<PAGE>
SUBJECT TO COMPLETION - Dated May 17, 1996
Information contained herein is subject to completion or amendment. A
registration statement relating to these securities has been filed with the
Securities and Exchange Commission. These securities may not be sold nor may
any offers to buy be accepted prior to the time the registration statement
becomes effective. This Statement of Additional Information does not constitute
a prospectus.
MORGAN STANLEY UNIVERSAL FUNDS, INC.
STATEMENT OF ADDITIONAL INFORMATION
Morgan Stanley Universal Funds, Inc. (the "Fund") is a no-load, open-
end management investment company with diversified and non-diversified series
("Portfolios"). The Fund currently consists of seventeen Portfolios offering a
broad range of investment choices. Shares of each Portfolio are offered with no
sales charge or exchange or redemption fee. Shares of each Portfolio may be
purchased only by the separate accounts of insurance companies for the purpose
of funding variable annuity and variable life insurance contracts and by certain
tax-qualified investors. The variable annuity and variable life contractholders
incur fees and expenses separate from the fees and expenses charged by the
Portfolios. This Statement of Additional Information addresses information of
the Fund applicable to each of the seventeen Portfolios. The Fund was
incorporated under the laws of the State of Maryland on April 6, 1996. The
Fund filed a registration statement with the SEC registering itself as an open-
end management investment company under the Investment Company Act of 1940, as
amended (the "1940 Act"), and its shares under the Securities Act of 1933, as
amended.
The Portfolios are managed by either Morgan Stanley Asset Management
Inc. ("MSAM" or the "Adviser") or Miller Anderson & Sherrerd, LLP ("MAS" or the
"Adviser") thereby making available in a single product the combined strength of
these leading investment management firms.
This Statement of Additional Information is not a prospectus but
should be read in conjunction with the prospectus of the Fund's Portfolios (the
"Prospectuses"). This Statement of Additional Information is incorporated by
reference into the Prospectus in its entirety. To obtain the Prospectus, please
call the Morgan Stanley Universal Funds, Inc. representative at [800-_______]
[or _________________ Insurance Company at 800-____________.]
TABLE OF CONTENTS
Page
----
Securities and Investment Techniques........................
Taxes.......................................................
Special Tax Considerations Relating to Foreign Investments..
Taxes and Foreign Shareholders..............................
Purchase of Shares..........................................
Redemption of Shares........................................
Exchange Features...........................................
State Law Restrictions......................................
Investment Limitations......................................
Determining Maturities of Certain Instruments...............
Management of the Fund......................................
Net Asset Value for the Money Market Portfolio..............
Performance Information.....................................
General Information.........................................
Description of Securities and Ratings.......................
Financial Statements........................................
Statement of Additional Information dated , 1996, relating to:
Prospectus, dated , 1996 for the Money Market, Fixed Income, High
Yield, Core Equity, Growth, Value, Mid Cap Growth, Mid Cap Value, U.S. Real
Estate, International Fixed Income, Emerging Markets Debt, Global Equity,
International Magnum, Emerging Markets Equity, Asian Equity, Balanced and Multi-
Asset-Class Portfolios.
<PAGE>
SECURITIES AND INVESTMENT TECHNIQUES
MSAM provides overall investment management for the following
Portfolios: Money Market, Growth, U.S Real Estate, Emerging Markets Debt, Global
Equity, International Magnum, Emerging Markets Equity and Asian Equity
Portfolios.
MAS provides overall investment management for the following
Portfolios: Fixed Income, High Yield, Core Equity, Value, Mid Cap Growth, Mid
Cap Value Portfolios, International Fixed Income, Balanced and Multi-Asset-
Class.
The following discussion of the securities and investment techniques
supplements the discussion of investment policies, securities and investment
techniques in the Fund's Prospectus:
Emerging Market Country Securities: Equity Securities and Fixed-Income
Securities
General. Each of the Emerging Markets Equity and Emerging Markets Debt
- -------
Portfolio's definition of Emerging Market Country Equity Securities or Fixed-
Income Securities includes securities of companies that may have characteristics
and business relationships common to companies in a country or countries other
than an Emerging Market Country. As a result, the value of the securities of
such companies may reflect economic and market forces applicable to other
countries, as well as to an Emerging Market Country. The Adviser believes,
however, that investment in such companies will be appropriate because the
Portfolio will invest only in those companies which, in its view, have
sufficiently strong exposure to economic and market forces in an Emerging Market
Country such that their value will tend to reflect developments in such Emerging
Market Country to a greater extent than developments in another country or
countries. For example, each of these Portfolios may invest in companies
organized and located in countries other than an Emerging Market Country,
including companies having their entire production facilities outside of an
Emerging Market Country, when securities of such companies meet one or more
elements of the Portfolio's definition of an Emerging Market Country Equity
Security or Fixed Income Security and so long as the Adviser believes at the
time of investment that the value of the company's securities will reflect
principally conditions in such Emerging Market Country.
The Emerging Markets Debt Portfolio is subject to no restrictions on
the maturities of the Emerging Market Country Fixed-Income Securities it holds.
The value of Fixed-Income Securities held by each Portfolio generally will vary
inversely to changes in prevailing interest rates. Each Portfolio's investments
in fixed-rated Fixed-Income Securities with longer terms to maturity are subject
to greater volatility than the Portfolio's investments in shorter-term
obligations. Debt obligations acquired at a discount are subject to greater
fluctuations of market value in response to changing interest rates than debt
obligations of comparable maturities which are not subject to such discount.
Investments in Emerging Market Country government Fixed-Income
Securities involve special risks. Certain emerging countries have historically
experienced, and may continue to experience, high rates of inflation, high
interest rates, exchange rate fluctuations, large amounts of external debt,
balance of payments and trade difficulties and extreme poverty and unemployment.
The issuer or governmental authority that controls the repayment of an Emerging
Market Country's debt may not be able or willing to repay the principal and/or
interest when due in accordance with the terms of such debt. As a result of the
foregoing, a government obligor may default on its obligations. If such an event
occurs, the Portfolio may have limited legal recourse against the issuer and/or
guarantor. Remedies must, in some cases, be pursued in the courts of the
defaulting party itself, and the ability of the holder of foreign government
Fixed-Income Securities to obtain recourse may be subject to the political
climate in the relevant country. In addition, no assurance can be given that the
holders of commercial bank debt will not contest payments to the holders of
other foreign government debt obligations in the event of default under their
commercial bank loan agreements.
2
<PAGE>
Brady Bonds. The Fixed Income, High Yield, International Fixed Income,
- -----------
Balanced, Multi-Asset-Class and Emerging Markets Debt Portfolios may invest in
certain Fixed-Income Securities customarily referred to as "Brady Bonds," which
are created through the exchange of existing commercial bank loans to foreign
entities for new obligations in connection with debt restructuring under a plan
introduced by former U.S. Secretary of the Treasury Nicholas F. Brady (the
"Brady Plan"). Brady Bonds have been issued only recently, and, accordingly, do
not have a long payment history. They may be collateralized or uncollateralized
and issued in various currencies (although most are U.S. dollar-denominated) and
they are actively traded in the over-the-counter secondary market. The
Portfolio may purchase Brady Bonds either in the primary or secondary markets.
The price and yield of Brady Bonds purchased in the secondary market will
reflect the market conditions at the time of purchase, regardless of the stated
face amount and the stated interest rate. With respect to Brady Bonds with no
or limited collateralization, each Portfolio will rely for payment of interest
and principal primarily on the willingness and ability of the issuing government
to make payment in accordance with the terms of the bonds.
U.S. dollar-denominated, collateralized Brady Bonds, which may be
fixed rate par bonds or floating rate discount bonds, are generally
collateralized in full as to principal due at maturity by U.S. Treasury zero
coupon obligations which have the same maturity as the Brady Bonds. Interest
payments on these Brady Bonds generally are collateralized by cash or securities
in an amount that, in the case of fixed rate bonds, is equal to at least one
year of rolling interest payments or, in the case of floating rate bonds,
initially is equal to at least one year's rolling interest payments based on the
applicable interest rate at that time and is adjusted at regular intervals
thereafter. Certain Brady Bonds are entitled to "value recovery payments" in
certain circumstances, which in effect constitute supplemental interest payments
but generally are not collateralized. Brady Bonds are often viewed as having
three or four valuation components: (i) the collateralized repayment of
principal at final maturity; (ii) the collateralized interest payments; (iii)
the uncollateralized interest payments; and (iv) any uncollateralized repayment
of principal at maturity (these uncollateralized amounts constitute the
"residual risk"). In the event of a default with respect to collateralized
Brady Bonds as a result of which the payment obligations of the issuer are
accelerated, the U.S. Treasury zero coupon obligations held as collateral for
the payment of principal will not be distributed to investors, nor will such
obligations be sold and the proceeds distributed. The collateral will be held
to the scheduled maturity of the defaulted Brady Bonds by the collateral agent,
at which time the face amount of the collateral will equal the principal
payments which would have then been due on the Brady Bonds in the normal course.
In addition, in light of the residual risk of the Brady Bonds and, among other
factors, the history of defaults with respect to commercial bank loans by public
and private entities of countries issuing Brady Bonds, investments in Brady
Bonds should be viewed as speculative.
Brady Plan debt restructuring totalling approximately $73 billion have
been implemented to date in Argentina, Bulgaria, Costa Rica, Ecuador, Mexico,
Nigeria, the Philippines, Uruguay and Venezuela, with the largest proportion of
Brady Bonds having been issued to date by Mexico and Venezuela. Brazil and
Poland have announced plans to issue Brady Bonds aggregating approximately $52
billion, based on current estimates. There can be no assurance that the
circumstances regarding the issuance of Brady Bonds by these countries will not
change.
Eurodollar and Yankee Obligations
- ---------------------------------
Eurodollar bank obligations are dollar-denominated certificates of
deposit and time deposits issued outside the U.S. capital markets by foreign
branches of banks and by foreign banks. Yankee bank obligations are dollar-
denominated obligations issued in the U.S. capital markets by foreign banks.
Eurodollar and Yankee obligations are subject to the same risks that
pertain to domestic issues, notably credit risk, market risk and liquidity risk.
Additionally, Eurodollar (and to a limited extent, Yankee) obligations are
subject to certain sovereign risks. One such risk is the possibility that a
sovereign country might prevent capital, in the form of dollars, from flowing
across their borders. Other risks
3
<PAGE>
include: adverse political and economic developments; the extent and quality of
government regulation of financial markets and institutions; the imposition of
foreign withholding taxes, and the expropriation or nationalization of foreign
issuers.
Forwards: Forward Foreign Currency Exchange Contracts
The U.S. dollar value of the assets of the Global Equity,
International Fixed Income, Asian Equity, International Magnum, Emerging Markets
Equity and Emerging Markets Debt Portfolios and, to the extent they invest in
securities denominated in foreign currencies, the assets of the Balanced, Multi-
Asset-Class, Fixed Income, High Yield, Value, Core Equity, Mid Cap Growth and
Mid Cap Value Portfolios may be affected favorably or unfavorably by changes in
foreign currency exchange rates and exchange control regulations, and each
Portfolio may incur costs in connection with conversions between various
currencies. The Portfolios will conduct their foreign currency exchange
transactions either on a spot (i.e., cash) basis at the spot rate prevailing in
the foreign currency exchange market, or through entering into forward contracts
to purchase or sell foreign currencies. A forward currency exchange contract
involves an obligation to purchase or sell a specific currency at a future date,
which may be any fixed number of days from the date of the contract agreed upon
by the parties, at a price set at the time of the contract. These contracts are
traded in the interbank market conducted directly between currency traders
(usually large commercial banks) and their customers. A forward contract
generally has no deposit requirement, and no commissions are charged at any
stage for such trades.
The Portfolios may enter into forward foreign currency exchange
contracts in several circumstances. When a Portfolio enters into a contract for
the purchase or sale of a security denominated in a foreign currency, or when a
Portfolio anticipates the receipt in a foreign currency of dividends or interest
payments on a security which it holds, the Portfolio may desire to "lock-in" the
U.S. dollar price of the security or the U.S. dollar equivalent of such dividend
or interest payment, as the case may be. By entering into a forward contract
for a fixed amount of dollars, for the purchase or sale of the amount of foreign
currency involved in the underlying transactions, each Portfolio will be able to
protect itself against a possible loss resulting from an adverse change in the
relationship between the U.S. dollar and the subject foreign currency during the
period between the date on which the security is purchased or sold, or on which
the dividend or interest payment is declared, and the date on which such
payments are made or received.
Additionally, when any of these Portfolios anticipates that the
currency of a particular foreign country may suffer a substantial decline
against the U.S. dollar, it may enter into a forward contract for a fixed amount
of dollars, to sell the amount of foreign currency approximating the value of
some or all of such Portfolio's securities denominated in such foreign currency.
The precise matching of the forward contract amounts and the value of the
securities involved will not generally be possible since the future value of
securities in foreign currencies will change as a consequence of market
movements in the value of these securities between the date on which the forward
contract is entered into and the date it matures. The projection of short-term
currency market movement is extremely difficult, and the successful execution of
a short-term hedging strategy is highly uncertain. None of the Portfolios intend
to enter into such forward contracts to protect the value of portfolio
securities on a continuous basis.
Under normal circumstances, consideration of the prospect for currency
parities will be incorporated into the long-term investment decisions made with
regard to overall diversification strategies. However, the management of the
Fund believes that it is important to have the flexibility to enter into such
forward contracts when it determines that the best interests of the performance
of each Portfolio will thereby be served. Except under circumstances where a
segregated account is not required under the 1940 Act or the rules adopted
thereunder, the Fund's Custodian will place cash, U.S. government securities, or
high-grade Fixed-Income Securities into a segregated account of a Portfolio in
an amount equal to the value of such Portfolio's total assets committed to the
consummation of forward currency exchange contracts. If the value of the
securities placed in the segregated account declines, additional cash or
4
<PAGE>
securities will be placed in the account on a daily basis so that the value of
the account will be equal to the amount of such Portfolio's commitments with
respect to such contracts.
The Portfolios generally will not enter into a forward contract with a
term of greater than one year. At the maturity of a forward contract, a
Portfolio may either sell the portfolio security and make delivery of the
foreign currency, or it may retain the security and terminate its contractual
obligation to deliver the foreign currency by purchasing an "offsetting"
contract with the same currency trader obligating it to purchase, on the same
maturity date, the same amount of the foreign currency.
It is impossible to forecast with absolute precision the market value
of a particular portfolio security at the expiration of the contract.
Accordingly, it may be necessary for a Portfolio to purchase additional foreign
currency on the spot market (and bear the expense of such purchase) if the
market value of the security is less than the amount of foreign currency that
such Portfolio is obligated to deliver and if a decision is made to sell the
security and make delivery of the foreign currency.
If a Portfolio retains the portfolio security and engages in an
offsetting transaction, such Portfolio will incur a gain or a loss (as described
below) to the extent that there has been movement in forward contract prices.
Should forward prices decline during the period between a Portfolio entering
into a forward contract for the sale of a foreign currency and the date it
enters into an offsetting contract for the purchase of the foreign currency,
such Portfolio will realize a gain to the extent that the price of the currency
it has agreed to sell exceeds the price of the currency it has agreed to
purchase. Should forward prices increase, such Portfolio would suffer a loss to
the extent that the price of the currency it has agreed to purchase exceeds the
price of the currency it has agreed to sell.
The Portfolios are not required to enter into such transactions with
regard to their foreign currency-denominated securities. It also should be
realized that this method of protecting the value of portfolio securities
against a decline in the value of a currency does not eliminate fluctuations in
the underlying prices of the securities. It simply establishes a rate of
exchange which one can achieve at some future point in time. Additionally,
although such contracts tend to minimize the risk of loss due to a decline in
the value of the hedged currency, at the same time, they tend to limit any
potential gain which might result should the value of such currency increase.
Futures: Futures Contracts and Options on Futures Contracts
The Fixed Income, High Yield, International Fixed Income, Emerging
Markets Debt, Balanced, Multi-Asset-Class, Growth, Value, Core Equity, Mid Cap
Growth, Mid Cap Value, U.S. Real Estate, International Magnum and Emerging
Markets Equity Portfolios may enter into futures contracts and options on
futures contracts for the purpose of remaining fully invested and reducing
transactions costs. The Money Market, Emerging Markets Debt, Growth, Emerging
Markets Equity, International Magnum and U.S. Real Estate Portfolios may also
enter into futures contracts for hedging purposes. No Portfolio will enter into
futures contracts or options thereon for speculative purposes. Futures
contracts provide for the future sale by one party and purchase by another party
of a specified amount of a specific security at a specified future time and at a
specified price. Futures contracts, which are standardized as to maturity date
and underlying financial instrument, are traded on national futures exchanges.
Futures exchanges and trading are regulated under the Commodity Exchange Act by
the Commodity Futures Trading Commission ("CFTC"), a U.S. government agency.
Although futures contracts by their terms call for actual delivery or
acceptance of the underlying securities or currencies, in most cases the
contracts are closed out before the settlement date without the making or taking
of delivery. Closing out an open futures position is done by taking an opposite
position ("buying" a contract which has previously been "sold" or "selling" a
contract previously "purchased") in an identical contract to terminate the
position. Brokerage commissions are incurred when a futures contract is bought
or sold.
5
<PAGE>
Futures contracts on securities indices or other indices do not
require the physical delivery of securities, but merely provide for profits and
losses resulting from changes in the market value of a contract to be credited
or debited at the close of each trading day to the respective accounts of the
parties to the contract. On the contract's expiration date a final cash
settlement occurs and the futures position is simply closed out. Changes in the
market value of a particular futures contract reflect changes in the level of
the index on which the futures contract is based.
Futures traders are required to make a good faith margin deposit in
cash or government securities with a broker or custodian to initiate and
maintain open positions in futures contracts. A margin deposit is intended to
assure completion of the contract (delivery or acceptance of the underlying
security) if it is not terminated prior to the specified delivery date. Minimal
initial margin requirements are established by the futures exchange and may be
changed. Brokers may establish deposit requirements which are higher than the
exchange minimums. Futures contracts are customarily purchased and sold for
prices that may range upward from less than 5% of the value of the contract
being traded.
After a futures contract position is opened, the value of the contract
is marked to market daily. If the futures contract price changes to the extent
that the margin on deposit does not satisfy margin requirements, payment of an
additional "variation" margin will be required. Conversely, a change in the
contract value may reduce the required margin, resulting in a repayment of
excess margin to the contract holder. Variation margin payments are made to and
from the futures broker for as long as the contract remains open. The
Portfolios expect to earn interest income on their margin deposits. With
respect to each long position in a futures contract or option thereon, the
underlying commodity value of such contract will always be covered by cash and
cash equivalents set aside plus accrued profits held at the futures commission
merchant.
The Portfolios may purchase and write call and put options on futures
contracts which are traded on a U.S. Exchange and enter into closing
transactions with respect to such options to terminate an existing position. An
option on a futures contract gives the purchaser the right (in return for the
premium paid) to assume a position in a futures contract (a long position if the
option is a call and a short position if the option is a put) at a specified
exercise price at any time during the term of the option. Upon exercise of the
option, the delivery of the accumulated balance in the writer's futures margin
account, which represents the amount by which the market price of the futures
contract at the time of exercise exceeds, in the case of a call, or is less
than, in the case of a put, the exercise price of the option on the futures
contract.
The Portfolios will purchase and write options on futures contracts
for identical purposes to those set forth above for the purchase of a futures
contract (purchase of a call option or sale of a put option) and the sale of a
futures contract (purchase of a put option or sale of a call option), or to
close out a long or short position in futures contracts.
Traders in futures contracts may be broadly classified as either
"hedgers" or "speculators." Hedgers use the futures markets primarily to offset
unfavorable changes in the value of securities otherwise held for investment
purposes or expected to be acquired by them. Speculators are less inclined to
own the underlying securities with futures contracts which they trade, and use
futures contracts with the expectation of realizing profits from market
fluctuations. The Portfolios intend to use futures contracts only for hedging
purposes.
Regulations of the CFTC applicable to the Portfolios require that all
futures transactions constitute bona fide hedging transactions except that a
Portfolio may engage in futures transactions that do not constitute bona fide
hedging to the extent that not more than 5% of the liquidation value of a
Portfolio's total assets are required as margin deposits or premiums for such
transactions. The Portfolios will only sell futures contracts to protect
securities owned against declines in price or purchase contracts to protect
against an increase in the price of securities intended for purchase. As
evidence of this hedging interest,
6
<PAGE>
each of the Portfolios expect that approximately 75% of its futures contracts
will be "completed"; that is, equivalent amounts of related securities will have
been purchased or are being purchased by the Portfolios upon sale of open
futures contracts.
Although techniques other than the sale and purchase of futures
contracts could be used to control the Portfolios' exposure to market
fluctuations, the use of futures contracts may be a more effective means of
hedging this exposure. While the Portfolios will incur commission expenses in
both opening and closing out futures positions, these costs are lower than
transaction costs incurred in the purchase and sale of the underlying
securities.
Restrictions on the Use of Futures Contracts. The Emerging Markets Debt,
- --------------------------------------------
Growth, U.S. Real Estate, International Magnum and Emerging Markets Equity
Portfolios will not enter into futures contract transactions to the extent that,
immediately thereafter, the sum of its initial margin deposits on open contracts
exceeds 5% of the market value of its total assets. The Fixed Income, High
Yield, International Fixed Income, Balanced, Multi-Asset-Class Value, Core
Equity, Mid Cap Growth and Mid Cap Value Portfolios will not enter into futures
contracts to the extent that their outstanding obligations to purchase
securities under these contracts in combination with their outstanding
obligations with respect to options transactions would exceed 50% of their
respective total assets, or in the case of the Emerging Markets Debt, Growth,
U.S. Real Estate, International Magnum and Emerging Markets Equity Portfolios,
outstanding obligations would not exceed 20% of their respective total assets.
The Portfolios will maintain assets sufficient to meet their respective
obligations under such contracts in a segregated account with the custodian bank
or will otherwise comply with the SEC's position on asset coverage.
Risk Factors in Futures Transactions. Positions in futures contracts may be
- ------------------------------------
closed out only on an exchange which provides a secondary market for such
futures. However, there can be no assurance that a liquid secondary market will
exist for any particular futures contracts at any specific time. Thus, it may
not be possible to close a futures position. In the event of adverse price
movements, the Portfolios would continue to be required to make daily cash
payments to maintain their required margin. In such situations, if a Portfolio
has insufficient cash, it may have to sell portfolio securities to meet its
daily margin requirement at a time when it may be disadvantageous to do so. In
addition, a Portfolio may be required to make delivery of the instruments
underlying futures contracts it holds. The inability to close options and
futures positions also could have an adverse impact on a Portfolio's ability to
effectively hedge.
The Portfolios will minimize the risk that they will be unable to
close out a futures contract by only entering into futures which are traded on
national futures exchanges and for which there appears to be a liquid secondary
market.
The risk of loss in trading futures contracts in some strategies can
be substantial, due both to the low margin deposits required, and the extremely
high degree of leverage involved in futures pricing. As a result, a relatively
small price movement in a futures contract may result in immediate and
substantial loss (as well as gain) to the investor. For example, if, at the
time of purchase, 10% of the value of the futures contract is deposited as
margin, a subsequent 10% decrease in the value of the futures contract would
result in a total loss of the margin deposit, before any deduction for the
transaction costs, if the account were then closed out. A 15% decrease would
result in a loss equal to 150% of the original margin deposit if the contract
were closed out. Thus, a purchase or sale of a futures contract may result in
losses in excess of the amount invested in the contract. However, because the
Portfolios may engage in futures strategies only for hedging purposes, the
Advisers do not believe that the Portfolios are subject to the risks of loss
frequently associated with futures transactions. A Portfolio would presumably
have sustained comparable losses if, instead of the futures contract, it had
invested in the underlying security or currency and sold it after the decline.
Utilization of futures transactions by the Portfolios does involve the
risk of imperfect or no correlation where the securities underlying futures
contracts have different maturities than the portfolio
7
<PAGE>
securities or currencies being hedged. It is also possible that a Portfolio
could both lose money on futures contracts and also experience a decline in
value of its portfolio securities. There is also the risk of loss by a
Portfolio of margin deposits in the event of bankruptcy of a broker with whom
the Portfolio has an open position in a futures contract or related option.
Most futures exchanges limit the amount of fluctuation permitted in
futures contract prices during a single trading day. The daily limit
establishes the maximum amount that the price of a futures contract may vary
either up or down from the previous day's settlement price at the end of a
trading session. Once the daily limit has been reached in a particular type of
contract, no trades may be made on that day at a price beyond that limit. The
daily limit governs only price movement during a particular trading day and
therefore does not limit potential losses, because the limit may prevent the
liquidation of unfavorable positions. Futures contract prices have occasionally
moved to the daily limit for several consecutive trading days with little or no
trading, thereby preventing prompt liquidation of futures positions and
subjecting some futures traders to substantial losses.
Loan Participations and Assignments
The Emerging Markets Equity and Emerging Markets Debt Portfolio may
also invest in fixed and floating rate loans ("Loans") arranged through private
negotiations between an issuer of sovereign debt obligations and one or more
financial institutions ("Lenders"). The Portfolio's investments in Loans are
expected in most instances to be in the form of participations in Loans
("Participations") and assignments of all or a portion of Loans ("Assignments")
from third parties. Each Portfolio's investment in Participations typically
will result in each Portfolio having a contractual relationship only with the
Lender and not with the borrower. Each Portfolio will have the right to receive
payments of principal, interest and any fees to which it is entitled only from
the Lender selling the Participation and only upon receipt by the Lender of the
payments from the borrower. In connection with purchasing Participations, each
Portfolio generally will have no right to enforce compliance by the borrower
with the terms of the loan agreement relating to the Loan, nor any rights of
set-off against the borrower, and each Portfolio may not directly benefit from
any collateral supporting the Loan in which it has purchased the Participation.
As a result, each Portfolio may be subject to the credit risk of both the
borrower and the Lender that is selling the Participation. In the event of the
insolvency of the Lender selling a Participation, each Portfolio may be treated
as a general creditor of the Lender and may not benefit from any set-off between
the Lender and the borrower. Certain Participations may be structured in a
manner designed to avoid purchasers of Participations being subject to the
credit risk of the Lender with respect to the Participation, but even under such
a structure, in the event of the Lender's insolvency, the Lender's servicing of
the Participation may be delayed and the assignability of the Participation
impaired. Each Portfolio will acquire Participations only if the Lender
interpositioned between the Portfolio and the borrower is determined by the
Adviser to be creditworthy.
When each Portfolio purchases Assignments from Lenders it will acquire
direct rights against the borrower on the Loan. Because Assignments are arranged
through private negotiations between potential assignees and potential
assignors, however, the rights and obligations acquired by each Portfolio as the
purchaser of an Assignment may differ from, and be more limited than, those held
by the assigning Lender. The assignability of certain sovereign debt
obligations is restricted by the governing documentation as to the nature of the
assignee such that the only way in which each Portfolio may acquire an interest
in a loan is through a Participation and not an Assignment. Each Portfolio may
have difficulty disposing of Assignments and Participations because to do so it
will have to assign such securities to a third party. Because there is no
liquid market for such securities, the Portfolio anticipates that such
securities could be sold only to a limited number of institutional investors.
The lack of a liquid secondary market may have an adverse impact on the value of
such securities and each Portfolio's ability to dispose of particular
Assignments or Participations when necessary to meet each Portfolio's liquidity
needs or in response to a specific economic event such as a deterioration in the
creditworthiness of the borrower. The lack of a liquid secondary market for
Assignments and Participations also may make it more difficult for
8
<PAGE>
each Portfolio to assign a value to these securities for purposes of valuing the
Portfolio's securities and calculating its net asset value.
Morgan Stanley Capital International EAFE Index
The International Magnum Portfolio uses the Morgan Stanley Capital
International EAFE (Europe, Australia and the Far East) Index (the "EAFE Index")
as a tool for investment decisions. The investment objective of the
International Magnum Portfolio is to provide long-term capital appreciation.
The International Magnum Portfolio seeks to achieve its objective by investing
primarily in Equity Securities securities of non-U.S. issuers in accordance with
the EAFE country (defined below) weightings determined by the Adviser. After
establishing regional allocation strategies, the Adviser then selects Equity
Securities among issuers of a region.The International Magnum Portfolio invests
in countries comprising the EAFE Index (each an "EAFE country").
The EAFE Index is one of seven International Indices, twenty National
Indices and thirty-eight International Industry Indices making up the Morgan
Stanley Capital International Indices. The Morgan Stanley Capital
International EAFE Index is based on the share prices of 1,066 companies listed
on the stock exchanges of Europe, Australia, New Zealand and the Far East.
"Europe" includes Austria, Belgium, Denmark, Finland, France, Germany, Italy,
The Netherlands, Norway, Spain, Sweden, Switzerland and the United Kingdom.
"Far East" includes Japan, Hong Kong and Singapore/Malaysia.
Options
General Information. As stated in the Prospectus, the Fixed Income, High Yield,
- -------------------
International Fixed Income, Balanced, Multi-Asset-Class, Value, Core Equity, Mid
Cap Growth, Mid Cap Value, Emerging Markets Debt, Growth, International Magnum,
Emerging Markets Equity and U.S. Real Estate Portfolios may purchase and sell
options on Equity Securities. Additional information with respect to option
transactions is set forth below. Call and put options on Equity Securities are
listed on various U.S. and foreign securities exchanges ("listed options") and
are written in over-the-counter transaction ("OTC Options").
Listed options are issued or guaranteed by the exchange on which they
trade or by a clearing corporation, such as Options Clearing Corporation ("OCC")
in the United States. Ownership of a listed call option gives the fund the right
to buy from the clearing corporation or exchange, the underlying security
covered by the option at the state exercise price (the price per unit of the
underlying security or currency) by filing an exercise notice prior to the
expiration date of the option. The writer (seller) of the option would then have
the obligation to sell to the clearing corporation or exchange, the underlying
security or currency at that exercise price prior to the expiration date of the
option, regardless of its current market price. Ownership of listed put option
would give each Portfolio the right to sell the underlying security or currency
to the clearing corporation or exchange at the state exercise price. Upon notice
of exercise of the put option, the writer of the option would have the
obligation to purchase the underlying security from the clearing corporation or
exchange at the exercise price.
OTC options are purchased from or sold (written) to dealers of
financial institutions which have entered into direct agreements with each
Portfolio. With OTC options, such variables as expiration date exercise price
and premium will be agreed upon between each Portfolio and the transactions
dealer, without the intermediate of a third party such as a clearing corporation
or exchange. If the transacting dealer fails to make or take delivery of the
securities underlying an option it has written, in accordance with the terms of
that option, each Portfolio would lose the premium paid for the option as well
as any anticipated benefit of the transaction.
Covered Call Writing. Each of the Portfolios may write (i.e., sell) covered
- --------------------
call options on portfolio securities. By doing so, the Portfolio would become
obligated during the terms of the option to deliver
9
<PAGE>
the securities underlying the option should the option holder choose to exercise
the option before the option's termination date. In return for the call it has
written, each Portfolio will receive from the purchaser (or option holder) a
premium which is the price of the option, less a commission charged by a broker.
Each Portfolio will keep the premium regardless of whether the option is
exercised. A call option is "covered" if the Portfolio owns the security
underlying the option it has written or has an absolute or immediate right to
acquire the security by holding a call option on such security, or maintains a
sufficient amount of cash, cash equivalents or liquid securities to purchase the
underlying security. When the Portfolio writes covered call options, it
augments its income by the premiums receive and is thereby hedged to the extent
of that amount against a decline in the price of the underlying securities and
the premiums received will offset a portion of the potential loss incurred by
the Portfolio if the securities underlying the options are ultimately sold by
the Portfolio at a loss. However, during the option period, each Portfolio has,
in return for the premium on the option, given up the opportunity for capital
appreciation above the exercise price should the market price of the underlying
security increase, but has retained the risk of loss should the price of the
underlying security decline. The size of premiums will fluctuate with varying
market conditions.
Covered Put Writing. Each of the Portfolios may write covered put options on
- -------------------
portfolio securities. By doing so, the Portfolio incurs an obligation to buy
the security underlying the option from the purchaser of the put at the option's
exercise price at any time during the option period, at the purchaser's election
(certain listed and OTC options written by the Portfolio will be exercisable by
the purchaser only on a specific date). Generally, a put option is "covered" if
the Portfolio maintains cash, U.S. Government securities or other high grade
debt obligations equal to the exercise price of the option or if the Portfolio
holds a put option on the same underlying security with a similar or higher
exercise price.
Each of the Portfolios will write put options (i) to receive the
premiums paid by purchasers; (ii) when the Adviser wishes to purchase the
security underlying the option at a price lower than its current market price,
in which case it will write the covered put at an exercise price reflecting the
lower purchase price sought; and (iii) to close out a long put option position.
Purchase of Put and Call Options. Each of the Portfolios may purchase listed or
- --------------------------------
OTC put or call options on its portfolio securities in amounts exceeding no more
than 5% of its total assets. When each Portfolio purchases a call option it
acquires the right to sell a designated security at a designated price (the
"exercise price"), and when each Portfolio purchases a put option it acquires
the right to purchase a designated security at the exercise price, in each case
on or before a specified date (the "termination date"), usually not more than
nine months from the date the option is issued.
Each Portfolio may purchase call options to close out a covered call
position or to protect against an increase in the price of a security it
anticipates purchasing. Each Portfolio may purchase put options on securities
which it holds in its portfolio only to protect itself against a decline in the
value of the security. If the value of the underlying security were to fall
below the exercise price of the put purchased in an amount greater than the
premium paid for the option, each Portfolio would incur no additional loss.
Each Portfolio may also purchase put options to close out written put positions
in a manner similar to call option closing purchase transactions.
The amount each Portfolio pays to purchase an option is called a
"premium," and the risk assumed by the Portfolio when it purchases an option is
the loss of this premium. Because the price of an option tends to move with
that of its underlying security, if a Portfolio is to make a profit, the price
of the underlying security must change and the change must be sufficient to
cover the premium and commissions paid. A price change in the security
underlying the option does not assure a profit since prices in the options
market may not always reflect such a change.
Special Risks Associated with Forward Contracts, Foreign Currency Futures
Contracts and Options Thereon and Options on Foreign Currencies.
Transactions in forward contracts, as well as futures and options on
foreign currencies, are subject to the risk of governmental actions affecting
trading in or the prices of currencies underlying such contracts, which could
restrict or eliminate trading and could have a substantial adverse effect on the
value of positions held by each Portfolio permitted to engage in such hedging
transactions. In addition, the value of such positions could be adversely
affected by a number of other complex political and economic factors applicable
to the countries issuing the underlying currencies.
Furthermore, unlike trading in most other types of instruments, there
is no systematic reporting of last sale information with respect to the foreign
currencies underlying forward contracts, futures contracts and options. As a
result, the available information on which a Portfolio's trading systems will be
based may not be as complete as the comparable data on which such Portfolio
makes investment and trading decisions in connection with securities and other
transactions. Moreover, because the foreign currency market is a global,
twenty-four hour market, events could occur on that market which will not be
reflected in the forward, futures or options markets until the following day,
thereby preventing a Portfolio from responding to such events in a timely
manner.
Settlements of over-the-counter forward contracts or of the exercise
of foreign currency options generally must occur within the country issuing the
underlying currency, which in turn requires parties to such contracts to accept
or make delivery of such currencies in conformity with any United States or
foreign restrictions and regulations regarding the maintenance of foreign
banking relationships, fees, taxes or other charges.
Unlike currency futures contracts and exchange-traded options, options
on foreign currencies and forward contracts are not traded on contract markets
regulated by the CFTC or (with the exception of certain foreign currency
options) the Commission. In an over-the-counter trading environment, many of
the protections associated with transactions on exchanges will not be available.
For example, there are no daily price fluctuation limits, and adverse market
movements could therefore continue to an unlimited extent over a period of time.
Although the purchaser of an option cannot lose more than the amount of the
premium plus related transaction costs, this entire amount could be lost.
Moreover, an option writer could lose amounts substantially in excess of its
initial investment due to the margin and collateral requirements associated with
such option positions. Similarly, there is no limit on the amount of potential
losses on forward contracts to which a Portfolio is a party.
In addition, over-the-counter transactions can only be entered into
with a financial institution willing to take the opposite side, as principal, of
a Portfolio's position unless the institution acts as broker and is able to find
another counterparty willing to enter into the transaction with such Portfolio.
Where no such counterparty is available, it will not be possible to enter into a
desired transaction. There also may be no liquid secondary market in the
trading of over-the-counter contracts, and a Portfolio may be unable to close
out options purchased or written, or forward contracts entered into, until their
exercise, expiration or maturity. This in turn could limit a Portfolio's
ability to realize profits or to reduce losses on open positions and could
result in greater losses.
Furthermore, over-the-counter transactions are not backed by the
guarantee of an exchange's clearing corporation. A Portfolio will therefore be
subject to the risk of default by, or the bankruptcy of, the financial
institution serving as its counterparty. One or more of such institutions also
may decide to discontinue its role as market-maker in a particular currency,
thereby restricting a Portfolio's ability to enter into desired hedging
transactions. A Portfolio will enter into over-the-counter transactions only
with parties whose creditworthiness has been reviewed and found satisfactory by
the Adviser.
Over-the-counter options on foreign currencies, like exchange-traded
commodity futures contracts and commodity option contracts, are within the
exclusive regulatory jurisdiction of the CFTC. The CFTC currently permits the
trading of such options, but only subject to a number of conditions regarding
the commercial purpose of the purchaser of such options. Forward contracts and
currency swaps are not presently subject to regulation by the CFTC, although the
CFTC may in the future assert or be granted authority to regulate such
instruments. In such event, a Portfolio's ability to utilize forward contracts
and currency swaps in the manner set forth above and in the applicable
Prospectus could be restricted.
Options on foreign currencies traded on a national securities exchange
are within the jurisdiction of the Commission, as are other securities traded on
such exchanges. As a result, many of the protections provided to traders on
organized exchanges will be available with respect to such transactions. In
particular, all foreign currency options positions entered into on a national
securities exchange are cleared and guaranteed by the Options Clearing
Corporation ("OCC"), thereby reducing the risk of counterparty default.
Further, a liquid secondary market in options traded on a national securities
exchange may be more readily available than in the over-the-counter market,
potentially permitting a Portfolio to liquidate open positions at a profit prior
to exercise or expiration, or to limit losses in the event of adverse market
movements.
The purchase and sale of exchange-traded foreign currency options,
however, is subject to the risks of the availability of a liquid secondary
market described above, as well as the risks regarding adverse market movements,
margining of options written, the nature of the foreign currency market,
possible intervention by governmental authorities and the effect of other
political and economic events. In addition, exchange-traded options on foreign
currencies involve certain risks not presented by the over-the-counter market.
For example, exercise and settlement of such options must be made exclusively
through the OCC, which has established banking relationships in applicable
foreign countries for this purpose. As a result, the OCC may, if it determines
that foreign governmental restrictions or taxes would prevent the orderly
settlement of foreign currency option exercises, or would result in undue
burdens on the OCC or its clearing member, impose special procedures for
exercise and settlement, such as technical changes in the mechanics of delivery
of currency, the fixing of dollar settlement prices or prohibitions on exercise.
10
<PAGE>
Portfolio Turnover
The portfolio turnover rate for a year is the lesser of the value of
the purchases or sales for the year divided by the average monthly market value
of the Portfolio for the year, excluding U.S. Government securities and
securities with maturities of one year or less. The portfolio turnover rate for
a year is calculated by dividing the lesser of sales or the average monthly
value of the Portfolio's portfolio purchases of portfolio securities during that
year by securities, excluding money market instruments. The rate of portfolio
turnover will not be a limiting factor when the Portfolio deems it appropriate
to purchase or sell securities for the Portfolio. However, the U.S. federal tax
requirement that the Portfolio derive less than 30% of its gross income from the
sale or disposition of securities held less than three months may limit the
Portfolio's ability to dispose of its securities. See "Taxes."
Repurchase Agreements
Each Portfolio may invest in repurchase agreements collateralized by
U.S. Government securities, certificates of deposit and certain bankers'
acceptances. Repurchase agreements are transactions by which a Portfolio
purchases a security and simultaneously commits to resell that security to the
seller (a bank or securities dealer) at an agreed upon price on an agreed upon
date (usually within seven days of purchase). The resale price reflects the
purchase price plus an agreed upon market rate of interest which is unrelated to
the coupon rate or date of maturity of the purchased security. In these
transactions, the securities purchased by a Portfolio have a total value in
excess of the value of the repurchase agreement and are held by the Portfolio's
custodian bank until repurchased. Such agreements permit a Portfolio to keep
all its assets at work while retaining "overnight" flexibility in pursuit of
investments of a longer-term nature. The Adviser and the Fund's Administrator
will continually monitor the value of the underlying securities to ensure that
their value always equals or exceeds the repurchase price.
The use of repurchase agreements involves certain risks. For example,
if the seller of the agreements defaults on its obligation to repurchase the
underlying securities at a time when the value of these securities has declined,
a Portfolio may incur a loss upon disposition of them. If the seller of the
agreement becomes insolvent and subject to liquidation or reorganization under
the Bankruptcy Code or other laws, a bankruptcy court may determine that the
underlying securities are collateral not within the control of a Portfolio and
therefore subject to sale by the trustee in bankruptcy. Finally, it is possible
that a Portfolio may not be able to substantiate its interest in the underlying
securities. While the Fund's management acknowledges these risks, it is
expected that they can be controlled through stringent security selection
criteria and careful monitoring procedures.
Securities Lending
Each Portfolio may lend its investment securities to qualified
institutional investors who need to borrow securities in order to complete
certain transactions, such as covering short sales, avoiding failures to deliver
securities or completing arbitrage operations. By lending its investment
securities, a Portfolio attempts to increase its net investment income through
the receipt of interest on the loan. Any gain or loss in the market price of
the securities loaned that might occur during the term of the loan would be for
the account of the Portfolio. Each Portfolio may lend its investment securities
to qualified brokers, dealers, domestic and foreign banks or other financial
institutions, so long as the terms, structure and the aggregate amount of such
loans are not inconsistent with the Investment Company Act of 1940, as amended
(the "1940 Act"), or the Rules and Regulations or interpretations of the
Securities and Exchange Commission (the "Commission") thereunder, which
currently require that (a) the borrower pledge and maintain with the Portfolio
collateral consisting of cash, an irrevocable letter of credit issued by a
domestic U.S. bank, or securities issued or guaranteed by the United States
Government having a value at all times not less than 100% of the value of the
securities loaned, (b) the borrower add to such collateral whenever the price of
the securities loaned rises (i.e., the borrower "marks to the market" on a daily
basis), (c) the loan be made subject to termination by the Portfolio at any
time, and (d) the Portfolio receive reasonable interest on the loan (which may
include the Portfolio investing any cash collateral in interest bearing short-
term investments), any distributions on the loaned securities and any increase
in their market value.
11
<PAGE>
There may be risks of delay in recovery of the securities or even loss of rights
in the collateral should the borrower of the securities fail financially.
However, loans will only be made to borrowers deemed by the Adviser to be of
good standing and when, in the judgment of the Adviser, the consideration which
can be earned currently from such securities loans justifies the attendant risk.
All relevant facts and circumstances, including the creditworthiness of the
broker, dealer or institution, will be considered in making decisions with
respect to the lending of securities, subject to review by the Board of
Directors of the Fund.
At the present time, the staff of the Commission does not object if an
investment company pays reasonable negotiated fees in connection with loaned
securities, so long as such fees are set forth in a written contract and
approved by the investment company's Board of Directors. In addition, voting
rights may pass with the loaned securities, but if a material event will occur
affecting an investment on loan, the loan must be called and the securities
voted.
Short Sales
The Emerging Markets Debt Portfolio may from time to time sell
securities short without limitation but consistent with applicable legal
requirements, although initially the Portfolio does not intend to sell
securities short. A short sale is a transaction in which the Portfolio would
sell securities it owns or has the right to acquire at no added cost (i.e.,
"against the box") or does not own (but has borrowed) in anticipation of a
decline in the market price of the securities. When the Portfolio makes a short
sale of borrowed securities, the proceeds it receives from the sale will be held
on behalf of a broker until the Portfolio replaces the borrowed securities. To
deliver the securities to the buyer, the Portfolio will need to arrange through
a broker to borrow the securities and, in so doing, the Portfolio will become
obligated to replace the securities borrowed at their market price at the time
of replacement, whatever that price may be. Each Portfolio may have to pay a
premium to borrow the securities and must pay any dividends or interest payable
on the securities until they are replaced.
Each Portfolio's obligation to replace the securities borrowed in
connection with a short sale will be secured by collateral deposited with the
broker that consists of cash, U.S. Government Securities or other liquid, high
grade debt obligations. In addition, if the short sale is not "against the
box," the Portfolio will place in a segregated account with its custodian, or
designated sub-custodian, an amount of cash, U.S. Government Securities or other
liquid high grade debt obligations equal to the difference, if any, between (1)
the market value of the securities sold at the time they were sold short and (2)
any cash, U.S. Government Securities or other liquid high grade debt obligations
deposited as collateral with the broker in connection with the short sale (not
including the proceeds of the short sale). Until it replaces the borrowed
securities, the Portfolio will maintain the segregated account daily at a level
so that (1) the amount deposited in the account plus the amount deposited with
the broker (not including the proceeds from the short sale) will equal the
current market value of the securities sold short and (2) the amount deposited
in the account plus the amount deposited with the broker (not including the
proceeds from the short sale) will not be less than the market value of the
securities at the time they were sold short.
Short sales by each Portfolio involve certain risks and special
considerations. Possible losses from short sales differ from losses that could
be incurred from a purchase of a security, because losses from short sales may
be unlimited, whereas losses from purchases can equal only the total amount
invested.
12
<PAGE>
Structured Securities
Each of the Fixed Income, Balanced, Multi-Asset-Class and Emerging Markets Debt
Portfolios may invest a portion of its assets in interests in entities organized
and operated solely for the purpose of restructuring the investment
characteristics of sovereign debt obligations. This type of restructuring
involves the deposit with or purchase by an entity, such as a corporation or
trust, of specified instruments (such as commercial bank loans or Brady Bonds)
and the issuance by that entity of one or more classes of securities
("Structured Securities") backed by, or representing interests in, the
underlying instruments. The cash flow on the underlying instruments may be
apportioned among the newly issued Structured Securities to create securities
with different investment characteristics such as varying maturities, payment
priorities and interest rate provisions, and the extent of the payments made
with respect to Structured Securities is dependent on the extent of the cash
flow on the underlying instruments. Because Structured Securities of the type
in which each Portfolio anticipates it will invest typically involve no credit
enhancement, their credit risk generally will be equivalent to that of the
underlying instruments. Each Portfolio is permitted to invest in a class of
Structured Securities that is either subordinated or unsubordinated to the right
of payment of another class. Subordinated Structured Securities typically have
higher yields and present greater risks than unsubordinated Structured
Securities. Certain issuers of Structured Securities may be deemed to be
"investment companies" as defined in the 1940 Act. As a result, each
Portfolio's investment in these Structured Securities may be limited by
restrictions contained in the 1940 Act. Structured Securities are typically
sold in private placement transactions, and there currently is no active trading
market for Structured Securities.
SWAPS: Swap Contracts
The Fixed Income, High Yield, Value, Core Equity, Mid Cap Growth, Mid Cap Value,
International Fixed Income, Emerging Markets Debt, Balanced and
Multi-Asset-Class Portfolios may enter into Swap Contracts. A swap is an
agreement to exchange the return generated by one instrument for the return
generated by another instrument. The payment streams are calculated by reference
to a specified index and agreed upon notional amount. The term "specified index"
includes currencies, fixed interest rates, prices, total return on interest rate
indices, fixed income indices, stock indices and commodity indices (as well as
amounts derived from arithmetic operations on these indices). For example, a
Portfolio may agree to swap the
13
<PAGE>
return generated by a fixed-income index for the return generated by a second
fixed-income index. The currency swaps in which the Portfolios may enter will
generally involve an agreement to pay interest streams in one currency based on
a specified index in exchange for receiving interest streams denominated in
another currency. Such swaps may involve initial and final exchanges that
correspond to the agreed upon notional amount.
The swaps in which the Portfolios may engage also include rate caps, floors and
collars under which one party pays a single or periodic fixed amount(s) (or
premium), and the other party pays periodic amounts based on the movement of a
specified index. Swaps do not involve the delivery of securities, other
underlying assets, or principal. Accordingly, the risk of loss with respect to
swaps is limited to the net amount of payments that a Portfolio is contractually
obligated to make. If the other party to a swap defaults, a Portfolio's risk of
loss consists of the net amount of payments that a Portfolio is contractually
entitled to receive. Currency swaps usually involve the delivery of the entire
principal value of one designated currency in exchange for the other designated
currency. Therefore, the entire principal value of a currency swap is subject
to the risk that the other party to the swap will default on its contractual
delivery obligations. If there is a default by the counterparty, the Portfolios
may have contractual remedies pursuant to the agreements related to the
transaction. The swap market has grown substantially in recent years with a
large number of banks and investment banking firms acting both as principals and
as agents utilizing standardized swap documentation. As a result, the swap
market has become relatively liquid. Caps, floors, and collars are more recent
innovations for which standardized documentation has not yet been fully
developed and, accordingly, they are less liquid than swaps.
The Portfolios will usually enter into swaps on a net basis, i.e., the two
payment streams are netted out in a cash settlement on the payment date or dates
specified in the instrument, with a Portfolio receiving or paying, as the case
may be, only the net amount of the two payments. A Portfolio's obligations
under a swap agreement will be accrued daily (offset against any amounts owing
to the Portfolio) and any accrued but unpaid net amounts owed to a swap
counterparty will be covered by the maintenance of a segregated account
consisting of cash, U.S. Government securities, or high grade debt obligations,
to avoid any potential leveraging of the Portfolio. To the extent that these
swaps, caps, floors, and collars are entered into for hedging purposes, the
Adviser believes such obligations do not constitute "senior securities" under
the Investment Company Act of 1940 and, accordingly, will not treat them as
being subject to a Portfolio's borrowing restrictions. The Fixed Income, High
Yield, International Fixed Income, Balanced, Value, Core Equity, Mid Cap Growth,
Mid Cap Value and Multi-Asset-Class Portfolios may enter into OTC Derivatives
transactions (Swaps, Caps, Floors, Puts, etc., but excluding foreign exchange
contracts) with counterparties that are approved by the Adviser in accordance
with guidelines established by the Board of Directors. These guidelines provide
for a minimum credit rating for each counterparty and various credit enhancement
techniques (for example, collateralization of amounts due from counterparties)
to limit exposure to counterparties with rating below AA.
The use of swaps is a highly specialized activity which involves investment
techniques and risks different from those associated with ordinary portfolio
securities transactions. If the Adviser is incorrect in its forecasts of market
values, interest rates, and currency exchange rates, the investment performance
of the Portfolios would be less favorable than it would have been if this
investment technique were not used.
Zero Coupons
Zero Coupon Bonds is a term used to describe notes and bonds which
have been stripped of their unmatured interest coupons, or the coupons
themselves, and also receipts or certificates representing interest in such
stripped debt obligations and coupons. The timely payment of coupon interest
and principal on these instruments remains guaranteed by the "full faith and
credit" of the United States Government.
14
<PAGE>
A zero coupon bond does not pay interest. Instead, it is issued at a
substantial discount to its "face value"--what it will be worth at maturity.
The difference between a security's issue or purchase price and its face value
represents the imputed interest an investor will earn if the security is held
until maturity. For tax purposes, a portion of this imputed interest is deemed
as income received by zero coupon bondholders each year. The Fund, which
expects to qualify as a regulated investment company, intends to pass along such
interest as a component of a Portfolio's distributions of net investment income.
Zero coupon bonds may offer investors the opportunity to earn higher
yields than those available on U.S. Treasury bonds of similar maturity.
However, zero coupon bond prices may also exhibit greater price volatility than
ordinary Fixed-Income Securities because of the manner in which their principal
and interest is returned to the investor.
Zero Coupon Treasury Bonds are sold under a variety of different
names, such as: Certificate of Accrual on Treasury Securities (CATS), Treasury
Receipts (Trs), Separate Trading of Registered Interest and Principal of
Securities (STIRPS) and Treasury Investment Growth Receipts (TIGERS).
TAXES
The following is only a summary of certain additional federal tax
considerations generally affecting the Fund and its shareholders that are not
described in the Prospectus. No attempt is made to present a detailed
explanation of the federal, state or local tax treatment of the Fund or its
shareholders, and the discussion here and in the Fund's Prospectus is not
intended as a substitute for careful tax planning.
The following discussion of federal income tax consequences is based
on the Internal Revenue Code of 1986, as amended (the "Code") and the
regulations issued thereunder as in effect on the date of this Statement of
Additional Information. New legislation, as well as administrative changes or
court decisions, may significantly change the conclusions expressed herein, and
may have a retroactive effect with respect to the transactions contemplated
herein.
Each Portfolio within the Fund is generally treated as a separate
corporation for federal income tax purposes, and thus the provisions of the Code
generally will be applied to each Portfolio separately, rather than to the Fund
as a whole.
Each Portfolio intends to qualify and elect to be treated for each
taxable year as a regulated investment company ("RIC") under Subchapter M of the
Code. Accordingly, each Portfolio must, among other things, (a) derive at least
90% of its gross income each taxable year from dividends, interest, payments
with respect to securities loans, gains from the sale or other disposition of
stock, securities or foreign currencies, and certain other related income,
including, generally, certain gains from options, futures and forward contracts;
(b) derive less than 30% of its gross income each taxable year from the sale or
other disposition of the following items if held less than three months (A)
stock or securities, (B) options, futures or forward contracts (other than
options, futures or forward contracts on foreign currencies), and (C) foreign
currencies (or options, futures, or forward contracts on foreign currencies)
that are not directly related to the Portfolio's principal business of investing
in stocks or securities (or options or futures with respect to stock or
securities) (the "short-short test") and (c) diversify its holdings so that, at
the end of each fiscal quarter of the Portfolio's taxable year, (i) at least 50%
of the market value of the Portfolio's total assets is represented by cash and
cash items, United States Government securities, securities of other RICs, and
other securities, with such other securities limited, in respect to any one
issuer, to an amount not greater than 5% of the value of the Portfolio's total
assets or 10% of the outstanding voting securities of such issuer, and (ii) not
more than 25% of the value of its total assets is invested in the securities
(other than United States Government securities or securities of other RICs) of
any one issuer or two or more issuers which the Portfolio controls and which are
engaged in the same,
15
<PAGE>
similar, or related trades or business. For purposes of the 90% of gross income
requirement described above, foreign currency gains which are not directly
related to a Portfolio's principal business of investing in stock or securities
(or options or futures with respect to stock or securities) may be excluded from
income that qualifies under the 90% requirement.
In addition to the requirements described above, in order to qualify
as a RIC, a Portfolio must distribute at least 90% of its net investment income
(which generally includes dividends, taxable interest, and the excess of net
short-term capital gains over net long-term capital losses less operating
expenses) and at least 90% of its net tax-exempt interest income, if any, to
shareholders. If a Portfolio meets all of the RIC requirements, it will not be
subject to federal income tax on any of its net investment income or capital
gains that it distributes to shareholders.
If a Portfolio fails to qualify as a RIC for any year, all of its
income will be subject to tax at corporate rates, and its distributions
(including capital gains distributions) will be taxable as ordinary income
dividends to its shareholders to the extent of the Portfolio's current and
accumulated earnings and profits, and will be eligible for the corporate
dividends received deduction for corporate shareholders.
Each Portfolio will decide whether to distribute or to retain all or
part of any net capital gains (the excess of net long-term capital gains over
net short-term capital losses) in any year for reinvestment. If any such gains
are retained, the Portfolio will pay federal income tax thereon, and, if the
Portfolio makes an election, the shareholders will include such undistributed
gains in their income, will increase their basis in Portfolio shares by 65% of
the amount included in their income and will be able to claim their share of the
tax paid by the Portfolio as a refundable credit against their federal income
tax liability.
A gain or loss realized by a shareholder on the sale or exchange of
shares of a Portfolio held as a capital asset will be capital gain or loss, and
such gain or loss will be long-term if the holding period for the shares exceeds
one year, and otherwise will be short-term. Any loss realized on a sale or
exchange of shares of a Portfolio will be disallowed to the extent the shares
disposed of are replaced within the 61-day period beginning 30 days before and
ending 30 days after the shares are disposed of. Any loss realized by a
shareholder on the disposition of shares held 6 months or less is treated as a
long-term capital loss to the extent of any distributions of net long-term
capital gains received by the shareholder with respect to such shares or any
inclusion of undistributed capital gain with respect to such shares.
Each Portfolio will generally be subject to a nondeductible 4% federal
excise tax to the extent it fails to distribute by the end of any calendar year
at least 98% of its ordinary income for that year and 98% of its capital gain
net income (the excess of short- and long-term capital gains over short- and
long-term capital losses) for the one-year period ending on October 31 of that
year, plus certain other amounts.
The excise tax is not applicable to any RIC whose shareholders are
either tax-exempt pension trusts or separate accounts of life insurance
companies funding variable contracts. Although each Portfolio believes that it
is not subject to the excise tax, each Portfolio intends to make the
distributions required to avoid the imposition of the tax, provided such
payments and distributions are determined to be in the best interest of such
Portfolio's shareholders.
Dividends declared by a Portfolio in October, November, or December of
any year and payable to shareholders of record on a date in such month will be
deemed to have been paid by the Portfolio and received by the shareholders on
December 31 of that year if paid by the Portfolio at any time during the
following January.
16
<PAGE>
For certain transactions, each Portfolio is required for federal
income tax purposes to recognize as gain or loss its net unrealized gains and
losses on forward currency and futures contracts as of the end of each taxable
year, as well as those actually realized during the year. In most cases, any
such gain or loss recognized with respect to a regulated futures contract is
considered to be 60% long-term capital gain or loss and 40% short-term capital
gain or loss, without regard to the holding period of the contract. Realized
gain or loss attributable to a foreign currency forward contract is treated as
100% ordinary income. Furthermore, foreign currency futures contracts which are
intended to hedge against a change in the value of securities held by a
Portfolio may affect the holding period of such securities and, consequently,
the nature of the gain or loss on such securities upon disposition.
As discussed above, in order for each Portfolio to continue to qualify
for federal income tax treatment as a RIC, at least 90% of its gross income for
a taxable year must be derived from certain qualifying income, including
dividends, interest, income derived from loans of securities, and gains from the
sale or other disposition of stock, securities or foreign currencies, or other
related income, including gains from options, futures and forward contracts,
derived with respect to its business of investing in stock, securities or
currencies. Any net gain realized from the closing out of futures contracts
will therefore generally be qualifying income for purposes of the 90%
requirement. Qualification as a RIC also requires that less than 30% of a
Portfolio's gross income be derived from the sale or other disposition of stock,
securities, options, futures or forward contracts (including certain foreign
currencies not directly related to the Portfolio's business of investing in
stock or securities) held less than three months. In order to avoid realizing
excessive gains on futures contracts held less than three months, the Portfolio
may be required to defer the closing out of futures contracts beyond the time
when it would otherwise be advantageous to do so.
Short sales engaged in by a Portfolio may reduce the holding period of
property held by a Portfolio which is substantially identical to the property
sold short. This rule may make it more difficult for the Portfolio to satisfy
the short-short test. This rule may also have the effect of converting capital
gains recognized by the Portfolio from long-term to short-term as well as
converting capital losses recognized by the Portfolio from short-term to long-
term.
SPECIAL TAX CONSIDERATIONS RELATING TO FOREIGN INVESTMENTS
Gains or losses attributable to foreign currency contracts, or to
fluctuations in exchange rates that occur between the time a Portfolio accrues
interest or other receivables or accrues expenses or other liabilities
denominated in a foreign currency and the time the Portfolio actually collects
such receivables or pays such liabilities are treated as ordinary income or
ordinary loss to the Portfolio. Similarly, gains or losses on disposition of
debt securities denominated in a foreign currency attributable to fluctuations
in the value of the foreign currency between the date of acquisition of the
security and the date of disposition also are treated as ordinary gain or loss
to the Portfolio. These gains or losses increase or decrease the amount of a
Portfolio's net investment income available to be distributed to its
shareholders as ordinary income.
Each Portfolio that invests in foreign securities may be subject to
foreign withholding taxes with respect to its dividend and interest income from
foreign countries, and a Portfolio may be subject to foreign income taxes with
respect to other income. So long as more than 50% in value of a Portfolio's
total assets at the close of the taxable year consists of stock or securities of
foreign corporations, the Portfolio may elect to treat certain foreign income
taxes imposed on it for United States federal income tax purposes as paid
directly by its shareholders. A Portfolio will make such an election only if it
deems it to be in the best interest of its shareholders and will notify
shareholders in writing each year if it makes an election and of the amount of
foreign income taxes, if any, to be treated as paid by the shareholders. If a
Portfolio
17
<PAGE>
makes the election, shareholders will be required to include in income their
proportionate shares of the amount of foreign income taxes treated as imposed on
the Portfolio and will be entitled to claim either a credit (subject to the
limitations discussed below) or, if they itemize deductions, a deduction, for
their shares of the foreign income taxes in computing their federal income tax
liability.
Shareholders who choose to utilize a credit (rather than a deduction)
for foreign taxes will be subject to a number of complex limitations regarding
the availability and utilization of the credit. Because of these limitations,
shareholders may be unable to claim a credit for the full amount of their
proportionate shares of the foreign income taxes paid by a Portfolio.
Shareholders are urged to consult their tax advisors regarding the application
of these rules to their particular circumstances.
TAXES AND FOREIGN SHAREHOLDERS
Taxation of a shareholder who, as to the United States, is a
nonresident alien individual, a foreign trust or estate, a foreign corporation,
or foreign a partnership ("Foreign Shareholder") depends on whether the income
from the Portfolio is "effectively connected" with a U.S. trade or business
carried on by such shareholder.
If the income from the Portfolio is not effectively connected with a
U.S. trade or business carried on by a Foreign Shareholder, distributions of net
investment income plus the excess of net short-term capital gains over net
long-term capital losses will be subject to U.S. withholding tax at the rate of
30% (or such lower treaty rate as may be applicable) upon the gross amount of
the dividend. Furthermore, Foreign Shareholders will generally be exempt from
U.S. federal income tax on gains realized on the sale of shares of the
Portfolio, distributions of net long-term capital gains, and amounts retained by
the Fund which are designated as undistributed capital gains.
If the income from the Portfolio is effectively connected with a U.S.
trade or business carried on by a Foreign Shareholder, then distributions from
the Portfolio and any gains realized upon the sale of shares of the Portfolio,
will be subject to U.S. federal income tax at the rates applicable to U.S.
citizens and residents or domestic corporations.
The Portfolio may be required to withhold U.S. federal income tax on
distributions that are otherwise exempt from withholding tax (or taxable at a
reduced treaty rate) unless the Foreign Shareholder complies with Internal
Revenue Service certification requirements.
The tax consequences to a Foreign Shareholder entitled to claim the
benefits of an applicable tax treaty may differ from those described here.
Furthermore, Foreign Shareholders are strongly urged to consult their own tax
advisors with respect to the particular tax consequences to them of an
investment in a Portfolio, including the potential application of the provisions
of the Foreign Investment in Real Estate Property Tax Act of 1980, as amended.
PURCHASE OF SHARES
The purchase price of each Portfolio of the Fund, except the Money
Market Portfolio, is the net asset value next determined after the order is
received. For each Portfolio of the Fund other than the Money Market Portfolio,
an order received prior to the regular close of the New York Stock Exchange (the
"NYSE") will be executed at the price computed on the date of receipt; and an
order received after the regular close of the NYSE will be executed at the price
computed on the next day the NYSE is open as long as the Fund's transfer agent
receives payment by check or in Federal Funds prior to the regular close of the
NYSE on such day. Shares of the Money Market Portfolio may be purchased at the
net asset value per share at the price next determined after Federal Funds are
available to such Portfolio. Shares
18
<PAGE>
of the Fund may be purchased on any day the NYSE is open. The NYSE will be
closed on the following days: New Year's Day, Presidents' Day, Good Friday,
Memorial Day, Independence Day, Labor Day, Thanksgiving Day and Christmas Day,
and on the preceding Friday or subsequent Monday when any of these holidays
falls on a Saturday or Sunday, respectively.
Each Portfolio reserves the right in its sole discretion (i) to
suspend the offering of its shares, (ii) to reject purchase orders when in the
judgment of management such rejection is in the best interest of the Portfolio,
and (iii) to reduce or waive the minimum for initial and subsequent investments
for certain fiduciary accounts such as employee benefit plans or under
circumstances where certain economies can be achieved in sales of a Portfolio's
shares.
REDEMPTION OF SHARES
Redemptions. Each Portfolio may suspend redemption privileges or
postpone the date of payment (i) during any period that the NYSE is closed, or
trading on the NYSE is restricted as determined by the Commission, (ii) during
any period when an emergency exists as defined by the rules of the Commission as
a result of which it is not reasonably practicable for a Portfolio to dispose of
securities owned by it, or fairly to determine the value of its assets, and
(iii) for such other periods as the Commission may permit.
Distributions in Kind. If the Board of Directors determines that it
would be detrimental to the best interests of the shareholders of a Portfolio to
make a redemption payment wholly in cash, the Fund may pay any portion of a
redemption by distribution in kind of portfolio securities in lieu of cash.
Securities issued in a distribution in kind will be readily marketable, although
shareholders receiving distributions in kind may incur brokerage commissions
when subsequently redeeming shares of those securities.
19
<PAGE>
EXCHANGE FEATURES
Shares of each Portfolio of the Fund may be exchanged for shares of
any other available Portfolio pursuant to the terms of the variable annuity or
variable life contract held by the contractholder.
STATE LAW RESTRICTIONS
The investments of variable annuity and variable life insurance
contracts are subject to the provisions of the insurance laws of the States of
domicile of the life insurance companies offering these contracts. The Fund and
its Portfolios will voluntarily comply with the statutory investment
restrictions applicable to the investments of life insurance company separate
accounts, of the States of domicile of the life insurance companies offering
these contracts, even though these state law investment restrictions do not
apply to the Fund and its Portfolios. For a description of the state law
restrictions applicable to the separate accounts of the life insurance companies
offering these contracts, see the accompanying prospectus for the variable
annuity and variable life insurance contracts.
INVESTMENT LIMITATIONS
Each current Portfolio has adopted the following restrictions which
are fundamental policies and may not be changed without the approval of the
lesser of: (1) at least 67% of the voting securities of the Portfolio present
at a meeting if the holders of more than 50% of the outstanding voting
securities of the Portfolio are present or represented by proxy, or (2) more
than 50% of the outstanding voting securities of the Portfolio. Each Portfolio
of the Fund will not:
(1) purchase or sell physical commodities unless acquired as a result
of ownership of securities or other instruments (except this shall not prevent
the Portfolio from purchasing or selling options or futures contracts or from
investing in securities or other instruments backed by physical commodities);
(2) purchase or sell real estate, although it may purchase and sell
securities of companies that deal in real estate and may purchase and sell
securities that are secured by interests in real estate;
(3) lend any security or make any other loan if, as a result, more
than 33 1/3% of its total assets would be lent to other parties, but this
limitation does not apply to purchases of debt securities or repurchase
agreements;
(4) except with respect to the International Fixed Income, Emerging
Markets Equity, Emerging Markets Debt, International Magnum and U.S. Real Estate
Portfolios (i) purchase more than 10% of any class of the outstanding voting
securities of any issuer and (ii) purchase securities of an issuer (except
obligations of the U.S. Government and its agencies and instrumentalities) if as
a result, with respect to 75% of its total assets, more than 5% of the
Portfolio's total assets, at market value, would be invested in the securities
of such issuer;
(5) issue senior securities and will not borrow, except from banks and
as a temporary measure for extraordinary or emergency purposes and then, in no
event, in excess of 33 1/3% of its total assets (including the amount borrowed)
less liabilities (other than borrowings), except that the Emerging Markets Debt
Portfolio may borrow from banks and other entities in an amount not in excess of
33 1/3% of its total assets (including the amount borrowed) less liabilities in
accordance with its investment objectives and policies;
(6) underwrite securities issued by others, except to the extent that
the Portfolio may be considered an underwriter within the meaning of the 1933
Act in the disposition of restricted securities;
(7) acquire any securities of companies within one industry if, as a
result of such acquisition, more than 25% of the value of the Portfolio's total
assets would be invested in securities of companies within such industry;
provided, however, that there shall be no limitation on the purchase of
obligations issued or guaranteed by the U.S. Government, its agencies or
instrumentalities or (in the case of the Money Market Portfolio) instruments
issued by U.S. Banks, except that the U.S. Real Estate Portfolio may invest more
than 25% of its total assets in the U.S. real estate industry; and
(8) write or acquire options or interests in oil, gas or other mineral
exploration or development programs.
20
<PAGE>
In addition, each current Portfolio of the Fund has adopted non-
fundamental investment limitations as stated below. Such limitations may be
changed without shareholder approval. Each current Portfolio of the Fund will
not:
(1) purchase on margin or sell short, except (i) that the Emerging
Markets Debt and Growth Portfolios may from time to time sell securities short
without limitation but consistent with applicable legal requirements as stated
in the Prospectus, (ii) that the Growth Portfolio may enter into option
transactions to the extent that not more than 5% of the Portfolio's total assets
are required as deposits to secure obligations under options and not more than
20% of its total assets are invested in options, futures contracts and options
on futures contracts at any time, and (iii) as specified above in Fundamental
Restriction No. (1);
(2) enter into futures contracts to the extent that its outstanding
obligations to purchase securities under these contracts in combination with its
outstanding obligations with respect to options transactions would exceed 50% of
its total assets, and will maintain assets sufficient to meet its obligations
under such contracts in a segregated account with the custodian bank or will
otherwise comply with the SEC's position on asset coverage (relating to the
Fixed Income, High Yield, International Fixed Income, Balanced, Value, Core
Equity, Mid Cap Growth, Mid Cap Value and Multi-Asset-Class Portfolios);
(3) purchase or retain securities of an issuer if those Officers and
Directors of the Fund or its investment advisers owning more than 1/2 of 1% of
such securities together own more than 5% of such securities;
(4) pledge, mortgage, or hypothecate any of its assets to an extent
greater than 10% of its total assets at fair market value (relating to the
Emerging Markets Debt, Growth, International Magnum, Emerging Markets Equity,
Asian Growth, Global Equity and U.S. Real Estate Portfolios);
(5) pledge, mortgage, or hypothecate any of its assets to an extent
greater than 50% of its total assets at fair market value relating to the Fixed
Income, High Yield, International Fixed Income, Balanced, Value, Core Equity,
Mid Cap Growth, Mid Cap Value and Multi-Asset-Class Portfolios;
(6) invest for the purpose of exercising control over management of
any company;
(7) invest its assets in securities of any investment company, except
by purchase in the open market involving only customary brokers' commissions or
in connection with mergers, acquisitions of assets or consolidations and except
as may otherwise be permitted by the 1940 Act;
(8) invest more than an aggregate of 15% of the net assets of the
Portfolio, determined at the time of investment, in securities subject to legal
or contractual restrictions on resale or securities for which there are no
readily available markets, including repurchase agreements having maturities of
more than seven days and OTC options provided that there is no limitation with
respect to or arising out of investment in (i) securities that have legal or
contractual restrictions on resale but have a readily available market, or (ii)
securities that are not registered under the Securities Act of 1933, as amended
(the "1933 Act") but which can be sold to qualified institutional investors in
accordance with Rule 144A under the 1933 Act;
(9) invest more than 5% of its total assets in securities of companies
which have (with predecessors) a record of less than three years' continuous
operation;
(10) purchase warrants if, by reason of such purchase, more than 5% of
the value of the Portfolio's net assets (taken at market value) would be
invested in warrants, valued at the lower of cost or market. Included within
this amount, but not to exceed 2% of the value of the Portfolio's net assets,
may be warrants that are not listed on a recognized stock exchange;
21
<PAGE>
(11) except for the U.S. Real Estate Portfolio, invest in real estate
limited partnership interests, and the U.S. Real Estate Portfolio may not invest
in such interests that are not publicly traded;
(12) make loans except (i) by purchasing bonds, debentures or similar
obligations (including repurchase agreements, subject to the limitations as
described in the prospectus) that are publicly distributed, and (ii) by lending
its portfolio securities to banks, brokers, dealers and other financial
institutions so long as such loans are not inconsistent with the 1940 Act or the
Rules and Regulations or interpretations of the Commission thereunder;
(13) invest in oil, gas or other mineral leases; and
(14) purchase puts, calls, straddles, spreads and any combination
thereof if for any reason thereof the value of its aggregate investment in such
classes of securities will exceed 5% of their respective total assets, except
that the Growth Portfolio may enter into option transactions to the extent that
not more than 5% of the Portfolio's total assets are required as deposits to
secure obligations under options and not more than 20% of its total assets are
invested in options, futures contracts and options on futures contracts at any
time.
(15) purchase on margin, except for use of short-term credit as may be
necessary for the clearance of purchases and sales of securities, but it may
make margin deposits in connection with transactions in options, futures, and
options on futures; or sell short unless, by virtue of its ownership of other
securities, it has the right to obtain securities equivalent in kind and amount
to the securities sold and, if the right is conditional, the sale is made upon
the same conditions. Transactions in futures contracts and options are not
deemed to constitute selling securities short (relating to the Fixed Income,
High Yield, International Fixed Income, Balanced, Value, Core Equity, Mid Cap
Growth, Mid Cap Value and Multi-Asset-Class Portfolio);
(16) borrow money other than from banks or other Portfolios of the
Fund, provided such borrowing is not inconsistent with the 1940 Act, as amended,
or the Rules and Regulations or interpretations or orders of the Securities and
Exchange Commission thereunder; or purchase additional securities when
borrowings exceed 5% of total (gross) assets;
Each of the International Fixed Income, Emerging Markets Debt,
Emerging Markets Equity, International Magnum and U.S. Real Estate Portfolios
will diversify its holdings so that, at the close of each quarter of its taxable
year, (i) at least 50% of the market value of the Portfolio's total assets is
represented by cash (including cash items and receivables), U.S. Government
securities, and other securities, with such other securities limited, in respect
of any one issuer, for purposes of this calculation to an amount not greater
than 5% of the value of the Portfolio's total assets and 10% of the outstanding
voting securities of such issuer, and (ii) not more than 25% of the value of its
total assets is invested in the securities of any one issuer (other than U.S.
Government securities).
The percentage limitations contained in these restrictions apply at
the time of purchase of securities. Future Portfolios of the Fund may adopt
different limitations.
DETERMINING MATURITIES OF CERTAIN INSTRUMENTS
Generally, the maturity of a portfolio instrument shall be deemed to
be the period remaining until the date noted on the face of the instrument as
the date on which the principal amount must be paid, or in the case of an
instrument called for redemption, the date on which the redemption payment must
be made. However, instruments having variable or floating interest rates or
demand features may be deemed to have remaining maturities as follows: (1) a
Government Obligation with a variable rate of interest readjusted no less
frequently than annually may be deemed to have a maturity equal to the period
22
<PAGE>
remaining until the next readjustment of the interest rate; (b) an instrument
with a variable rate of interest, the principal amount of which is scheduled on
the face of the instrument to be paid in one year or less, may be deemed to have
a maturity equal to the period remaining until the next readjustment of the
interest rate; (c) an instrument with a variable rate of interest that is
subject to a demand feature may be deemed to have a maturity equal to the longer
of the period remaining until the next readjustment of the interest rate or the
period remaining until the principal amount can be recovered through demand; (d)
an instrument with a floating rate of interest that is subject to a demand
feature may be deemed to have a maturity equal to the period remaining until the
principal amount can be recovered through demand; and (e) a repurchase agreement
may be deemed to have a maturity equal to the period remaining until the date on
which the repurchase of the underlying securities is scheduled to occur, or
where no date is specified, but the agreement is subject to demand, the notice
period applicable to a demand for the repurchase of the securities.
MANAGEMENT OF THE FUND
Officers and Directors
The Fund's officers, under the supervision of the Board of Directors,
manage the day-to-day operations of the Fund. The Directors set broad policies
for the Fund and choose its officers. [Three Directors and all of the officers
of the Fund are directors, officers or employees of MSAM, distributor or
administrators. Directors and officers of the Fund are also directors and
officers of some or all of the other investment companies managed, administered,
advised or distributed by Morgan Stanley Asset Management Inc., Miller Anderson
& Sherrerd, LLP or their affiliates. The other Directors have no affiliation
with the Fund's advisers, distributor or administrators. A list of the Directors
and officers of the Fund and a brief statement of their present positions and
principal occupations during the past five years is set forth below:
<TABLE>
<CAPTION>
Principal Occupation During
Name, Address and Age Position with Fund Past Five Years
- ----------------------- ---------------------- ---------------------------
<S> <C> <C>
W. Blair Garff Director
Michael F. Klein Director and President Vice President of MSAM;
Previously with Roger & Wells
(Law Firm).
Harold J. Schaaff, Jr.* Director Principal of Morgan Stanley & Co.
1221 Avenue of the Incorporated; General Counsel and
Americas Secretary of MSAM; Officer of
New York, NY 10020 various investment companies by
(35) MSAM.
Joseph P. Stadler* Treasurer Vice President of MSAM; Previously
1221 Avenue of the with Price Waterhouse LLP (accounting);
Americas Officer of various investment companies
New York, NY 10020 managed by MSAM.
(41)
Valerie Y. Lewis* Secretary Vice President of MSAM; Previously with
1221 Avenue of the Citicorp (banking); Officer of various
Americas investment companies managed by MSAM.
New York, NY 10020
(40)
</TABLE>
23
<PAGE>
Remuneration of Directors and Officers
The Fund pays each Director who is not also an officer or affliated person
of the Advisers, the Fund's distibutor, or administrators or any of their
affiliates an annual fee, plus travel and other expenses incurred in attending
board meetings. Directors who are also officers or affiliated persons receive no
remuneration for their services as Directors. The Fund's officers and employees
are paid by the Advisers or its agents. As of December 18, 1995, to Fund
management's knowledge, the Directors and officers of the Fund, as a group,
owned less than 1% of the outstanding common stock of each Portfolio of the
Fund.
Investment Advisory and Administrative Agreements
MSAM is a wholly-owned subsidiary of Morgan Stanley Group Inc. The
principal offices of Morgan Stanley Group Inc. are located at 1221 Avenue of the
Americas, New York, NY 10020.
MAS is a Pennsylvania limited liability partnership founded in 1969 and is
located at One Tower Bridge, West Conshohocken, PA 19428. On January 3, 1996,
Morgan Stanley Group Inc. acquired Miller Anderson & Sherrerd, LLP (the
"Adviser") in a transaction in which Morgan Stanley Asset Management Holdings
Inc., an indirect wholly owned subsidiary of Morgan Stanley Group Inc., became
the sole general partner of the Adviser. Morgan Stanley Asset Management
Holdings Inc. and two other wholly owned subsidiaries of Morgan Stanley Group
Inc. became the limited partners of the Adviser.
Pursuant to the MSAM Administration Agreement between MSAM and the
Fund, MSAM provides Administrative Services. For its services under the
Administration Agreement, the Fund pays MSAM a monthly fee which on an
annual basis equals [_____] of 1% of the average daily net assets of each
Portfolio.
Under the Agreement between MSAM and The Chase Manhattan Bank, N.A.
("Chase"), Chase Global Funds Services Company ("CGFSC," a Chase subsidiary)
provides certain administrative services to the Fund. CGFSC provides
operational and administrative services to investment companies with
approximately $42 billion in assets and having approximately _________
shareholder accounts as of February 29, 1996. CGFSC's business address is
73 Tremont Street, Boston, Massachusetts 02108-3913.
Code of Ethics
The Board of Directors of the Fund has adopted a Code of Ethics under
Rule 17j-1 of the 1940 Act which incorporates the Code of Ethics of each Adviser
(together, the "Codes"). The Codes significantly restrict the personal investing
activities of all employees of the Adviser and, as described below, impose
additional, more onerous, restrictions on the Fund's investment personnel.
The Codes require that all employees of each Adviser preclear any personal
securities investment (with limited exceptions, such as government securities).
The preclearance requirement and associated procedures are designed to identify
any substantive prohibition or limitation applicable to the proposed investment.
The substantive restrictions applicable to all employees of the Adviser include
a ban on acquiring any securities in a "hot" initial public offering and a
prohibition from profiting on short-term trading in securities. In addition, no
employee may purchase or sell any security that at the time is being purchased
or sold (as the case may be), or to the knowledge of the employee is being
considered for purchase or sale, by any fund advised by the Adviser.
Furthermore, the Codes provide for trading "blackout periods" that prohibit
trading by investment personnel of the Fund within periods of trading by the
Fund in the same (or equivalent) security.
24
<PAGE>
Control Persons and Principal Holders of Securities
The names and addresses of the holders of 5% or more of the outstanding
shares of any class of the Fund as of _________________ and the percentage of
outstanding shares of such classes owned beneficially or of record by such
shareholders as of such date are, to Fund management's knowledge, as follows:
NET ASSET VALUE FOR THE MONEY MARKET PORTFOLIO
The Money Market Portfolio seeks to maintain a stable net asset value per
share of $1.00. The Portfolio uses the amortized cost method of valuing its
securities, which does not take into account unrealized gains or losses. The
use of amortized cost and the maintenance of the Portfolio's per share net asset
value at $1.00 is based on the Portfolio's election to operate under the
provisions of Rule 2a-7 under the 1940 Act. As a condition of operating under
that Rule, the Money Market Portfolio must maintain a dollar-weighted average
portfolio maturity of 90 days or less, purchase only instruments having
remaining maturities of 397 days or less, and invest only in securities which
are of "eligible quality" as determined in accordance with regulations of the
Commission.
The Rule also requires that the Directors, as a particular responsibility
within the overall duty of care owed to shareholders, establish procedures
reasonably designed, taking into account current market conditions and the
Portfolio's investment objectives, to stabilize the net asset value per share as
computed for the purposes of sales and redemptions at $1.00. These procedures
include periodic review,as the Directors deem appropriate and at such intervals
as are reasonable in light of current market conditions, of the relationship
between the amortized cost value per share and a net asset value per share based
upon available indications of market value. In such review, investments for
which market quotations are readily available are valued at the most recent bid
price or quoted yield available for such securities or for securities of
comparable maturity, quality and type as obtained from one or more of the major
market makers for the securities to be valued. Other investments and assets are
valued at fair value, as determined in good faith by the Directors.
In the event of a deviation of over 1/2 of 1% between the Portfolio's net
asset value based upon available market quotations or market equivalents and
$1.00 per share based on amortized cost, the Directors will promptly consider
what action, if any, should be taken. The Directors will also take such action
as they deem appropriate to eliminate or to reduce to the extent reasonably
practicable any material dilution or other unfair results which might arise from
differences between the two. Such action include redemption in kind, selling
instruments prior to maturity to realize capital gains or losses or to shorten
the average maturity, withholding dividends, paying distributions from capital
or capital gains or utilizing a net asset value per share as determined by using
available market quotations.
There are various methods of valuing the assets and of paying dividends and
distributions from a money market fund. The Money Market Portfolio values its
assets at amortized cost while also monitoring the available market bid price,
or yield equivalents. Since dividends from net investment income will be
declared daily and paid monthly, the net asset value per share of the Portfolio
will ordinarily remain at $1.00, but the Portfolio's daily dividends will vary
in amount. Net realized gains, if any, will normally be declared and paid
monthly.
PERFORMANCE INFORMATION
The Fund may from time to time quote various performance figures to
illustrate the Portfolios' past performance.
Performance quotations by investment companies are subject to rules adopted
by the Commission, which require the use of standardized performance quotations.
In the case of total return, non-standardized
25
<PAGE>
performance quotations may be furnished by the Fund but must be accompanied by
certain standardized performance information computed as required by the
Commission. Current yield and average annual compounded total return quotations
used by the Fund are based on the standardized methods of computing performance
mandated by the Commission. An explanation of those and other methods used by
the Fund to compute or express performance follows.
Total Return
From time to time each Portfolio may advertise total return for the shares
of the Portfolio. Total returns figures are based on historical earnings and are
not intended to indicate future performance. The average annual total return is
determined by finding the average annual compounded rates of return over 1-, 5-,
and 10-year periods (or over the life of the Portfolio) that would equate an
initial hypothetical $1,000 investment to its ending redeemable value. The
calculation assumes that all dividends and distributions are reinvested when
paid. The quotation assumes the amount was completely redeemed at the end of
each 1-, 5-, and 10-year period (or over the life of the Portfolio) and the
deduction of all applicable Fund expenses on an annual basis.
These total returns are calculated according to the following formula:
P(1+T)/n/ = ERV
where:
P = a hypothetical initial payment of $1,000
T = average annual total return
n = number of years
ERV = ending redeemable value of hypothetical $1,000 payment made at the
beginning of the 1-, 5-, or 10-year periods at the end of the 1-, 5-,
or 10-year periods (or fractional portion thereof).
Calculation of Yield For Non-Money Market Portfolios
From time to time certain of the Fund's Portfolios may advertise yield.
Current yield reflects the income per share earned by a Portfolio's investments.
Current yield is determined by dividing the net investment income per share
earned during a 30-day base period by the maximum offering price per share on
the last day of the period and annualizing the result. Expenses accrued for the
period include any fees charged to all shareholders during the base period.
Yield is obtained using the following formula:
Yield = 2[(/a/ - /b/ + 1 )/6/ - 1]
--------
/cd/
where:
a = dividends and interest earned during the period
b = expenses accrued for the period (net of
reimbursements)
c = the average daily number of shares outstanding during the
period that were entitled to receive income distributions
26
<PAGE>
d = the maximum offering price per share on the last day of
the period.
Calculation of Yield for the Money Market Portfolio
The current yield of the Money Market Portfolio is calculated daily on a
base period return for a hypothetical account having a beginning balance of one
share for a particular period of time (generally 7 days). The return is
determined by dividing the net change (exclusive of any capital changes in such
account) by its average net asset value for the period, and then multiplying it
by 365/7 to determine the annualized current yield. The calculation of net
change reflects the value of additional shares purchased with the dividends by
the Portfolio, including dividends on both the original share and on such
additional shares. An effective yield, which reflects the effects of
compounding and represents an annualization of the current yield with all
dividends reinvested, may also be calculated for the Portfolio by dividing the
base period return by 7, adding 1 to the quotient, raising the sum to the 365th
power, and subtracting 1 from the result.
The yield of a Portfolio will fluctuate. The annualization of a week's
dividend is not a representation by the Portfolio as to what an investment in
the Portfolio will actually yield in the future. Actual yields will depend on
such variables as investment quality, average maturity, the type of instruments
the Portfolio invests in, changes in interest rates on instruments, changes in
the expenses of the Fund and other factors. Yields are one basis investors may
use to analyze the Portfolios of the Fund, and other investment vehicles;
however, yields of other investment vehicles may not be comparable because of
the factors set forth in the preceding sentence, differences in the time periods
compared, and differences in the methods used in valuing portfolio instruments,
computing net asset value and calculating yield.
Comparisons
To help investors better evaluate how an investment in a Portfolio of
Morgan Stanley Universal Fund, Inc. might satisfy their investment objective,
advertisements regarding the Fund may discuss various measures of Fund
performance as reported by various financial publications. Advertisements may
also compare performance (as calculated above) to performance as reported by
other investments, indices and averages. The following publications may be
used:
(a) CDA Mutual Fund Report, published by CDA Investment Technologies, Inc.
analyzes price, current yield, risk, total return and average rate
of return (average annual compounded growth rate) over specified time
periods for the mutual fund industry.
(b) Financial publications: Business Week, Changing Times, Financial
World, Forbes, Fortune, Money, Barron's, Consumer's Digest, Financial
Times, Global Investor, Investor's Daily, Lipper Analytical Services,
Inc., Morningstar, Inc., New York Times, Personal Investor, Wall
Street Journal and Weisenberger Investment Companies Service -
publications that rate fund performance over specified time periods.
(c) Historical data supplied by the research departments of First Boston
Corporation, the J.P. Morgan companies, Salomon Brothers, Merrill
Lynch, Pierce, Fenner & Smith, Lehman Brothers and Bloomberg L.P.
(d) Lipper - Mutual Fund Performance Analysis and Lipper - Fixed Income
Fund Performance Analysis - measures total return and average current
yield for the mutual fund industry. Ranks individual mutual fund
performance over specified time periods, assuming reinvestment of all
distributions, exclusive of any applicable sales charges.
27
<PAGE>
(e) Mutual Fund Source Book, published by Morningstar, Inc. - analyzes
price, yield, risk and total return for equity funds.
(f) Savings and Loan Historical Interest Rates - as published in the U.S.
Savings & Loan League Fact Book.
(g) Stocks, Bonds, Bills and Inflation, published by Hobson Associates -
historical measure of yield, price and total return for common and
small company stock, long-term government bonds, U.S. Treasury bills
and inflation.
The following indices and averages may also be used:
(a) Composite Indices - 70% Standard & Poor's 500 Stock Index and 30%
NASDAQ Industrial Index; 35% Standard & Poor's 500 Stock Index and 65%
Salomon Brothers High Grade Bond Index; and 65% Standard & Poor's 500
Stock Index and 35% Salomon Brothers High Grade Bond Index.
(b) Consumer Price Index (or Cost of Living Index), published by the U.S.
Bureau of Labor Statistics - a statistical measure of change, over
time, in the price of goods and services in major expenditure groups.
(c) Donoghue's Money Fund Average - an average of all major money market
fund yields, published weekly for 7 and 30-day yields.
(d) Dow Jones Composite Average or its component averages - an unmanaged
index composed of 30 blue-chip industrial corporation stocks (Dow
Jones Industrial Average), 15 utilities company stocks and 20
transportation stocks. Comparisons of performance assume reinvestment
of dividends.
(e) EMBI+ -- Expanding on the EMBI, which includes only Bradys, the EMBI+
includes a broader group of Brady Bonds, loans, Eurobonds and the U.S.
Dollar local markets instruments. A more comprehensive benchmark than
the EMBI, the EMBI+ covers 49 instruments from 14 countries. At $96
billion, its market cap is nearly 50% higher than the EMBI's. The
EMBI+ is not, however, intended to replace the EMBI but rather to
complement it. The EMBI continues to represent the most liquid, most
easily traded segment of the market, including more of the assets that
investors typically hold in their portfolios. Both of these indices
are published daily.
(f) First Boston High Yield Index - generally includes over 180 issues
with an average maturity range of seven to ten years with a minimum
capitalization of $100 million. All issues are individually trader-
priced monthly.
(g) First Boston Upper/Middle Tier High Yield Index - an unmanaged index
of bonds rated B to BBB.
(h) Goldman Sachs 100 Convertible Bond Index - currently includes 67 bonds
and 33 preferred. The original list of names was generated by
screening for convertible issues of 100 million or greater in market
capitalization. The index is priced monthly.
(i) IFC Global Total Return Composite Index - an unmanaged index of common
stocks and includes 18 developing countries in Latin America, East and
South Asia, Europe, the Middle East and Africa (net of dividends
reinvested).
28
<PAGE>
(j) Indata Balanced-Median Index - an unmanaged index and includes an
asset allocation of 7% cash, 39% bonds and 54% equity based on $37.8
billion in assets among 538 portfolios for the year ended December 31,
1995 (assumes dividends reinvested).
(k) Indata Equity-Median Stock Index - an unmanaged index which includes
an average asset allocation of 5% cash and 95% equity based on $30.6
billion in assets among 562 portfolios for the year ended December 31,
1995.
(l) J.P. Morgan Emerging Markets Bond Index - a market-weighted index
composed of all Brady bonds outstanding and includes Argentina,
Brazil, Bulgaria, Mexico, Nigeria, the Philippines, Poland and
Venezuela.
(m) J.P. Morgan Traded Global Bond Index - an unmanaged index of
securities and includes Australia, Belgium, Canada, Denmark, France,
Germany, Italy, Japan, The Netherlands, Spain, Sweden, United Kingdom
and the United States.
(n) Lehman Brothers Aggregate Bond Index - an unmanaged index made up of
the Government/Corporate Index, the Mortgage Backed Securities Index
and the Asset-Backed Securities Index.
(o) Lehman Brothers LONG-TERM Treasury Bond - composed of all bonds
covered by the Lehman Brothers Treasury Bond Index with maturities of
10 years or greater.
(p) The Lehman 7 Year Municipal Bond Index -- an unmanaged index which
consists of investment grade bonds with maturities between 6-8 years
rated BAA or better. All bonds have been taken from deals done within
the last 5 years, with assets of $50 million or larger.
(q) Lipper Capital Appreciation Index -- a composite of mutual funds
managed for maximum capital gains.
(r) Morgan Stanley Capital International Combined Far East Free ex-Japan
Index - a market-capitalization weighted index comprising stocks in
Hong Kong, Indonesia, Korea, Malaysia, Philippines, Singapore, Taiwan
and Thailand. Korea is included in the MSCI Combined Far East Free ex-
Japan Index at 20% of its market capitalization.
(s) Morgan Stanley Capital International EAFE Index - an arithmetic,
market value-weighted average of the performance of over 900
securities on the stock exchanges of countries in Europe, Australia
and the Far East.
(t) Morgan Stanley Capital International Emerging Markets Global Latin
American Index --an unmanaged, arithmetic market value weighted
average of the performance of over 196 securities on the stock
exchanges of Argentina, Brazil, Chile, Colombia, Mexico, Peru and
Venezuela (Assumes reinvestment of dividends).
(u) Morgan Stanley Capital International Europe Index - an unmanaged index
of common stocks and includes 14 countries throughout Europe.
(v) Morgan Stanley Capital International Japan Index - an unmanaged index
of common stocks.
29
<PAGE>
(w) Morgan Stanley Capital International Latin America Index - a broad-
based market capitalization-weighted composite index covering at least
60% of markets in Mexico, Argentina, Brazil, Chile, Colombia, Peru and
Venezuela (assumes dividends reinvested).
(x) Morgan Stanley Capital International World Index - an arithmetic,
market value-weighted average of the performance of over 1,470
securities listed on the stock exchanges of countries in Europe,
Australia, the Far East, Canada and the United States.
(y) NASDAQ Composite Index - an unmanaged index of common stocks.
(z) NASDAQ Industrial Index - a capitalization-weighted index composed of
more than 3,000 domestic stocks taken from the following industry
sectors: agriculture, mining, construction, manufacturing, electronic
components, services and public administration enterprises. It is a
value-weighted index calculated on price change only and does not
include income.
(aa) National Association of Real Estate Investment Trusts ("NAREIT")
Index -- an unmanaged market weighted index of tax qualified REITs
(excluding healthcare REITs) listed on the New York Stock Exchange,
American Stock Exchange and the NASDAQ National Market System
including dividends.
(bb) The New York Stock Exchange composite or component indices -
unmanaged indices of all industrial, utilities, transportation and
finance company stocks listed on the New York Stock Exchange.
(cc) Philadelphia Gold and Silver Index - an unmanaged index comprised of
seven leading companies involved in the mining of gold and silver.
(dd) Russell 2500 Index - comprised of the bottom 500 stocks in the
Russell 1000 Index which represents the universe of stocks from which
most active money managers typically select; and all the stocks in the
Russell 2000 Index. The largest security in the index has a market
capitalization of approximately 1.3 billion.
(ee) Salomon Brothers GNMA Index - includes pools of mortgages originated
by private lenders and guaranteed by the mortgage pools of the
Government National Association.
(ff) Salomon Brothers High Grade Corporate Bond Index - consists of
publicly issued, non-convertible corporate bonds rated AA or AAA. It
a is value-weighted, total return index, including approximately 800
issues with maturities of 12 years or greater.
(gg) Salomon Brothers Broad Investment Grade Bond - a market-weighted
index that contains approximately 4700 individually priced investment
grade corporate bonds rated BBB or better, U.S. Treasury/agency issues
and mortgage pass-through securities.
(hh) Standard & Poor's 500 Stock Index or its component indices -
unmanaged index composed of 400 industrial stocks, 40 financial
stocks, 40 utilities company stocks and 20 transportation stocks.
Comparisons of performance assume reinvestment of dividends.
(ii) Standard & Poor's Small Cap 600 Index - a capitalization-weighted
index of 600 domestic stocks having market capitalizations which
reside within the 50th and the 83rd percentiles of the market
capitalization of the entire stock market, chosen for certain
liquidity characteristics and for industry representation.
30
<PAGE>
(jj) Wilshire 5000 Equity Index or its component indices - represents the
return on the market value of all common equity securities for which
daily pricing is available. Comparisons of performance assume
reinvestment of dividends.
In assessing such comparisons of performance an investor should keep in
mind that the composition of the investments in the reported indices and
averages is not identical to the composition of investments in the Fund's
Portfolios, that the averages are generally unmanaged, and that the items
included in the calculations of such averages may not be identical to the
formula used by the Fund to calculate its futures. In addition, there can be no
assurance that the Fund will continue this performance as compared to such other
averages.
GENERAL INFORMATION
Description of Shares and Voting Rights
The Fund's Articles of Incorporation permit the Directors to issue nine
billion shares of common stock, par value $.001 per share, from an unlimited
number of classes ("Portfolios") of shares. Currently the Fund consists of
shares of seventeen Portfolios.
The shares of each Portfolio of the Fund are fully paid and nonassessable,
and have no preference as to conversion, exchange, dividends, retirement or
other features. The shares of each Portfolio of the Fund have no pre-emptive
rights. The shares of the Fund have non-cumulative voting rights, which means
that the holders of more than 50% of the shares voting for the election of
Directors can elect 100% of the Directors if they choose to do so. A
shareholder is entitled to one vote for each full share held (and a fractional
vote for each fractional share held), then standing in his name on the books of
the Fund.
Dividends and Capital Gains Distributions
The Fund's policy is to distribute substantially all of each Portfolio's
net investment income, if any. The Fund may also distribute any net realized
capital gains in the amount and at the times that will avoid both income
(including taxable gains) taxes on it and the imposition of the federal excise
tax on income and capital gains (see discussion under "Taxes" in this Statement
of Additional Information). However, the Fund may also choose to retain net
realized capital gains and pay taxes on such gains. The amounts of any income
dividends or capital gains distributions cannot be predicted.
Any dividend or distribution paid shortly after the purchase of shares of a
Portfolio by an investor may have the effect of reducing the per share net asset
value of that Portfolio by the per share amount of the dividend or distribution.
Furthermore, such dividends or distributions, although in effect a return of
capital, are subject to income taxes for shareholders subject to tax as set
forth herein and in the applicable Prospectus.
As set forth in the Prospectus, unless the shareholder elects otherwise in
writing, all dividends and capital gains distributions for a class of shares are
automatically received in additional shares of such class of that Portfolio of
the Fund at the net asset value as of the business day following the record
date. This automatic reinvestment of dividends and distributions will remain in
effect until the Fund is notified by the shareholder in writing at least three
days prior to the record date that either the Income Option (income dividends in
cash and capital gains distributions in additional shares at net asset value) or
the Cash Option (both income dividends and capital gains distributions in cash)
has been elected.
Custody Arrangements
31
<PAGE>
Chase serves as the Fund's domestic custodian. Chase is not affiliated
with Morgan Stanley & Co. Incorporated. Morgan Stanley Trust Company, Brooklyn,
NY, acts as the Fund's custodian for foreign assets held outside the United
States and employs subcustodians who were approved by the Directors of the Fund
in accordance with Rule 17f-5 adopted by the Commission under the 1940 Act.
Morgan Stanley Trust Company is an affiliate of Morgan Stanley & Co.
Incorporated. In the selection of foreign subcustodians, the Directors consider
a number of factors, including, but not limited to, the reliability and
financial stability of the institution, the ability of the institution to
provide efficiently the custodial services required for the Fund, and the
reputation of the institution in the particular country or region.
DESCRIPTION OF SECURITIES AND RATINGS
I. Description of Commercial Paper Ratings
Description of Moody's ratings of state and municipal notes: Moody's
------------------------------------------------------------
ratings for state and municipal notes and other short-term obligations are
designated Moody's Investment Grade ("MIG"). Symbols used are as follows: MIG-
1 - best quality, enjoying strong protection from established cash flows of
funds for their servicing or from established broad-based access to the market
for refinancing, or both; MIG-2 - high quality with margins of protection ample
although not so large as in the preceding group; MIG-3 - favorable quality, with
all security elements accounted for but lacking the undeniable strength of the
preceding grades.
Description of Moody's highest commercial paper rating: Prime-1 ("P1") -
------------------------------------------------------
Judged to be of the best quality. Their short-term debt obligations carry the
smallest degree of investment risk.
Excerpt from S&P's rating of municipal note issues: S-1+ - very strong
--------------------------------------------------
capacity to pay principal and interest; SP-2 - strong capacity to pay principal
and interest.
Description of S&P's highest commercial paper ratings: A-1+ - this
-----------------------------------------------------
designation indicates the degree of safety regarding timely payment is
overwhelming. A-1 - this designation indicates the degree of safety regarding
timely payment is very strong.
II. Description of U.S. Government Securities
The term "U.S. Government securities" refers to a variety of securities
which are issued or guaranteed by the U.S. Government, and by various
instrumentalities which have been established or sponsored by the U.S.
Government.
U.S. Treasury securities are backed by the "full faith and credit" of the
United States. Securities issued or guaranteed by Federal agencies and U.S.
Government sponsored instrumentalities may or may not be backed by the full
faith and credit of the United States. In the case of securities not backed by
the full faith and credit of the United States, the investor must look
principally to the agency or instrumentality issuing or guaranteeing the
obligation for ultimate repayment, and may not be able to assert a claim against
the United States itself in the event the agency or instrumentality does not
meet its commitment. Agencies which are backed by the full faith and credit of
the United States include the Export-Import Bank, Farmers Home Administration,
Federal Financing Bank, and others. Certain agencies and instrumentalities,
such as the Government National Mortgage Associates, are, in effect, backed by
the full faith and credit of the United States through provisions in their
charters that they may make "indefinite and unlimited" drawings on the Treasury,
if needed to service debt. Debt from certain other agencies and
instrumentalities, including the Federal Home Loan Bank and Federal National
Mortgage Association, are not guaranteed by the United States, but those
institutions are protected by the discretionary authority for the U.S. Treasury
to purchase certain amounts of their securities to assist the
32
<PAGE>
institution in meeting its debt obligations. However, the U.S. Treasury has no
lawful obligation to assume the financial liabilities of these agencies or
others. Finally, other agencies and instrumentalities, such as the Farm Credit
System and the Federal Home Loan Mortgage Corporation, are federally chartered
institutions under Government supervision, but their debt securities are backed
only by the creditworthiness of those institutions, not the U.S. Government.
Some of the U.S. Government agencies that issue or guarantee securities
include the Export-Import Bank of the United States, Farmers Home
Administration, Federal Housing Administration, Maritime Administration, Small
Business Administration, and the Tennessee Valley Authority.
An instrumentality of the U.S. Government is a Government agency organized
under Federal charter with Government supervision. Instrumentalities issuing or
guaranteeing securities include, among others, Federal Home Loan Banks, the
Federal Land Banks, Central Bank for Cooperatives, Federal Immediate Credit
Banks, and the Federal National Mortgage Association.
III. Description of Municipal Bonds
Municipal Bonds generally include debt obligations issued by states and
their political subdivisions, and duly constituted authorities and corporations,
to obtain funds to construct, repair or improve various public facilities such
as airports, bridges, highways, hospitals, housing, schools, streets and water
and sewer works. Municipal Bonds may also be issued to refinance outstanding
obligations as well as to obtain funds for general operating expenses and for
loans to other public institutions and facilities.
The two principal classifications of Municipal Bonds are "general
obligation" and "revenue" or "special tax" bonds. General obligation bonds are
secured by the issuer's pledge of its full faith, credit and taxing power for
the payment of principal and interest. Revenue or special tax bonds are payable
only from the revenues derived from a particular facility or class of facilities
or, in some cases, from the proceeds of a special excise or other tax, but not
from general tax revenues.
Industrial revenue bonds (i.e., private activity bonds) in most cases are
revenue bonds and generally do not have the pledge of the credit of the issuer.
The payment of the principal and interest on such industrial revenue bonds is
dependent solely on the ability of the user of the facilities financed by the
bonds to meet its financial obligations and the pledge, if any, of real and
personal property so financed as security for such payment. Short-term
municipal obligations issued by states, cities, municipalities or municipal
agencies include Tax Anticipation Notes, Revenue Anticipation Notes, Bond
Anticipation Notes, Construction Loan Notes and Short-Term Discount Notes.
Project Notes are instruments guaranteed by the Department of Housing and Urban
Development but issued by a state or local housing agency. While the issuing
agency has the primary obligation on such Project notes, they are also secured
by the full faith and credit of the United States.
Note obligations with demand or put options may have a stated maturity in
excess of one year, but allow any holder to demand payment of principal plus
accrued interest upon a specified number of days' notice. Frequently, such
obligations are secured by letters of credit or other credit support
arrangements provided by banks. The issuer of such notes normally has a
corresponding right, after a given period, to repay in its discretion the
outstanding principal of the notes plus accrued interest upon a specific number
of days' notice to the bondholders. The interest rate on a demand note may be
based upon a known lending rate, such as a bank's prime rate, and be adjusted
when such rate changes, or the interest rate on a demand note may be a market
rate that is adjusted at specified intervals.
The yields of Municipal Bonds depend on, among other things, general money
market conditions, conditions in the Municipal Bond market, the size of a
particular offering, the maturity of the obligation, and the rating of the
issue. The ratings of Moody's and S&P represent their opinions of the quality
of
33
<PAGE>
the Municipal Bonds. It should be emphasized that such ratings are general and
are not absolute standards of quality. Consequently, Municipal Bonds with the
same maturity, coupon and rating may have different yields, while Municipal
Bonds of the same maturity and coupon, but with different ratings, may have the
same yield.
Municipal Bonds are sometimes purchased on a "when issued" basis meaning
the buyer has committed to purchasing certain specified securities at an agreed-
upon price when they are issued. The period between commitment date and
issuance date can be a month or more. It is possible that the securities will
never be issued and the commitment canceled.
From time to time proposals have been introduced before Congress to
restrict or eliminate the Federal income tax exemption for interest on Municipal
Bonds. Similar proposals may be introduced in the future.
Similarly, from time to time proposals have been introduced before State
and local legislatures to restrict or eliminate the State and local income tax
exemption (to the extent such an exemption applies, which may not apply in all
cases) for interest on Municipal Bonds. Similar proposals may be introduced in
the future.
IV. Description of Mortgage-Backed Securities
- ----------------------------------------------
"Mortgage-Backed Securities" are securities that, directly or indirectly,
represent a participation in, or are secured by and payable from, mortgage loans
on real property. Mortgage-backed securities include collateralized mortgage
obligations ("CMOs"), pass-through securities issued or guaranteed by agencies
or instrumentalities of the U.S. government or by private sector entities.
Collateralized Mortgage Obligations. Collateralized mortgage obligations
-----------------------------------
("CMOs") are debt obligations or multiclass pass-through certificates issued by
agencies or instrumentalities of the U.S. government or by private originators
or investors in mortgage loans. They are backed by Mortgage Pass-Through
Securities (discussed below) or whole loans (all such assets, the "Mortgage
Assets") and are evidenced by a series of bonds or certificates issued in
multiple classes or "tranches." The principal and interest on the underlying
Mortgage Assets may be allocated among the several classes of a series of CMOs
in many ways.
CMOs may be issued by agencies or instrumentalities of the U.S. government,
or by private originators of, or investors in, mortgage loans, including savings
and loan associations, mortgage bankers, commercial banks, investment banks and
special purpose subsidiaries of the foregoing. CMOs that are issued by private
sector entities and are backed by assets lacking a guarantee of an entity having
the credit status of a governmental agency or instrumentality are generally
structured with one or more types of credit enhancement as described below. An
issuer of CMOs may elect to be treated, for federal income tax purposes, as a
Real Estate Mortgage Investment Conduit (a "REMIC"). An issuer of CMOs issued
after 1991 must elect to be treated as a REMIC or it will be taxable as a
corporation under rules regarding taxable mortgage pools.
In a CMO, a series of bonds or certificates are issued in multiple classes.
Each class of CMOs, often referred to as a "tranche," may be issued with a
specific fixed or floating coupon rate and has a stated maturity or final
scheduled distribution date. Principal prepayments on the underlying Mortgage
Assets may cause the CMOs to be retired substantially earlier than their stated
maturities or final scheduled distribution dates. Interest is paid or accrues
on CMOs on a monthly, quarterly or semi-annual basis. The principal of and
interest on the Mortgage Assets may be allocated among the several classes of a
CMO in many ways. The general goal in allocating cash flows on Mortgage Assets
to the various classes of a CMO is to create certain tranches on which the
expected cash flows have a higher degree of predictability than the underlying
Mortgage Assets. As a general matter, the more predictable the cash
34
<PAGE>
flow is on a particular CMO tranche, the lower the anticipated yield will be on
that tranche at the time of issuance relative to prevailing market yields on
Assets. As part of the process of creating more predictable cash flows on
certain tranches of a CMO, one or more tranches generally must be created that
absorb most of the changes in the cash flows on the underlying Mortgage Assets.
The yields on these tranches are generally higher than prevailing market yields
on Mortgage-Backed Securities with similar average lives. Because of the
uncertainty of the cash flows on these tranches, the market prices of and yields
on these tranches are more volatile.
Included within the category of CMOs are PAC Bonds. PAC Bonds are a type
of CMO tranche or series designed to provide relatively predictable payments of
principal provided that, among other things, the actual prepayment experience on
the underlying mortgage loans falls within a predefined range. If the actual
prepayment experience on the underlying mortgage loans is at a rate faster or
slower than the predefined range or if deviations from other assumptions occur,
principal payments on the PAC Bond may be earlier or later than predicted. The
magnitude of the predefined range varies from one PAC Bond to another; a
narrower range increases the risk that prepayments on the PAC Bond will be
greater or smaller than predicted. Because of these features, PAC Bonds
generally are less subject to the risks of prepayment than are other types of
mortgage-backed securities.
Mortgage Pass-Through Securities. Mortgage pass-through securities issued
--------------------------------
or guaranteed by private sector originators of or investors in mortgage loans
and are structured similarly to governmental pass-through securities. Because
private pass-throughs typically lack a guarantee by an entity having the credit
status of a governmental agency or instrumentality, they are generally
structured with one or more types of credit enhancement described below. FNMA
and FHLMC obligations are not backed by the full faith and credit of the U.S.
government as GNMA certificates are, but FNMA and FHLMC securities are supported
by the instrumentalities' right to borrow from the United States Treasury. Each
of GNMA, GNMA and FHLMC guarantees timely distributions of interest to
certificate holders. Each of GNMA and FNMA also guarantees timely distributions
of scheduled principal. FHLMC has in the past guaranteed only the ultimate
collection of principal of the underlying mortgage loan; however, FHLMC now
issued Mortgage-Backed Securities (FHLMC Gold Pcs) which also guarantee timely
payment of monthly principal reductions. REFCORP obligations are backed, as to
principal payments, by zero coupon U.S. Treasury bonds, and as to interest
payment, ultimately by the U.S. Treasury. Obligations issued by such U.S.
governmental agencies and instrumentalities are described more fully below.
Ginnie Mae Certificates. Ginnie Mae is a wholly-owned corporate
-----------------------
instrumentality of the United States within the Department of Housing and Urban
Development. The National Housing Act of 1934, as amended (the "Housing Act"),
authorizes Ginnie Mae to guarantee the timely payment of the principal of and
interest on certificates that are based on and backed by a pool of mortgage
loans insured by the Federal Housing Administration under the Housing Act, or
Title V of the Housing Act of 1949 ("FHA Loans"), or guaranteed by the
Department of Veterans Affairs under the Servicemen's Readjustment Act of 1944,
as amended ("VA Loans"), or by pools of other eligible mortgage loans. The
Housing Act provides that the full faith and credit of the United States
government is pledged to the payment of all amounts that may be required to be
paid under any guaranty. In order to meet its obligations under such guaranty,
Ginnie Mae is authorized to borrow from the United States Treasury with no
limitations as to amount.
Each Ginnie Mae Certificate will represent a pro rata interest in one or
more of the following types of mortgage loans: (i) fixed rate level payment
mortgage loans; (ii) fixed rate graduated payment mortgage loans; (iii) fixed
rate growing equity mortgage loans; (iv) fixed rate mortgage loans secured by
manufactured (mobile) homes; (v) mortgage loans on multi-family residential
properties under construction; (vi) mortgage loans on completed multi-family
projects; (vii) fixed rate mortgage loans as to which escrowed funds are used to
reduce the borrower's monthly payments during the early years of the mortgage
loans ("buydown" mortgage loans); (viii) mortgage loans that provide for
adjustments in payments based on periodical changes in interest rates or in
other payment terms of the mortgage loans;
35
<PAGE>
and (ix) mortgage-backed serial notes. All of these mortgage loans will be FHA
Loans or VA Loans and, except as otherwise specified above, will be fully-
amortizing loans secured by first liens on one- to four-family housing units.
Fannie Mae Certificates. Fannie Mae is a federally chartered and privately
-----------------------
owned corporation organized and existing under the Federal National Mortgage
Association Charter Act of 1938. The obligations of Fannie Mae are not backed
by the full faith and credit of the United States government.
Each Fannie Mae Certificate will represent a pro rata interest in one or
more pools of FHA Loans, VA Loans or conventional mortgage loans (i.e., mortgage
loans that are not insured or guaranteed by any governmental agency) of the
following types: (i) fixed rate level payment mortgage loans; (ii) fixed rate
growing equity mortgage loans; (iii) fixed rate graduated payment mortgage
loans; (iv) variable rate California mortgage loans; (v) other adjustable rate
mortgage loans; and (vi) fixed rate and adjustable mortgage loans secured by
multi-family projects.
Freddie Mac Certificates. Freddie Mac is a corporate instrumentality of
------------------------
the United States created pursuant to the Emergency Home Finance Act of 1970, as
amended (the "FHLMC Act"). The obligations of Freddie Mac are obligations
solely of Freddie Mac and are not backed by the full faith and credit of the
U.S. government.
Freddie Mac Certificates represent a pro rata interest in a group of
mortgage loans (a "Freddie Mac Certificate group") purchased by Freddie Mac.
The mortgage loans underlying the Freddie Mac Certificates will consist of fixed
rate or adjustable rate mortgage loans with original terms to maturity of
between ten and thirty years, substantially all of which are secured by first
liens on one- to four-family residential properties or multi-family projects.
Each mortgage loan must meet the applicable standards set forth in the FHLMC
Act. A Freddie Mac Certificate group may include whole loans, participation
interests in whole loans and undivided interests in whole loans and
participations comprising another Freddie Mac Certificate group.
Credit enhancement. Mortgage-backed securities are often backed by a pool
------------------
of assets representing the obligations of a number of different parties. To
lessen the effect of failure by obligors on underlying assets to make payments,
such securities may contain elements of credit support. Such credit support
falls into two categories: (i) liquidity protection and (ii) protection against
losses resulting from ultimate default by an obligor on the underlying assets.
Liquidity protection generally refers to the provision of advances, typically by
the entity administering the pool of assets, to ensure that the pass-through of
payments due on the underlying pool occurs in a timely fashion. Protection
against losses resulting from ultimate default enhances the likelihood of
ultimate payment of the obligations on at least a portion of the assets in the
pool. Such protection may be provided through guarantees, insurance policies or
letters of credit obtained by the issuer or sponsor from third parties (referred
to herein as "third party credit support"), through various means of structuring
the transaction or through a combination of such approaches.
The ratings of mortgage-backed securities for which third-party credit
enhancement provides liquidity protection or protection against losses from
default are generally dependent upon the continued creditworthiness of the
provider of the credit enhancement. The ratings of such securities could be
subject to reduction in the event of deterioration in the creditworthiness of
the credit enhancement provider even in cases where the delinquency and loss
experience on the underlying pool of assets is better than expected.
Examples of credit support arising out of the structure of the transaction
include "senior-subordinated securities" (multiple class securities with one or
more classes subordinate to other classes as to the payment of principal thereof
and interest thereon, with defaults on the underlying assets being borne first
by the holders of the most subordinated class), creation of "reserve funds"
(where cash or investments, sometimes funded from a portion of the payments on
the underlying assets, are held in
36
<PAGE>
reserve against future losses) and "over-collateralization" (where the scheduled
payments on, or the principal amount of, the underlying assets exceed those
required to make payment of the securities and pay any servicing or other fees).
The degree of credit support provided for each security is generally based on
historical information with respect to the level of credit risk associated with
the underlying assets. Delinquency or loss in excess of that which is
anticipated could adversely affect the return on an investment in such a
security.
V. Foreign Investments
The Asian Equity, International Fixed Income, Global Equity, Emerging
Markets Debt, International Magnum and Emerging Markets Equity Portfolios will
invest, and the High Yield, Balanced, Growth and Multi-Asset-Class Portfolios
may invest, in securities of foreign issuers. Investors should recognize that
investing in such foreign securities involves certain special considerations
which are not typically associated with investing in U.S. issuers. For a
description of the effect on the Portfolios of currency exchange rate
fluctuation, see "Investment Objectives and Policies - Forward Foreign Currency
Exchange Contracts" above. As foreign issuers are not generally subject to
uniform accounting, auditing and financial reporting standards, and may have
policies that are not comparable to those of domestic issuers, there may be less
information available about certain foreign companies than about domestic
issuers. Securities of some foreign issuers are generally less liquid and more
volatile than securities of comparable domestic issuers. There is generally less
government supervision and regulation of stock exchanges, brokers and listed
issuers than in the U.S. In addition, with respect to certain foreign countries,
there is the possibility of expropriation or confiscatory taxation, political or
social instability, or diplomatic developments which could affect U.S.
investments in those countries. Foreign securities not listed on a recognized
domestic or foreign exchange are regarded as not readily marketable and
therefore such investments will be limited to 15% of a Portfolio's net asset
value at the time of purchase.
Although the Portfolios will endeavor to achieve the most favorable
execution costs in their portfolio transactions, fixed commissions on many
foreign stock exchanges are generally higher than negotiated commissions on U.S.
exchanges.
Certain foreign governments levy withholding or other taxes on dividend and
interest income. Although in some countries a portion of these taxes are
recoverable, the non-recovered portion of foreign withholding taxes will reduce
the income received from investments in such countries. Except in the case of
the Asian Equity, International Magnum, Emerging Markets Equity and Global
Equity Portfolios, it is not expected that a Portfolio or its shareholders would
be able to claim a credit for U.S. tax purposes with respect to any such foreign
taxes. However, these foreign withholding taxes may not have a significant
impact on such Portfolios, because each Portfolio's investment objective is to
seek long-term capital appreciation, which generally (but not always) is subject
to tax, and any dividend or interest income should be considered incidental.
FINANCIAL STATEMENTS
There are no financial statements for the Portfolios.
37
