<PAGE>
EMERGING MARKETS EQUITY PORTFOLIO
A PORTFOLIO OF THE
MORGAN STANLEY UNIVERSAL FUNDS, INC.
MORGAN STANLEY ASSET MANAGEMENT INC.
MORGAN STANLEY UNIVERSAL FUNDS, INC. (THE "FUND") IS A MUTUAL FUND DESIGNED TO
PROVIDE INVESTMENT VEHICLES FOR VARIABLE ANNUITY CONTRACTS AND VARIABLE LIFE
INSURANCE POLICIES AND FOR CERTAIN TAX-QUALIFIED INVESTORS. THIS PROSPECTUS
PERTAINS TO THE FUND'S EMERGING MARKETS EQUITY PORTFOLIO WHICH IS MANAGED BY
MORGAN STANLEY ASSET MANAGEMENT INC. THE FUND ALSO OFFERS 16 OTHER PORTFOLIOS
MANAGED BY EITHER MORGAN STANLEY ASSET MANAGEMENT INC. ("MSAM") OR MILLER
ANDERSON & SHERRERD, LLP, AN AFFILIATE OF MSAM.
SHARES OF THE EMERGING MARKETS EQUITY PORTFOLIO MAY BE PURCHASED ONLY BY THE
SEPARATE ACCOUNTS OF INSURANCE COMPANIES FOR THE PURPOSE OF FUNDING VARIABLE
ANNUITY CONTRACTS AND VARIABLE LIFE INSURANCE POLICIES AND BY CERTAIN TAX-
QUALIFIED INVESTORS. THE EMERGING MARKETS EQUITY PORTFOLIO MAY NOT BE AVAILABLE
IN YOUR STATE DUE TO VARIOUS INSURANCE REGULATIONS. PLEASE CHECK WITH YOUR
INSURANCE COMPANY FOR AVAILABILITY OF THE EMERGING MARKETS EQUITY PORTFOLIO IN
YOUR STATE. IF THE EMERGING MARKETS EQUITY PORTFOLIO IS NOT AVAILABLE IN YOUR
STATE THIS PROSPECTUS IS NOT TO BE CONSIDERED A SOLICITATION.
THIS PROSPECTUS CONTAINS IMPORTANT INFORMATION ABOUT THE EMERGING MARKETS
EQUITY PORTFOLIO'S INVESTMENTS AND SERVICES. YOU SHOULD READ IT BEFORE
INVESTING, AND KEEP IT ON FILE FOR FUTURE REFERENCE ALONG WITH THE PROSPECTUS
OF THE SEPARATE ACCOUNT OF THE SPECIFIC INSURANCE PRODUCT WHICH ACCOMPANIES
THIS PROSPECTUS.
A STATEMENT OF ADDITIONAL INFORMATION DATED OCTOBER 1, 1996, HAS BEEN FILED
WITH THE SECURITIES AND EXCHANGE COMMISSION AND IS INCORPORATED HEREIN BY
REFERENCE, AND, THEREFORE, LEGALLY FORMS A PART OF THE PROSPECTUS. FOR A FREE
COPY CONTACT THE FUND OR YOUR INSURANCE COMPANY.
THESE SECURITIES HAVE NOT BEEN APPROVED OR DISAPPROVED BY THE SECURITIES AND
EXCHANGE COMMISSION OR ANY STATE SECURITIES COMMISSION, NOR HAS THE SECURITIES
AND EXCHANGE COMMISSION OR ANY STATE SECURITIES COMMISSION PASSED UPON THE
ACCURACY OR ADEQUACY OF THIS PROSPECTUS. ANY REPRESENTATION TO THE CONTRARY IS
A CRIMINAL OFFENSE.
THE EMERGING MARKETS EQUITY PORTFOLIO MAY INVEST IN EQUITY SECURITIES OF
RUSSIAN COMPANIES. RUSSIA'S SYSTEM OF SHARE REGISTRATION AND CUSTODY INVOLVES
CERTAIN RISKS OF LOSS THAT ARE NOT NORMALLY ASSOCIATED WITH INVESTMENTS IN
OTHER SECURITIES MARKETS. SEE "SECURITIES AND INVESTMENT TECHNIQUES--RUSSIAN
SECURITIES."
Prospectus dated October 1, 1996
MORGAN STANLEY UNIVERSAL FUNDS, INC.
P.O. Box 2798, Boston, MA 02208-2798
<PAGE>
PAGE
THE FUND
The Fund is an open-end management investment company, or mutual fund. The
following pages describe the types of securities and investment techniques that
the Fund's Emerging Markets Equity Portfolio (the "Portfolio") uses to seek its
objective, as well as the risks inherent in those types of securities and
investment techniques.
MANAGEMENT
Morgan Stanley Asset Management Inc. ("MSAM") advises the Portfolio.
MSAM conducts a worldwide investment advisory business and, together with its
affiliates, currently manages assets of approximately $103.5 billion.
OFFERING OF SHARES
The Fund is intended to be a funding vehicle for all types of variable annuity
contracts and variable life insurance policies offered by various insurance
companies. Shares of the Fund may also be offered to certain tax-qualified
investors, including qualified pension and retirement plans. It is possible
that material conflicts among the various insurance companies and other
investors in the Fund may arise. The Fund's Board of Directors will monitor
events in order to identify the existence of any material conflicts and to
determine what action, if any, should be taken in response to any such
conflicts.
PROSPECTUS OUTLINE
PORTFOLIO SUMMARY 3
- -----------------
The Portfolio's investment objective and a summary of strategy, potential
investors, and investment characteristics and risks.
THE PORTFOLIO'S INVESTMENTS 3
- ---------------------------
A more detailed review of how the Portfolio invests and investment
characteristics and risks.
SECURITIES AND INVESTMENT TECHNIQUES 4
- ------------------------------------
More information about the types of investment strategies used by the
Portfolio and information about investment risks and limitations.
FUNDAMENTAL INVESTMENT LIMITS 17
- -----------------------------
Certain policies that may be changed only by shareholders.
MANAGEMENT OF THE FUND 17
- ----------------------
General information on organization and operations of the Fund, including
details about MSAM and the individual portfolio managers, as well as fees,
expenses and performance calculations.
ACCOUNT POLICIES 20
- ----------------
Information on net asset value calculation, income and gain distributions,
taxes and share purchases and redemptions.
2
<PAGE>
PORTFOLIO SUMMARY
- -----------------
Certain investment terms used below have initial capital letters ("Emerging
Market Country Securities," for example). These terms are further described
under "Securities and Investment Techniques" below.
EMERGING MARKETS EQUITY PORTFOLIO
OBJECTIVE AND STRATEGY: Long-term capital appreciation by investing primarily
in Equity Securities of emerging market country issuers with a focus on those
in which MSAM believes the economies are developing strongly and in which the
markets are becoming more sophisticated.
INVESTOR PROFILE: The Portfolio may be appropriate for investors who seek to
achieve long-term capital appreciation by investing in Emerging Market Country
Securities. By including emerging market country investments in their
portfolio, investors can achieve additional diversification and participate in
growth opportunities in emerging market countries.
RISK PROFILE: Very high potential risk and reward. In addition to general risks
involved in Equity Securities, including fluctuations in the stock market and
changes in the economy, international investing involves different or increased
risks. The performance of the Portfolio will be affected by Foreign Currency
values, the political and regulatory environment, the greater volatility of
securities exchanges and overall political and economic factors in the
countries in which the Portfolio invests.
THE PORTFOLIO'S INVESTMENTS
- ---------------------------
EMERGING MARKETS EQUITY PORTFOLIO
The Portfolio seeks long-term capital appreciation by investing primarily in
Common and Preferred Stocks, Convertible Securities, Rights and Warrants to
purchase Common Stocks, sponsored or unsponsored ADRs and other Equity
Securities of emerging market country issuers. Under normal circumstances, at
least 65% of the Portfolio's total assets will be invested in Emerging Market
Country Equity Securities.
The Portfolio may also invest in Fixed Income Securities denominated in the
currency of an emerging market country or issued or guaranteed by an emerging
market country company or the government of an emerging market country, Equity
Securities or Fixed Income Securities of corporate or governmental issuers
located in industrialized countries, Foreign Currency, Investment Funds, Loan
Participations and Assignments, Money Market Instruments, Investment Company
Securities, Repurchase Agreements, Non-Publicly Traded Securities, Private
Placements, Restricted Securities, Temporary Investments, When-Issued and
Delayed Delivery Securities, and Derivatives, including but not limited to
Forwards, Futures and Options and may engage in Loans of Portfolio Securities.
It is likely that many of the Fixed Income Securities in which the Portfolio
will invest will be unrated, and whether or not rated, such securities may have
speculative characteristics.
When deemed appropriate by MSAM, the Portfolio may also invest up to 10% of its
total assets (measured at the time of the investment) in Fixed Income
Securities that are not Investment Grade Securities (commonly referred to as
High Yield Securities or junk bonds). For temporary, defensive purposes, the
Portfolio may invest less than 65% of its total assets in Emerging Market
Country Equity Securities, in which case the Portfolio may invest in other
Equity Securities or may invest in Fixed Income Securities as described in
"Securities and Investment Techniques--Temporary Investments" below. The
Portfolio also has the ability to invest without limitation in high quality
Money Market Instruments or Temporary Investments for temporary, defensive
purposes. For additional information about investments, see "Securities and
Investment Techniques" below.
MSAM's approach is to focus the Portfolio's investments on those emerging
market countries in which it believes the economies are developing strongly and
in which the markets are becoming more sophisticated. There are currently over
130 countries which, in the opinion of MSAM, are generally considered to be
emerging or developing countries by the international financial community,
approximately 40 of which currently have stock markets. Currently, investing in
many emerging market countries is not feasible or may involve unacceptable
political risks.
The Portfolio intends to invest primarily in some or all of the following
emerging market countries:
<TABLE>
<S> <C> <C> <C>
Argentina Botswana Brazil Chile
China Colombia Greece Hong Kong
Hungary India Indonesia Jamaica
Jordan Kenya Malaysia Mexico
Nigeria Pakistan Peru Philippines
Poland Portugal Russia South Africa
South Korea Sri Lanka Taiwan Thailand
Turkey Venezuela Zimbabwe
</TABLE>
As markets in other countries develop, the Portfolio expects to expand and
further diversify the emerging market countries in which it invests. The
Portfolio does not intend to invest in any security in a country where the
currency is not freely convertible to U.S. dollars, unless the Portfolio has
obtained the necessary governmental licensing to convert such currency or other
appropriately licensed or sanctioned contractual guarantees to protect such
investment against loss of that currency's external value, or the Portfolio has
a reasonable expectation at the time the investment is made that such
governmental licensing or other appropriately
3
<PAGE>
licensed or sanctioned guarantees would be obtained or that the currency in
which the security is quoted would be freely convertible at the time of any
proposed sale of the security by the Portfolio. MSAM will analyze assets,
revenues and earnings of an issuer. In selecting industries and particular
issuers, MSAM will evaluate costs of labor and raw materials, access to
technology, export of products and government regulation. Although the
Portfolio seeks to invest in larger companies, it may invest in small and
medium-size companies that, in MSAM's view, have potential for growth.
The value of the Portfolio's investments and the income they generate will vary
from day-to-day and generally reflect market conditions, interest rates, and
other company, political, or economic news both in the United States and
abroad. In the short-term, stock prices can fluctuate dramatically in response
to these factors. Over time, however, stocks have shown greater growth
potential than other types of securities. The prices of Fixed Income Securities
also fluctuate and generally move in the opposite direction from interest
rates.
The Portfolio spreads investment risk by limiting its holdings in any one
company or industry. Nevertheless, the Portfolio will experience price
volatility the extent of which will be affected by the types of securities and
techniques the Portfolio uses. Additionally, because the Portfolio is a non-
diversified portfolio and is permitted greater flexibility to invest its assets
in the obligations of a single issuer, it is exposed to increased risk of loss
if such an investment underperforms expectations. See "Non-Diversified Status"
in this Prospectus and "Investment Limitations" in the Statement of Additional
Information ("SAI"). MSAM may use various investment techniques to hedge risks,
including Derivatives, but there is no guarantee that these strategies will
work as intended.
Investments in foreign securities, including Emerging Market Country
Securities, may involve risks in addition to those of U.S. investments. The
performance of the Portfolio's investments in foreign securities, including
Emerging Market Country Securities, will be affected by Foreign Currency
values, the political and regulatory environment, and overall economic factors
in the countries in which investments are made. See "Foreign Investments" and
"Foreign Equities" in "Securities and Investment Techniques" below. Emerging
Market Country Securities also pose greater liquidity risks than securities of
companies located in developed countries and traded in more established
markets. The Portfolio may not be able to hedge Foreign Currency risk
adequately. Also, the registration, clearing and settlement of securities
transactions in Russia are subject to significant risks not normally associated
with securities transactions in the United States and other more developed
markets. See "Securities and Investment Techniques--Russian Securities."
When Portfolio shares are redeemed, they may be worth more or less than their
original cost. An investment in the Portfolio is not in itself a balanced
investment plan. As with any mutual fund, there is no assurance that the
Portfolio will achieve its goal.
SECURITIES AND INVESTMENT TECHNIQUES
- ------------------------------------
The following pages contain more detailed information about types of
instruments in which the Portfolio may invest, and strategies MSAM may employ
in pursuit of the Portfolio's investment objective. A summary of risks and
restrictions associated with these instruments and investment practices is
included as well. A complete listing of the Portfolio's policies and
limitations and more detailed information about the Portfolio's investments is
contained in the SAI. Policies and limitations are considered at the time of
purchase; the sale of instruments is not required in the event of a subsequent
change in circumstances, for example, a rating downgrade.
The investments of life insurance company separate accounts made under variable
annuity contracts and variable life insurance policies are subject to state
insurance laws and regulations. The Fund and the Portfolio will, when required,
comply with investment restrictions imposed under such laws and regulations on
life insurance company separate accounts investing in the Portfolio.
MSAM may not buy all of these instruments or use all of these techniques to the
full extent permitted unless it believes that doing so will help the Portfolio
achieve its investment objective. Current holdings and recent investment
strategies are described in the Portfolio's financial reports, which will be
sent to the Portfolio's shareholders twice a year. For a free SAI or financial
report, contact the Fund or your insurance company.
INSTRUMENTS AND INVESTMENTS
AGENCIES. Agencies are securities which are not guaranteed by, or backed by the
full faith and credit of, the U.S. Government, but which are issued, sponsored
or guaranteed by a federal agency or federally sponsored agency such as the
Student Loan Marketing Association, Resolution Funding Corporation, or any of
several other agencies. For further information on these securities, see
"Description of U.S. Government Securities" in the SAI.
ASSET-BACKEDS. Asset-backed securities ("Asset-Backeds") are securities
collateralized by shorter term loans such as automobile loans, home equity
loans, computer leases or credit card receivables. The payments from the
collateral are passed through to the security holder. The collateral behind
Asset-Backeds tends to have prepayment rates that usually do not vary with
interest rates. In addition the short-term nature of the loans reduces the
impact of any change in prepayment level. Due to amortization, the average life
for Asset-Backeds is also the conventional proxy for maturity.
4
<PAGE>
Due to the possibility that prepayments (on automobile loans and other
collateral) will alter the cash flow on Asset-Backeds, it is not possible to
determine in advance the actual final maturity date or average life. Faster
prepayment will shorten the average life and slower prepayments will lengthen
it. However, it is possible to determine what the range of that movement could
be and to calculate the effect that it will have on the price of the security.
In selecting these securities, MSAM will look for those securities that offer a
higher yield to compensate for any variation in average maturity.
BRADY BONDS. Brady Bonds are Fixed Income Securities 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
Nicholas F. Brady when he was the U.S. Secretary of the Treasury (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 dollar-denominated) and they
are actively traded in the over-the-counter secondary market. For further
information on these securities, see the SAI. The Portfolio will invest in
Brady Bonds only if they are consistent with quality specifications.
CASH EQUIVALENTS. Cash Equivalents are short-term Fixed Income Securities
comprising:
(1)Time deposits, certificates of deposit (including marketable variable rate
certificates of deposit) and bankers' acceptances issued by a commercial bank
or savings and loan association. Time deposits are non-negotiable deposits
maintained in a banking institution for a specified period of time at a stated
interest rate. Certificates of deposit are negotiable short-term obligations
issued by commercial banks or savings and loan associations against funds
deposited in the issuing institution. Variable rate certificates of deposit are
certificates of deposit on which the interest rate is periodically adjusted
prior to their stated maturity based upon a specified market rate. A bankers'
acceptance is a time draft drawn on a commercial bank by a borrower, usually in
connection with an international commercial transaction (to finance the import,
export, transfer or storage of goods).
The Portfolio may invest in obligations of U.S. banks, obligations of foreign
branches of U.S. banks ("Eurodollars") and obligations of U.S. branches of
foreign banks ("Yankee dollars"). Investments in Eurodollars and Yankee dollars
involve some of the same risks of investing in international securities that
are discussed in "Foreign Investment" below.
The Portfolio will not invest in any security issued by a commercial bank
unless (i) the bank has total assets of at least $1 billion, or the equivalent
in other currencies, or, in the case of domestic banks which do not have total
assets of at least $1 billion, the aggregate investment made in any one such
bank is limited to $100,000 and the principal amount of such investment is
insured in full by the Federal Deposit Insurance Corporation ("FDIC"), (ii) in
the case of U.S. banks, it is a member of the FDIC, and (iii) in the case of
foreign branches of U.S. banks, the security is deemed by MSAM to be of an
investment quality comparable with other Fixed Income Securities which may be
purchased by the Portfolio.
(2)Commercial paper rated at time of purchase by one or more nationally
recognized statistical ratings organization ("NRSRO") to be in one of their two
highest categories, (e.g., A-1 or A-2 by Standard & Poor's Ratings Group
("S&P") or Prime 1 or Prime 2 by Moody's Investors Service, Inc. ("Moody's")),
or, if not rated, issued by a corporation having an outstanding unsecured debt
issue rated high-grade by an NRSRO (e.g., A or better by Moody's, S&P or Fitch
Investors Service, Inc. ("Fitch")).
(3)Short-term corporate obligations rated high-grade at the time of purchase by
an NRSRO (e.g., A or better by Moody's, S&P or Fitch).
(4)U.S. Governments and Agencies.
(5)Repurchase Agreements collateralized by securities listed above.
CMOS. Collateralized Mortgage Obligations ( "CMOs") are Derivatives which are
collateralized by mortgage pass-through securities. Cash flows from the
mortgage pass-through securities are allocated to various tranches (a "tranche"
is essentially a separate security) in a predetermined, specified order. Each
tranche has a stated maturity--the latest date by which the tranche can be
completely repaid, assuming no prepayments--and has an average life--the
average of the time to receipt of a principal payment weighted by the size of
the principal payment. The average life is typically used as a proxy for
maturity because the debt is amortized (repaid a portion at a time), rather
than paid off entirely at maturity, as would be the case in a straight debt
instrument.
Due to the possibility that prepayments (on home mortgages and other
collateral) will alter the cash flow on CMOs, it is not possible to determine
in advance the actual final maturity date or average life. Faster prepayment
will shorten the average life and slower prepayments will lengthen it. However,
it is possible to determine what the range of that movement could be and to
calculate the effect that it will have on the price of the security. In
selecting these securities, MSAM will look for those securities that offer a
higher yield to compensate for any variation in average maturity.
Prepayment risk has two important effects. First, like Fixed Income Securities
in general, MBSs will generally decline in price when interest rates rise.
However, when interest rates fall, MBSs may not enjoy as large a gain in market
value due to prepayment risk. Second, when interest rates fall,
5
<PAGE>
additional mortgage prepayments must be reinvested at lower interest rates. In
part to compensate for these risks, MBSs will generally offer higher yields
than comparable bonds.
COMMON STOCKS. Common Stocks are Equity Securities which represent an ownership
interest in a corporation, entitling the shareholder to voting rights and
receipt of dividends paid based on proportionate ownership.
CONVERTIBLE SECURITIES. Convertible Securities are securities, such as
convertible Corporate Bonds, convertible Preferred Stocks, Warrants or other
securities which may be exchanged under certain circumstances for a fixed
number of shares of Common Stock.
CORPORATE BONDS. Corporate Bonds are Fixed Income Securities issued by private
corporations. Bondholders, as creditors, have a prior legal claim over common
and preferred stockholders of the corporation as to both income and assets for
the principal and interest due to the bondholder. The Portfolio will buy
Corporate Bonds subject to any quality constraints. If a security held by the
Portfolio is down-graded, the Portfolio may retain the security.
DEPOSITARY RECEIPTS. Depositary Receipts are securities representing ownership
interests in securities of foreign companies (an "underlying issuer") and are
deposited with the depositary. Depositary Receipts are not necessarily
denominated in the same currency as the underlying securities. Depositary
Receipts include American Depositary Receipts ("ADRs"), Global Depositary
Receipts ("GDRs") and other types of Depositary Receipts (which, together with
ADRs and GDRs, are hereinafter collectively referred to as "Depositary
Receipts"). ADRs are dollar-denominated Depositary Receipts typically issued by
a U.S. financial institution which evidence ownership interests in a security
or pool of securities issued by a foreign issuer. ADRs are listed and traded in
the United States. GDRs and other types of Depositary Receipts are typically
issued by foreign banks or trust companies, although they also may be issued by
U.S. financial institutions, and evidence ownership interests in a security or
pool of securities issued by either a foreign or a U.S. corporation. Generally,
Depositary Receipts in registered form are designed for use in the U.S.
securities market and Depositary Receipts in bearer form are designed for use
in securities markets outside the United States.
Depositary Receipts may be "sponsored" or "unsponsored". Sponsored Depositary
Receipts are established jointly by a depositary and the underlying issuer,
whereas unsponsored Depositary Receipts may be established by a depositary
without participation by the underlying issuer. Holders of an unsponsored
Depositary Receipt generally bear all the costs associated with establishing
the unsponsored Depositary Receipt. In addition, the issuers of the securities
underlying unsponsored Depositary Receipts are not obligated to disclose
material information in the U.S. and, therefore, there may be less information
available regarding such issuers and there may not be a correlation between
such information and the market value of the Depositary Receipts. For purposes
of the Portfolio's investment policies, the Portfolio's investments in
Depositary Receipts will be deemed to be investments in the underlying
securities except as noted.
DERIVATIVES. Derivatives are financial products or instruments that derive
their value from the value of an underlying asset, reference rate or index.
Derivatives include, but are not limited to, the following: CMOs, SMBSs (i.e.,
Stripped Mortgage-Backed Securities), Convertible Securities, Warrants,
Forwards, Futures, Options, Structured Notes, structured investments and Swaps.
MSAM will use Derivatives only in circumstances where they offer the most
economic means of improving the risk/reward profile of the Portfolio. MSAM will
not use Derivatives to increase Portfolio risk above the level that could be
achieved in the Portfolio using only traditional investment securities. In
addition, MSAM will not use Derivatives to acquire exposure to changes in the
value of assets or indexes of assets that are not listed in the applicable
allowable investments for the Portfolio. The Portfolio may enter into over-the-
counter derivative transactions (Swaps, Caps, Floors, etc., but excluding CMOs,
Forwards, Futures, Options, and SMBSs) with counterparties approved by MSAM in
accordance with guidelines established by the Fund's 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
ratings below AA.
See elsewhere in this "Securities and Investment Techniques" section for
descriptions of these various Derivatives, and see the SAI for more information
regarding any investment policies or limitations applicable to their use.
EASTERN EUROPEAN SECURITIES. The economies of Eastern European countries are
currently suffering both from the stagnation resulting from centralized
economic planning and control and the higher prices and unemployment associated
with the transition to market economics. Unstable economic and political
conditions may adversely affect security values. Upon the accession to power of
Communist regimes approximately 40 years ago, the governments of a number of
Eastern European countries expropriated a large amount of property. The claims
of many property owners against those governments were never finally settled.
In the event of the return to power of the Communist Party, there can be no
assurance that the Portfolio's investments in Eastern Europe would not be
expropriated, nationalized or otherwise confiscated.
EMERGING MARKET COUNTRY SECURITIES. An Emerging Market Country Security is one
issued by a company that has one or more of the following characteristics: (i)
its principal securities trading market is in an emerging market, (ii) alone
6
<PAGE>
or on a consolidated basis it derives 50% or more of its annual revenue from
either goods produced, sales made or services performed in emerging markets, or
(iii) it is organized under the laws of, and has a principal office in, an
emerging market country. MSAM will base determinations as to eligibility on
publicly available information and inquiries made to the companies.
The economies of individual emerging market countries may differ favorably or
unfavorably from the U.S. economy in such respects as growth of gross domestic
product, rate of inflation, currency depreciation, capital reinvestment,
resource self-sufficiency and balance of payments position. Further, the
economies of developing countries generally are heavily dependent upon
international trade and, accordingly, have been, and may continue to be,
adversely affected by trade barriers, exchange controls, managed adjustments in
relative currency values and other protectionist measures imposed or negotiated
by the countries with which they trade. These economies also have been, and may
continue to be, adversely affected by economic conditions in the countries with
which they trade.
Investing in emerging market countries may entail purchasing securities issued
by or on behalf of entities that are insolvent, bankrupt, in default or
otherwise engaged in an attempt to reorganize or reschedule their obligations,
and in entities that have little or no proven credit rating or credit history.
In any such case, the issuer's poor or deteriorating financial condition may
increase the likelihood that the Portfolio will experience losses or diminution
in available gains due to bankruptcy, insolvency or fraud.
With respect to any emerging market country, there is the possibility of
nationalization, expropriation or confiscatory taxation, political changes,
government regulation, social instability or diplomatic developments (including
war) that could affect adversely the economies of such countries or the value
of the Portfolio's investments in those countries. In addition, it may be
difficult to obtain and enforce a judgment in a court outside of the United
States.
EQUITY SECURITIES. Equity Securities commonly include, but are not limited to,
Common Stocks, Preferred Stocks, Depositary Receipts, Rights, Warrants, and
Foreign Equities. Preferred Stock is contained in both the definition of Equity
Securities and Fixed Income Securities because it exhibits characteristics
commonly associated with each type of security. See the "The Portfolio's
Investments" section to determine in which of the above the Portfolio may
invest.
FIXED INCOME SECURITIES. Fixed Income Securities commonly include, but are not
limited to, debentures, U.S. Governments, Zero Coupons, Agencies, Corporate
Bonds, High Yield Securities, MBSs, SMBSs, CMOs, Asset-Backeds, Convertible
Securities, Brady Bonds, Floaters, Inverse Floaters, Cash Equivalents,
Municipals, Repurchase Agreements, Preferred Stocks and Foreign Bonds.
Preferred Stock is contained in both the definition of Equity Securities and
Fixed Income Securities since it exhibits characteristics commonly associated
with each type of security. See the "Portfolio's Investments" section to
determine in which of the above the Portfolio may invest.
FLOATERS. Floaters are Fixed Income Securities with a floating or variable rate
of interest, i.e. the rate of interest varies with changes in specified market
rates or indices, such as the prime rate, or at specified intervals. Certain
Floaters may carry a demand feature that permits the holder to tender them back
to the issuer of the underlying instrument, or to a third party, at par value
prior to maturity. When the demand feature of certain Floaters represents an
obligation of a foreign entity, the demand feature will be subject to certain
risks discussed under "Foreign Investment".
FOREIGN BONDS. Foreign Bonds are Fixed Income Securities denominated in Foreign
Currency and issued and traded primarily outside the United States, including:
(1) obligations issued or guaranteed by foreign national governments, their
agencies, instrumentalities, or political subdivisions; (2) Fixed Income
Securities issued, guaranteed or sponsored by supranational organizations
established or supported by several national governments, including the World
Bank, the European Community, the Asian Development Bank and others; (3) non-
government foreign corporate debt securities; (4) foreign MBSs and various
other MBSs and Asset Backeds denominated in Foreign Currency; and (5) Brady
Bonds. Investing in foreign companies involves certain special considerations
that are not typically associated with investing in U.S. companies. See
"Foreign Investment" below.
FOREIGN CURRENCY. The Portfolio invests in foreign securities and will
regularly transact security purchases and sales in Foreign Currencies. The
Portfolio may hold Foreign Currency or purchase or sell Foreign Currency on a
forward basis (see "Forwards").
FOREIGN CURRENCY FUTURES CONTRACTS AND OPTIONS. As another means of reducing
the risks associated with investing in securities denominated in Foreign
Currencies, the Portfolio may enter into contracts for the future acquisition
or delivery of Foreign Currencies and may purchase Foreign Currency Options
("Forex Options"). These investment techniques are designed primarily to hedge
against anticipated future changes in currency prices, that otherwise might
adversely affect the value of the Portfolio's investments.
Foreign Currency Futures Contracts ("Forex Futures") are standardized contracts
for the future delivery of a specified amount of a Foreign Currency at a future
date at a price set at the time of the contract. Forex Futures traded in the
United States are traded on regulated futures exchanges. The Portfolio will
incur brokerage fees when it purchases or sells
7
<PAGE>
Forex Futures or Forex Options, and it will be required to maintain margin
deposits. Parties to a Forex Future must make initial margin deposits to secure
performance of the contract, which generally range from 2% to 5% of the
contract price. There also are requirements to make "variation" margin deposits
as the value of the Futures contract fluctuates. In addition, the Portfolio may
enter into a Futures contract only if immediately thereafter not more than 5%
of its total assets are required as deposit to secure obligations under such
contracts. The Portfolio also will be required to segregate assets to cover its
Futures contracts obligations.
At the maturity of a Forex Future, the Portfolio may either accept or make
delivery of the currency specified in the contract or, prior to maturity, enter
into a closing purchase transaction involving the purchase or sale of an
offsetting contract. Closing purchase transactions with respect to Forex
Futures are effected on a regulated futures exchange. The Portfolio will only
enter into such a Forex Future if it is expected that there will be a liquid
market in which to close out such contract. There can, however, be no assurance
that such a liquid market will exist in which to close a Forward or Futures
contract, in which case the Portfolio may suffer a loss.
The Portfolio may also purchase put or call Forex Options on exchanges. A put
option gives the Portfolio the right to sell a currency at the exercise price
until the expiration of the option. A call option gives the Portfolio the right
to purchase a currency at the exercise price until the expiration of the
option.
Purposes for which such Forex Futures and Forex Options may be used include
protecting against a decline in a Foreign Currency against the U.S. dollar
between the trade date and settlement date when the Portfolio purchases or
sells securities, locking in the U.S. dollar value of dividends declared on
securities held by the Portfolio and generally protecting the U.S. dollar value
of securities held by the Portfolio against exchange rate fluctuations. Such
contracts will be used only as a protective measure against the effects of
fluctuating rates of currency exchange and exchange control regulations. While
Forex Futures and Forex Options may limit losses to the Portfolio as a result
of exchange rate fluctuation, they will also limit any gains that may otherwise
have been realized.
The primary risks associated with the use of Forex Futures and Forex Options
are (i) failure to predict accurately the direction of currency movements and
(ii) market risks (e.g., lack of liquidity or lack of correlation between the
change in value of underlying currencies and that of the value of the
Portfolio's Forex Futures or Forex Options). The risk that the Portfolio will
be unable to close out a Forex Futures position or Forex Options contract will
be minimized by the Portfolio only entering into such transactions when there
appears to be a liquid secondary market. For more detailed information about
Futures transactions, see "Securities and Investment Techniques" in the SAI.
FOREIGN EQUITIES. Foreign Equity Securities ("Foreign Equities") include, but
are not limited to, Common Stock, Preferred Stock, Depositary Receipts, Rights,
Warrants and Convertible Securities of foreign issuers. Investing in foreign
companies involves certain special considerations which are not typically
associated with investing in U.S. companies. See "Foreign Investment" below.
FOREIGN INVESTMENT. Investment in securities and obligations of foreign issuers
and in foreign branches of domestic banks involves somewhat different
investment risks than those affecting obligations of U.S. issuers. There may be
limited publicly available information with respect to foreign issuers, and
foreign issuers are not generally subject to uniform accounting, auditing and
financial standards and requirements comparable to those applicable to U.S.
companies. There may also be less government supervision and regulation of
foreign securities exchanges, brokers and listed companies than in the U.S.
Many foreign securities markets have substantially less volume than U.S.
national securities exchanges, and securities of some foreign issuers are less
liquid and more volatile than securities of comparable domestic issuers.
Brokerage commissions and other transaction costs on foreign securities
exchanges are generally higher than in the United States. Dividends and
interest paid by foreign issuers may be subject to withholding and other
foreign taxes, which may decrease the net return on Foreign Investments as
compared to dividends and interest paid by U.S. companies. Additional risks
include future political and economic developments, the possibility that a
foreign jurisdiction will impose or change withholding taxes on income payable
with respect to foreign securities, and the possible adoption of foreign
governmental restrictions such as exchange controls.
Prior governmental approval for Foreign Investments may be required under
certain circumstances in some emerging countries, and the extent of Foreign
Investment in certain Fixed Income Securities and domestic companies may be
subject to limitation in other emerging countries. Foreign ownership
limitations also may be imposed by the charters of individual companies in
emerging countries to prevent, among other concerns, violation of Foreign
Investment limitations.
Repatriation of investment income, capital and the proceeds of sales by foreign
investors may require governmental registration and/or approval in some
emerging countries. The Portfolio could be adversely affected by delays in, or
a refusal to grant, any required governmental registration or approval for such
repatriation. Any investment subject to such repatriation controls will be
considered illiquid if it appears reasonably likely that this process will take
more than seven days.
8
<PAGE>
Investments in securities of foreign issuers are frequently denominated in
Foreign Currencies. Because the Portfolio may temporarily hold uninvested
reserves in bank deposits in Foreign Currencies, the value of the Portfolio's
assets, as measured in U.S. dollars, may be affected favorably or unfavorably
by changes in currency rates and in exchange control regulations and the
Portfolio may incur costs in connection with conversions between various
currencies.
FORWARDS. Forward Foreign Currency exchange contracts ("Forwards" or "forward
contracts") are obligations to purchase or sell an amount of a specified
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. Forwards are traded in the interbank market conducted directly
between currency traders (usually large commercial banks).
The Portfolio may use currency exchange contracts in the normal course of
business to lock in an exchange rate in connection with purchases and sales of
securities (transaction hedge) or to lock in the dollar value of portfolio
positions (position hedge). In addition the Portfolio may cross-hedge
currencies by entering into a transaction to purchase or sell one or more
currencies that are expected to decline in value relative to other currencies
to which the Portfolio has or expects to have portfolio exposure. The Portfolio
may also engage in proxy hedging which is defined as entering into positions in
one currency to hedge investments denominated in another currency, where the
two currencies are economically linked. Forwards will be used only as a
protective measure against the effects of fluctuating rates of currency
exchange and exchange control regulations. While such contracts may limit
losses to the Portfolio as a result of exchange rate fluctuation, they will
also limit any gains that may otherwise have been realized.
The Portfolio may also combine forward contracts with investments in securities
denominated in other currencies in order to achieve desired credit and currency
exposures. Such combinations are generally referred to as synthetic securities.
For example, in lieu of purchasing a Foreign Bond, the Portfolio may purchase a
U.S. dollar-denominated security and at the same time enter into a forward
contract to exchange U.S. dollars for the contract's underlying currency at a
future date. By matching the amount of U.S. dollars to be exchanged with the
anticipated value of the U.S. dollar-denominated security, the Portfolio may be
able to lock in the Foreign Currency value of the security and adopt a
synthetic investment position reflecting the credit quality of the U.S. dollar-
denominated security.
There is a risk in adopting a synthetic investment position to the extent that
the value of a security denominated in the U.S. dollar or other Foreign
Currency is not exactly matched with the Portfolio's obligation under the
forward contract. On the date of maturity, the Portfolio may be exposed to some
risk of loss from fluctuations in that currency. Although MSAM will attempt to
hold such mismatching to a minimum, there can be no assurance that MSAM will be
able to do so. When the Portfolio enters into a forward contract for purposes
of creating a synthetic security, it will generally be required to hold liquid
assets in a segregated account with a daily value at least equal to its
obligation under the forward contract.
Except in circumstances where segregated accounts are not required by the 1940
Act and the rules adopted thereunder, the Portfolio's entry into Forwards, as
well as any use of cross or proxy hedging techniques, will generally require
the Portfolio's custodian to place liquid assets into a segregated account of
the Portfolio in an amount equal to the value of the Portfolio's total assets
committed to the consummation of forward contracts. If the value of the
securities placed in the segregated account declines, additional liquid assets
will be placed in the account on a daily basis so that the value of the account
will be at least equal to the amount of the Portfolio's commitments with
respect to such contracts. See "Investment Objectives and Policies Forward
Foreign Currency Exchange Contracts" in the SAI.
At the maturity of a forward contract, the Portfolio may either accept or make
delivery of the currency specified in the contract or, prior to maturity, enter
into a closing purchase transaction involving the purchase or sale of an
offsetting contract. Closing purchase transactions with respect to Forwards are
usually effected with the currency trader who is a party to the original
forward contract. The Portfolio will only enter into such a forward contract if
it is expected that there will be a liquid market in which to close out such
contract. There can, however, be no assurance that such a liquid market will
exist in which to close a forward contract, in which case the Portfolio may
suffer a loss.
FUTURES. The term "Futures" includes futures contracts and Options on futures
contracts. Futures contracts provide for the sale by one party and purchase by
another party of a specified amount of a specific security, at a specified
future time and price. 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.
In addition, the Portfolio may enter into a Futures contract only if
immediately thereafter not more than 5% of its total assets are required as
deposit to secure obligations under such contracts. The Portfolio also will be
required to segregate assets to cover its Futures contracts obligations.
9
<PAGE>
Futures are derivative securities, in which the Portfolio may invest for
hedging purposes, as well as to remain fully invested and to reduce transaction
costs. Investing for the latter two purposes may be considered speculative. The
primary risks associated with the use of Futures are (i) imperfect correlation
between the change in market value of the stocks held by the Portfolio and the
prices of Futures and Options relating to the stocks purchased or sold by the
Portfolio and (ii) possible lack of a liquid secondary market for an Option or
a futures contract and the resulting inability to close a Futures position
which could have an adverse impact on the Portfolio's ability to hedge.
Additional risks associated with Options transactions are (i) the risk that an
Option will expire worthless; (ii) the risk that the issuer of an over-the-
counter Option will be unable to fulfill its obligation to the Portfolio due to
bankruptcy or related circumstances; (iii) the risk that Options may exhibit
greater short-term price volatility than the underlying security; and (iv) the
risk that the Portfolio may be forced to forego participation in the
appreciation of the value of underlying securities, futures contracts or
currency due to the writing of a call Option.
HIGH YIELD SECURITIES. High Yield Securities are generally considered to
include Corporate Bonds, Preferred Stocks and Convertible Securities rated Ba
through C by Moody's or BB through D by S&P, and unrated securities considered
to be of equivalent quality. Securities rated less than Baa by Moody's or BBB
by S&P are classified as non-Investment Grade Securities and are commonly
referred to as junk bonds or High Yield Securities. Such securities carry a
high degree of risk and are considered speculative by the major credit rating
agencies. The following are excerpts from the Moody's and S&P definitions for
speculative-grade debt obligations:
Moody's: Ba-rated bonds have "speculative elements" so their future
"cannot be considered assured," and protection of principal and interest
is "moderate" and "not well safeguarded during both good and bad times in
the future." B-rated bonds "lack characteristics of a desirable
investment" and the assurance of interest or principal payments "may be
small." Caa-rated bonds are "of poor standing," and "may be in default"
or may have "elements of danger with respect to principal or interest."
Ca-rated bonds represent obligations which are speculative in a high
degree. Such issues are often in default or have other marked
shortcomings. C-rated bonds are the "lowest rated" class of bonds, and
issues so rated can be regarded as having "extremely poor prospects" of
ever attaining any real investment standing.
S&P: BB-rated bonds have "less near-term vulnerability to default" than
B- or CCC-rated securities but face major ongoing uncertainties . . .
which may lead to inadequate capacity" to pay interest or principal. B-
rated bonds have a "greater vulnerability to default than BB-rated bonds
and the ability to pay interest or principal will likely be impaired by
adverse business conditions." CCC-rated bonds have a currently
identifiable "vulnerability to default" and, without favorable business
conditions, will be "unable to repay interest and principal." The rating
C is reserved for income bonds on which "no interest is being paid." Debt
rated D is in default," and "payment of interest and/or repayment of
principal is in arrears."
While such securities offer high yields, they also normally carry with them a
greater degree of risk than securities with higher ratings. High Yield
Securities may be issued as a consequence of corporate restructuring or similar
events. Also, High Yield Securities are often issued by smaller, less credit
worthy companies, or by highly leveraged (indebted) firms, which are generally
less able than more established or less leveraged firms to make scheduled
payments of interest and principal. The price movement of these securities is
influenced less by changes in interest rates and more by the financial and
business position of the issuing corporation when compared to Investment Grade
Securities.
The risks posed by securities issued under such circumstances are substantial.
If a security held by the Portfolio is down-graded, the Portfolio may retain
the security.
INVERSE FLOATERS. Inverse floating rate obligations ("Inverse Floaters") are
Fixed Income Securities, which have coupon rates that vary inversely at a
multiple of a designated floating rate, such as LIBOR (London Inter-Bank
Offered Rate). Any rise in the reference rate of an inverse floater (as a
consequence of an increase in interest rates) causes a drop in the coupon rate
while any drop in the reference rate of an inverse floater causes an increase
in the coupon rate. Inverse Floaters may exhibit substantially greater price
volatility than fixed rate obligations having similar credit quality,
redemption provisions and maturity, and inverse floater CMOs exhibit greater
price volatility than the majority of mortgage pass-through securities or CMOs.
In addition, some inverse floater CMOs exhibit extreme sensitivity to changes
in prepayments. As a result, the yield to maturity of an inverse floater CMO is
sensitive not only to changes in interest rates but also to changes in
prepayment rates on the related underlying mortgage assets.
INVESTMENT COMPANY SECURITIES. Investments in investment companies are
securities of other open-end or closed-end investment companies. The Investment
Company Act of 1940, as amended (the "1940 Act"), generally prohibits the
Portfolio from acquiring more than 3% of the outstanding voting shares of an
investment company and limits such investments to no more than 5% of the
Portfolio's total assets in any one investment company and no more than 10% in
any combination of investment companies. The 1940 Act also prohibits the
Portfolio from acquiring in the
10
<PAGE>
aggregate more than 10% of the outstanding voting shares of any registered
close-end investment company.
To the extent the Portfolio invests a portion of its assets in Investment
Company Securities, those assets will be subject to the expenses of the
purchased investment company as well as to the expenses of the Portfolio
itself. The Portfolio may not purchase shares of any affiliated investment
company except as permitted by a rule or order of the Securities and Exchange
Commission ("SEC").
INVESTMENT FUNDS. Some emerging market countries have laws and regulations that
currently preclude direct investment in the securities of their companies.
However, indirect investment in the securities of companies listed and traded
on the stock exchanges in these countries is permitted by certain emerging
market countries through Investment Funds that have been specifically
authorized. The Portfolio may invest in these Investment Funds subject to the
provisions of the 1940 Act, as applicable, and other applicable laws as
discussed in "Investment Limitations" in the SAI. The Portfolio will invest in
such Investment Funds only where appropriate given that the Portfolio's
shareholders will bear not only their proportionate share of the expenses of
the Portfolio (including operating expenses and the fees of MSAM), but also
will indirectly bear similar expenses of the underlying Investment Funds.
Certain Investment Funds are advised by MSAM. The Portfolio may, to the extent
permitted under the 1940 Act and other applicable law, invest in these
Investment Funds. If the Portfolio does elect to make an investment in such an
Investment Fund, it will only purchase the securities of such Investment Fund
in the secondary market.
INVESTMENT GRADE SECURITIES. Investment Grade Securities are those rated by one
or more NRSRO in one of the four highest rating categories at the time of
purchase (e.g., AAA, AA, A or BBB by S&P or Fitch, or Aaa, Aa, A or Baa by
Moody's). Securities rated BBB or Baa represent the lowest of four levels of
Investment Grade Securities and are regarded as borderline between definitely
sound obligations and those in which the speculative element begins to
predominate. MBSs, including mortgage pass-throughs and CMOs, deemed investment
grade by MSAM, will either carry a guarantee from an agency of the U.S.
Government or a private issuer of the timely payment of principal and interest
(such guarantees do not extend to the market value of such securities or the
net asset value per share of the Portfolio) or, in the case of unrated
securities, be sufficiently seasoned that they are considered by MSAM to be
investment grade quality. MSAM may retain a security if its rating falls below
investment grade if it deems retention of the security to be in the best
interests of the Portfolio. The Portfolio may hold unrated securities if MSAM
considers the risks involved in owning that security to be equivalent to the
risks involved in holding an Investment Grade Security.
LOAN PARTICIPATIONS AND ASSIGNMENTS. Loan Participations are loans or other
direct debt instruments which are interests in amounts owed by a corporate,
governmental or other borrower to another party. They may represent amounts
owed to lenders or lending syndicates, to suppliers of goods or services (trade
claims or other receivables) or to other parties. The Portfolio may invest in
fixed rate 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 participation in Loans
("Participations") and assignments of all or a portion of Loans ("Assignments")
from third parties. The 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 the event of the insolvency of the Lender selling a
Participation, the 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. 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 may be impaired. The
Portfolio will acquire Participations only if the Lender interpositioned
between the Portfolio and the borrower is determined by MSAM to be
creditworthy.
When the Portfolio purchases Assignments from Lenders it will acquire direct
rights against the borrower on the Loan. However, because Assignments are
arranged through private negotiations between potential assignees and potential
assignors, the rights and obligations acquired by the Portfolio as the
purchaser of an Assignment may differ from, and be more limited than, those
held by the assigning Lender. 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 the
Portfolio's ability to dispose of particular Assignments or Participations when
necessary to meet the 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 the Portfolio to assign a value to these
securities for purposes of valuing the Portfolio's securities and calculating
its NAV.
Direct debt instruments involve the risk of loss in case of default or
insolvency of the borrower. Direct debt instruments may offer less legal
protection to the Portfolio in the event of fraud or misrepresentation and may
involve a risk of insolvency of the lending bank or other financial
11
<PAGE>
intermediary. Direct debt instruments may also include standby financing
commitments that obligate the investing Portfolio to supply additional cash to
the borrower on demand. Participations involving emerging market country
issuers may relate to loans as to which there has been or currently exists an
event of default or other failure to make payment when due, and may represent
amounts owed to financial institutions that are themselves subject to political
and economic risks, including the risk of currency devaluation, expropriation,
or failure. Such Participations present additional risks of default or loss.
LOANS OF PORTFOLIO SECURITIES. The Portfolio may lend its securities to
brokers, dealers, domestic and foreign banks or other financial institutions
for the purpose of increasing its net investment income. These loans must be
secured continuously by cash or equivalent collateral, or by a letter of credit
at least equal to the market value of the securities loaned plus accrued
interest or income. There may be a risk of delay in recovery of the securities
or even loss of rights in the collateral should the borrower of the securities
fail financially. The Portfolio will not enter into securities loan
transactions exceeding, in the aggregate, 33 1/3% of its total assets. For more
detailed information about securities lending, see "Securities and Investment
Techniques" in the SAI.
MONEY MARKET INSTRUMENTS. The Portfolio may invest in Money Market Instruments,
although the Portfolio intends to stay invested in securities satisfying its
primary investment objective to the extent practical. The Portfolio may invest
in Money Market Instruments pending other investment or settlement for
liquidity, or in adverse market conditions. The Money Market Instruments
permitted for the Portfolio include obligations of the U.S. Government and its
agencies and instrumentalities; obligations of foreign sovereignties;
obligations of the International Bank for Reconstruction and Development; other
debt securities; commercial paper, including bank obligations; certificates of
deposit (including Eurodollar certificates of deposit); and Repurchase
Agreements. For more detailed information about these Money Market Instruments,
see "Description of Certain Securities and Ratings" in the SAI.
MORTGAGE-BACKED SECURITIES. Mortgage-Backed Securities ("MBSs") are instruments
that entitle the holder to a share of all interest and principal payments from
pools of residential and commercial mortgage loans underlying the instruments,
and may take the form of pass-through securities or CMOs. Generally, these
securities are designed to provide monthly payments of interest and principal
to the investor.
Pass-Through Securities. The mortgagee's monthly payments to his or her lending
institution are passed through to investors such as the Portfolio. Most issuers
or poolers provide guarantees of payments, regardless of whether the mortgagor
actually makes the payment. The guarantees made by issuers or poolers are
supported by various forms of credit, collateral, guarantees or insurance,
including individual loan, title, pool and hazard insurance purchased by the
issuer. The pools are assembled by various governmental, Government-related and
private organizations. The Portfolio may invest in securities issued or
guaranteed by the Government National Mortgage Association ("GNMA"), Federal
Home Loan Mortgage Corporation ("FHLMC"), Federal National Mortgage Association
("FNMA"), private issuers and other government agencies. There can be no
assurance that the private insurers can meet their obligations under the
policies. MBSs issued by non-agency issuers, whether or not such securities are
subject to guarantees, may entail greater risk. If there is no guarantee
provided by the issuer, MBSs purchased by the Portfolio will be those which at
time of purchase are rated investment grade by one or more NRSRO, or, if
unrated, are deemed by MSAM to be of investment grade quality.
Due to the possibility that prepayments on home mortgages will alter cash flow
on MBSs, it is not possible to determine in advance the actual final maturity
date or average life. Faster prepayment will shorten the average life and
slower prepayments will lengthen it. However, it is possible to determine what
the range of that movement could be and to calculate the effect that it will
have on the price of the security. In selecting these securities, MSAM will
look for those securities that offer a higher yield to compensate for any
variation in average maturity.
There are two methods of trading MBSs. A specified pool transaction is a trade
in which the pool number of the security to be delivered on the settlement date
is known at the time the trade is made. This is in contrast with the typical
MBS transaction, called a TBA (to be announced) transaction, in which the type
of MBS to be delivered is specified at the time of trade but the actual pool
numbers of the securities that will be delivered are not known at the time of
the trade. The pool numbers of the pools to be delivered at settlement will be
announced shortly before settlement takes place. The terms of the TBA trade may
be made more specific if desired. Generally, agency pass-through MBSs are
traded on a TBA basis.
CMOs. CMOs are debt securities that are issued by a thrift or other financial
institution and are collateralized as follows. The bondholder has a first
priority perfected security interest in collateral, usually consisting of
agency mortgage pass-through securities, although other assets, including U.S.
Treasuries (including Zero Coupons), Agencies, Cash Equivalents, whole loans
and Corporate Bonds, may qualify. The amount of collateral must be continuously
maintained at levels from 115% to 150% of the principal amount of the bonds
issued, depending on the specific issue structure and collateral type. See
"CMOs" above.
MUNICIPALS. Municipal securities ("Municipals") are debt obligations issued by
local, state and regional governments that provide interest income that is
exempt from federal
12
<PAGE>
income taxes. Municipals include both municipal bonds (those securities with
maturities of five years or more) and municipal notes (those with maturities of
less than five years). Municipal bonds are issued for a wide variety of
reasons: to construct public facilities, such as airports, highways, bridges,
schools, hospitals, mass transportation, streets, water and sewer works; to
obtain funds for operating expenses; to refund outstanding municipal
obligations; and to loan funds to various public institutions and facilities.
Certain industrial development bonds are also considered municipal bonds if
their interest is exempt from federal income tax. Industrial development bonds
are issued by or on behalf of public authorities to obtain funds for various
privately-operated manufacturing facilities, housing, sports arenas, convention
centers, airports, mass transportation systems and water, gas or sewer works.
Industrial development bonds are ordinarily dependent on the credit quality of
a private user, not the public issuer.
NON-DIVERSIFIED STATUS. The Portfolio is a non-diversified portfolio under the
1940 Act, which means that the Portfolio is not limited by the 1940 Act in the
proportion of its assets that may be invested in the obligations of a single
issuer. Thus, the Portfolio may invest a greater proportion of its assets in
the securities of a small number of issuers and as a result will be subject to
greater risk with respect to its portfolio securities. However, the Portfolio
intends to comply with diversification requirements imposed by the Internal
Revenue Code of 1986, as amended (the "Code"), for qualification as regulated
investment company. See "Investment Limitations" and "Taxes" in the SAI.
NON-PUBLICLY TRADED SECURITIES, PRIVATE PLACEMENTS AND RESTRICTED
SECURITIES. The Portfolio may invest in securities that are neither listed on a
stock exchange nor traded over-the-counter, including privately placed
securities. Such unlisted Equity Securities may involve a higher degree of
business and financial risk that can result in substantial losses. As a result
of the absence of a public trading market for these securities, they may be
less liquid than publicly traded securities. Although these securities may be
resold in privately negotiated transactions, the prices realized from these
sales could be less than those originally paid by the Portfolio or less than
what may be considered the fair value of such securities. Furthermore,
companies whose securities are not publicly traded may not be subject to the
disclosure and other investor protection requirements which might be applicable
if their securities were publicly traded. If such securities are required to be
registered under the securities laws of one or more jurisdictions before being
resold, the Portfolio may be required to bear the expenses of registration.
As a general matter, the Portfolio may not invest more than 15% of its net
assets in illiquid securities, including securities for which there is no
readily available secondary market and securities that are restricted from sale
to the public without registration ("Restricted Securities") under the
Securities Act of 1933, as amended (the "1933 Act") and are deemed to be
illiquid. Restricted Securities that can be offered and sold to qualified
institutional buyers under Rule 144A under the 1933 Act ("144A Securities") may
be deemed to be liquid under guidelines adopted by the Fund's Board of
Directors. The Portfolio may invest up to 25% of its total assets in 144A
Securities that are deemed to be liquid.
The Fund's Board of Directors has delegated to MSAM, subject to the supervision
of the Board of Directors, the daily function of determining and monitoring the
liquidity of Rule 144A Securities. Rule 144A Securities may become illiquid if
qualified institutional buyers are not interested in acquiring the securities.
Investors should note that investment of 5% of the Portfolio's total assets in
Restricted Securities may be considered a speculative activity and may involve
greater risk and expense to the Portfolio.
OPTIONS. Options are legal contracts that give the holder the right to buy or
sell a specified amount of the underlying security or futures contract at a
fixed or determinable price upon the exercise of the Option. A call Option
conveys the right to buy and a put Option conveys the right to sell a specified
quantity of the underlying security.
The Portfolio may write (i.e., sell) covered call Options on portfolio
securities which give the purchaser the right to buy the underlying security
covered by the Option from the Portfolio at the stated exercise price. A
"covered" call Option means that so long as the Portfolio is obligated as the
writer of the Option, it will own (i) the underlying securities subject to the
Option, or (ii) securities convertible or exchangeable without the payment of
any consideration into the securities subject to the Option. By selling a
covered call Option, the Portfolio would become obligated during the term of
the Option to deliver 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, the 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. The Portfolio will keep the premium regardless
of whether the Option is exercised. When the Portfolio writes covered call
Options, it augments its income by the premiums received and is thereby hedged
to the extent of that amount against a decline in the price of the underlying
securities. 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,
the 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. As a matter of operating
policy, the value of the underlying securities on which stock Options will be
written at any one time will not exceed 5% of the Portfolio's total assets.
13
<PAGE>
The Portfolio may also write (i.e., sell) covered put Options. Generally, a put
Option is "covered" if the Portfolio maintains cash, U.S. Governments 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.
By selling a covered put Option, 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 Options written by the Portfolio will be exercisable by the
purchaser only on a specific date). The Portfolio may sell put Options to
receive the premiums paid by purchasers and to close out a long put Option
position. In addition, when MSAM wishes to purchase a security at a price lower
than its current market price, the Portfolio may write a covered put Option at
an exercise price reflecting the lower purchase price sought.
The Portfolio may purchase put or call Options on individual securities or
baskets of securities. When the Portfolio purchases a call Option it acquires
the right to buy a designated security at a designated price ("exercise
price"), and when the Portfolio purchases a put Option it acquires the right to
sell a designated security at the exercise price, in each case on or before a
specified date ("termination date"), usually not more than nine months from the
date the Option is issued. The 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. The Portfolio may purchase put Options on
securities which it holds in its portfolio 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, the Portfolio would incur no additional loss.
The Portfolio may also purchase put Options to close out written put positions
in a manner similar to call Option closing purchase transactions.
PREFERRED STOCKS. Preferred Stocks are non-voting securities which evidence
ownership in a corporation and which pay a fixed or variable stream of
dividends.
RIGHTS. Rights represent a preemptive right of stockholders to purchase
additional shares of a stock at the time of a new issuance, before the stock is
offered to the general public, allowing the stockholder to retain the same
ownership percentage after the new stock offering.
REPURCHASE AGREEMENTS. Repurchase Agreements are transactions in which the
Portfolio purchases a security and simultaneously commits to resell that
security to the seller (a bank, broker or dealer) at a mutually agreed upon
date and price. The term of these agreements is usually from overnight to one
week, and never exceeds one year. Repurchase Agreements may be viewed as a
fully collateralized loan of money by the Portfolio to the seller. 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 received by the Portfolio have a market
value at least equal to the purchase price (including accrued interest) of the
Repurchase Agreement as collateral, and this value is maintained during the
term of the agreement. These securities are held by the Portfolio's custodian
or an approved third party for the benefit of the Portfolio until repurchased.
Repurchase Agreements permit the Portfolio to keep all its assets invested
while retaining overnight flexibility in pursuit of investments of a longer
term nature. If the seller defaults and the collateral value declines, the
Portfolio might incur a loss. If bankruptcy proceedings are commenced with
respect to the seller, the Portfolio's realization upon the collateral may be
delayed or limited.
REVERSE REPURCHASE AGREEMENTS. The Portfolio may enter into Reverse Repurchase
Agreements with brokers, dealers, domestic and foreign banks or other financial
institutions. In a Reverse Repurchase Agreement, the Portfolio sells a security
and agrees to repurchase it at a mutually agreed upon date and price,
reflecting the interest rate effective for the term of the agreement. It may
also be viewed as the borrowing of money by the Portfolio. The Portfolio's
investment of the proceeds of a Reverse Repurchase Agreement is the speculative
factor known as leverage. The Portfolio may enter into a Reverse Repurchase
Agreement only if the interest income from investment of the proceeds is
greater than the interest expense of the transaction and the proceeds are
invested for a period no longer than the term of the agreement. The Portfolio
will maintain with the custodian a separate account with a segregated portfolio
of unencumbered liquid assets in an amount at least equal to its purchase
obligations under these agreements. If interest rates rise during a Reverse
Repurchase Agreement, it may adversely affect the Portfolio's ability to
maintain a stable NAV.
RUSSIAN SECURITIES. The registration, clearing and settlement of securities
transactions involving Russian issuers are subject to significant risks not
normally associated with securities transactions in the United States and other
more developed markets. Ownership of Equity Securities in Russian companies is
evidenced by entries in a company's share register (except where shares are
held through depositories that meet the requirements of the 1940 Act) and the
issuance of extracts from the register or, in certain limited cases, by formal
share certificates. However, Russian share registers are frequently unreliable
and the Portfolio could possibly lose its registration through oversight,
negligence or fraud. Moreover, Russia lacks a centralized registry to record
securities transactions and registrars located throughout Russia or the
companies themselves maintain share registers. Registrars are under no
obligation to provide extracts to potential purchasers in a timely manner or at
all and are not
14
<PAGE>
necessarily subject to effective state supervision. In addition, while
registrars are liable under law for losses resulting from their errors, it may
be difficult for the Portfolio to enforce any rights it may have against the
registrar or issuer of the securities in the event of loss of share
registration. Although Russian companies with more than 1,000 shareholders are
required by law to employ an independent company to maintain share registers,
in practice, such companies have not always followed this law. Because of this
lack of independence of registrars, management of a Russian company may be able
to exert considerable influence over who can purchase and sell the company's
shares by illegally instructing the registrar to refuse to record transactions
on the share register. Furthermore, these practices may prevent the Portfolio
from investing in the securities of certain Russian companies deemed suitable
by MSAM and could cause a delay in the sale of Russian Securities by the
Portfolio if the company deems a purchaser unsuitable, which may expose the
Portfolio to potential loss on its investment.
In light of the risks described above, the Board of Directors of the Fund has
approved certain procedures concerning the Fund's investments in Russian
Securities. Among these procedures is a requirement that the Portfolio will not
invest in the securities of a Russian company unless that issuer's registrar
has entered into a contract with the Fund's sub-custodian containing certain
protective conditions, including, among other things, the sub-custodian's right
to conduct regular share confirmations on behalf of the Portfolio. This
requirement will likely have the effect of precluding investments in certain
Russian companies that the Portfolio would otherwise make.
SMBSS. Stripped Mortgage-Backed Securities ("SMBSs") are Derivatives in the
form of multi-class mortgage securities. SMBSs may be issued by agencies or
instrumentalities of the U.S. Government and private originators of, or
investors in, mortgage loans, including savings and loan associations, mortgage
banks, commercial banks, investment banks and special purpose entities of the
foregoing.
SMBSs are usually structured with two classes that receive different
proportions of the interest and principal distributions on a pool of mortgage
assets. One type of SMBS will have one class receiving some of the interest and
most of the principal from the mortgage assets, while the other class will
receive most of the interest and the remainder of the principal. In some cases,
one class will receive all of the interest ("IO class"), while the other class
will receive all of the principal ("principal-only" or "PO class"). The yield
to maturity on IO classes and PO classes is extremely sensitive to the rate of
principal payments (including prepayments) on the related underlying mortgage
assets, and a rapid rate of principal payments may have a material adverse
effect on the portfolio yield to maturity. If the underlying mortgage assets
experience greater than anticipated prepayments of principal, the Portfolio may
fail to fully recoup its initial investment in these securities, even if the
security is in one of the highest rating categories.
Although SMBSs are purchased and sold by institutional investors through
several investment banking firms acting as brokers or dealers, these securities
were only recently developed. As a result, established trading markets have not
yet developed and, accordingly, certain of these securities may be deemed
illiquid and subject to the Portfolio's limitations on investment in illiquid
securities.
STRUCTURED NOTES. Structured Notes are Derivatives on which the amount of
principal repayment and/or interest payments is based upon the movement of one
or more factors. These factors include, but are not limited to, currency
exchange rates, interest rates (such as the prime lending rate and LIBOR) and
stock indices such as the S&P 500. In some cases, the impact of the movements
of these factors may increase or decrease through the use of multipliers or
deflators. The use of Structured Notes allows the Portfolio to tailor its
investments to the specific risks and returns MSAM wishes to accept while
avoiding or reducing certain other risks.
SWAPS. Swap Contracts are Derivatives in the form of a contract or other
similar instrument which 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, but is not limited to,
currencies, fixed interest rates, prices and 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, the
Portfolio may agree to swap the return generated by a fixed-income index for
the return generated by a second fixed-income index. The currency Swaps in
which the Portfolio 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 Portfolio will usually enter into Swaps on a net basis, i.e., the two
return streams are netted out in a cash settlement on the payment date or dates
specified in the instrument, with the Portfolio receiving or paying, as the
case may be, only the net amount of the two returns. The 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. Governments, or high grade debt obligations. The
Portfolio will not enter into any Swap agreement unless the counterparty meets
the rating requirements set forth in guidelines established by the Fund's Board
of Directors.
15
<PAGE>
Interest rate and total rate of return Swaps do not involve the delivery of
securities, other underlying assets, or principal. Accordingly, the risk of
loss with respect to interest rate and total rate of return Swaps is limited to
the net amount of interest payments that the Portfolio is contractually
obligated to make. If the other party to an interest rate or total rate of
return Swap defaults, the Portfolio's risk of loss consists of the net amount
of interest payments that the Portfolio is contractually entitled to receive.
In contrast, 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 Portfolio
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. Swaps that include 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
"traditional" Swaps.
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 MSAM is incorrect in its forecasts of market
values, interest rates, and currency exchange rates, the investment performance
of the Portfolio would be less favorable than it would have been if this
investment technique was not used.
TEMPORARY INVESTMENTS. During periods in which MSAM believes changes in
economic, financial or political conditions make it advisable, the Portfolio
may reduce its holdings for temporary defensive purposes and may invest in
certain short-term (less than twelve months to maturity) and medium-term (not
greater than five years to maturity) debt securities or may hold cash. The
short-term and medium-term debt obligations in which the Portfolio may invest
consist of (a) obligations of the U.S. or foreign country governments, their
respective agencies or instrumentalities; (b) bank deposits and bank
obligations (including certificates of deposit, time deposits and bankers'
acceptances) of U.S. or foreign country banks denominated in any currency; (c)
Floaters and other instruments denominated in any currency issued by
international development agencies; (d) finance company and corporate
commercial paper and other short-term corporate debt obligations of U.S. and
foreign country corporations meeting the Portfolio's credit quality standards;
and (e) Repurchase Agreements with banks and broker-dealers with respect to
such securities. For temporary defensive purposes, the Portfolio intends to
invest only in short-term and medium-term debt obligations that MSAM believes
to be of high quality, i.e., subject to relatively low risk of loss of interest
or principal (there is currently no rating system for foreign debt
obligations).
U.S. GOVERNMENTS. U.S. Governments are Fixed Income Securities that are backed
by the full faith and credit of the U.S. Government as to the payment of both
principal and interest. U.S. Governments may include securities issued by the
U.S. Treasury and securities issued by federal agencies and U.S. Government
sponsored instrumentalities. For further information on these securities, see
"Description of U.S. Government Securities" in the SAI.
WARRANTS. Warrants are instruments giving holders the right, but not the
obligation, to buy shares of a company at a given price during a specified
period.
WHEN-ISSUED AND DELAYED DELIVERY SECURITIES. When-Issued and Delayed Delivery
Securities are securities purchased with payment and delivery taking place in
the future in order to secure what is considered to be an advantageous yield or
price at the time of the transaction. Delivery of and payment for these
securities may take as long as a month or more after the date of the purchase
commitment, but will take place no more than 120 days after the trade date. The
payment obligation and the interest rates that will be received are each fixed
at the time the Portfolio enters into the commitment and no interest accrues to
the Portfolio until settlement. Thus, it is possible that the market value at
the time of settlement could be higher or lower than the purchase price if the
general level of interest rates has changed. The Portfolio will maintain with
the custodian a separate account with a segregated portfolio of high-grade debt
securities or cash in an amount at least equal to these commitments. The
Portfolio will not enter into When-Issued or Delayed Delivery Securities
commitments exceeding, in the aggregate, 15% of the Portfolio's total assets
other than the obligations created by these commitments.
ZERO COUPONS, PAY-IN-KIND SECURITIES OR DEFERRED PAYMENT SECURITIES. Zero
Coupons are Fixed Income Securities that do not make regular interest payments.
Instead, Zero Coupons are sold at substantial discounts from their face value.
The difference between a Zero Coupon's issue or purchase price and its face
value represents the imputed interest an investor will earn if the obligation
is held until maturity. Zero Coupons may offer investors the opportunity to
earn higher yields than those available on ordinary interest-paying obligations
of similar credit quality and maturity. However, Zero Coupon prices may also
exhibit greater price volatility than ordinary Fixed Income Securities because
of the manner in which their principal and interest are returned to the
investor. Pay-In-Kind Securities are securities that have interest payable by
delivery of additional securities. Upon maturity, the holder is entitled to
receive the aggregate par value of the securities. Deferred Payment Securities
are securities that remain Zero Coupons until a predetermined date, at which
time the stated coupon rate becomes effective and interest becomes payable at
regular
16
<PAGE>
intervals. Zero Coupon, Pay-In-Kind and Deferred Payment Securities may be
subject to greater fluctuation in value and lesser liquidity in the event of
adverse market conditions than comparably rated securities paying cash interest
at regular interest payment periods.
FUNDAMENTAL INVESTMENT LIMITS
- -----------------------------
The investment objective of the Portfolio discussed on the preceding pages is a
fundamental policy, that is, a policy subject to change only by shareholder
approval. All policies stated throughout this Prospectus, other than those
identified as fundamental, can be changed without shareholder approval. For
additional fundamental and nonfundamental investment limits, see "Investment
Limitations" in the SAI.
INTERNAL REVENUE SERVICE (IRS) LIMITATIONS. In addition to the above, the
Portfolio also follows certain limitations imposed by the IRS on separate
accounts of insurance companies relating to the tax-deferred status of variable
annuity contracts and variable life insurance policies. More specific
information may be contained in the insurance company's separate account
prospectus.
MANAGEMENT OF THE FUND
- ----------------------
The Fund is governed by a Board of Directors which is responsible for the
management of the business and affairs of the Fund as provided in the laws of
the State of Maryland and the Fund's Articles of Incorporation and By-Laws. The
Board of Directors of the Fund has undertaken to monitor the Fund for the
existence of any material irreconcilable conflict among the interests of
variable annuity contract owners, variable life insurance policy owners and
qualified plans that invest in the Fund due to differences in tax treatment and
other considerations, and shall report any such conflict to the boards of the
respective life insurance companies that use the Fund as an investment vehicle
for their respective variable annuity contracts and variable life insurance
policies and to qualified plans. The Boards of Directors of those life
insurance companies and the fiduciaries of certain qualified plans and MSAM,
have agreed or will agree to be responsible for reporting any potential or
existing conflicts to the Directors of the Fund. If a material irreconcilable
conflict exists that affects those life insurance companies, they will be
required, at their own cost, to remedy such conflict up to and including
establishing a new registered management investment company and segregating the
assets underlying the variable annuity contracts and the variable life
insurance policies. Qualified plans which acquire more than 10% of the assets
of the Fund will be required to report any potential or existing conflicts to
the Directors of the Fund, and if a material irreconcilable conflict exists, to
remedy such conflict, up to and including redeeming shares of the Portfolio
held by the qualified plans. The majority of the Fund's Directors are not
affiliated with MSAM, any of its affiliates, any of the other companies that
provide services to the Fund or any of their affiliates. The officers of the
Fund conduct and supervise its daily business operations.
THE FUND MAY HOLD SPECIAL MEETINGS. The Fund will not hold annual shareholder
meetings, but may call special meetings when required by law, when requested by
a sufficient number of shareholders or for other reasons. An insurance company
issuing a variable annuity contract or variable life insurance policy that
participates in the Portfolio will vote shares held in its separate account as
required by law and interpretations thereof, as may be amended or changed from
time to time. In accordance with current law and interpretations thereof, a
participating insurance company is required to request voting instructions from
contract or policy owners and must vote shares in the separate account in
proportion to the voting instructions received. For a further discussion,
please refer to your insurance company's separate account prospectus.
INVESTMENT MANAGEMENT
INVESTMENT ADVISER. MSAM serves as the adviser for the Emerging Markets Equity
Portfolio. It provides investment advice and portfolio management services,
pursuant to an Investment Advisory Agreement and, subject to the supervision of
the Fund's Board of Directors, makes the Portfolio's day-to-day investment
decisions, arranges for the execution of portfolio transactions and generally
manages the Portfolio's investments. MSAM, with principal offices at 1221
Avenue of the Americas, New York, New York 10020, conducts a worldwide
investment management business, providing a broad range of portfolio management
services to customers in the United States and abroad. MSAM is a wholly owned
subsidiary of Morgan Stanley Group Inc., which is a publicly owned financial
services corporation listed on the New York, London and Pacific stock
exchanges. MSAM, a registered investment adviser under the Investment Advisers
Act of 1940, as amended, serves as investment adviser to numerous open-end and
closed-end investment companies. As of June 30, 1996, MSAM, together with its
affiliated asset management companies, had approximately $103.5 billion in
assets under management and fiduciary care. See "Management of the Fund" in the
SAI.
PORTFOLIO MANAGERS. The following individuals have primary responsibility for
the Portfolio.
Madhav Dhar and Marianne L. Hay. Madhav Dhar is a Managing Director of MSAM and
Morgan Stanley & Co. Incorporated ("Morgan Stanley"). He joined MSAM in 1984 to
focus on global asset allocation and investment strategy and now heads MSAM's
emerging markets group and serves as the group's principal Portfolio Manager.
Mr. Dhar also coordinates MSAM's developing country funds effort and has been
involved in the launching of MSAM's country funds. He is a Director of the
Morgan Stanley Emerging Markets Fund, Inc. (a closed-end investment company).
He holds a B.S. (honors) from St. Stephens College, Delhi University
17
<PAGE>
(India), and an M.B.A. from Carnegie-Mellon University. Marianne L. Hay, a
Managing Director of Morgan Stanley, joined the Adviser in June 1993 to work
with the Adviser's senior management covering all emerging markets asset
allocation, product development and client services. Ms. Hay has 17 years of
investment experience. Prior to joining the Adviser, she was a director of
Martin Currie Investment Management, Ltd. ("Martin Currie") where her
responsibilities included geographic asset allocation and portfolio management
for global and emerging markets funds, as well as being director in charge of
the company's North American clients. Prior to her tenure at Martin Currie, she
worked for the Bank of Scotland and the investment management firm of Ivory and
Sime plc. She graduated with an honors degree in genetics from Edinburgh
University and holds a Diploma in Education and the qualification of the
Association of the Institute of Bankers in Scotland. Mr. Dhar and Ms. Hay have
shared primary responsibility for managing the Portfolio's assets since its
inception.
OTHER SERVICES
DISTRIBUTOR. Under its Distribution Agreement with the Fund, Morgan Stanley
serves as the exclusive distributor of the Fund and sells shares of the
Portfolio upon the terms and at the current offering price described in this
Prospectus. Morgan Stanley is not obligated to sell any certain number of
shares of the Portfolio. Morgan Stanley, as principal underwriter, or the
insurance companies whose variable products are funded by the Fund, will bear
all of the Fund's marketing expenses. This includes the cost of reproducing
prospectuses, statements of additional information or any other Fund documents
(such as semiannual reports) used as sales materials.
ADMINISTRATION. MSAM also provides the Portfolio with administrative services
pursuant to an Administration Agreement. The services provided under the
Administration Agreement are subject to the supervision of the officers and the
Board of Directors of the Fund, and include day-to-day administration of
matters related to the corporate existence of the Fund, maintenance of its
records, preparation of reports, supervision of the Fund's arrangements with
its custodian, and assistance in the preparation of the Fund's registration
statements under federal and state laws. The Administration Agreement also
provides that the Administrator through its agents will provide the Fund with
dividend disbursing and transfer agent services. For its services under the
Administration Agreement, the Fund pays MSAM a monthly fee which on an annual
basis equals 0.25% of the average daily net assets of the Portfolio.
MSAM has entered into a Sub-Administration Agreement with Chase Global Funds
Services Company ("Chase Global"), a corporate affiliate of The Chase Manhattan
Bank ("Chase"), pursuant to which Chase Global has agreed to provide certain
administrative services to the Fund. MSAM supervises and monitors such
administrative services provided by Chase Global. The services provided under
the Administration Agreement and the Sub-Administration Agreement are also
subject to the supervision of the Board of Directors of the Fund. The Board of
Directors of the Fund has approved the provision of services described above
pursuant to the Administration Agreement and the Sub-Administration Agreement
as being in the best interests of the Fund. Chase Global's business address is
73 Tremont Street, Boston, Massachusetts 02108-3913. For additional information
regarding the Administration Agreement or the Sub-Administration Agreement, see
"Management of the Fund" in the SAI.
Chase Global calculates the net asset value ("NAV") and dividends, maintains
the general accounting records and administers the securities lending program
for the Portfolio.
CUSTODIANS. Chase serves as the custodian of domestic securities and cash of
the Portfolio. Chase is not an affiliate of either MSAM or Morgan Stanley.
Morgan Stanley Trust Company, Brooklyn, New York ("MSTC"), an affiliate of MSAM
and Morgan Stanley, acts as the Fund's custodian for foreign assets held
outside the United States and employs sub-custodians approved by the Board of
Directors of the Fund in accordance with regulations of the SEC for the purpose
of providing custodial services for such assets. MSTC may also hold certain
domestic assets for the Fund. For more information on the custodians, see
"General Information--Custody Arrangements" in the SAI.
DIVIDEND DISBURSING AND TRANSFER AGENT. CGFSC acts as dividend disbursing and
transfer agent for the Fund.
INDEPENDENT ACCOUNTANTS. Price Waterhouse LLP serves as independent accountants
for the Fund and will audit the annual financial statements of the Portfolio.
LEGAL COUNSEL. Morgan, Lewis & Bockius LLP serves as legal counsel to the Fund.
BREAKDOWN OF EXPENSES
The Portfolio pays fees and other costs related to its daily operations.
Expenses paid out of the Portfolio's assets are reflected in its share price.
The Portfolio pays a management fee to MSAM for managing its investments and
business affairs. MSAM pays fees to affiliates who provide assistance with
these services. The Portfolio also pays other expenses, which are explained
below. MSAM may, from time to time, reduce its fees or reimburse the Portfolio
for expenses above a specified limit. These fee reductions or expense
reimbursements, which may be terminated at any time without notice, can
decrease the Portfolio's expenses and boost its performance.
18
<PAGE>
MANAGEMENT FEE
The Adviser is entitled to receive from the Portfolio a management fee, payable
quarterly, at an annual rate as a percentage of average daily net assets as
follows: 1.25% of the first $500 million, 1.20% of the next $500 million, and
1.15% of net assets in excess of $1 billion.
However, MSAM has agreed to a reduction in its management fees and to reimburse
the Portfolio, if necessary, if such fees would cause the total annual
operating expenses of the Portfolio to exceed 1.75% of average daily net
assets.
OTHER EXPENSES
In addition to investment advisory and certain administrative expenses charged
by the administrator of the Portfolio, the Portfolio pays all expenses not
assumed by MSAM. Such expenses include or could include investment-related
expenses, such as brokers' commissions, transfer taxes and fees related to the
purchase, sale, or loan of securities; fees and expenses for Directors not
affiliated with MSAM; fees and expenses of its independent accountants and
legal counsel; costs of Director and shareholder meetings; SEC fees; expenses
of preparing and filing registration statements; the cost of providing proxy
statements, prospectuses and statements of additional information to existing
variable annuity contract and variable life insurance policy owners; expenses
of preparing and printing the annual and semiannual shareholder reports to
variable annuity contract and variable life insurance policy owners; bank
transaction charges and certain custodians' fees and expenses; federal, state
or local income or other taxes; costs of maintaining the Portfolio's corporate
existence; membership fees for the Investment Company Institute and similar
organizations; fidelity bond and Directors' liability insurance premiums; and
any extraordinary expenses such as indemnification payments or damages awarded
in litigation or settlements made. All these expenses that are incurred by the
Portfolio will be passed on to the shareholders through a daily charge made to
the assets held in the Portfolio, which will be reflected in the share price.
PERFORMANCE OF THE PORTFOLIO
The Portfolio's total return may be quoted in advertising if accompanied by
performance of your insurance company's separate account. Performance is based
on historical results and is not intended to indicate future performance. For
additional performance information, contact your insurance company for a free
annual report.
TOTAL RETURN is the change in value of an investment in the Portfolio over a
given period, assuming reinvestment of any dividends and capital gains. A
cumulative total return reflects actual performance over a stated period of
time. An average annual total return is a hypothetical rate of return that, if
achieved annually, would have produced the same cumulative total return if
performance had been constant over the entire period. Average annual total
returns smooth out variations in performance; they are not the same as actual
year-by-year results.
Average annual total returns covering periods of less than one year assume that
performance will remain constant for the rest of the year.
Total return quoted for the Portfolio includes the Portfolio's expenses, but
may not include charges and expenses attributable to any particular insurance
product. Since shares of the Portfolio may be purchased only through variable
annuity contracts and variable life insurance policies and by tax qualified
investors, such as qualified pension and retirement plans, you should carefully
review the prospectus of the insurance product you have chosen for information
on relevant charges and expenses. Excluding these charges from quotations of
the Portfolio's performance has the effect of increasing the performance
quoted. You should bear in mind the effect of these charges when comparing the
Portfolio's performance to that of other mutual funds.
19
<PAGE>
PERFORMANCE OF MSAM
MSAM manages a portfolio of Morgan Stanley Institutional Fund, Inc. ("MSIF")
which served as the model for the Portfolio of the Fund. The portfolio of MSIF
has substantially the same investment objectives and policies as the Portfolio
of the Fund. In addition, MSAM intends the Portfolio of the Fund and the
corresponding portfolio of MSIF to be managed by the same personnel and to
continue to have closely similar investment strategies, techniques, and
characteristics. The Emerging Markets portfolio of MSIF corresponds to the
Portfolio and is the MSIF portfolio from which the Portfolio is cloned.
Past investment performance of the MSIF portfolio, as shown in the table below,
may be relevant to your consideration of the Portfolio. The investment
performance of the MSIF portfolio is not necessarily indicative of future
performance of the Portfolio. Also, the operating expenses of the Portfolio
will be different from, and may be higher than, the operating expenses of the
corresponding MSIF portfolio. The investment performance of the MSIF
portfolio is provided merely to indicate the experience of MSAM in managing a
similar portfolio.
<TABLE>
<CAPTION>
SINCE INCEPTION SINCE INCEPTION
SIX MONTHS ONE YEAR (9/25/92) (9/25/92)
CUMULATIVE CUMULATIVE CUMULATIVE AVERAGE ANNUAL
TOTAL RETURN TOTAL RETURN TOTAL RETURN TOTAL RETURN
FUND ENDED ENDED ENDED ENDED
NAME 6/30/96 6/30/96 6/30/96 6/30/96
-------- ------------ ------------ --------------- ---------------
<S> <C> <C> <C> <C>
MSIF:
Emerging
Markets 20.32% 13.41% 80.08% 16.93%
</TABLE>
ACCOUNT POLICIES
- ----------------
DISTRIBUTIONS AND TAXES
The Fund intends the Portfolio to qualify as a separate entity under the
Internal Revenue Code of 1986, as amended (the "Code"), and to qualify as a
"regulated investment company" under Subchapter M of the Code. As a regulated
investment company under the Code, net income and net realized gains of the
Portfolio will be distributed to shareholders at least once a year.
As stated on the cover of this prospectus, shares of the Portfolio will be
purchased by life insurance companies for their separate accounts under
variable annuity contracts and variable life insurance policies and by other
entities under qualified pension and retirement plans. Under the provisions of
the Code currently in effect, net income and realized capital gains are not
currently taxable when left to accumulate within a variable annuity contract or
variable life insurance policy or under a qualified pension or retirement plan.
For information on federal income taxation of a life insurance company with
respect to its receipt of distributions from the Fund and federal income
taxation of owners of variable annuity contracts or variable life insurance
policies, refer to the life insurance company's variable annuity contract or
variable life insurance policy prospectus.
TRANSACTION DETAILS
THE PORTFOLIO IS OPEN FOR BUSINESS each day the New York Stock Exchange
("NYSE") is open. The Portfolio's NAV is determined as of the close of business
of the NYSE (normally 4:00 p.m. Eastern time) on each day that the NYSE is open
for business. The NYSE is currently scheduled to be closed on New Year's Day,
Washington's Birthday, 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.
THE PORTFOLIO'S NAV is the value of a single share. The NAV is computed by
adding the value of the Portfolio's investments, cash and other assets,
subtracting its liabilities, and then dividing the result by the number of
shares outstanding.
The Portfolio's assets are valued primarily on the basis of market quotations.
Foreign securities are valued on the basis of quotations from the primary
market in which they are traded, and are translated from the local currency
into U.S. dollars using current exchange rates. If quotations are not readily
available or if the values have been materially affected by events occurring
after the closing of a foreign market, assets are valued by a method that the
Fund's Board of Directors believes accurately reflects fair value.
THE PORTFOLIO'S OFFERING PRICE (price to buy one share) and REDEMPTION PRICE
(price to sell one share) are its NAV.
THE PORTFOLIO RESERVES THE RIGHT TO SUSPEND THE OFFERING OF SHARES for a period
of time. The Portfolio also reserves the right to reject any specific order.
Purchase orders may be refused if, in MSAM's opinion, they would disrupt
management of the Portfolio.
20
<PAGE>
INVESTMENTS AND REDEMPTIONS. Investments may be made only by separate accounts
established and maintained by insurance companies for the purpose of funding
variable annuity contracts and variable life insurance policies and by tax
qualified investors, such as qualified pension and retirement plans. Please
refer to the prospectus of your insurance company's separate account or the
qualified plan documents for information on how to invest in and redeem shares
of the Portfolio.
Each participating insurance company receives orders from its variable annuity
contract and variable life insurance policy owners to purchase or redeem shares
of the Portfolio each business day. That night, all orders received by that
insurance company on that business day are aggregated, and the insurance
company places a net purchase or redemption order for shares of the Portfolio
the morning of the next business day. These orders are normally executed at the
NAV that was computed at the close of the previous business day in order to
provide a match between the variable contract and policy owners' orders to the
insurance companies and the insurance companies' orders to the Portfolio. In
some cases, an insurance company's orders for Portfolio shares may be executed
at the NAV next computed after the order is actually transmitted to the
Portfolio.
Redemption proceeds will normally be wired to the insurance company on the next
business day after receipt of the redemption instructions by the Portfolio but
in no event later than seven days following receipt of instructions. The
Portfolio may suspend redemptions or postpone payment dates on days when the
NYSE is closed (other than weekends or holidays), when trading on the NYSE is
restricted, or as permitted by the SEC.
21
<PAGE>
MORGAN STANLEY UNIVERSAL FUNDS, INC.
P.O. BOX 2798, BOSTON, MA 02208-2798
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 CONTRACTS AND VARIABLE LIFE INSURANCE POLICIES AND
BY CERTAIN TAX-QUALIFIED INVESTORS. THE VARIABLE ANNUITY CONTRACT AND VARIABLE
LIFE INSURANCE POLICY HOLDERS 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 MARCH 26, 1996. THE FUND FILED A REGISTRATION STATEMENT WITH THE
SECURITIES AND EXCHANGE COMMISSION (THE "COMMISSION") 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 AN "ADVISER") OR MILLER ANDERSON & SHERRERD, LLP ("MAS" OR AN
"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 FOR THE FUND'S PORTFOLIO(S) (THE
"PROSPECTUS"). THIS STATEMENT OF ADDITIONAL INFORMATION IS INCORPORATED BY
REFERENCE INTO THE PROSPECTUS IN ITS ENTIRETY. TO OBTAIN THE PROSPECTUS, PLEASE
CONTACT THE FUND OR YOUR INSURANCE COMPANY.
TABLE OF CONTENTS
<TABLE>
<S> <C>
SECURITIES AND INVESTMENT TECHNIQUES 2
TAXES 12
PURCHASE OF SHARES 14
REDEMPTION OF SHARES 14
INVESTMENT LIMITATIONS 14
DETERMINING MATURITIES OF CERTAIN INSTRUMENTS 15
MANAGEMENT OF THE FUND 16
NET ASSET VALUE FOR THE MONEY MARKET PORTFOLIO 20
PERFORMANCE INFORMATION 20
GENERAL INFORMATION 24
DESCRIPTION OF CERTAIN SECURITIES AND RATINGS 24
FINANCIAL STATEMENTS 30
</TABLE>
Statement of Additional Information dated October 1, 1996, relating to:
Prospectus dated October 1, 1996, for the Money Market, Fixed Income, High
Yield Equity, 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
Prospectus dated October 1, 1996, for the Emerging Markets Equity Portfolio.
<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,
International Fixed Income, Balanced and Multi-Asset-Class Portfolios.
The following discussion of the securities and investment techniques
supplements the discussion of investment policies, securities and investment
techniques set forth 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 each 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 market 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.
BRADY BONDS. The Fixed Income, High Yield, International Fixed Income,
Balanced, Multi-Asset-Class, Emerging Markets Equity 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 in recent years, 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
2
<PAGE>
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.
EURODOLLAR AND YANKEE DOLLAR OBLIGATIONS
Eurodollar bank obligations are dollar-denominated certificates of deposit and
time deposits issued outside the U.S. capital markets by foreign branches of
U.S. banks and by foreign banks. Yankee dollar bank obligations are dollar-
denominated obligations issued in the U.S. capital markets by foreign banks.
Eurodollar and Yankee dollar 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 dollar)
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 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.
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.
3
<PAGE>
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 liquid, unencumbered assets, the
value of which is marked to market daily, 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 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 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. 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.
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
4
<PAGE>
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. In addition, a
Portfolio may purchase and write call and put options on futures that are
traded on an international exchange, traded over-the-counter or which are
synthetic options or futures or equity swaps, and may 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 accumulated balance in the writer's futures margin
account is delivered to the option holder, 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.
Regulations of the CFTC applicable to the Portfolios permit the use of futures
transactions for bona fide hedging purposes without regard to the percentage of
assets committed to futures margins and for options premiums. In addition, CFTC
regulations also allow the Portfolios to employ futures transactions for other
non-hedging purposes to the extent that aggregate initial futures margins and
options premiums do not exceed 5% of the liquidation value of a Portfolio's
total assets. The Portfolios will only sell futures contracts to protect
securities owned against declines in price or purchase futures contracts to
protect against an increase in the price of securities intended for purchase.
As evidence of this hedging interest, 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. A Portfolio 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. In addition, the Emerging Markets
Equity Portfolio will not enter into any futures contract or option if
immediately thereafter the value of all the foreign currencies underlying its
futures contracts and foreign currency options would exceed 10% of the value of
its 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.
5
<PAGE>
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 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 Balanced, Emerging Markets Debt, Emerging Markets Equity, Fixed Income,
High Yield and Multi-Asset-Class Portfolios may invest in loans and other
direct debt instruments ("Loans") from third parties ("Lenders"). A 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 portions
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. The Emerging Markets Equity and Emerging Markets
Debt Portfolio may invest in fixed and floating rate loans arranged through
private negotiations between an issuer of sovereign debt obligations and one or
more financial institutions.
6
<PAGE>
When a 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 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 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 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 stated 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 a
listed put option would give each Portfolio the right to sell the underlying
security or currency to the clearing corporation or exchange at the stated
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 or 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 intermediary 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 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 in a segregated account a
sufficient amount of cash, cash equivalents or liquid securities to purchase
the underlying security. When
7
<PAGE>
the Portfolio writes covered call options, it augments its income by the
premiums received 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 in a segregated account an
amount of 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. When each Portfolio
purchases a call option it acquires the right to purchase a designated security
at a designated price (the "exercise price"), and when each Portfolio purchases
a put option it acquires the right to sell 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 other securities and
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 Securities and Exchange Commission (the "Commission"). In an over-
the-counter trading environment, many of the protections associated with
transactions on exchanges will
8
<PAGE>
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.
PORTFOLIO TURNOVER
The portfolio turnover rate for a year is calculated by dividing the lesser of
the value of the purchases or sales for the year by the average monthly market
value of the Portfolio for the year, excluding from this calculation securities
with maturities of one year or less. The rate of portfolio turnover will not be
a limiting factor when a Portfolio deems it appropriate to purchase or sell
securities for the Portfolio. However, the U.S. federal tax requirement that a
Portfolio derive less than 30% of its gross income from the sale or disposition
of securities held less than three months may limit a Portfolio's ability to
dispose of its securities. For additional information, see "Taxes".
REPURCHASE AGREEMENTS
Each Portfolio may invest in repurchase agreements collateralized by liquid,
unencumbered assets, the value of which is marked to market daily. 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
9
<PAGE>
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 Portfolio's Adviser and the 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 1940 Act or the Rules and Regulations or
interpretations of the Commission thereunder, which currently require that (a)
the borrower pledge and maintain with the Portfolio collateral consisting of
liquid, unencumbered assets 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. 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, Fixed Income, High Yield, Core Equity, Value, Mid
Cap Growth, Mid Cap Value, International Fixed Income, Balanced and Multi-
Asset-Class Portfolios may from time to time sell securities short without
limitation but consistent with applicable legal requirements. 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. The 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.
The 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 liquid unencumbered assets. 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 unencumbered liquid assets
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 unencumbered liquid assets
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
10
<PAGE>
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 the 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.
STRUCTURED SECURITIES
Each of the Fixed Income, Balanced, International Fixed Income, Multi-Asset-
Class, High Yield, Emerging Markets Equity, 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.
SWAP CONTRACTS
The Fixed Income, High Yield, Value, Core Equity, Mid Cap Growth, Mid Cap
Value, International Fixed Income, Emerging Markets Debt, Emerging Markets
Equity, 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
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 unencumbered liquid assets, 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
11
<PAGE>
1940 Act 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 that have a 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
The Portfolios may invest in zero coupon bonds. 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. With
respect to U.S. Governments, as defined in the Prospectus, the timely payment
of coupon interest and principal on these instruments remains guaranteed by the
"full faith and credit" of the United States Government.
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 accreted interest an investor will earn if the security is held
until maturity. For tax purposes, a portion of this accreted 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.
With respect to U.S. Governments, Zero Coupon 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 (STRIPS) and Treasury Investment Growth Receipts (TIGERS).
TAXES
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.
The Fund intends that each of its Portfolios 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, 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.
12
<PAGE>
In addition to the requirements described above, in order to qualify as a RIC,
each Portfolio must distribute at least 90% of each Portfolio's 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.
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.
Dividends declared by the Fund 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 Fund and received by the shareholders on December 31 of
that year if paid by the Fund at any time during the following January.
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.
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 Fund may elect to treat certain foreign income taxes
imposed on a Portfolio for United States federal income tax purposes as paid
directly by its shareholders. The Fund will make such an election for a
Portfolio 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 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
13
<PAGE>
itemize deductions, a deduction, for their shares of the foreign income taxes.
The foregoing is a summary of certain additional federal income tax
considerations generally affecting the Fund and its shareholders. It does not
constitute 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.
Shares of the Portfolios will be purchased by life insurance companies for
their separate accounts under variable annuity contracts and variable life
insurance policies and by other entities under qualified pension and retirement
plans. Under the provisions of the Code currently in effect, net income and
realized capital gains of Portfolios of the Fund are not currently taxable when
left to accumulate within a variable annuity contract or variable life
insurance policy or under a qualified pension or retirement plan.
For information on federal income taxation of a life insurance company's with
respect to its receipt of distributions from the Fund and federal income
taxation of owners of the company's variable annuity contracts or variable life
insurance policies, refer to the life insurance company's variable annuity
contract or variable life insurance policy prospectus.
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 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 to suspend the
offering of its shares and to reject purchase orders when in the judgment of
management such rejection is in the best interest of the Portfolio.
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, and subject to applicable agreements with
life insurance companies and entities qualified under qualified pension and
profit sharing plans, 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.
INVESTMENT LIMITATIONS
FUNDAMENTAL 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 futures contracts or options thereon 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
14
<PAGE>
(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 in an amount
not in excess of 33 1/3% of its total assets (including the amount borrowed)
less liabilities;
(6)underwrite securities issued by others, except to the extent that the
Portfolio may be considered an underwriter within the meaning of the Securities
Act of 1933, as amended (the "1933 Act") in the disposition of restricted
securities; and
(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,
that (i) 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; (ii)
utility companies will be divided according to their services, for example,
gas, gas transmission, electric and telephone will each be considered a
separate industry; (iii) financial service companies will be classified
according to the end users of their services, for example, automobile finance,
bank finance and diversified finance will each be considered a separate
industry; and (iv) Asset-Backeds will be classified according to the underlying
assets securing such securities; and provided further that the U.S. Real Estate
Portfolio may invest more than 25% of its total assets in the U.S. real estate
industry.
NON-FUNDAMENTAL LIMITATIONS
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)sell short (other than "against the box") unless the Portfolio's obligation
is covered by unencumbered liquid assets in a segregated account and by
collateral held by the lending broker; provided that transactions in futures
contracts and options are not deemed to constitute selling securities short;
(2)invest for the purpose of exercising control over management of any company;
(3)invest its assets in securities of any investment company except as may be
permitted by the 1940 Act;
(4)invest more than an aggregate of 15% of the net assets of the Portfolio (10%
in the case of the Money Market Portfolio), determined at the time of
investment, in illiquid securities.
(5)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;
(6)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; and
(7) except in the case of the Emerging Markets Debt Portfolio, borrow money,
other than temporarily or for extraordinary or emergency purposes 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.
The investments of life insurance company separate accounts made under variable
annuity contracts and variable life insurance policies are subject to state
insurance laws and regulations. The Fund and its Portfolios will, when
required, comply with investment restrictions imposed under such laws and
regulations on life insurance company separate accounts investing in the
Portfolios.
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
15
<PAGE>
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: (a) 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 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. In addition, for securities
that are subject to prepayments, the weighted average life of the security will
be used in the weighted average maturity calculation instead of the stated
maturity date on the instrument. The weighted average life of a security takes
into consideration the impact of prepayments on the length of time the security
will be outstanding and typically indicates an actual maturity that is shorter
than the maturity date stated on the face of the instrument.
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. 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. Three
Directors and all of the officers of the Fund are directors, officers or
employees of the Fund's advisers, distributor or administrators. 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>
Name, Address and
Date of Birth Position with Fund Principal Occupation During Past Five Years
----------------- ---------------------------- -------------------------------------------
<S> <C> <C>
Barton M. Biggs* Chairman and Director Chairman and Director of Morgan Stanley
1221 Avenue of the Asset Management Inc. and Morgan Stanley
Americas Asset Management Limited; Managing Director
New York, NY 10020 of Morgan Stanley & Co. Incorporated;
11/26/32 Director of Morgan Stanley Group Inc.;
Member of Investment Advisory Counsel of
the Thailand Fund; Director of the Rand
McNally Company; Member of the Yale
Development Board; Director and Officer of
various investment companies managed by
Morgan Stanley Asset Management Inc.
Thomas L. Bennett* Director Chairman of the Board of Trustees, MAS
One Tower Bridge Funds; Member of the Executive Committee,
West Conshohocken, PA Miller Anderson & Sherrerd, LLP; Managing
19428 Director of Morgan Stanley Asset Management
10/4/47 Inc.; Director, MAS Fund Distribution, Inc.
Warren J. Olsen* Director and President Principal of Morgan Stanley Asset
1221 Avenue of the Management Inc.; President and Director of
Americas various investment companies managed by
New York, NY 10020 Morgan Stanley Asset Management Inc.
12/21/56
John D. Barrett, II Director Chairman and Director of Barrett
521 Fifth Avenue Associates, Inc. (investment counseling);
New York, NY 10135 Director of the Ashforth Company (real
8/21/35 estate); Director of the Morgan Stanley
Fund, Inc., Morgan Stanley Institutional
Fund, Inc. and PCS Cash Fund, Inc.
</TABLE>
16
<PAGE>
<TABLE>
<CAPTION>
Name, Address and
Date of Birth Position with Fund Principal Occupation During Past Five Years
----------------- ---------------------------- -------------------------------------------
<S> <C> <C>
Gerard E. Jones Director Partner in Richards & O'Neil LLP (law
43 Arch Street firm); Director of the Morgan Stanley Fund,
Greenwich, CT 06830 Inc., Morgan Stanley Institutional Fund,
1/23/37 Inc. and PCS Cash Fund, Inc.
Andrew McNally IV Director Chairman and Chief Executive Officer of
8255 North Central Rand McNally (publication); Director of
Park Avenue Allendale Insurance Co., Mercury Finance
Skokie, IL 60076 (consumer finance); Zenith Electronics,
11/11/39 Hubbell, Inc. (industrial electronics);
Director of the Morgan Stanley Fund, Inc.,
Morgan Stanley Institutional Fund, Inc. and
PCS Cash Fund, Inc.
Samuel T. Reeves Director Chairman of the Board and CEO, Pinacle
8211 North Fresno Street Trading L.L.C. (investment firm); Director,
Fresno, CA 93720 Pacific Gas and Electric and PG&E
7/28/34 Enterprises (utilities); Director of the
Morgan Stanley Fund, Inc., Morgan Stanley
Institutional Fund, Inc. and PCS Cash Fund,
Inc.
Fergus Reid Director Chairman and Chief Executive Officer of
85 Charles Colman Blvd LumeLite Corporation (injection molding
Pawling, NY 12564 firm); Trustee and Director of Vista Mutual
8/12/32 Fund Group; Director of the Morgan Stanley
Fund, Inc., Morgan Stanley Institutional
Fund, Inc. and PCS Cash Fund, Inc.
Frederick O. Robertshaw Director Of Counsel, Copple, Chamberlin & Boehm,
2800 North Central P.C. and Rake, Copple, Downey & Black, P.C.
Avenue (law firms); Director of the Morgan Stanley
Phoenix, AZ 85004 Fund, Inc., Morgan Stanley Institutional
1/24/34 Fund, Inc. and PCS Cash Fund, Inc.
Frederick B. Whittemore* Director Advisory Director of Morgan Stanley & Co.
1221 Avenue of the Incorporated; Vice-Chairman and Director of
Americas, various investment companies managed by
30th Flr. Morgan Stanley Asset Management Inc.
New York, NY 10020
11/12/30
Michael F. Klein* Vice President Vice President of Morgan Stanley Asset
1221 Avenue of the Management Inc.; Officer of various
Americas investment companies managed by Morgan
New York, NY 10020 Stanley Asset Management Inc. Previously
12/12/58 practiced law with the New York law firm of
Rogers & Wells.
Douglas W. Kugler* Vice President Treasurer, MAS Funds; Manager of Mutual
One Tower Bridge Fund Administration, Miller Anderson &
West Conshohocken, PA Sherrerd, LLP; Vice President of Morgan
19428 Stanley Asset Management Inc.; formerly
11/19/61 Assistant Vice President, Provident
Financial Processing Corporation.
Harold J. Schaaff, Jr.* Vice President Principal of Morgan Stanley & Co.
1221 Avenue of the Amer- Incorporated; General Counsel and Secretary
icas of Morgan Stanley Asset Management Inc.;
New York, NY 10020 Officer of various investment companies
6/10/60 managed by Morgan Stanley Asset Management
Inc.
Joseph P. Stadler* Vice President Vice President of Morgan Stanley Asset
1221 Avenue of the Amer- Management Inc.; Previously with Price
icas Waterhouse LLP (accounting); Officer of
New York, NY 10020 various investment companies managed by
6/7/54 Morgan Stanley Asset Management Inc.
</TABLE>
17
<PAGE>
<TABLE>
<CAPTION>
Name, Address and
Date of Birth Position with Fund Principal Occupation During Past Five Years
----------------- ---------------------------- -------------------------------------------
<S> <C> <C>
Lorraine Truten* Vice President Vice President, MAS Funds; Head of Mutual
One Tower Bridge Fund Administration, Miller Anderson &
West Conshohocken, PA Sherrerd, LLP; Principal of Morgan Stanley
19428 Asset Management Inc.; President, MAS Fund
5/11/61 Distribution, Inc.
Valerie Y. Lewis* Secretary Vice President of Morgan Stanley Asset
1221 Avenue of the Amer- Management Inc.; Previously with Citicorp
icas (banking); Officer of various investment
New York, NY 10020 companies managed by Morgan Stanley Asset
3/26/56 Management Inc.
Karl O. Hartmann* Assistant Secretary Senior Vice President, Secretary and
73 Tremont Street General Counsel of Chase Global Funds
Boston, MA 02108-3913 Services Company; Previously with Leland,
3/7/55 O'Brien, Rubinstein Associates, Inc.
(investments).
James R. Rooney* Treasurer Vice President, Chase Global Funds Services
73 Tremont Street Company; Director of Fund Administration;
Boston, MA 02108-3913 Officer of various investment companies
10/21/58 managed by Morgan Stanley Asset Management
Inc.; Previously with Scudder, Stevens &
Clark, Inc. (investments) and Ernst & Young
LLP (accounting).
Joanna Haigney* Assistant Treasurer Supervisor of Fund Administration and
73 Tremont Street Compliance, Chase Global Funds Services
Boston, MA 02108-3913 Company; Previously with Coopers & Lybrand
10/10/66 LLP; Officer of various investment
companies managed by Morgan Stanley Asset
Management Inc.
</TABLE>
- -------
* "Interested Person" within the meaning of the 1940 Act.
18
<PAGE>
REMUNERATION OF DIRECTORS AND OFFICERS
Members of the Board of Directors who are not "interested persons" within the
meaning of the 1940 Act ("Noninterested Directors") receive compensation from
the Fund (beginning August 15, 1996) and from other investment companies
advised by MSAM or MAS (or by affiliated companies) (the Fund and such other
investment companies are referred to as the "Fund Complex"). The open-end
investment companies in the Fund Complex pay each of the Noninterested
Directors an annual aggregate fee of $65,000, plus out-of-pocket expenses, and
pay each of the Noninterested Directors on the Board Audit Committees an
additional annual aggregate fee of $10,000 for serving on such committees. The
aggregate of such fees for each Noninterested Director is allocated among the
open-end investment companies in direct proportion to their respective average
annual net assets. The following table sets forth the portions of the annual
aggregate fees estimated to be paid by the Fund and by the Fund Complex to
each Director during the period August 15, 1996 to December 31, 1996 (the end
of the Fund's fiscal year). Directors who are officers or otherwise
"interested persons" receive no renumeration for their services as Directors.
COMPENSATION TABLE
<TABLE>
<CAPTION>
(5)
Total
(3) (4) Compensation
(2) Pension or Estimated From Fund
Aggregate Retirement Annual and Fund
(1) Compensation Benefits Accrued Benefits Complex
Name of From as Part of Fund Upon Paid to
Director Fund(a) Expenses Retirement Directors(b)
-------- ------------ ---------------- ---------- ------------
<S> <C> <C> <C> <C>
Barton M. Biggs $ 0 $0 $0 $ 0
Warren J. Olsen 0 0 0 0
Thomas L. Bennett 0 0 0 0
John D. Barrett, II(c) 34 0 0 28,484(d)
Gerard E. Jones,(c) 34 0 0 31,408(d)(e)
Andrew McNally, IV 29 0 0 24,686(d)
Director
Samuel T. Reeves 29 0 0 24,686(d)
Fergus Reid(c) 34 0 0 31,408(d)(e)
Frederick O. Robertshaw 29 0 0 24,686(d)
Frederick B. Whittemore 0 0 0 0
</TABLE>
- -------
(a) Amounts are allocated based on estimated average net assets of $10,000,000
for the Fund for the period August 15, 1996 to December 31, 1996 and on
actual average net assets of the other open-end investment companies
during the period January 1, 1996 to September 12, 1996. Amounts do not
include reimbursement of out-of-pocket expenses.
(b) Estimated amounts are based on estimated average net asset of $10,000,000
for the Fund for the period August 15, 1996 to December 31, 1996 and on
actual average net assets of the other open-end investment companies
during the period January 1, 1996 to September 12, 1996. Amounts do not
include reimbursement of out-of-pocket expenses, but include $24,657,
$24,657 and $28,450 of deferred compensation for Messrs. McNally, Reeves
and Reid, respectively, assuming these Directors continue to defer for the
remainder of 1996.
(c) Member of Audit Committee of the Board of Directors of the Fund.
(d) Number of other investment companies in Fund Complex from whom Director is
expected to receive compensation: Mr. Barrett--3; Mr. Jones--4; Mr.
McNally--3; Mr. Reeves--3; Mr. Reid--4; Mr. Robertshaw--3.
(e) Includes amounts paid for service as Director of a closed-end investment
company in the Fund Complex, in addition to amounts paid by the open-end
investment companies.
19
<PAGE>
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 restrict the personal investing activities
of all employees of each 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 that
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.
CONTROL PERSONS AND PRINCIPAL HOLDERS OF SECURITIES
As of the date of this statement of additional information, MSAM, 1221 Avenue
of the Americas, New York, New York 10020, a Delaware corporation, is the
record and beneficial owner of 100% of the outstanding shares of the Emerging
Markets Equity Portfolio of the Fund. MSAM is a wholly owned subsidiary of
Morgan Stanley Group Inc., which is a publicly owned financial service
corporation listed on the New York, London and Pacific stock exchanges.
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
a 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 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
20
<PAGE>
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 return 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
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 Funds, 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:
21
<PAGE>
(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.
(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 stocks. 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).
(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 which
includes Australia, Belgium, Canada, Denmark, France, Germany, Italy, Japan,
The Netherlands, Spain, Sweden, United Kingdom and the United States.
22
<PAGE>
(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 greater.
(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.
(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)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.
(dd)Salomon Brothers GNMA Index--includes pools of mortgages originated by
private lenders and guaranteed by the mortgage pools of the Government National
Mortgage Association.
(ee)Salomon Brothers High Grade Corporate Bond Index--consists of publicly
issued, non-convertible corporate bonds rated AA or AAA. It is a value-
weighted, total return index, including approximately 800 issues with
maturities of 12 years or greater.
(ff)Salomon Brothers Broad Investment Grade Bond Index--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.
(gg)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.
(hh)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.
23
<PAGE>
(ii)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
The Chase Manhattan Bank ("Chase") serves as the Fund's domestic custodian.
Chase is not affiliated with Morgan Stanley & Co. Incorporated. Morgan Stanley
Trust Company, Brooklyn, New York, acts as the Fund's custodian for foreign
assets held outside the United States and employs sub-custodians who have been
or will be 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
sub-custodians, 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 CERTAIN SECURITIES AND RATINGS
I. 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
24
<PAGE>
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 Association, 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 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.
II. 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 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
25
<PAGE>
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.
III. 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, mortgage 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 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, FNMA 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 has 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
26
<PAGE>
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; 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
27
<PAGE>
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 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.
IV. 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, International Fixed Income, 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, Multi-Asset-
Class, International Fixed Income, Emerging Markets Debt 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.
V. 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.
VI. DESCRIPTION OF MOODY'S CORPORATE BOND RATINGS:
AAA -- Bonds rated Aaa are judged to be of the best quality. They carry the
smallest degree of investment risk and are generally referred to as "gilt-
edge." Interest payments are protected by a large or by an exceptionally stable
margin and principal is secure. While the various protective elements are
likely to change, such changes as can be visualized are most unlikely to impair
the fundamentally strong position of such issues.
AA -- Bonds rated Aa are judged to be of high quality by all standards.
Together with the Aaa group they comprise what are generally known as high-
grade bonds. They are rated
28
<PAGE>
lower than the best bonds because margins of protection may not be as large as
for Aaa securities or fluctuation of protective elements may be of greater
amplitude or there may be other elements present which make the long-term risks
appear somewhat larger than in Aaa securities.
A -- Bonds rated A possess many favorable investment attributes and are to be
considered as upper medium grade obligations. Factors giving security to
principal and interest are considered adequate but elements may be present
which suggest a susceptibility to impairment sometime in the future.
BAA -- Bonds rated Baa are considered as medium-grade obligations, i.e., they
are neither highly protected nor poorly secured. Interest payments and
principal security appear adequate for the present but certain protective
elements may be lacking or may be characteristically unreliable over any great
length of time. Such bonds lack outstanding investment characteristics and in
fact have speculative characteristics as well.
BA -- Bonds rated Ba are judged to have speculative elements. Their future
cannot be considered as well assured. Often the protection of interest and
principal payments may be very moderate and thereby not well safeguarded during
both good and bad times over the future. Uncertainty of position characterizes
bonds in this class.
B -- Bonds rated B generally lack characteristics of the desirable investment.
Assurance of interest and principal payments or of maintenance of other terms
of the contract over any long period of time may be small.
CAA -- Bonds rated Caa are of poor standing. Such issues may be in default or
there may be present elements of danger with respect to principal or interest.
CA -- Bonds rated Ca represent obligations which are speculative in a high
degree. Such issues are often in default or have other marked short-comings.
C -- Bonds rated C are the lowest-rated class of bonds and issued so rated can
be regarded as having extremely poor prospects of ever attaining any real
investment standing.
Moody's applies numerical modifiers 1, 2 and 3, in each generic rating
classification from Aa through B in its corporate bond rating system. The
modifier 1 indicates that the security ranks in the higher end of its generic
rating category; the modifier 2 indicates a mid-range ranking; and the modifier
3 indicates that the issue ranks in the lower end of its generic rating
category.
VII. DESCRIPTION OF S&P'S CORPORATE BOND RATINGS:
AAA -- Debt rated AAA has the highest rating assigned by S&P's to a debt
obligation. Capacity to pay interest and repay principal is extremely strong.
AA -- Debt rated AA has a very strong capacity to pay interest and repay
principal and differs from the higher-rated issues only in small degree.
A -- Debt rated A has a strong capacity to pay interest and repay principal
although it is somewhat more susceptible to the adverse effects of changes in
circumstances and economic conditions.
BBB -- Debt rated BBB is regarded as having an adequate capacity to pay
interest and repay principal. Whereas it normally exhibits adequate protection
parameters, adverse economic conditions or changing circumstances are more
likely to lead to a weakened capacity to pay interest and repay principal for
debt in this category than in higher rated categories.
BB -- Debt rated BB has less near-term vulnerability to default than other
speculative issues. However, it faces major ongoing uncertainties or exposure
to adverse business, financial, or economic conditions that could lead to
inadequate capacity to meet timely interest and principal payments.
B -- Debt rated B has greater vulnerability to default but currently has the
capacity to meet interest payments and principal repayments. Adverse business,
financial, or economic conditions will likely impair capacity or willingness to
pay interest and repay principal. The B rating category is also used for debt
subordinated to senior debt that is assigned an actual or implied BB- rating.
CCC -- Debt rated CCC has a currently identifiable vulnerability to default,
and is dependent upon favorable business, financial, and economic conditions to
meet timely payment of interest and repayment of principal. In the event of
adverse business, financial, or economic conditions, it is not likely to have
the capacity to pay interest and repay principal.
CC -- Debt rated CC is typically applied to debt subordinated to senior debt
which is assigned an actual or implied CCC debt rating.
29
<PAGE>
C -- The rating C is typically applied to debt subordinated to senior debt
which is assigned an actual or implied CCC- debt rating. The C rating may be
used to cover a situation where a bankruptcy petition has been filed but debt
service payments are continued.
CI -- The rating CI is reserved for income bonds on which no interest is being
paid.
D -- Debt rated D is in payment default. The D rating category is used when
interest payments or principal payments are not made on the date due even if
the applicable grace period has not expired, unless S&P believes that such
payments will be made during such grace period. The D rating will also be used
upon the filing of a bankruptcy petition if debt service payments are
jeopardized.
FINANCIAL STATEMENTS
The initial statement of assets and liabilities of the Fund are set forth in
the following pages.
REPORT OF INDEPENDENT ACCOUNTANTS
To the Shareholder and Board of Directors of Morgan Stanley Universal Funds,
Inc.
In our opinion, the accompanying statement of assets and liabilities presents
fairly, in all material respects, the financial position of The Emerging
Markets Equity Portfolio of Morgan Stanley Universal Funds, Inc. (the "Fund")
at September 11, 1996 in conformity with generally accepted accounting
principles. This financial statement is the responsibility of the Fund's
management, our responsibility is to express an opinion on this financial
statement based on our audit. We conducted our audit of this financial
statement in accordance with generally accepted auditing standards which
require that we plan and perform the audit to obtain reasonable assurance about
whether the financial statement is free of material misstatement. An audit
includes examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statement, assessing the accounting principles
used and significant estimates made by management, and evaluating the overall
financial statement presentation. We believe that our audit provides a
reasonable basis for the opinion expressed above.
PRICE WATERHOUSE LLP
1177 Avenue of the Americas
New York, New York
September 13, 1996
30
<PAGE>
MORGAN STANLEY UNIVERSAL FUNDS, INC.
EMERGING MARKETS EQUITY PORTFOLIO
STATEMENT OF ASSETS AND LIABILITIES
SEPTEMBER 11, 1996
<TABLE>
<S> <C>
ASSETS
Assets
Cash............................................................... $100,000
----------
Deferred organization costs (Note 1)............................... 360,000
----------
Total Assets...................................................... 460,000
Liabilities:
Organization costs payable......................................... 360,000
----------
Commitments and contingencies (Note 2)
Net Assets:
Common Stock, $.001 par value, 500,000,000 shares authorized;
10,000 shares issued and outstanding.............................. 10
----------
Paid-in Surplus.................................................... 99,990
----------
Total Net Assets.................................................. $ 100,000
----------
Net Asset Value per share........................................... $ 10.00
==========
</TABLE>
NOTE 1: ORGANIZATION
Morgan Stanley Universal Funds, Inc. (the "Fund") was organized in Maryland on
March 26, 1996 and is registered with the Securities and Exchange Commission,
under the Investment Company Act of 1940, as amended, as an open-end management
investment company, with diversified and non-diversified series ("Portfolios").
The Fund had no operations other than the issuance of shares of its common
stock of the Emerging Markets Equity Portfolio to Morgan Stanley Asset
Management Inc. ("MSAM" ) on September 11, 1996. Organization costs estimated
at $360,000 will be deferred and amortized on a straight-line basis over a 60-
month period from the date the Fund commences operations. MSAM has agreed that
in the event any of its initial shares in the Fund are redeemed, the proceeds
on redemption will be reduced by the pro-rata portion of any unamortized
deferred organizational costs in the same proportion as the number of shares
redeemed bears to the initial shares held at the time of redemption.
NOTE 2: AGREEMENTS
The Fund intends to enter into an Investment Advisory Agreement with MSAM
pursuant to which MSAM will be responsible for providing investment management
services to the Fund with respect to the Emerging Markets Equity Portfolio.
For its services under the Investment Advisory Agreement, MSAM will receive an
annual fee, calculated daily and payable monthly, at the following rates: 1.25%
of the first $500 million of net assets; 1.20% of net assets from $500 million
to $1 billion; and 1.15% of net assets in excess of $1 billion.
The Fund intends to enter into an administrative agreement with MSAM pursuant
to which MSAM will provide administrative services to certain portfolios of the
Fund, including the Emerging Markets Equity Portfolio. For its administrative
services, MSAM will receive an annual fee of .25% of the average daily net
assets of the respective Portfolios of the Fund. MSAM intends to enter into a
sub-administration agreement with Chase Global Funds Services Company ("Chase
Global"), a subsidiary of The Chase Manhattan Bank ("Chase"), pursuant to which
Chase Global will provide certain transfer agent, fund accounting and
administrative services to the Fund with respect to the Emerging Markets Equity
Portfolio. Certain employees of MSAM and Chase Global are officers of the Fund.
The Fund also intends to enter into a custody agreement with Morgan Stanley
Trust Company (the "International Custodian") pursuant to which the
International Custodian will provide the Fund with custody services for the
Fund's assets held outside the United States. With respect to its assets in the
United States, the Fund intends to enter into another custody agreement with
Chase (in such capacity, the "U.S. Custodian"). The custody agreements with the
International Custodian and the U.S. Custodian provide for an annual fee based
on the amount of assets under custody, plus transactional fees. The Fund
intends to enter into a Distribution Agreement with Morgan Stanley & Co.
Incorporated ("Morgan Stanley") pursuant to which Morgan Stanley will serve as
the exclusive Distributor of the Fund and sell shares of each Portfolio upon
the terms described in the Fund's Prospectus.
31
