“...the Kayne Anderson Rudnick International Portfolio continued to participate in the strong upward move of the international equity markets that started three years ago.” Jean-Baptiste Nadal, CFA Managing Director of International Equity & Portfolio Manager

Market Overview
International equity markets performed strongly during the first quarter, again outperforming the U.S. equity markets. The MSCI EAFE Index, which tracks the performance of the international developed equity markets, appreciated by 9.40% during the quarter, while the S&P 500 Index rose 4.21%. In the quarter, Europe led the advance, while Japan and the other developed markets of Asia, with the exception of Singapore, lagged the MSCI EAFE Index. Emerging markets and small-capitalization foreign stocks were, again, the best performing segments of the international equity markets with low double-digit returns in both instances. The U.S. dollar, after a year of recovery in 2005, experienced some renewed weakness during the quarter (the Dollar Index declined 1.58%), which boosted the performance of foreign stocks when expressed in U.S. dollars. From an investment style standpoint, again, the “value” style outperformed the “growth” style by a small margin during the quarter, with the MSCI EAFE Value Index up 9.78% versus an increase of 9.01% for the MSCI EAFE Growth Index.

The best performing countries were Norway (+23.46%), Portugal (+21.25%), and Finland (+20.53%), while New Zealand (-4.19%), Australia (+6.23%), and Japan (+6.84%) posted the lowest returns. The world’s top-five markets accounted for 72.4% of the total market capitalization of the MSCI EAFE Index at the end of the first quarter. Two of the top-five largest markets, namely Germany (+13.86%) and France (+13.24%), outperformed the MSCI EAFE Index, while Japan (+6.84%), Switzerland (+7.29%), and the U.K. (+8.30%) underperformed.

From an economic-sector standpoint, materials (+13.96%), financials (+11.86%), and utilities (+11.24%) were the strongest groups, while telecommunications services (+0.31%), consumer staples (+5.44%), and health care (+6.55%) were the weakest sectors.

Within the MSCI EAFE Index, small-capitalization stocks outperformed large and mega-cap stocks during the quarter. Specifically, stocks with a market capitalization under $1 billion returned 13.95%, strongly outperforming the MSCI EAFE Index, while stocks with more than $40 billion in market capitalization returned 7.77%, underperforming the overall benchmark.

From a financial-strength standpoint, as expressed by companies’ debt credit rating, the stocks of companies with the strongest balance sheets underperformed the overall market. Indeed, AAA rated and AA rated companies returned 4.43% and 8.58%, respectively.

Portfolio Overview
The Kayne Anderson Rudnick International Portfolio performed strongly in the first quarter, after posting a solid return in the fourth quarter of 2005. The market conditions during the quarter that favored emerging markets, small-cap, value, and more indebted companies were not the best for our large to mega-cap, growth-oriented, and high-quality portfolio. However, the vast majority of the stocks in the portfolio are performing very well and are supported by strong fundamentals. From a country perspective, the portfolio’s geographic exposure is well balanced. The portfolio participated nicely in the revival of the Japanese market since August 2005 and, since the start of 2006, the portfolio has benefited from the strong performance of the largest stocks in the Japanese Topix Index. From a sector perspective, our slight overweight in the financials and energy sectors helped to keep the portfolio’s performance close to that of the benchmark.

Country allocation had a positive effect on the portfolio’s relative performance during the quarter. The portfolio’s overweight position in France and Norway, and its underweight position in Japan, more than offset the negative effect on relative performance of its overweight position in Switzerland and its lack of exposure to Finland and Sweden. Residual stock selection was positive in Japan (Nomura Securities, Denso, and Millea Holding), Australia (BHP and Rio Tinto), and Norway (Statoil), while it was negative in the U.K. (Vodafone, HBOS, and Tesco), France (Peugeot and Total), and Switzerland (Swiss Re and Nestle).

Sector allocation had a modest negative impact on the portfolio’s relative performance during the quarter. On the positive side, the portfolio was helped by its overweight exposure to the financials sector, the second best performing market sector during the quarter. Nevertheless, that was not enough to compensate for the negative effect on the portfolio’s relative performance of its overweight exposure to the consumer-staples and telecommunications-services sectors, and its underweight exposure to the industrials and utilities sectors. Residual stock selection was very positive in the energy sector (Statoil) and in the information-technology sector (Canon and SAP). Negative stock selection was noticeable in financials (Swiss Re, HBOS, and DBS), industrials (Secom), and materials (BASF and Air Liquide), primarily reflecting the overall defensive qualities and large size of the companies that we own in a market that favored lower quality and smaller issues.

The stocks that contributed the most to performance were Statoil (energy), BNP (financials), and BBVA (financials). The stocks that detracted the most from performance were Secom (industrials), Vodafone (telecommunications services), and Swiss Re (financials).

Purchases and Sales
During the first quarter, we bought BHP (materials) and Reuters (consumer discretionary). BHP is the world’s largest natural-resources company that continues to benefit from the unabating Chinese demand for industrial metals. Reuters is the largest provider of financial information and solutions to the financial community. After several years of restructuring and repositioning, the business looks poised to benefit from the increasing global appetite for financial assets and the related needs for information.

We reduced our position in Statoil, taking some profits after its strong performance over the last 12 months. We sold our positions in Pearson, Prudential, and Rio Tinto, as they all reached our target prices. We also sold Peugeot out of disappointment with its underlying weak performance in the European auto market.

Overall, from a sector standpoint, we remain overweight in the consumer discretionary, consumer staples, energy, financials, health care, and telecommunications-services sectors, while we maintain an underexposure to the industrials, information-technology, materials, and utilities sectors. From a regional standpoint, we remain mildly underweight in Asia/Japan, overweight in Continental Europe, and slightly underweight in the U.K.

Summary
During the first quarter of 2006, the Kayne Anderson Rudnick International Portfolio continued to participate in the strong upward move of the international equity markets that started three years ago. Although market conditions were again more supportive of small- cap rather than mega-cap stocks, emerging rather than developed markets, and lower quality rather than high-quality companies, the portfolio held up well during the quarter. It is clear that the gap of valuation between large and small-cap stocks has narrowed considerably over the last few years; slowly, but surely, the valuation argument is becoming more favorable to the larger cap segments of the market. The new stance toward higher interest rates in the Euro zone and soon in Japan will, in our opinion, progressively drain liquidity away from the most risky sub-segments of the foreign markets, such as emerging markets, small-cap stocks, and indebted low-quality businesses. This should create the optimum conditions for high-quality, large-cap stock portfolios, such as ours, to outperform the overall foreign market again.