Fund provided an impressive twelve-month return of 15.3%, well ahead of the Russell 2000 Value Index return of 8.5% and the Lipper Small Cap Value Index at 5.1%. For complete fund performance, click here.

Sectors related to consumer spending such as retail, housing, and apparel have been the strongest performers throughout the year. The Fund was overweighted in these groups due to their attractive valuations, and the holdings have performed well relative to consumer stocks overall. The consumer discretionary sector contributed over 1.9% in excess relative returns versus the Russell 2000 Value Index. Key names in this sector included M/I Schottenstein Homes (up 33.3%), MDC Holdings, Inc. (up 20.6%), and Lone Star Steakhouse (up 14.5%). The largest negative contributor to the Fund’s return relative to the benchmark was its underweighting in financial stocks, since financials was the highest performing sector of the Russell 2000 Value Index for the quarter, up 5.0%.

Further stock market volatility is expected as accounting scandals have affected investors’ confidence. Despite the seemingly endless stream of earnings restatements and other reports of poor corporate behavior, the Fund’s advisers remain hopeful that the slowly emerging economic recovery will eventually drive the stock market higher. When this occurs, it is expected to create value opportunities for the Fund.

International Equity Fund

Unlike the first quarter of 2002, when the international markets finished with a roar, they exited the second quarter with a whimper. Investors were confronted with the realization that the economic recovery would be subdued at best, despite record low interest rates, and might lead to weak corporate earnings. The MSCI EAFE Index was up nearly 2% through the end of May, before slumping in June to end the second quarter down just over 2%. While the lack of economic recovery and accounting concerns impacted market returns, the sharp decline of the U.S. Dollar provided some relief to overseas investors, as it weakened relative to all the major currencies. The Euro gained over 13% in the quarter to close near parity with the U.S. Dollar, a level last reached in February of 2000. Also, despite numerous interventions by the Bank of Japan, the Yen strengthened by nearly 10% relative to the U.S. Dollar during the quarter.

The American AAdvantage International Equity Fund Institutional Class returned -0.9% during the quarter, outperforming the MSCI EAFE Index return of -2.1% and the Lipper International Index return of -1.9% for the same period. The Fund returned 3.0% year-to date, ahead of the EAFE Index return of -1.6% and the Lipper return of 0.5%. For complete fund performance, click here.

The Fund performed reasonably well during the market decline due to the Fund’s advisers’ continued focus on solid valuations. The Fund’s advisers underweighted the technology sector, which was the worst sector for the quarter as it dropped over 20%. The weighting in the telecom sector has increased over the past couple of quarters, but the focus has been on companies with more dependable growth forecasts and valuations. This strategy allowed the Fund to add 1.0% in relative performance over the EAFE Index by avoiding such names as Vodafone (down 25.2%), Deutsche Telekom (down 35.8%), and France Telecom (down, 68.0%).

From a country standpoint, the Fund’s advisers added value through strong stock selection in key European markets, particularly the United Kingdom, Finland, Switzerland, and Sweden. In the UK, the Fund’s advisers’ significant overweightings in Unilever (up 15.7%), Bae Systems (up 8.7%) and Cadbury Schweppes (up 8.5%) contributed to the excess returns over the EAFE Index. In Finland, the Fund’s advisers also added value by overweighting Upm-Kymmene Corp (up 15.1%) and avoiding Nokia (down 30.8%).

Volatility in the global equity markets has provided the Fund with opportunities to find bargain stocks. The recent market decline may represent a turning point for the dollar. Consequently, with valuations at a significant discount to those in the U.S., supportive global monetary policy, and currency movements now enhancing returns, the outlook for international investing appears relatively bright.