Investment Commentary

Fund Performance

Performance Summary

For the three-month period ended September 30, the Columbia Small Cap Value Fund I underperformed the primary benchmark, the Russell 2000 Value Index. On a year-to-date basis, the fund remains significantly ahead of the benchmark. We do not strive for the highest return in any one period. Our goal is to provide our clients the strongest risk adjusted total return over all periods.

Economic crisis: perception versus reality

Imagine an investor who left to live in a remote area in September 2008 for a year. No TV, no newspaper, no access to financial information. What would such an investor return to find? That investor would have returned to find that the S&P 500 Index was down 6.9%. It seems incongruous that we experienced what the media dubbed the “Great Recession,” which brought the world to the brink of financial collapse, yet on a point-to-point basis, it has resulted in merely a bad year — a significant improvement from the catastrophe most investors were facing in March 2009.

What changed so dramatically? We have always subscribed to the theory that liquidity is essential for small-cap performance. Over the last year, we have seen systematic liquidity issues lead to the Russell 2000 Value Index’s extreme decline from last year’s September high to its March 2009 low. Despite the central banks’ pumping significant cash into the monetary system worldwide, short-term borrowing costs had remained well above the fed funds rates, leading to higher borrowing costs for companies. We have also seen a significant rise in credit spreads, tied to an increased outlook for bankruptcies and an uncertain economic outlook. A number of write- downs and losses at banks, due to investment portfolios and increasing charge-offs of residential construction books, have caused some banks to tighten their lending standards to preserve capital ratios. Additional pressures include the seizing up of the commercial paper and ABS/MBS/CMBS markets

Yet, since November, there has been a significant rebound in the high-yield market, sowing the seeds for a rebound in the overall market. The dislocation of the high-yield market was the most severe over the past 25 years. Current excess liquidity in money markets, coupled with extremely low rates, has been driving an increase in investors’ risk appetite. Secondary offerings have reappeared to capitalize on the resurging equity market to help fill gaps in the balance sheets of moderately leveraged companies. The liquefying of the economy has stimulated an 81.5% rebound from the March 9 lows in the Russell 2000 Value Index. Our fund has been strong throughout the rebound, producing a similar return since the March 9 lows, despite trailing in the third quarter.

There is a significant risk to our strategy of identifying companies with strong balance sheets and cash flows, a rapid revaluation of highly leveraged companies. During periods of stress, companies with outsized debt relative to their future prospects often see their equity value dwindle to extremely low levels. Many of these securities replicate the payoff of a call option, with the key variable being their ability to recapitalize. We believe that despite the significant improvement to the high-yield market, this economic cycle has impaired the availability to overleverage. We contend that with excess capital our investments will continue to find exceptional opportunities to redeploy capital in order to create additional value for shareholders. Even in the third quarter, the companies with stronger balance sheets continued to outperform. The risk factor that was identified that detracted from relative performance was the snapback in companies with high volatility, likely tied to the exuberance coming out of the second-quarter earnings.

While improvements have been made, we still are in a historically distressed period, with the continued economic pressures and fragility of the market. Second-quarter earnings gave reasons for optimism for some stabilization in the end markets. We believe that we are likely in the eye of the storm, an eerie calm that may lull some investors into complacency. We continue to see storm clouds brewing with respect to commercial real estate, exotic mortgages, consumer credit tied to high unemployment and commercial loans underwritten with a lack of covenants during the 2005–2007 underwriting bubble. We continue to manage the portfolio with a balance of companies with economic sensitivity and those with stability.

Questions about being a long-term investor

Recently, in discussions with some astute consultants, we were questioned about a statement we made in last quarter’s commentary. Last quarter, we wrote:

We are long-term investors, looking for companies with strong management, capable of unlocking significant value for shareholders. As such, we typically view our investments with a 3–5 year time horizon, and as a testament to our discipline, our portfolio-weighted holding period is 2 years and 11 months with 16% of today’s portfolio weight purchased in 2002. These names still, we believe, trade at a discount to their intrinsic value with the attractive valuations and fundamentals that made them a buy in the first place.

One question arose in regard to the percentage of the portfolio that we have been invested in since 2002. The first consultant asked: “What gives you the conviction to remain with a company after seven years without it meeting your return objective? What keeps you invested in these value traps?”

In answer to the first question, we would like to dispel the notion that a long investment period corresponds to a stock that has underperformed, hence a value trap that we continue to hold, hoping that it will eventually pay off. Below is a table of the top 12 holdings with weights over 50 bp that have remained in the portfolio since 2002, and the related performance versus its industry, sector and overall index since the end of 2002. The high weight in these names indicates our continued high conviction in these ideas. Our willingness to continue to invest is a simple result of our opinion that there continues to be attractive upside for our clients in these investments as the management teams of these companies continue to create additional value on behalf of their investors.

In another meeting, another consultant asked: “Doesn’t having a long investment holding period lead you to naturally fall in love with your investments? Does this affect your ability to sell a position?”

Our answer to the second question regarding falling in love with our investments circles back to our investment process. Our sell discipline centers on companies that we believe no longer present attractive risk-adjusted returns for our clients, or companies that, in our opinion, have presented information such that our evaluation of intrinsic value has been impaired. Recall that we have averaged 99.7% equity investment and 0.30% cash over the past seven years. Given that we manage our portfolio to be fully invested, when a new idea presents an attractive risk-adjusted return potential, we have to source a sell to allow an investment. This discipline is important in our opinion, because we are not just evaluating the merits of a new investment, but this investment has to have a higher risk-adjusted total return potential than an investment already in the portfolio. We believe that this portfolio construction discipline leads us to present our clients with our greatest risk-adjusted total return potential. It forces us to sell some great companies that we may hold in the portfolio, because they no longer have enough upside in our analysis. The other half of our sell decisions regards companies who have altered their strategy and may have destroyed capital in the process. Our evaluation of balance sheet strength is only as valuable as the company management’s ability to create value through reinvesting in the business or returning it to shareholders efficiently. We have made investments in companies that have exercised poor management decisions, which have negatively affected shareholder value. An example of an acquisition for which we significantly overpaid might be characterized by a management team that deploys excess capital rapidly rather than wisely. In these instances, we want to sell early rather than late. Our process requires attention to how excess capital is being deployed and the evaluation of intrinsic value. Often, mismanagement of capital leads us to sell.

We understand that our long-term investment style is unique these days, given the propensity for trading in other small-cap strategies. These thoughtful questions are likely to be on the minds of many of our investors, and as such, we felt it was important to answer to a broader audience.

Contributors ¹

In the third quarter, the fund was only able to add significant relative value in one sector for the quarter — utilities.

Most utilities are thought of as being defensive, and in this quarter this proved to be true. Utilities posted the worst total return of any sector for the quarter with a slight positive gain, significantly trailing the Russell 2000 Value Index by more than 1500 bp. Our utilities generated relative outperformance for the quarter mostly because we avoided gas and water utilities. These two industries represent half of the weight of the sector and underperformed electric companies that have more economic sensitivity in the quarter. We had been devoid of any gas utilities for some time due to our inability to find companies that fit our disciplined philosophy and provide a satisfactory risk-adjusted return for our clients. Despite recently adding a particular gas utility that met our criteria, we remain underweight gas utilities relative to the benchmark.

Detractors¹

In the third quarter, the fund struggled with relative performance in financials, materials, information technology and health care.

Financials had negative relative performance deriving from our overweight and stock selection in the thrift industry. Our continued investment in high-quality thrifts is through the identification of extremely strong balance sheets. These investments are characteristically very stable investments, and while as a group it had positive absolute performance, it trailed the industry, sector and benchmark averages. Within thrifts, there was a rebound off depressed valuations of mortgage insurance providers, to which we do not have any exposure. With our future expectation of housing deflation and their weak balance sheets due to credit losses, we do not believe that mortgage insurers merit an investment for our clients.

Materials had a negative relative performance stemming from stock selection within chemicals. Commodity chemicals particularly benefited from low feedstock prices as well as a general exuberance regarding future economic prospects. Within chemicals, we continue to favor specialty chemicals over commodity chemicals as we prefer the stability of the earning stream and value creation prospects.

Technology was a strong absolute performer for the quarter; however, our stock selection trailed, offset slightly by our appropriate overweight of the sector. Within IT services, a large acquisition of Perot Systems by Dell led to relative underperformance, as we did not hold Perot in our portfolio. Investors seemingly preferred more expensive companies with stronger growth profiles to those with stronger balance sheets in the quarter. Despite trying to delicately balance finding attractive growth at reasonable values, the market seemed to reward higher growth in this period. Our technology companies within our business outsourcing basket contributed nicely, helping offset the relative underperformance. Over time, we feel that strong balance sheets coupled with attractive growth offer our clients a better total return potential in technology rather than seeking out expensive, pure high-growth companies.

Health care had relative underperformance within the health care providers due to overweighting the industry and the stock selection. Washington’s push for health care reform created questions within the health care sector, particularly the providers. We believe our investments pose attractive upside, despite the uncertainly of potential legislation.

Basket Positioning

Basket technique is a tool we use to create alpha, which is designed to invest in attractive long-duration themes. Once a theme is identified, we seek out companies with operational exposure to a theme and invest in only those names that meet our rigorous fundamental and valuation criteria. Weights in each name are determined by the liquidity available per name, the conviction of the operational exposure and the attractiveness of the valuation. Those that do not meet our fundamental criteria will not be included in the portfolio. Over time, we believe approximately 50% of the portfolio is associated with a basket. The basket approach expands the liquidity in the product, reduces stock-specific risks and increases the portfolio exposure to the attractive theme the manager identifies.

Portfolio Positioning

At quarter end, the fund was weighted toward higher-quality companies (consistent with the portfolio managers’ philosophy), with stable, positive earnings when compared to their peers, and a consistent value bias. We believe our positioning will enhance returns in 2009 and longer term.

Performance data quoted represents past performance, and current performance may be lower or higher. Past performance is no guarantee of future results.

Please read and consider the investment objectives, risks, charges and expenses for any fund carefully before investing. For a prospectus, which contains this and other important information about the fund, contact your Columbia Management representative or financial advisor or go to www.columbiamanagement.com.

The Russell 2000 Value Index tracks the performance of those Russell 2000 Index companies with lower price-to-book ratios and lower forecasted growth values.

Unlike mutual funds, indices are not investments, do not incur fees or expenses and are not professionally managed. It is not possible to invest directly in an index.

¹ Determinations of contributors and detractors are based on performance relative to the fund’s benchmark.

This fund is available with no transaction fee on all major platforms. The sales charge typically applied to Class A shares, which carry a 12b-1 fee, is waived for purchases of the fund through registered investment advisors (RIAs) and defined contribution (DC) plans. Class Z shares, also offered to RIAs and DC plans, are sold without a 12b-1 fee at NAV.

Since economic and market conditions change frequently, there can be no assurance that the trends described here will continue or that the forecasts will come to pass. The views and opinions expressed are those of the portfolio managers and analysts of the affiliated advisors of Columbia Management Group, are subject to change without notice at any time, may not come to pass and may differ from views expressed by other Columbia Management associates or other divisions of Bank of America. These materials are provided for informational purposes only and should not be used or construed as a recommendation of any security or sector.

There is no assurance that any securities discussed herein will remain in an account’s portfolio at the time you receive this report or that securities sold have not been repurchased. It should not be assumed that any securities transactions or holdings discussed were or will prove to be profitable, or that the investment recommendations or decisions made in the future will be profitable or will equal the investment performance of the securities discussed herein. All results shown assume reinvestment of distributions and do not reflect the deduction of taxes that a shareholder would pay on fund distributions or the redemption of fund shares.

Columbia Management Group, LLC (“Columbia Management”) is the investment management division of Bank of America Corporation. Columbia Management entities furnish investment management services and products for institutional and individual investors. Columbia Funds are distributed by Columbia Management Distributors, Inc., member FINRA and SIPC. Columbia Management Distributors, Inc. is part of Columbia Management and an affiliate of Bank of America Corporation.