<PAGE>
SUPPLEMENT DATED OCTOBER 1, 1997
TO
STATEMENT OF ADDITIONAL INFORMATION DATED MAY 1, 1997
Previously Supplemented September 19, 1997
MORGAN STANLEY UNIVERSAL FUNDS, INC. (the "Fund")
P.O. BOX 2798
BOSTON, MA 02208-2798
-------------------
The Statement of Additional Information ("SAI") is being supplemented to
reflect the creation of an additional prospectus of the Fund. The following
sentence is added at the end of the second column on the first page of the SAI:
Prospectus dated October 1, 1997 for the High Yield, U.S. Real Estate,
Emerging Markets Debt and Asian Equity Portfolios.
-------------------
PLEASE RETAIN THIS SUPPLEMENT FOR FUTURE REFERENCE
<PAGE>
MORGAN STANLEY UNIVERSAL FUNDS, INC.
MORGAN STANLEY MILLER ANDERSON &
ASSET MANAGEMENT INC. SHERRERD, LLP
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
DESCRIBES FOUR PORTFOLIOS MANAGED BY EITHER MORGAN STANLEY ASSET MANAGEMENT
INC. ("MSAM") OR MILLER ANDERSON & SHERRERD, LLP ("MAS"). THE FUND MAKES
AVAILABLE IN A SINGLE PRODUCT THE COMBINED STRENGTH OF THESE LEADING INVESTMENT
MANAGEMENT FIRMS. THE FUND ALSO OFFERS THIRTEEN OTHER PORTFOLIOS MANAGED BY
MSAM OR MAS.
THIS PROSPECTUS CONTAINS IMPORTANT INFORMATION ABOUT THE FUND'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 ("SAI") DATED MAY 1, 1997 AS SUPPLEMENTED
THROUGH SEPTEMBER 19, 1997, 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 COPY OF THE SAI AT NO CHARGE, CONTACT THE
FUND BY CALLING 1-800-422-6464 EXT.7182 OR CONTACT YOUR INSURANCE COMPANY.
SHARES OF EACH PORTFOLIO MAY BE PURCHASED ONLY BY INSURANCE COMPANIES FOR THEIR
SEPARATE ACCOUNTS FOR THE PURPOSE OF FUNDING VARIABLE ANNUITY CONTRACTS AND
VARIABLE LIFE INSURANCE POLICIES AND BY CERTAIN TAX-QUALIFIED INVESTORS.
PARTICULAR PORTFOLIOS MAY NOT BE AVAILABLE IN YOUR STATE DUE TO VARIOUS
INSURANCE REGULATIONS. PLEASE CHECK WITH YOUR INSURANCE COMPANY FOR AVAILABLE
PORTFOLIOS. INCLUSION OF A PORTFOLIO IN THIS PROSPECTUS WHICH IS NOT AVAILABLE
IN YOUR STATE IS NOT TO BE CONSIDERED A SOLICITATION.
THESE SECURITIES HAVE NOT BEEN APPROVED OR DISAPPROVED BY THE SECURITIES AND
EXCHANGE COMMISSION, NOR HAS THE SECURITIES AND EXCHANGE COMMISSION PASSED UPON
THE ACCURACY OR ADEQUACY OF THIS PROSPECTUS. ANY REPRESENTATION TO THE CONTRARY
IS A CRIMINAL OFFENSE.
THE PORTFOLIOS:
High Yield Emerging Markets Debt
U.S. Real Estate Asian Equity
AN INVESTMENT IN ANY PORTFOLIO IS NEITHER INSURED NOR GUARANTEED BY THE U.S.
GOVERNMENT. YOU MAY RECEIVE MORE OR LESS THAN YOU INVESTED WHEN YOU REDEEM YOUR
SHARES.
THE HIGH YIELD AND EMERGING MARKETS DEBT PORTFOLIOS MAY INVEST WITHOUT
LIMITATION IN LOWER-QUALITY DEBT SECURITIES, SOMETIMES CALLED "JUNK BONDS." YOU
SHOULD CONSIDER THAT THESE SECURITIES CARRY GREATER RISKS, SUCH AS THE RISK OF
DEFAULT, THAN OTHER DEBT SECURITIES. REFER TO "SECURITIES AND INVESTMENT
TECHNIQUES--HIGH YIELD SECURITIES" FOR FURTHER INFORMATION.
THE EMERGING MARKETS DEBT 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, 1997
MORGAN STANLEY UNIVERSAL FUNDS, INC.
P.O. Box 2798, Boston, MA 02208-2798
<PAGE>
THE FUND
The Fund is an open-end management investment company, or mutual fund. Each of
the four separate investment portfolios (each, a "Portfolio") described in this
Prospectus has a distinct investment objective. The following pages describe
the types of securities and investment techniques each 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" or the "Adviser") advises the
following Portfolios:
U.S. Real Estate Asian Equity
Emerging Markets Debt
MSAM conducts a worldwide investment advisory business. As of August 31, 1997,
MSAM and its affiliated asset management companies (exclusive of MAS, Van
Kampen American Capital, Inc. ("Van Kampen") and Dean Witter InterCapital Inc.)
managed assets of approximately $80.9 billion.
Miller Anderson & Sherrerd, LLP ("MAS" or the "Adviser") advises the High Yield
Portfolio.
MAS's institutional investment advisory business was established in 1969. As of
August 31, 1997, MAS managed assets of approximately $57.6 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.
PAGE
----
PROSPECTUS OUTLINE
FINANCIAL HIGHLIGHTS 3
- --------------------
Financial highlights tables as of June 30, 1997.
PORTFOLIO SUMMARIES 4
- -------------------
For each Portfolio, the investment objective and a summary of strategy,
potential investors, and investment characteristics and risks.
THE PORTFOLIOS' INVESTMENTS 5
- ---------------------------
A more detailed review of how each Portfolio invests and investment
characteristics and risks.
SECURITIES AND INVESTMENT TECHNIQUES 8
- ------------------------------------
More information about the types of investment strategies that may be used
by some or all of the Portfolios and information about investment risks and
limitations.
FUNDAMENTAL INVESTMENT LIMITS 23
- -----------------------------
Certain policies that may be changed only by shareholders.
MANAGEMENT OF THE FUND 23
- ----------------------
General information on organization and operations of the Fund, including
details about MSAM, MAS and the individual portfolio managers, as well as fees,
expenses and performance calculations.
ACCOUNT POLICIES 28
- ----------------
Information on net asset value calculation, income and gain distributions,
taxes and share purchases and redemptions.
2
<PAGE>
FINANCIAL HIGHLIGHTS
The following financial tables provide unaudited financial highlights for the
shares of the High Yield, U.S. Real Estate, Emerging Markets Debt and Asian
Equity Portfolios for the periods indicated. These unaudited financial
highlights appear in the Fund's current Statement of Additional Information and
in the Fund's June 30, 1997 Semi-Annual Report to Shareholders. Additional
performance information for these Portfolios is also included in the Semi-
Annual Report. The Fund's Statement of Additional Information and Semi-Annual
Report and the financial statements therein are available at no cost from the
Fund at the toll-free number noted on the cover page to this Prospectus or from
your insurance company.
<TABLE>
<CAPTION>
HIGH YIELD U.S. REAL ESTATE EMERGING MARKETS ASIAN EQUITY
PORTFOLIO PORTFOLIO DEBT PORTFOLIO PORTFOLIO
------------- ---------------- ---------------- -----------------
PERIOD FROM PERIOD FROM PERIOD FROM PERIOD FROM
JANUARY 2, MARCH 3, JUNE 16, MARCH 3,
1997* TO 1997* TO 1997* TO 1997* TO
SELECTED PER SHARE DATA JUNE 30, 1997 JUNE 30, 1997 JUNE 30, 1997 JUNE 30, 1997
AND RATIOS (UNAUDITED) (UNAUDITED) (UNAUDITED) (UNAUDITED)
- ----------------------- ------------- ---------------- ---------------- -----------------
<S> <C> <C> <C> <C>
NET ASSET VALUE,
BEGINNING OF PERIOD.... $10.00 $ 10.00 $ 10.00 $ 10.00
------ ------- ------- -------
INCOME FROM INVESTMENT
OPERATIONS
Net Invested Income... 0.35 0.10 0.03 0.03
Net Realized and
Unrealized Gain
(Loss)............... 0.23 0.27 (0.03) 0.63
------ ------- ------- -------
Total From Investment
Operations........... 0.58 0.37 -- 0.66
------ ------- ------- -------
NET ASSET VALUE, END OF
PERIOD................. $10.58 $ 10.37 $ 10.00 $ 10.66
====== ======= ======= =======
TOTAL RETURN............ 5.80% 3.70% 0.00% 6.60%
====== ======= ======= =======
RATIOS AND SUPPLEMENTAL
DATA:
Net Assets, End of
Period (000's)......... $9,282 $ 6,025 $10,049 $10,946
Ratio of Expenses to
Average Net Assets..... 0.80%** 1.10%** 1.30%** 1.20%**
Ratio of Net Investment
Income to Average Net
Assets................. 7.41%** 3.52%** 6.48%** 1.06%**
Portfolio Turnover
Rate................... 63% 56% 14% 49%
Average Commission Rate:
Per Share............. NA $0.0576 NA $0.0170
As a Percentage of
Trade Amount......... NA NA NA 0.56%
- -------------------------------------------------------------------------------------------
Effect of Voluntary
Expense Limitation
During the Period:
Per Share Benefit to
Net Investment Income
(Loss)............... $ 0.02 $ 0.08 $ 0.01 $ 0.04
Ratios Before Expense
Limitation:
Expenses to Average
Net Assets........... 1.30%** 3.71%** 2.77%** 2.55%**
Net Investment Income
(Loss) to Average Net
Assets............... 6.91%** 0.90%** 5.01%** (0.22)%**
- -------------------------------------------------------------------------------------------
</TABLE>
*Commencement of operations.
**Annualized.
3
<PAGE>
PORTFOLIO SUMMARIES
- -------------------
Certain investment terms used below have initial capital letters ("Common
Stocks," for example). These terms are further described under "Securities and
Investment Techniques" below.
HIGH YIELD PORTFOLIO
OBJECTIVE AND STRATEGY: Above-average total return over a market cycle of three
to five years by investing primarily in a diversified portfolio of High Yield
Securities, including Corporate Bonds and other Fixed Income Securities and
Derivatives. High Yield Securities are rated below investment grade and are
commonly referred to as "junk bonds." The Portfolio's average weighted maturity
will ordinarily exceed five years and will usually be between five and fifteen
years.
INVESTOR PROFILE: The Portfolio may be appropriate for long-term, aggressive
investors who understand the potential risks and rewards of investing in lower-
quality securities, including defaulted securities, and are willing to accept
their greater price movements and credit risks.
RISK PROFILE: High potential risk and reward. Securities rated below investment
grade, as well as unrated securities of lower quality, usually entail greater
risk (including the possibility of default or bankruptcy of the issuers), and
generally involve greater price volatility and risk of principal and income,
and may be less liquid than securities in higher rated categories.
U.S. REAL ESTATE PORTFOLIO
OBJECTIVE AND STRATEGY: Above-average current income and long-term capital
appreciation by investing primarily in Equity Securities of U.S. and non-U.S.
companies principally engaged in the U.S. real estate industry, including real
estate investment trusts ("REITs").
INVESTOR PROFILE: The Portfolio may be appropriate for investors who seek
above-average current income and long-term capital appreciation by investing in
Equity Securities of U.S. and non-U.S. companies principally engaged in the
U.S. real estate industry, including REITs.
RISK PROFILE: High potential risk and reward. In addition to general risks
involved in equity investments, including fluctuations in the stock market and
changes in the economy, the Portfolio's investments may be subject to the risks
associated with the direct ownership of real estate and direct investments of
REITs.
EMERGING MARKETS DEBT PORTFOLIO
OBJECTIVE AND STRATEGY: High total return by investing primarily in Fixed
Income Securities of government and government-related issuers located in
emerging market countries, which securities provide a high level of current
income, while at the same time holding the potential for capital appreciation
if the perceived creditworthiness of the issuer improves due to improving
economic, financial, political, social or other conditions in the country in
which the issuer is located.
INVESTOR PROFILE: The Portfolio is designed for those who seek a high level of
current income from Emerging Market Country Securities that are Fixed Income
Securities, while holding the potential for capital appreciation.
RISK PROFILE: Very high potential risk and reward. The Portfolio's performance
is subject to high risk and will not be required to meet a minimum rating
standard and may purchase securities that are not rated for creditworthiness by
any internationally recognized credit rating organization. These types of debt
obligations are predominantly speculative with respect to the capacity to pay
interest and repay principal in accordance with their terms and generally
involve a greater risk of default and of volatility in price than securities in
higher rating categories. In addition, Foreign Investment involves different or
increased risks. The performance of the Portfolio will be affected by foreign
currency values, the greater volatility of foreign securities exchanges, risks
in connection with registration, clearing and settlement of securities
transactions and the overall political, economic and regulatory environment in
the countries in which the Portfolio invests. The risks of Foreign Investment
are exacerbated in the case of Emerging Market Country Securities.
ASIAN EQUITY PORTFOLIO
OBJECTIVE AND STRATEGY: Long-term capital appreciation by investing primarily
in Equity Securities of Asian issuers (excluding Japan) using an approach that
is oriented to the selection of individual stocks that the Adviser believes are
undervalued. The Portfolio intends to invest primarily in Equity Securities
that are traded on recognized stock exchanges of countries in Asia and in
Equity Securities of companies organized under the laws of an Asian country
whose business is conducted principally in Asia.
INVESTOR PROFILE: The Portfolio may be appropriate for investors who seek to
pursue their investment goals in markets of Asian countries other than Japan.
RISK PROFILE: High potential risk and reward. In addition to general risks
involved in equity investments, international investing involves different or
increased risks. The performance of the Portfolio will be affected by foreign
currency values, the greater volatility of foreign securities exchanges, and
the overall political, economic and regulatory environment in the countries in
which the Portfolio invests.
4
<PAGE>
THE PORTFOLIOS' INVESTMENTS
- ---------------------------
INVESTMENT CHARACTERISTICS AND RISKS
The value of each 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.
The Portfolios spread investment risk by limiting, to varying degrees, holdings
in any one company or industry. Nevertheless, each Portfolio will experience
price volatility the extent of which will be affected by the types of
securities and techniques the particular Portfolio uses. In the short term,
Common Stock prices can fluctuate dramatically in response to these factors.
Over time, however, Common 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.
Foreign Investment may involve risks in addition to those of U.S. investments.
The performance of the Portfolios investing in foreign securities will be
affected by foreign currency values, the greater volitility of foreign
securities exchanges, and the overall political, economic and regulatory
environment in the countries in which investments are made.
Because the U.S. Real Estate and Emerging Markets Debt Portfolios are non-
diversified portfolios and are permitted greater flexibility to invest their
assets in the obligations of a single issuer, they are exposed to increased
risk of loss if such an investment underperforms expectations. See "Non-
Diversified Status" in this Prospectus and "Investment Limitations" in the SAI.
Investments in securities rated below investment grade, sometimes called high
risk or High Yield Securities or junk bonds, carry a high degree of risk and
are considered speculative. MSAM and MAS may use various investment techniques
to hedge risks, including investment in Derivatives, but there is no guarantee
that these strategies will work as intended.
Each Portfolio will be invested according to its investment strategy. However,
the Portfolios also have the ability to invest without limitation in high
quality Money Market Instruments or Temporary Investments for temporary,
defensive purposes. See "Securities and Investment Techniques" below.
When Portfolio shares are redeemed, they may be worth more or less than their
original cost. An investment in any one Portfolio is not in itself a balanced
investment plan. As with any mutual fund, there is no assurance that a
Portfolio will achieve its goal.
HIGH YIELD PORTFOLIO
The Portfolio seeks above-average total return over a market cycle of three to
five years by investing at least 65% of its total assets in High Yield
Securities of U.S. and foreign issuers including Corporate Bonds and other
Fixed Income Securities. High Yield Securities are rated below investment grade
and are commonly referred to as high yield bonds or junk bonds. The Portfolio
expects to achieve its objective through maximizing current income, although
the Portfolio may seek capital growth opportunities when consistent with its
objective. The Portfolio's average weighted maturity ordinarily will exceed
five years and will usually be between five and fifteen years.
Under normal circumstances, the Portfolio will invest at least 65% of its total
assets in High Yield Securities. The Portfolio may also invest in Investment
Grade Fixed Income Securities of domestic and foreign issuers, including
Eastern European and Emerging Market Country Securities, and in Foreign
Currency Transactions, Investment Company Securities, Foreign Equities, Loan
Participations and Assignments, Municipals, Brady Bonds, ABSs, When-Issued or
Delayed Delivery Securities, Derivatives, SMBSs and CMOs. For risks associated
with High Yield Securities and additional information about investments, see
"Securities and Investment Techniques" below.
The Adviser's approach is to use equity and fixed income valuation techniques
and analyses of economic and industry trends to determine portfolio structure.
Individual securities are selected and monitored by fixed income portfolio
managers who specialize in credit analysis of Fixed Income Securities and use
in-depth financial analysis to uncover opportunities in undervalued issues. For
additional information about strategies employed in managing the Portfolio, see
"High Yield Investing," "Maturity and Duration Management," "Value Investing,"
"Mortgage Investing," "Foreign Fixed Income Investing," "Foreign Investing" and
"Emerging Markets Investing" in "Securities and Investment Techniques" below.
U.S. REAL ESTATE PORTFOLIO
The Portfolio seeks above-average current income and long-term capital
appreciation by investing primarily in Equity Securities of companies in the
U.S. real estate industry. Such Equity Securities include Common Stocks, shares
or units of beneficial interest of REITs, limited partnership interests in
master limited partnerships, Rights or Warrants to purchase Common Stocks,
Convertible Securities, and Preferred Stock.
Under normal circumstances, at least 65% of the Portfolio's total assets will
be invested in income-producing Equity
5
<PAGE>
Securities of U.S. and non-U.S. companies principally engaged in the U.S. real
estate industry. For purposes of the Portfolio's investment policies, a company
is "principally engaged" in the real estate industry if (i) it derives at least
50% of its revenues or profits from the ownership, construction, management,
financing or sale of residential, commercial or industrial real estate or (ii)
it has at least 50% of the fair market value of its assets invested in
residential, commercial or industrial real estate. Companies in the real estate
industry may include among others: REITs, master limited partnerships that
invest in interests in real estate, real estate operating companies, and
companies with substantial real estate holdings, such as hotel companies,
residential builders and land-rich companies.
The Portfolio may also invest in Fixed Income Securities issued or guaranteed
by real estate companies or secured by real estate assets and are Investment
Grade Securities or Money Market Instruments, such as notes, certificates of
deposit or bankers' acceptances issued by domestic or foreign issuers, or high-
grade debt securities, consisting of corporate debt securities and U.S.
Governments and Agencies. Securities rated in the lowest category of Investment
Grade Securities have speculative characteristics. The Portfolio may also
invest in certain securities or obligations, including Non-Publicly Traded
Securities, Private Placements, Restricted Securities, Repurchase Agreements,
When-Issued and Delayed Delivery Securities, Temporary Investments and
Derivatives and may engage in Loans of Portfolio Securities. For additional
information about the Portfolio's investments, see "Securities and Investment
Techniques" and "Non-Diversified Status" below.
The Adviser's approach is to invest in Equity Securities of companies that it
believes will provide a dividend yield that exceeds the composite dividend
yield of securities comprising the Standard & Poor's Ratings Group ("S&P") 500
Index. A substantial portion of the Portfolio's total assets will be invested
in Equity Securities of REITs. REITs pool investors' funds for investment
primarily in income producing real estate or real estate related loans or
interests, with certain tax advantages if regulatory requirements are met.
Generally, REITs can be classified as Equity REITs, Mortgage REITs or Hybrid
REITs. Equity REITs invest the majority of their assets directly in real
property and derive their income primarily from rents and capital gains from
appreciation realized through property sales. Equity REITs are further
categorized according to the types of real estate securities they own, e.g.,
apartment properties, retail shopping centers, office and industrial
properties, hotels, health-care facilities, manufactured housing and mixed-
property types. Mortgage REITs invest the majority of their assets in real
estate mortgages and derive their income primarily from interest payments.
Hybrid REITs combine the characteristics of both Equity and Mortgage REITs. The
Portfolio will invest primarily in Equity REITs. A shareholder in the Portfolio
investing in REITs indirectly through the Portfolio will bear not only his or
her proportionate share of the expenses of the Portfolio, but also indirectly,
the management expenses of underlying REITs.
EMERGING MARKETS DEBT PORTFOLIO
The Portfolio seeks high total return by investing primarily in Fixed Income
Securities of issuers in emerging market countries. Under normal circumstances,
the Portfolio will invest at least 65% of its total assets in government Fixed
Income Securities, including Loan Participations and Assignments between
governments and financial institutions, securities issued by government owned,
controlled or sponsored entities and securities of entities organized to
restructure outstanding debt of such issuers.
The Portfolio may also invest in Fixed Income Securities of corporate issuers
located in or organized under the laws of emerging market countries, Brady
Bonds, Zero Coupon, Pay-In-Kind or Deferred Payment Securities, American
Depositary Receipts ("ADRs"), Foreign Currency Transactions, Investment Company
Securities, Investment Funds, Loan Participations and Assignments, Money Market
Instruments, Repurchase Agreements, Reverse Repurchase Agreements, Temporary
Investments, Non-Publicly Traded Securities, Private Placements, Restricted
Securities, When-Issued or Delayed Delivery Securities and Derivatives, and may
engage in Loans of Portfolio Securities. The Portfolio may also invest up to 5%
of its total assets in MBSs, CMOs and in other ABSs issued by non-governmental
entities, such as banks and other financial institutions. Also, the Portfolio
is authorized to borrow up to 33 1/3% of its total assets (including the amount
borrowed), less all liabilities and indebtedness other than the borrowing, for
investment purposes to increase the opportunity for greater return and for
payment of dividends. Such borrowings would constitute leverage, which is a
speculative characteristic. Leveraging will magnify declines as well as
increases in the Net Asset Value ("NAV") of the Portfolio's shares and
increases in the yield on the Portfolio's investments. For additional
information about investments, see "Securities and Investment Practices" and
"Non-Diversified Status" below.
MSAM's approach is to invest the Portfolio's assets in Emerging Market Country
Fixed Income Securities that provide a high level of current income, while at
the same time holding the potential for capital appreciation if the perceived
creditworthiness of the issuer improves due to improving economic, financial,
political, social or other conditions in the country in which the issuer is
located. As used in this Prospectus, emerging markets describes any country
which is generally considered to be an emerging or developing country by the
international financial community such as the International Bank for
Reconstruction and Development (commonly known as the World Bank) and the
International Finance Corporation. There are currently over 130 countries which
are generally considered to be emerging
6
<PAGE>
or developing countries by the international financial community. Emerging
markets can include every nation in the world except the United States, Canada,
Japan, Australia, New Zealand and most nations located in Western Europe.
Currently, investing in many emerging market countries is not feasible or may
involve unacceptable political risks.
Initially, MSAM expects that its investments in Emerging Market Country Fixed
Income Securities will be made primarily in some or all of the following
emerging market countries:
<TABLE>
<S> <C> <C> <C>
Algeria Argentina Brazil Bulgaria
Chile China Colombia Costa Rica
Czech Republic Democratic Republic Dominican Republic Ecuador
Egypt of Congo Indonesia Greece
Hungary India Malaysia Ivory Coast
Jamaica Jordan Nigeria Mexico
Morocco Nicaragua Peru Pakistan
Panama Paraguay Russia Philippines
Poland Portugal Trinidad & Slovakia
South Thailand Tobago Tunisia
Africa Uruguay Venezuela
Turkey
</TABLE>
In selecting Emerging Market Country Fixed Income Securities for investment by
the Portfolio, MSAM will apply a market risk analysis contemplating assessment
of factors such as liquidity, volatility, tax implications, interest rate
sensitivity, counterparty risks and technical market considerations. As
opportunities to invest in debt securities in other countries develop, MSAM
expects to expand and further diversify the universe of emerging market
countries in which the Portfolio invests. While the Portfolio generally is not
restricted in the portion of its assets which may be invested in a single
country or region, it is anticipated that, under normal conditions, the
Portfolio's assets will be invested in issuers in at least three countries.
Interests in issuers organized and operated for the purpose of restructuring
the investment characteristics of instruments issued by governments, government
agencies or instrumentalities, political subdivisions or government owned,
controlled or sponsored entities involves the deposit with or purchase by an
entity of specific instruments and the issuance by that entity of one or more
classes of securities backed by, or representing interests in, the underlying
instruments. Certain issuers of such structured securities may be deemed to be
"Investment Companies" as defined in the Investment Company Act of 1940, as
amended (the "1940 Act"). As a result, the Portfolio's investment in such
securities may be limited by certain investment restrictions contained in the
1940 Act.
The Portfolio's investments in Fixed Income Securities of governments, and
government-related and restructured Fixed Income Securities are subject to
special risks, including the inability or unwillingness of the issuer to repay
principal and interest, requests to reschedule or restructure outstanding debt
and requests to extend additional loan amounts. The Portfolio may have limited
recourse in the event of default on such Fixed Income Securities. 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."
The portion of the Portfolio's assets invested in securities denominated in
currencies other than the U.S. dollar is not restricted and will vary depending
on market conditions. Although the Portfolio is permitted to engage in
investment practices to hedge against currency exchange rate risks with respect
to such assets, the Portfolio may be limited in its ability to hedge against
these risks.
Emerging Market Country Fixed Income Securities in which the Portfolio may
invest will be subject to high risk and will not be required to meet a minimum
rating standard and may not be rated for creditworthiness by any
internationally recognized credit rating organization. These types of Fixed
Income Securities are predominantly speculative and generally involve a greater
risk of default and of volatility in price than securities in higher rating
categories. Ratings of Fixed Income Securities of foreign issuers, to the
extent that those ratings are undertaken, are related to evaluations of the
country in which the issuer of the instrument is located and generally take
into account the currency in which the Fixed Income Securities of a foreign
issuer is denominated.
ASIAN 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, Depositary Receipts and other Equity Securities that
are traded on recognized stock exchanges of the countries in Asia described
below and such Equity Securities of companies organized under the laws of any
such Asian country whose business is conducted principally in Asia. Although
the Portfolio intends to invest primarily in Equity Securities listed on stock
exchanges, it will also invest in Equity Securities traded in over-the-counter
markets. Securities traded in over-the-counter markets pose liquidity risks.
The production of any current income is incidental to the Portfolio's
objective.
The Portfolio does not intend to invest in Asian Equity Securities that are
principally traded in markets in Japan or in companies organized under the laws
of Japan. The Asian countries to be represented in the Portfolio, which include
the following countries, have the more established markets in the region: China
(Hong Kong), Singapore, Malaysia, Thailand, the Philippines and Indonesia. The
Portfolio may also invest in Common Stocks traded in markets in Taiwan, South
Korea, India, Pakistan, Sri Lanka and other developing markets that are open to
foreign investment. Under normal circumstances, the Portfolio will invest at
least 65% of the total assets of the Portfolio in such Asian Equity Securities.
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The Portfolio may also invest in Fixed Income Securities, bills and bonds of
governmental entities in Asia and the United States, notes, debentures and
bonds of companies in Asia, U.S. Money Market Instruments, Foreign Currency
Transactions, Investment Company Securities and Repurchase Agreements, When-
Issued or Delayed Delivery Securities and Derivatives and may engage in Loans
of Portfolio Securities. Although the Portfolio will not invest for short-term
trading purposes, portfolio securities may be sold from time to time without
regard to the length of time they have been held. Pending investment or
settlement, and for liquidity purposes, the Portfolio may invest in domestic,
Eurodollar and foreign short-term Money Market Instruments. The Portfolio may
also purchase such instruments to temporarily reduce its equity holdings for
defensive purposes in response to adverse market conditions. Because of the
lack of hedging facilities in the currency markets of Asia, no active currency
hedging strategy is anticipated currently. Instead, each investment will be
considered on a total currency adjusted basis with the U.S. dollar as a base
currency.
The Adviser's approach is oriented to individual stock selection and is value
driven. In selecting stocks for the Portfolio, the Adviser initially identifies
those stocks that it believes to be undervalued in relation to the issuer's
assets, cash flow, earnings and revenues, and then evaluates the future value
of such stocks by running the results of an in-depth study of the issuer
through a dividend discount model. In selecting investments, the Adviser
utilizes the research of a number of sources, including Morgan Stanley Capital
International, an affiliate of the Adviser located in Geneva, Switzerland.
Portfolio holdings are regularly reviewed and subjected to fundamental analysis
to determine whether they continue to conform to the Adviser's value criteria.
Equity Securities that no longer conform to such investment criteria will be
sold.
There is no requirement that the Portfolio, at any given time, invest in any or
all of the countries listed above or in any other Asian countries. The
Portfolio has no set policy for allocating investments among the various Asian
countries. Allocation of investments will depend on the relative attractiveness
of the stocks of issuers in the respective countries. Government regulation and
restrictions in many of the countries of interest may limit the amount, mode
and extent of investment in companies of such countries. The Adviser will
analyze assets, revenues and earnings of an issuer. In selecting industries and
particular issuers, the Adviser 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 the Adviser's view, have potential for growth.
The Portfolio's investments will include Emerging Market Country Securities.
These securities pose greater liquidity risks and other risks than securities
of companies located in developed countries and traded in more established
markets. For a description of special considerations and certain risks
associated with investment in foreign issuers, see "Securities and Investment
Techniques--Emerging Market Country Securities."
SECURITIES AND INVESTMENT TECHNIQUES
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The following pages contain more detailed information about types of
instruments in which a Portfolio may invest and strategies each Adviser may
employ in pursuit of a 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 each Portfolio's policies and
limitations and more detailed information about each Portfolio's investments is
contained in the SAI. Policies and limitations are considered at the time such
investments are purchased; the sale of instruments is not required in the event
of a subsequent change in circumstances, for example, a rating's 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 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.
The Advisers may not buy all of these instruments or use all of these
techniques to the full extent permitted unless they believe that doing so will
help a Portfolio achieve its investment objective. Current holdings and recent
investment strategies are described in the Portfolios' financial reports, which
will be sent to the Portfolios' shareholders twice a year. For a copy of an SAI
or financial report, at no charge, contact the Fund or your insurance company.
STRATEGIES
EMERGING MARKETS INVESTING: The Adviser's approach to Emerging Markets
Investing is based on the Adviser's evaluation of both short-term and long-term
international economic trends and the relative attractiveness of emerging
markets and individual emerging market securities.
As used in this Prospectus, emerging markets describes any country which is
generally considered to be an emerging, or developing country by the
international financial community such as the International Bank for
Reconstruction and Development (commonly known as the World Bank) and the
International Finance Corporation. There are currently over 130 countries which
are generally considered to be emerging or developing countries by the
international financial community, approximately 40 of which currently have
stock markets. Emerging markets can include every nation in the world except
the United States, Canada, Japan, Australia, New Zealand and most nations
located in Western Europe.
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Currently, investing in many emerging market countries is either not feasible
or very costly, or may involve unacceptable political risks. Other special
risks include the possible increased likelihood of expropriation or the return
to power of a political regime which would institute policies to expropriate,
nationalize or otherwise confiscate investments. A Portfolio will focus its
investments on those emerging market countries in which the Adviser believes
the potential for market appreciation outweighs these risks and/or the cost of
investment. Investing in emerging markets also involves an extra degree of
custodial and/or market risk, especially where the securities purchased are not
traded on an official exchange or where ownership records regarding the
securities are maintained by an unregulated entity (or even the issuer itself).
FOREIGN FIXED INCOME INVESTING: The Adviser seeks to invest in Foreign Bonds
and other Fixed Income Securities denominated in foreign currencies, where, in
the opinion of the Adviser, the combination of current yield and currency value
offer attractive expected returns. When the total return opportunities in a
foreign bond market appear attractive in local currency terms, but where in the
Adviser's judgment unacceptable currency risk exists, Foreign Currency
Transactions and Swaps may be used to hedge the currency risk.
FOREIGN INVESTING: Investing in securities issued by foreign companies or
governments involves certain special considerations which are not typically
associated with investing in U.S. issuers. Since the securities of foreign
issuers may be denominated in foreign currencies, and since a Portfolio may
temporarily hold uninvested reserves in bank deposits of foreign currencies
prior to reinvestment or conversion to U.S. dollars, a Portfolio may be
affected favorably or unfavorably by changes in currency exchange rates and in
exchange control regulations, and may incur costs in connection with
conversions between various currencies.
Because non-U.S. companies are not generally subject to uniform accounting,
auditing and financial reporting standards and practices comparable to those
applicable to U.S. companies, there may be less publicly available information
about certain foreign companies than about U.S. companies. Securities of some
non-U.S. companies may be less liquid and more volatile than securities of
comparable U.S. companies. There is generally less government supervision and
regulation of stock exchanges, brokers and listed companies than in the United
States. 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.
Additionally, there may be difficulty in obtaining and enforcing judgments
against foreign issuers.
Although a Portfolio will endeavor to achieve the most favorable execution
costs in its portfolio transactions in foreign securities, fixed commissions on
many foreign stock exchanges are generally higher than negotiated commissions
on U.S. exchanges. In addition, it is expected that the expenses for custodial
arrangements of a Portfolio's foreign securities will be greater than the
expenses for the custodial arrangements for handling U.S. securities of equal
value. Certain foreign governments levy withholding taxes against dividend and
interest income. Although in some countries a portion of these taxes is
recoverable, the non-recovered portion of foreign withholding taxes will reduce
the income a Portfolio receives from the companies comprising the Portfolio's
investments.
HIGH YIELD INVESTING: The Adviser seeks to invest in High Yield Securities
based on the Adviser's analysis of economic and industry trends and individual
security characteristics. The Adviser conducts a credit analysis for each
security considered for investment to evaluate its attractiveness relative to
its risk. A high level of diversification is also maintained to limit credit
exposure to individual issuers.
To the extent a Portfolio invests in High Yield Securities it will be exposed
to a substantial degree of credit risk. Lower-rated bonds are considered
speculative by traditional investment standards. 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) companies, which are generally
less able than more established or less leveraged companies to make scheduled
payments of interest and principal. The risks posed by securities issued under
such circumstances are substantial.
The market for High Yield Securities is still relatively new. Because of this,
a long-term track record for bond default rates does not exist. In addition,
the secondary market for High Yield Securities is generally less liquid than
that for investment grade corporate securities. In periods of reduced market
liquidity, High Yield Security prices may become more volatile, and both the
high yield market and a Portfolio may experience sudden and substantial price
declines. This lower liquidity might have an effect on a Portfolio's ability to
value or dispose of such securities. Also, there may be significant disparities
in the prices quoted for High Yield Securities by various dealers. Under such
conditions, a Portfolio may find it difficult to value its securities
accurately. A Portfolio may also be forced to sell securities at a significant
loss in order to meet shareholder redemptions. These factors add to the risks
associated with investing in High Yield Securities.
High Yield Securities may also present risks based on payment expectations. For
example, High Yield Securities may contain redemption or call provisions. If an
issuer exercises these provisions in a declining interest rate market, a
Portfolio would have to replace the security with a lower yielding security,
resulting in a decreased return for investors.
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Conversely, a High Yield Security's value will decrease in a rising interest
rate market.
Certain types of High Yield Securities are non-income paying securities. For
example, Zero Coupons pay interest only at maturity and Pay-In-Kind Securities
pay interest in the form of additional securities. Payment in the form of
additional securities, or interest income recognized through discount
accretion, will, however, be treated as ordinary income which will be
distributed to shareholders even though the Portfolio does not receive periodic
cash flow from these investments.
MATURITY AND DURATION MANAGEMENT: One of two primary components of the
Adviser's fixed income investment strategy is Maturity and Duration Management.
The second primary component of fixed income strategy is Value Investing. See
"Value Investing" below.
The maturity and duration structure of a Portfolio investing in Fixed Income
Securities is actively managed in anticipation of cyclical interest rate
changes. Adjustments are not made in an effort to capture short-term, day-to-
day movements in the market, but instead are implemented in anticipation of
longer-term shifts in the levels of interest rates. Adjustments made to shorten
Portfolio maturity and duration are made to limit capital losses during periods
when interest rates are expected to rise. Conversely, adjustments made to
lengthen maturity are intended to produce capital appreciation in periods when
interest rates are expected to fall. The foundation for maturity and duration
strategy lies in analysis of the U.S. and global economies, focusing on levels
of real interest rates, monetary and fiscal policy actions, and cyclical
indicators.
Most Fixed Income Securities provide interest (coupon) payments in addition to
a final (par) payment at maturity. Some securities also have call provisions.
Depending on the relative magnitude of these payments and the nature of the
call provisions, the market values of Fixed Income Securities may respond
differently to changes in the level and structure of interest rates.
Traditionally, a Fixed Income Security's term-to-maturity has been used as a
proxy for the sensitivity of the security's price to changes in interest rates
(which is the interest rate risk or volatility of the security). However, term-
to-maturity measures only the time until a Fixed Income Security provides its
final payment, taking no account of the pattern of the security's payments
prior to maturity.
Duration is a measure of the expected life of a Fixed Income Security on a
present value basis that was developed as a more precise alternative to the
concept of term-to-maturity. Duration incorporates a Fixed Income Security's
yield, coupon interest payments, final maturity and call features into one
measure. Duration is one of the fundamental tools used by the Adviser in the
selection of Fixed Income Securities.
Duration takes the length of the time intervals between the present time and
the time that the interest and principal payments are scheduled or, in the case
of a callable bond, expected to be received, and weights them by the present
values of the cash to be received at each future point in time. For any Fixed
Income Security with interest payments occurring prior to the payment of
principal, duration is always less than maturity. In general, all other factors
being the same, the lower the stated or coupon rate of interest of a Fixed
Income Security, the longer the duration of the security; conversely, the
higher the stated or coupon rate of interest of a Fixed Income Security, the
shorter the duration of the security.
There are some situations where even the standard duration calculation does not
properly reflect the interest rate exposure of a security. For example,
Floaters often have final maturities of ten or more years; however, their
interest rate exposure corresponds to the frequency of the coupon reset.
Another example where the interest rate exposure is not properly captured by
duration is the case of mortgage pass-through securities. The stated final
maturity of such securities is generally 30 years, but current prepayment rates
are more critical in determining the securities' interest rate exposure. In
these and other similar situations, the Adviser's analysis of interest rate
exposure incorporates the economic life of a security.
MORTGAGE INVESTING: At times it is anticipated that greater than 50% of a fixed
income Portfolio's assets may be invested in MBSs. These include securities
which represent pools of mortgage loans made by lenders such as commercial
banks, savings and loan associations, mortgage bankers and others. The pools
are assembled by various governmental, government-related and private
organizations. A Portfolio will invest in securities issued by the Government
National Mortgage Association ("GNMA"), Federal Home Loan Mortgage Corporation
("FHLMC"), Federal National Mortgage Association ("FNMA"), other government
agencies, and private issuers. It is expected that the Portfolio's primary
emphasis will be in MBSs issued by the various government-related
organizations. However, a Portfolio may invest, without limit, in MBSs issued
by private issuers when the Adviser deems that the quality of the investment,
the quality of the issuer, and market conditions warrant such investments.
Securities issued by private issuers will be rated investment grade by Moody's
Investors Service, Inc. ("Moody's") or S&P or be deemed by the Adviser to be of
comparable investment quality.
VALUE INVESTING: One of two primary components of the Adviser's fixed income
strategy is Value Investing, whereby the Adviser seeks to identify undervalued
sectors and securities through analysis of credit quality, Option
characteristics and liquidity. Quantitative models are used in conjunction with
judgement and experience to evaluate and select securities with embedded put or
call Options which are
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attractive on a risk- and option-adjusted basis. Successful Value Investing
will permit a Portfolio to benefit from the price appreciation of individual
securities during periods when interest rates are unchanged. See "Maturity and
Duration Management" for a description of the other key component of the
Adviser's fixed income investment strategy.
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.
ABSS. Asset-backed securities ("ABSs") 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 ABSs 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 ABSs is also the conventional proxy for
maturity.
Due to the possibility that prepayments (on automobile loans and other
collateral) will alter the cash flow on ABSs, 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 prepayment 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, the Adviser 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 that 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 in relatively 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. For further information on these securities, see the SAI. A
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).
A 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.
A 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 a U.S. bank, it is a member of the FDIC, and (iii) in the case of a
foreign branch of a U.S. bank, the security is deemed by the Adviser 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 NRSROs in one of
their two highest categories, (e.g., A-1 or A-1+ by S&P or Prime 1 by 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
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"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 prepayment 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, the Adviser 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 bonds 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, 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.
See "MBSs" below.
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. A Portfolio will buy
Corporate Bonds subject to any quality constraints. If a security held by a
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 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 United States 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 a 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. The Portfolios are permitted to invest in various derivative
instruments for both hedging and non-hedging purposes. Derivatives include
Options, Futures, Structured Notes, Caps, Floors, Collars and Swaps.
Additionally, the Portfolios may invest in other Derivatives that are developed
over time if their use would be consistent with the objectives of the
Portfolios. Each of the U.S. Real Estate, Emerging Markets Debt and Asian
Equity Portfolios will limit its use of the foregoing Derivatives for non-
hedging purposes to 33 1/3% of its total assets measured by the aggregate
notional amount of outstanding derivative instruments. The High Yield Portfolio
will not enter into Futures to the extent that the Portfolio's outstanding
obligations to purchase securities under these contracts, in combination with
its outstanding obligations with respect to Options, would exceed 50% of its
total assets. The Portfolios' investments in Derivatives for hedging purposes
and in forward foreign currency contracts are not subject to the foregoing
limits.
The Portfolios may use Derivatives under a number of different circumstances to
further their investment objectives. The Portfolios may use Derivatives when
doing so provides more liquidity than the direct purchase of the securities
underlying such Derivatives. For example, a Portfolio may
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purchase Derivatives to quickly gain exposure to a market in response to
changes in the Portfolio's asset allocation policy or upon the inflow of
investable cash when the Derivative provides greater liquidity than the
underlying securities market. A Portfolio may also use Derivatives when it is
restricted from directly owning the underlying securities due to foreign
investment restrictions or other reasons or when doing so provides a price
advantage over purchasing the underlying securities directly, either because of
a pricing differential between the Derivatives and securities markets or
because of lower transaction costs associated with the Derivatives transaction.
Derivatives may also be used by a Portfolio for hedging purposes and under
other circumstances in which the Portfolio's portfolio manager believes it
advantageous to do so consistent with the Portfolio's investment objective. A
Portfolio will not, however, use Derivatives in a manner that creates leverage,
except to the extent that the use of leverage is expressly permitted by the
Portfolio's investment policies, and then only in a manner consistent with such
policies.
Some of the Derivatives in which the Portfolios may invest and the risks
related thereto are described in more detail below.
Caps, Floors and Collars. The Portfolios may invest in Caps, Floors and
Collars, which are instruments analogous to Options. In particular, a Cap is
the right to receive the excess of a reference rate over a given rate and is
analogous to a put Option. A Floor is the right to receive the excess of a
given rate over a reference rate and is analogous to a call Option. Finally, a
Collar is an instrument that combines a Cap and a Floor. That is, the buyer of
a Collar buys a Cap and writes a Floor, and the writer of a Collar writes a Cap
and buys a Floor. The risks associated with Caps, Floors and Collars are
similar to those associated with Options. In addition, Caps, Floors and Collars
are subject to risk of default by the counterparty because they are privately
negotiated instruments.
Futures. The Portfolios may purchase and sell futures contracts and options on
futures contracts, including but not limited to securities index futures,
foreign currency exchange futures, interest rate futures contracts and other
financial futures (collectively, "Futures"). Futures contracts provide for the
sale of one party and purchase by another party of a specified amount of a
specific security, instrument or basket thereof, at a specific future date and
at a specified price. An option on a futures contract is a legal contract that
gives the holder the right to buy or sell a specified amount of futures
contracts at a fixed or determinable price upon the exercise of the option.
The Portfolios may sell securities index futures contracts and/or options
thereon in anticipation of or during a market decline to attempt to offset the
decrease in market value of investments in its portfolio, or purchase
securities index futures in order to gain market exposure. Subject to
applicable laws, the Portfolios may engage in transactions in securities index
futures contracts (and options thereon) which are traded on a recognized
securities or futures exchange, or may purchase or sell such instruments in the
over-the-counter market. There currently are limited securities index futures
and options on such futures in many countries, particularly emerging countries.
The nature of the strategies adopted by the Adviser, and the extent to which
those strategies are used, may depend on the development of such markets.
The Portfolios may engage in transactions involving foreign currency exchange
futures contracts. Such contracts involve an obligation to purchase or sell a
specific currency at a specified future date and at a specified price. The
Portfolios may engage in such transactions to hedge their respective holdings
and commitments against changes in the level of future currency rates or to
adjust their exposure to a particular currency. For more information, see
"Foreign Currency Transactions" below.
The Portfolios may engage in transactions in interest futures transactions.
Interest rate futures contracts involve an obligation to purchase or sell a
specific debt security, instrument or basket thereof at a specified future date
at a specified price. The value of the contract rises and falls inversely with
changes in interest rates. The Portfolios may engage in such transactions to
hedge their holdings of debt instruments against future changes in interest
rates.
Financial futures are futures contracts relating to financial instruments, such
as U.S. Government securities, foreign currencies, and certificates of deposit.
Such contracts involve an obligation to purchase or sell a specific security,
instrument or basket thereof at a specified future date at a specified price.
Like interest rate futures contracts, the value of financial futures contracts
rises and falls inversely with changes in interest rates. The Portfolios may
engage in financial futures contracts for hedging and non-hedging purposes.
Under the rules adopted by the Commodity Futures Trading Commission, each
Portfolio may enter into futures contracts and options thereon for both hedging
and non-hedging purposes, provided that not more than 5% of such Portfolio's
total assets at the time of entering the transaction are required as margin and
option premiums to secure obligations under such contracts relating to non-
hedging activities.
Gains and losses on futures contracts and options thereon depend on the
Adviser's ability to predict correctly the direction of securities prices,
interest rates and other economic factors. Other risks associated with the use
of futures and options are (i) imperfect correlation between the change in
market value of investments held by a Portfolio and the prices of futures and
options relating to investments purchased or sold by the Portfolio, and (ii)
possible lack of a liquid secondary market for a futures contract and the
resulting inability to close a futures position. The risk that a Portfolio will
be unable to close out a futures position or options contract will be minimized
by only entering into futures contracts or options transactions for which there
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appears to be a liquid exchange or secondary market. The risk of loss in
trading on 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.
Options. The Portfolios may seek to increase their returns or may hedge their
portfolio investments through Options transactions with respect to securities,
instruments, indices or baskets thereof in which such Portfolios may invest, as
well as with respect to foreign currency. Purchasing a put Option gives a
Portfolio the rights to sell a specified security, currency or basket of
securities or currencies at the exercise price until the expiration of the
Option. Purchasing a call Option gives a Portfolio the right to purchase a
specified security, currency or basket of securities or currencies at the
exercise price until the expiration of the Option.
Each Portfolio also may write (i.e., sell) put and call Options on investments
held in its portfolio, as well as with respect to foreign currency. A Portfolio
that has written an Opinion receives a premium, which increases the Portfolio's
return on the underlying security or instrument in the event the Option expires
unexercised or is closed out at a profit. However, by writing a call Option, a
Portfolio will limit its opportunity to profit from an increase in the market
value of the underlying security or instrument above the exercise price of the
Option for as long as the Portfolio's obligations as writer of the Option
continues. The Portfolios may only write Options that are "covered." A covered
call Option means that so long as the Portfolio is obligated as the writer of
the Option, it will earmark or segregate sufficient liquid assets to cover its
obligations under the Option or own (i) the underlying security or instrument
subject to the Option, (ii) securities or instruments convertible or
exchangeable without the payment of any consideration into the security or
instrument subject to the Option, or (iii) a call Option on the same underlying
security with a strike price no higher than the price at which the underlying
instrument was sold pursuant to a short Option position.
By writing (or selling) a put Option, a Portfolio incurs an obligation to buy
the security or instrument 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. The Portfolios may also write Options that may be
exercisable by the purchaser only on a specific date. A Portfolio that has
written a put Option will earmark or segregate sufficient liquid assets to
cover its obligations under the Option or will own a put Option on the same
underlying security with an equal or higher strike price.
The Portfolios may engage in transactions in Options which are graded on
recognized exchanges or over-the-counter. There currently are limited Options
markets in many countries, particularly emerging countries such as Latin
American countries, and the nature of the strategies adopted by the Adviser and
the extent to which those strategies are used will depend on the development of
such Option markets. The primary risks associated with the use of Options are
(i) imperfect correlation between the change in market value of investments
held, purchased or sold by a Portfolio and the prices of Options relating to
such investments; and (ii) possible lack of a liquid secondary market for an
Option.
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 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 a Portfolio to tailor its
investments to the specific risks and returns the Adviser's wish to accept
while avoiding or reducing certain other risks.
Swaps. Swap Contracts ("Swaps") are Derivatives in the form of a contract or
other similar instrument in which two parties agree to exchange the returns
generated by a security, instrument, basket thereof or index for the returns
generated by another security, instrument, basket thereof or index. The payment
streams are calculated by reference to a specific security, index or instrument
and an agreed upon notional amount. The relevant indices include but are 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, 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.
A 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 a Portfolio receiving or paying, as the case
may be, only the net amount of the two returns. A Portfolio's obligations under
a Swap agreement will be accrued daily (offset against any amounts owing to the
Portfolio) and any accrued, but unpaid, net amounts owed to a Swap counterparty
will be covered by the maintenance of a segregated account consisting of cash
and liquid securities. A 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.
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
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total rate of return Swaps is limited to the net amount of payments that a
Portfolio is contractually obligated to make. If the other party to an interest
rate or total rate of return Swap defaults, a Portfolio's risk of loss consists
of the net amount of payments that a Portfolio is contractually entitled to
receive. In contrast, currency Swaps may 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 may be
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, a
Portfolio may have contractual remedies pursuant to the agreements related to
the transaction. The Swaps 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 Swaps
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 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.
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 a 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 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. The Adviser 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 investing 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 a 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 Portfolios'
Investments" section applicable to a particular Portfolio to determine in which
of the above a 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, ABSs, 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 "The Portfolios' Investments" section applicable to a
particular Portfolio to determine in which of the above a Portfolio may invest.
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The short-term and medium-term Fixed Income Securities in which the
International Magnum Portfolio may invest consist of (a) obligations of
governments, agencies or instrumentalities of any member state of the
Organization for Economic Cooperation and Development ("OECD"), including the
United States; (b) bank deposits and bank obligations (including certificates
of deposit, time deposits and bankers' acceptances) of banks organized under
the laws of any member state of the OECD, including the United States,
denominated in any currency; and (c) finance company and corporate commercial
paper and other short-term corporate debt obligations of corporations organized
under the laws of any member state of the OECD, including the United States,
meeting the Portfolio's credit quality standards, provided that no more than
20% of the Portfolio's assets are invested in any one of such issuers. The
short-term and medium-term securities in which the Portfolio may invest will be
rated investment grade by an NRSRO (e.g., rated A or higher by Moody's or S&P),
or if unrated, will be determined to be of comparable quality by the Adviser.
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 ABSs 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 TRANSACTIONS. Portfolios investing in foreign securities will
regularly transact security purchases and sales in foreign currencies. The
Portfolios may hold foreign currency or engage in the Foreign Currency
Transactions discussed below.
As a means of reducing the risks associated with investing in securities
denominated in foreign currencies, a Portfolio may purchase or sell foreign
currency on a forward basis ("Forwards" or "forward contracts"), enter into
foreign currency futures and options on futures contracts ("Forex Futures") and
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.
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. A Portfolio will incur brokerage fees when it purchases or
sells Forex Futures 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.
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.
Forwards 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).
A Portfolio may use Forwards 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 a 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 a Portfolio has or
expects to have portfolio exposure. A 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
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result of exchange rate fluctuation, they will also limit any gains that may
otherwise have been realized.
A 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, a 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, a 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 U.S. dollars or other foreign currency
is not exactly matched with a Portfolio's obligation under the forward
contract. On the date of maturity, a Portfolio may be exposed to some risk of
loss from fluctuations in that currency. Although the Adviser will attempt to
hold such mismatching to a minimum, there can be no assurance that the Adviser
will be able to do so. When a 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.
A Portfolio engaging in Forwards will comply with the segregation requirements
required by the 1940 Act and the rules adopted thereunder. See "Investment
Objectives and Policies--Forward Foreign Currency Exchange Contracts" in the
SAI.
At the maturity of a forward contract, a 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. A 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.
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 United
States. 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. A 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.
Investments in securities of foreign issuers are frequently denominated in
foreign currencies. Because a 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 exchange rates and in exchange control regulations and a
Portfolio may incur costs in connection with conversions between various
currencies.
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
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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. Lower-rated bonds
are considered speculative by traditional investment standards. 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 a 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 1940 Act
generally prohibits a 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 a Portfolio from acquiring any security of a registered closed-end
investment company if the Portfolio and other investment companies with the
same adviser would own more than 10% of the outstanding voting shares of the
company.
To the extent a 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. A
Portfolio may not purchase shares of any affiliated investment company except
as permitted under the 1940 Act or 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. A 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 Emerging Markets Equity
Portfolio will invest in such Investment Funds only where appropriate given
that the Portfolio's shareholders will bear not only their proportionate
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share of the expenses of the Portfolio (including operating expenses and the
fees of the Adviser), but also will indirectly bear similar expenses of the
underlying Investment Funds.
Certain Investment Funds are advised by an Adviser. The Portfolios may, to the
extent permitted under the 1940 Act and other applicable law, invest in these
Investment Funds. If a 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 NRSROs 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 the Adviser, 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 and considered by the Adviser to be of
comparable quality. The Adviser 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. Any Portfolio permitted to hold Investment Grade
Securities may hold unrated securities if the Adviser 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. A 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"). A 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. A 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, a 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. A Portfolio
will acquire Participations only if the Lender interpositioned between a
Portfolio and the borrower is determined by the Adviser to be creditworthy.
When a 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 a 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, a
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 a Portfolio's
ability to dispose of particular Assignments or Participations when necessary
to meet a 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 a Portfolio to assign a value to these securities for
purposes of valuing a 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 a Portfolio in the event of fraud or misrepresentation and may
involve a risk of insolvency of the lending bank or other financial
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. Each 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. A 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.
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MONEY MARKET INSTRUMENTS. Each Portfolio may invest in Money Market
Instruments, although the Portfolios intend to stay invested in securities
satisfying their primary investment objective to the extent practical. Each
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 Portfolios 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.
MBSS. 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 (see "CMOs" above). 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 or pooler. The pools are assembled by various governmental, government-
related and private organizations. A Portfolio may invest in securities issued
or guaranteed by the GNMA, FHLMC, 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 a Portfolio
will be those which at the time of purchase are rated investment grade by one
or more NRSRO, or, if unrated, are deemed by the Adviser to be of comparable
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. Like Fixed Income Securities in general, MBSs will
generally decline in price when interest rates rise. Due to prepayment risk,
rising interest rates also tend to discourage refinancings of home mortgages,
with the result that the average life of MBSs held by a Portfolio may be
lengthened. This extension of average life causes the market price of the MBSs
to decrease further than if their average lives were fixed. However, when
interest rates fall, mortgages may not enjoy as large a gain in market value
due to prepayment risk because additional mortgage prepayments must be
reinvested at lower interest rates. 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 MBS. In selecting these MBSs, the Adviser
will look for those 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 income taxes. Municipals include both municipal bonds
(those securities with maturities of five years or more) and municipal notes
(those securities 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
taxes. 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.
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NON-DIVERSIFIED STATUS. The U.S. Real Estate and Emerging Markets Debt
Portfolios are non-diversified portfolios under the 1940 Act, which means that
the Portfolios are not limited by the 1940 Act in the proportion of their
assets that may be invested in the obligations of a single issuer. Thus, the
Portfolios may invest a greater proportion of their assets in the securities of
a small number of issuers and, as a result, will be subject to greater risk
with respect to their portfolio securities. However, the Portfolios intend to
comply with diversification requirements imposed by the Internal Revenue Code
of 1986, as amended (the "Internal Revenue Code"), for qualification as
regulated investment companies. See "Investment Limitations" and "Taxes" in the
SAI.
NON-PUBLICLY TRADED SECURITIES, PRIVATE PLACEMENTS AND RESTRICTED
SECURITIES. The U.S. Real Estate, Emerging Markets Debt and High Yield
Portfolios 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, a 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 ("Rule 144A Securities") may be deemed to be
liquid under guidelines adopted by the Fund's Board of Directors. The U.S. Real
Estate Portfolio may invest up to 15% of its assets and the Emerging Markets
Debt Portfolio may invest up to 25% of its total assets in Rule 144A Securities
that are deemed to be liquid. The High Yield Portfolio is not limited in its
ability to invest in Rule 144A Securities that are deemed to be liquid.
The Fund's Board of Directors has adopted guidelines and delegated to each
Adviser, 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 a Portfolio's total assets in Restricted Securities may be
considered a speculative activity and may involve greater risk and expense to
that Portfolio.
PREFERRED STOCKS. Preferred Stocks are non-voting securities which evidence
ownership in a corporation and which pay a fixed or variable stream of
dividends.
REPURCHASE AGREEMENTS. Repurchase Agreements are transactions in which a
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 a 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 a 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.
Pursuant to an order expected to be issued by the SEC, the Portfolios may pool
their daily uninvested cash balances in order to invest in Repurchase
Agreements on a joint basis. By entering into Repurchase Agreements on a joint
basis, it is expected that the Portfolios will incur lower transaction costs
and potentially obtain higher rates of interest on such Repurchase Agreements.
Each Portfolio's participation in the income from jointly purchased Repurchase
Agreements will be based on that Portfolio's percentage share in the total
Repurchase Agreement. The Portfolios' ability to invest in Repurchase
Agreements on a joint basis will be contingent upon issuance of the order by
the SEC described above.
REVERSE REPURCHASE AGREEMENTS. A 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
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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 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.
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.
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 a 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 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 a 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 registrar, 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 a Portfolio from investing
in the securities of certain Russian companies deemed suitable by the Adviser
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 a 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 a 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 ("interest-only" or "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, a 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
TEMPORARY INVESTMENTS. During periods in which the Adviser believes changes in
economic, financial or political conditions make it advisable, each 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 a Portfolio may invest
consist of (a) obligations of the U.S. or foreign 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 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
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debt obligations of U.S. and foreign corporations meeting a Portfolio's credit
quality standards; and (e) Repurchase Agreements with banks and broker-dealers
with respect to such securities. For temporary defensive purposes, the
Portfolios intend to invest only in short-term and medium-term debt obligations
that the Adviser 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 a 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 liquid
securities or cash in an amount at least equal to these commitments. The U.S.
Real Estate, Emerging Markets Debt and Asian Equity Portfolios 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 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 each Portfolio discussed under "Portfolio
Summaries" above is a fundamental policy, that is, a policy subject to change
only by shareholder approval. The policy for each Portfolio in the following
paragraph is also fundamental. All policies stated throughout this Prospectus,
other than those identified as fundamental, can be changed without shareholder
approval. For additional fundamental and non-fundamental investment limits, see
"Investment Limitations" in the SAI.
Each Portfolio (excluding the U.S. Real Estate and Emerging Markets Debt
Portfolios) is a diversified investment company and is therefore subject to the
following fundamental limitations: as to 75% of its total assets, a Portfolio
may not (a) invest more than 5% of its total assets in the securities of any
one issuer, except obligations of the U.S. Government, its agencies and
instrumentalities, or (b) own more than 10% of the outstanding voting
securities of any one issuer.
INTERNAL REVENUE SERVICE ("IRS") LIMITATIONS. In addition to the above, each
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. For additional
information, see "Investment Limitations" in the SAI.
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
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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 the Adviser 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 a Portfolio 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 Portfolios held by the qualified plans. The
majority of the Fund's Directors are not affiliated with MSAM, MAS, any of
their 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 Portfolios 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 ADVISERS. The Adviser assigned to a Portfolio 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 serves as the Adviser for the U.S. Real Estate, Emerging
Markets Debt and Asian Equity Portfolios. MAS serves as the Adviser for the
High Yield Portfolio. 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 subsidiary of Morgan Stanley, Dean
Witter, Discover & Co. ("MSDWD"), which is a publicly owned financial services
corporation listed on the New York 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 and provides investment services to employee benefit
plans, endowment funds, foundations and other institutional investors. MAS is a
Pennsylvania limited liability partnership founded in 1969 with principal
offices at One Tower Bridge, West Conshohocken, Pennsylvania 19428. MAS is also
a subsidiary of MSDWD. MAS provides investment services to employee benefit
plans, endowment funds, foundations and other institutional investors and has
served as investment adviser to several open-end investment companies since
1984. As of August 31, 1997, MSAM, together with its affiliated asset
management companies (other than MAS, Van Kampen and Dean Witter InterCapital
Inc.), managed assets totaling approximately $80.9 billion and MAS managed
assets totaling approximately $57.6 billion. See "Management of the Fund" in
the SAI.
PORTFOLIO MANAGERS. The following individuals have primary responsibility for
the Portfolios as indicated below.
HIGH YIELD PORTFOLIO -- Robert E. Angevine, Thomas L. Bennett, and Stephen F.
Esser. Robert Angevine is a Principal of Morgan Stanley & Co. Incorporated
("Morgan Stanley") and the Portfolio Manager for high yield investments. Mr.
Angevine received an M.B.A. from Fairleigh Dickinson University and a B.A. in
Economics from Lafayette College. Thomas L. Bennett, a Managing Director of
Morgan Stanley, joined MAS in 1984. He assumed responsibility for the MAS Funds
Fixed Income Portfolio in 1984, the MAS Funds Domestic Fixed Income Portfolio
in 1987, the MAS Funds High Yield Portfolio in 1985, the MAS Funds Fixed Income
Portfolio II in 1990, the MAS Funds Special Purpose Fixed Income and Balanced
Portfolios in 1992 and the MAS Funds Multi-Asset-Class Portfolio in 1994. Mr
Bennett is Chairman of the Board of Trustees of MAS Funds, a member of the
Executive Committee of MAS and a Director of MAS Fund Distributors, Inc. Mr.
Bennett holds a B.S. in Chemistry and an M.B.A. from University of Cincinnati.
Stephen F. Esser, a Managing Director of Morgan Stanley, joined MAS in 1988. He
assumed responsibility for the MAS Funds High Yield Portfolio in 1989. Mr.
Esser holds a B.S. from University of Delaware. Messrs. Bennett, Angevine and
Esser have shared primary responsibility for managing the Portfolio's assets
since inception.
U.S. REAL ESTATE PORTFOLIO -- Theodore R. Bigman and Russell Platt. Mr. Bigman,
a Principal of Morgan Stanley, joined MSAM in 1995. Together with Russell
Platt, he is responsible for MSAM's real estate securities research. Prior to
joining MSAM, he was a Director at CS First Boston, where he worked for eight
years in the Real Estate Group. Mr. Bigman graduated from Brandeis University
with a B.A. in Economics and received an M.B.A. from Harvard University.
Russell Platt joined MSAM in 1994. Mr. Platt, a Managing Director of Morgan
Stanley, previously served as a Director of the General Partner of The Morgan
Stanley Real Estate Fund I, where he was involved in capital raising,
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acquisitions, oversight of investments and investor relations. From 1991 to
1993, Mr. Platt was head of Morgan Stanley Realty's Transaction Development
Group. As such, he was actively involved in Morgan Stanley's worldwide real
estate business. Mr. Platt graduated from Williams College with a B.A. in
Economics and received an M.B.A. from Harvard Business School. Mr. Bigman and
Mr. Platt have had primary responsibility for managing the Portfolio's assets
since inception.
EMERGING MARKETS DEBT PORTFOLIO -- Paul Ghaffari. Paul Ghaffari is a Managing
Director of Morgan Stanley. He joined MSAM in June 1993 as a Vice President and
Portfolio Manager for the Morgan Stanley Emerging Markets Debt Fund Inc. (a
closed-end investment company). Prior to joining MSAM, Mr. Ghaffari was a Vice
President in the Fixed Income Division of the Emerging Markets Sales and
Trading Department at Morgan Stanley. He holds a B.A. in International
Relations from Pomona College and an M.S. in Foreign Service from Georgetown
University. Mr. Ghaffari has had primary responsibility for managing the
Portfolio's assets since inception.
ASIAN EQUITY PORTFOLIO -- Ean Wah Chin and Seah Kiat Seng. Ean Wah Chin is a
Managing Director of Morgan Stanley, and is responsible for MSAM's regional
Asia ex-Japan operations based in Singapore. Prior to joining Morgan Stanley in
1986, Ms. Chin spent eight years with the Monetary Authority of Singapore and
the Government of Singapore Investment Corporation, where she was a portfolio
manager of one of the largest portfolios in Asia. Ms. Chin was an ASEAN scholar
educated at the University of Singapore. Seah Kiat Seng joined the Adviser's
Singapore office in 1990 as a portfolio manager/analyst specializing in the
Southeast Asian markets. He is currently a Vice President, responsible for
investments in Thailand. He has had primary management responsibility for the
Investment Fund since its inception. Kiat Seng is a Chartered Financial Analyst
and a qualified real estate valuer who has worked for the Singapore Ministry of
Finance. He was a Colombo Plan Scholar educated in New Zealand. Ms. Chin and
Mr. Seng have shared primary responsibility for managing the Portfolio's assets
since inception.
OTHER SERVICES
DISTRIBUTOR. Under its Distribution Agreement with the Fund, Morgan Stanley, a
subsidiary of MSDWD, serves as the exclusive Distributor of the Fund and sells
shares of each 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 any 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.
ADMINISTRATOR. MSAM and MAS also provide the respective Portfolios of the Fund
which they manage with administrative services pursuant to Administration
Agreements. The services provided under the respective Administration
Agreements 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 Agreements also provide that the
Administrators through their agents will provide the Fund with dividend
disbursing and transfer agent services. For their services under the
Administration Agreements, the Fund pays MSAM and MAS a monthly fee which on an
annual basis equals 0.25% of the average daily net assets of each Portfolio
that they administer.
MSAM and MAS have each 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 and MAS supervise and
monitor such administrative services provided by Chase Global. The services
provided under the Administration Agreements and the Sub-Administration
Agreements 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 Agreements and the Sub-
Administration Agreements 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 Agreements or the
Sub-Administration Agreements, see "Management of the Fund" in the SAI.
Certain administrative and recordkeeping services that would otherwise be
performed by the Advisers or their service providers, may be performed by
insurance companies that purchase shares of the Portfolios. An Adviser may make
payments to these insurance companies to defray the cost of providing those
services.
Chase Global calculates the NAV and dividends, maintains the general accounting
records and administers the securities lending program for each Portfolio.
CUSTODIANS. Chase serves as the Custodian of domestic securities and cash of
the Portfolios. Chase is not an affiliate of either of the Advisers or the
Distributor. Morgan Stanley Trust Company, Brooklyn, New York ("MSTC"), an
affiliate of MSAM, MAS and the Distributor, acts as the Fund's Custodian for
foreign assets held outside the United States (including, through sub-
custodians, securities held in Russia) and employs sub-custodians approved by
the Board of Directors of the Fund in accordance with regulations of
25
<PAGE>
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. Chase Global acts as dividend
disbursing and transfer agent for the Fund.
INDEPENDENT ACCOUNTANTS. Price Waterhouse LLP serves as independent accountants
for the Fund and audits the annual financial statements of each Portfolio.
LEGAL COUNSEL. Morgan, Lewis & Bockius LLP serves as legal counsel to the Fund.
BREAKDOWN OF EXPENSES
The Portfolios pay fees and other costs related to their daily operations.
Expenses paid out of a Portfolio's assets are reflected in its share price.
Each Portfolio pays a management fee to its Adviser for managing its
investments and business affairs. MSAM and MAS pay fees to affiliates who
provide assistance with these services. Each Portfolio also pays other
expenses, which are explained below. The Advisers may, from time to time,
reduce their fees or reimburse the Portfolios for expenses above a specified
limit. These fee reductions or expense reimbursements, which may be terminated
at any time without notice, can decrease a Portfolio's expenses and boost its
performance.
MANAGEMENT FEE
The Adviser assigned to a Portfolio is entitled to receive from such Portfolio
a management fee, payable quarterly, at an annual rate as a percentage of
average daily net assets as set forth in the table below.
PORTFOLIO ADVISORY FEES
<TABLE>
<CAPTION>
U.S. Real Emerging
Assets High Yield Estate Markets Debt Asian Equity
- ------------------------------------------------------------
<S> <C> <C> <C> <C>
First $500
million 0.50% 0.80% 0.80% 0.80%
- ------------------------------------------------------------
From $500
million to $1
billion 0.45% 0.75% 0.75% 0.75%
- ------------------------------------------------------------
More than $1
billion 0.40% 0.70% 0.70% 0.70%
</TABLE>
However, the Advisers, with respect to certain of the Portfolios, have
voluntarily waived receipt of their management fees and agreed to reimburse the
Portfolio, if necessary, if such fees would cause the total annual operating
expenses of the Portfolio to exceed the respective percentage of average daily
net assets set forth in the table below.
<TABLE>
<CAPTION>
Maximum Total Annual
Operating Expenses After
Portfolio Fee Waivers
- --------- ------------------------
<S> <C>
High Yield............................................. 0.80%
U.S. Real Estate....................................... 1.10%
Asian Equity........................................... 1.20%
Emerging Markets Debt.................................. 1.30%
</TABLE>
The fee restrictions are voluntary and may be terminated by the Adviser at any
time.
OTHER EXPENSES
In addition to investment advisory and certain administrative expenses charged
by the administrators, each Portfolio pays all expenses not assumed by MSAM or
MAS. 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
or MAS; fees and expenses of its independent accountants and legal counsel;
costs of Directors 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 Portfolios, which will be reflected in share prices.
PORTFOLIO TRANSACTIONS
The Investment Advisory Agreement authorizes the Adviser to select the brokers
or dealers that will execute the purchases and sales of investment securities
for the Portfolios and directs the Adviser to use its best efforts to obtain
the best available price and most favorable execution with respect to all
transactions for the Portfolios. The Fund has authorized the Adviser to pay
higher commissions in recognition of brokerage services which, in the opinion
of the Adviser, are necessary for the achievement of better
26
<PAGE>
execution, provided the Adviser believes this to be in the best interest of the
Fund.
Since shares of the Portfolios are not marketed through intermediary brokers or
dealers, it is not the Fund's practice to allocate brokerage or principal
business on the basis of sales of shares which may be made through such firms.
In purchasing and selling securities for the Portfolios, it is the Fund's
policy to seek to obtain quality execution at the most favorable prices through
responsible broker-dealers. In selecting broker-dealers to execute the
securities transactions for the Portfolios, consideration will be given to such
factors as the price of the security, the rate of the commission, the size and
difficulty of the order, the reliability, integrity, financial condition,
general execution and operational capabilities of competing broker-dealers, and
the brokerage and research services which they provide to the Fund. Some
securities considered for investment by the Portfolios may also be appropriate
for other clients served by the Adviser. If the purchase or sale of securities
consistent with the investment policies of the Portfolios and one or more of
these other clients serviced by the Adviser is considered at or about the same
time, transactions in such securities will be allocated among the Portfolios
and such other clients in a manner deemed fair and reasonable by the Adviser.
Although there is no specified formula for allocating such transactions, the
various allocation methods used by the Adviser, and the results of such
allocations, are subject to periodic review by the Fund's Board of Directors.
Subject to the overriding objective of obtaining the best possible execution of
orders, the Adviser may allocate a portion of the Portfolio's brokerage
transactions to Morgan Stanley or broker affiliates of Morgan Stanley. In order
for Morgan Stanley or its affiliates to effect any portfolio transactions for
the Fund, the commissions, fees or other remuneration received by Morgan
Stanley or such affiliates must be reasonable and fair compared to the
commissions, fees or other remuneration paid to other brokers in connection
with comparable transactions involving similar securities being purchased or
sold on a securities exchange during a comparable period of time. Furthermore,
the Board of Directors of the Fund, including a majority of those Directors who
are not "interested persons", as defined in the 1940 Act, have adopted
procedures which are reasonably designed to provide that any commissions, fees
or other remuneration paid to Morgan Stanley or such affiliates are consistent
with the foregoing standard.
Portfolio securities will not be purchased from or through, or sold to or
through, the Adviser or Morgan Stanley or any "affiliated persons", as defined
in the 1940 Act of Morgan Stanley when such entities are acting as principals,
except to the extent permitted by law.
PORTFOLIO TURNOVER
Under certain market conditions, a Portfolio may experience high portfolio
turnover as a result of its investment strategies. For example, the purchase or
sale of securities by a Portfolio in anticipation of a rise or decline in
interest rates or to take advantage of yield disparities among different issues
of Fixed Income Securities could result in high portfolio turnover. As a result
of their investment strategies, the Emerging Markets Debt and U.S. Real Estate
Portfolios' annual portfolio turnover rates are expected to be as high as 200%.
The High Yield Portfolio's rate is expected to be as high as 150%. Higher
portfolio turnover rates for the Portfolios can result in corresponding
increases in expenses such as brokerage commissions and transaction costs.
Although none of the Portfolios will invest for short-term trading purposes,
investment securities may be sold from time to time without regard to the
length of time they have been held and the Portfolios will not consider
portfolio turnover rate a limiting factor in making investment decisions
consistent with their respective objectives and policies.
PERFORMANCE OF PORTFOLIOS
Each Portfolio's total return and yield 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. Total return is the change in value of an investment in a
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.
YIELD. Yield refers to the income generated by an investment in a Portfolio
over a given period of time, expressed as an annual percentage rate. When a
yield assumes that income is reinvested, it is called an effective yield.
Total returns and yields quoted for the Portfolios include each Portfolio's
expenses, but may not include charges and expenses attributable to any
particular insurance product. Since shares of the Portfolios may be purchased
only through variable annuity contracts and variable life insurance policies
27
<PAGE>
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 each Portfolio's performance has the effect of
increasing the performance quoted. You should bear in mind the effect of these
charges when comparing a Portfolio's performance to that of other mutual funds.
PERFORMANCE OF INVESTMENT ADVISERS
The Advisers manage portfolios of Morgan Stanley Institutional Fund, Inc.
("MSIF") and MAS Funds, which served as the models for the Portfolios of the
Fund. The portfolios of MSIF and MAS Funds have substantially the same
investment objectives, policies and strategies as the Portfolios of the Fund.
In addition, the Advisers intend the Portfolios of the Fund and the
corresponding portfolios of MSIF and MAS Funds to be managed by the same
personnel and to continue to have closely similar investment strategies,
techniques and characteristics. The following table sets forth the name of each
Portfolio of the Fund and the name of the corresponding portfolio of MSIF or
MAS Funds from which the Portfolio is cloned.
<TABLE>
<CAPTION>
Corresponding Corresponding
MSIF MAS Funds
Fund Portfolio portfolio portfolio
-------------- ------------- -------------
<S> <C> <C>
U.S. Real Estate U.S. Real Estate
High Yield High Yield
Emerging Markets Debt Emerging Markets Debt
Asian Equity Asian Equity
</TABLE>
Past investment performance of the Class A Shares of the MSIF portfolios and
the Institutional Class Shares of the MAS High Yield Portfolio, as shown in the
table below, may be relevant to your consideration of the Portfolios. The
investment performance of the portfolios of MSIF and MAS Funds is not
necessarily indicative of future performance of the Portfolios of the Fund.
Also, the operating expenses of each of the Portfolios of the Fund will be
different from, and may be higher than, the operating expenses of the
corresponding portfolio of the MSIF or MAS Funds. The investment performance of
the Class A Shares of the MSIF portfolios and the Institutional Class Shares of
the MAS High Yield Portfolio is provided merely to indicate the experience of
the Advisers in managing similar portfolios.
<TABLE>
<CAPTION>
Average Average
Annual Annual Average
Total Return Total Return Total Return Total Return Total Return Total Return Annual
Six Months One Year Five Years Ten Years Five Years Ten Years Total Return
Inception Ended Ended Ended Ended Ended Ended Since
Fund Name Date 6/30/97 6/30/97 6/30/97 6/30/97 6/30/97 6/30/97 Inception
- --------- --------- ------------ ------------ ------------ ------------ ------------ ------------ ------------
<S> <C> <C> <C> <C> <C> <C> <C> <C>
MSIF:
U.S. Real Estate.... 2/24/95 11.46% 40.01% NA NA NA NA 30.94%
Emerging Markets
Debt............... 2/1/94 17.24% 49.05% NA NA NA NA 21.51%
Asian Equity........ 7/1/91 2.30% 0.11% 86.23% NA 14.43% NA 17.09%
MAS Fund:
High Yield.......... 2/28/89 8.41% 19.11% 91.95% NA 13.93% NA 12.01%
</TABLE>
PRINCIPAL HOLDERS OF SECURITIES
At August 8, 1997, MSDWD owned more than 25% of the outstanding voting
securities of the High Yield, U.S. Real Estate, Emerging Markets Debt and Asian
Equity Portfolios.
As currently required under law, insurance companies vote their shares of the
Portfolios in accordance with instructions received from their variable annuity
contract and variable life insurance policy owners. MSDWD will vote the shares
of each Portfolio that it owns in the same proportions as shares of the
Portfolio are voted by the insurance companies. Accordingly, neither MSDWD nor
the insurance companies are deemed to be in control of the Portfolios.
For more information, see "Control Persons and Principal Holders of Securities"
in the SAI.
ACCOUNT POLICIES
- ----------------
DISTRIBUTIONS AND TAXES
The Fund intends each of its Portfolios to qualify as a separate entity under
the Internal Revenue Code, and to qualify as a "regulated investment company"
under Subchapter M of the Internal Revenue Code. As a regulated investment
company under the Internal Revenue Code, net income and net realized gains of
each Portfolio will be distributed to shareholders at least once a year.
28
<PAGE>
As stated on the cover of this prospectus, 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 Internal Revenue 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 Portfolios are open for business each day the New York Stock Exchange
("NYSE") is open. Each of the U.S. Real Estate, Emerging Markets Debt and Asian
Equity 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,
Presidents' Day, Martin Luther King, Jr. 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.
The High Yield Portfolio's NAV is determined as of one hour after the close of
the bond markets (normally 4:00 p.m. Eastern time) on each day that the
Portfolio is open for business.
Each 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.
Each 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.
Each Portfolio's offering price (price to buy one share) and redemption price
(price to sell one share) are its NAV.
Each Portfolio reserves the right to suspend the offering of shares for a
period of time. Each Portfolio also reserves the right to reject any specific
order. Purchase orders may be refused if, in the Adviser's opinion, they would
disrupt management of a Portfolio.
INVESTMENTS AND REDEMPTIONS. Investments and redemptions are made by insurance
companies for their variable annuity contracts and variable life insurance
policies and by tax qualified investors, such as qualified pension and
retirement plans.
Each participating insurance company receives orders from its variable annuity
contract and variable life insurance policy owners to purchase or redeem shares
of the Portfolios 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 one or more
Portfolios 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 a
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 a Portfolio.
Redemption proceeds will normally be wired to the insurance company on the next
business day after receipt of the redemption instructions by a Portfolio but in
no event later than seven days following receipt of instructions. Each
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.
29
