<PAGE>
MORGAN STANLEY UNIVERSAL FUNDS, INC.
- --------------------------------------------------------------------------------
U.S. REAL ESTATE PORTFOLIO
SEMI-ANNUAL REPORT
JUNE 30, 1998
<PAGE>
MORGAN STANLEY UNIVERSAL FUNDS, INC.
U.S. REAL ESTATE PORTFOLIO
- --------------------------------------------------------------------------------
INVESTMENT OVERVIEW
COMPOSITION OF NET ASSETS (AT JUNE 30, 1998)
EDGAR REPRESENTATION OF DATA POINTS USED IN PRINTED GRAPHIC
<TABLE>
<S> <C>
Diversified 8.7%
Lodging and Resorts 7.9%
Office/Industrial 38.1%
Residential 19.1%
Retail 17.0%
Self Storage 2.1%
Other 7.1%
</TABLE>
PERFORMANCE COMPARED TO THE NATIONAL ASSOCIATION OF REAL ESTATE INVESTMENT
TRUSTS (NAREIT) EQUITY INDEX(1)
- ------------------------------------
<TABLE>
<CAPTION>
TOTAL RETURNS(2)
-------------------------------------------
ONE AVERAGE ANNUAL
YTD YEAR SINCE INCEPTION(3)
---------- ---------- -------------------
<S> <C> <C> <C>
PORTFOLIO... -4.73% 8.39% 9.22%
INDEX....... -5.03% 8.05% 9.79%
</TABLE>
1. The NAREIT Equity Index is an unmanaged market weighted index of tax
qualified REITs listed on the New York Stock Exchange, American Stock
Exchange and the NASDAQ Natonal Market Systems (including dividends).
2. Total returns for the Portfolio reflect expenses waived and reimbursed, if
applicable, by the Adviser. Without such waiver and reimbursement, total
returns would be lower.
3. Commenced operations on March 3, 1997.
PAST PERFORMANCE IS NOT PREDICTIVE OF FUTURE PERFORMANCE.
<TABLE>
<CAPTION>
TOP FIVE HOLDINGS
PERCENT OF
SECURITY INDUSTRY NET ASSETS
- ---------------------------- ------------------- ---------------
<S> <C> <C>
Arden Realty Group, Inc. Office/Industrial 5.0%
CarrAmerica Realty Corp.
REIT Office/Industrial 4.6%
Starwood Lodging Trust REIT Lodging and Resorts 4.5%
Brookfield Properties Corp. Office/Industrial 4.3%
Avalon Bay Communities,
Inc. REIT Residential 4.1%
</TABLE>
<TABLE>
<CAPTION>
TOP FIVE SECTORS
VALUE PERCENT OF
INDUSTRY (000) NET ASSETS
- ------------------------- --------- -------------
<S> <C> <C>
Office/Industrial $ 5,781 38.1%
Residential 2,903 19.1%
Retail 2,569 17.0%
Diversified 1,326 8.7%
Lodging and Resorts 1,194 7.9%
</TABLE>
THE PERFORMANCE RESULTS PROVIDED ARE FOR INFORMATIONAL PURPOSES ONLY AND SHOULD
NOT BE CONSTRUED AS A GUARANTEE OF THE PORTFOLIO'S FUTURE PERFORMANCE. PAST
PERFORMANCE SHOWN IS NOT PREDICTIVE OF FUTURE PERFORMANCE. INVESTMENT RETURN AND
PRINCIPAL VALUE WILL FLUCTUATE SO THAT AN INVESTOR'S SHARES, WHEN REDEEMED, MAY
BE WORTH MORE OR LESS THAN THEIR ORIGINAL COST.
The U.S. Real Estate Portfolio seeks to provide 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").
For the six months ended June 30, 1998, the Portfolio had a total return of
- -4.73% compared to -5.03% for the National Association of Real Estate Investment
Trusts (NAREIT) Equity Index (the "Index"). For the one year period ended June
30, 1998, the Portfolio had a total return of 8.39% compared to 8.05% for the
Index. From inception on March 3, 1997 to June 30, 1998, the Portfolio had an
average annual total return of 9.22% compared to 9.79% for the Index.
Following a difficult first quarter, the second quarter provided very little for
REIT investors to cheer about. The Index declined 4.59% for the quarter and is
now down 5.03% year-to-date. In the first quarter the key reason for the
difficulties in REIT prices appeared to be technical -- the continued strength
in the U.S. equity market led many non-dedicated real estate investors to move
funds to the broad market from the REIT sector. However, in the second quarter
the discussion with regard to the continuation of price weakness led to a
greater focus on real estate fundamentals going forward. As the U.S. real estate
cycle continues to age, the level of new construction has begun to raise
concerns among a spectrum of public and private real estate industry
participants. Markets are now being gauged for a view as to when supply will
surpass demand. Since the public market tends to look forward, we can expect
multiples to contract in anticipation of a deterioration in fundamentals.
After three years of strong performance, the sector is faced with competing
rallying cries of both REIT bulls and bears. One group of analysts finds value
in the sector by demonstrating the large disparity between the relative average
multiple of the S&P 500 versus REITs. These analysts also cite REITs for their
defensive characteristics and for providing portfolio diversification. The bears
point to the cyclical nature of the real estate asset class and argue that
multiples have begun to
1
<PAGE>
MORGAN STANLEY UNIVERSAL FUNDS, INC.
U.S. REAL ESTATE PORTFOLIO
- --------------------------------------------------------------------------------
INVESTMENT OVERVIEW (CONT.)
contract in anticipation of a slowdown in the rate of return in U.S. commercial
real estate and an eventual downturn in capital values. Other favorite
criticisms brought forth by the bears include the notion that REITs' reliance on
raising equity capital to grow creates a supply-demand imbalance for REIT
shares, thus keeping a ceiling on share prices. This opinion reflects the idea
that non-dedicated investors will continue to avoid the sector; in addition, it
is not clear how much demand will be provided by value-oriented investors or
those investors searching for defensive vehicles.
As we have discussed, the multifamily and industrial markets have already
achieved equilibrium, with limited pockets of current supply problems. Despite a
rapidly accelerating pace of new office development, the potential for
widespread occupancy pressures from this sector does not appear on the horizon
until 1999 or 2000. New development is confined primarily to sunbelt suburban
locations and is only lightly scattered in a number of central business
districts. In the hotel sector, although recent concerns were focused on the
limited service segment of the market, the cautionary yellow flag is now being
waved for each of the categories. The reason that potential oversupply in the
hotel sector creates greater concern than other sectors is that the typical
lease in a hotel is for only one night and, as a result, economics can
deteriorate rapidly. In light of the strong economy, retail sales have been
buoyant resulting in strong results for retailers and greater demand to open new
stores. We expect new development to meet this demand.
It is not surprising that the equity offering calendar has become very light and
the few deals that were completed in the quarter were priced at far lower levels
than were desired by issuers. We expect that, given current valuations, a number
of the IPOs that have been filed will be postponed until the market can recover.
In addition, a number of companies that have made large acquisitions and had
expected to complete equity follow-on offerings need to study their alternatives
carefully. Clearly, if current pricing levels persist, the rapid pace of equity
securitization will slow as companies will be reluctant (or unable) to raise
equity capital to finance their growth. This should apply to both acquisitions
financed by cash as well as the trend of trading property for shares with
institutional investors and private companies. Finally, we expect that the
merger environment may heat-up as some companies are trading at or below
valuation levels that approximate their private real estate value.
The current market also may require a change of focus by the majority of the
REIT analyst community. The recent focus has been on setting targets for a
company's annual acquisitions pace and utilizing these targets to establish
estimates of funds from operations ("FFO") per share. Since this analysis is
highly dependent on projecting future equity issuance and the corresponding
price for that issuance, current FFO estimates have become suspect. Our style of
focusing on net asset value ("NAV") per share does not face this issue. However,
to the extent we have attributed some portion of the NAV to "development value"
we must analyze the feasibility of a REIT completing its identified projects. We
have spent considerable time discussing the attitude of management toward
enhancing shareholder value by focusing on internal growth, development and
redevelopment of assets as well as stock buybacks and the sale of non-strategic
assets.
The REIT market has come under pressure by selling from non-dedicated investors;
these investors were most heavily concentrated in the larger capitalization
companies, particularly those companies focusing in the office and hotel sectors
(which have been the two best performing sectors over the course of the last
three years). We have continued to shape the Portfolio with companies offering
attractive fundamental valuations relative to their underlying real estate
value. As a result, we have added a number of large cap companies that have
faced the greatest price compression. From a top-down perspective, we have
significantly added to the office sector as a result of price declines. We have
attempted to overweight the office sector previously due to favorable
fundamentals, but lofty prices caused us to temper that overweighting. These
high prices had been the result of external growth expectations, which are in
the process of being downgraded. Despite the price pressure in the hotel sector,
we have modestly decreased our exposure due to the concerns discussed above. In
order to pay for the addition to office, we have decreased our exposure to both
multifamily and healthcare. These two sectors have been modestly valued and have
not suffered the same declines in share price.
July 1998
2
<PAGE>
MORGAN STANLEY UNIVERSAL FUNDS, INC.
U.S. REAL ESTATE PORTFOLIO
- --------------------------------------------------------------------------------
STATEMENT OF NET ASSETS
JUNE 30, 1998
(UNAUDITED)
<TABLE>
<CAPTION>
VALUE
SHARES (000)
<C> <S> <C>
- ------------------------------------------------------------------------
COMMON STOCKS (92.9%)
DIVERSIFIED (8.7%)
2,700 Capital Automotive REIT.......................... $ 38
600 Crescent Real Estate Equities Co. REIT........... 20
20,600 Pacific Gulf Properties, Inc. REIT............... 446
10,500 Pennsylvania REIT................................ 233
5,000 Vornado Realty Trust REIT........................ 199
(a)27,607 Wellsford Real Properties, Inc................... 390
-------
1,326
-------
LODGING AND RESORTS (7.9%)
(a)8,000 CapStar Hotel Co................................. 224
(a)12,000 Host Marriott Corp............................... 214
14,187 Starwood Lodging Trust REIT...................... 685
(a)4,800 Station Casinos, Inc............................. 71
-------
1,194
-------
OFFICE/INDUSTRIAL (38.1%)
INDUSTRIAL (2.1%)
1,700 Meridian Industrial Trust, Inc. REIT............. 39
16,700 Prime Group Realty Trust REIT.................... 286
-------
325
-------
OFFICE/INDUSTRIAL--MIXED (4.2%)
8,800 Bedford Property Investors, Inc. REIT............ 161
7,100 Reckson Associates Realty Corp. REIT............. 168
8,100 Spieker Properties, Inc. REIT.................... 314
-------
643
-------
OFFICE (31.8%)
29,300 Arden Realty Group, Inc.......................... 758
25,000 Brandywine Realty Trust REIT..................... 559
47,600 Brookfield Properties Corp....................... 655
24,700 CarrAmerica Realty Corp. REIT.................... 701
21,087 Equity Office Properties Trust REIT.............. 598
22,000 Great Lakes, Inc. REIT........................... 384
7,000 Kilroy Realty Corp. REIT......................... 175
6,900 Mack-Cali Realty Corp. REIT...................... 237
10,400 SL Green Realty Corp. REIT....................... 234
23,900 Trizec Hahn Corp................................. 512
-------
4,813
-------
TOTAL OFFICE/INDUSTRIAL...................................... 5,781
-------
OTHER (0.2%)
(a)10,848 Atlantic Gulf Communities Corp................... 22
(a)1,168 Reckson Services Industries, Inc................. 4
-------
26
-------
RESIDENTIAL (19.1%)
RESIDENTIAL APARTMENTS (13.5%)
16,500 Avalon Bay Communities, Inc. REIT................ 627
4,500 Equity Residential Properties Trust REIT......... 214
15,400 Essex Property Trust, Inc. REIT.................. 477
7,800 Irvine Apartment Communities, Inc. REIT.......... 226
18,183 Security Capital Atlantic, Inc. REIT............. 406
2,100 Security Capital Pacific Trust REIT.............. 47
1,600 Smith (Charles E.) Residential Realty, Inc.
REIT........................................... 51
-------
2,048
-------
<CAPTION>
VALUE
SHARES (000)
<C> <S> <C>
- ------------------------------------------------------------------------
RESIDENTIAL MANUFACTURED HOMES (5.6%)
21,400 Chateau Properties, Inc. REIT.................... $ 615
1,300 Manufactured Home Communities, Inc. REIT......... 31
6,300 Sun Communities, Inc. REIT....................... 209
-------
855
-------
TOTAL RESIDENTIAL............................................ 2,903
-------
RETAIL (16.8%)
RETAIL REGIONAL MALLS (6.9%)
8,000 CBL & Associates Properties, Inc. REIT........... 194
40,100 Taubman Centers, Inc. REIT....................... 571
8,700 Urban Shopping Centers, Inc. REIT................ 274
-------
1,039
-------
RETAIL STRIP CENTERS (9.9%)
32,400 Burnham Pacific Property Trust REIT.............. 460
25,400 Federal Realty Investment Trust REIT............. 611
9,100 Pan Pacific Retail Properties, Inc. REIT......... 176
100 Ramco-Gershenson Properties Trust REIT........... 2
9,900 Regency Realty Corp.............................. 249
-------
1,498
-------
TOTAL RETAIL................................................. 2,537
-------
SELF STORAGE (2.1%)
5,300 Public Storage, Inc. REIT........................ 149
6,100 Shurgard Storage Centers, Inc., Series A REIT.... 169
-------
318
-------
TOTAL COMMON STOCK (COST $14,355)............................ 14,085
-------
PREFERRED STOCK (0.1%)
OTHER (0.1%)
(a)1,401 Atlantic Gulf Communities Corp. (COST $14)....... 10
-------
CONVERTIBLE PREFERRED STOCKS (0.3%)
OTHER (0.1%)
(a)2,003 Atlantic Gulf Communities Corp., Series B........ 14
-------
RETAIL STRIP CENTERS (0.2%)
1,100 First Washington Realty Trust, Series A REIT..... 32
-------
TOTAL CONVERTIBLE PREFERRED STOCKS (COST $54)................ 46
-------
</TABLE>
<TABLE>
<CAPTION>
NO. OF
WARRANTS
<C> <S> <C>
- -----------
WARRANTS (0.0%)
OTHER (0.0%)
(a,d)2,812 Atlantic Gulf Communities Corp., Class A,
expiring 6/24/04............................... 1
(a,d)2,812 Atlantic Gulf Communities Corp., Class B,
expiring 6/24/04............................... 1
(a,d)2,812 Atlantic Gulf Communities Corp., Class C,
expiring 6/24/04............................... 1
-------
TOTAL WARRANTS (COST $0)....................................... 3
-------
</TABLE>
The accompanying notes are an integral part of the financial statements.
3
<PAGE>
MORGAN STANLEY UNIVERSAL FUNDS, INC.
U.S. REAL ESTATE PORTFOLIO
- --------------------------------------------------------------------------------
STATEMENT OF NET ASSETS (CONT.)
JUNE 30, 1998
(UNAUDITED)
<TABLE>
<CAPTION>
FACE
AMOUNT VALUE
(000) (000)
<C> <S> <C>
- ------------------------------------------------------------------------
SHORT-TERM INVESTMENT (7.2%)
REPURCHASE AGREEMENT (7.2%)
$1,089 Chase Securities, Inc. 5.40%, dated 6/30/98, due
7/1/98, to be repurchased at $1,089,
collateralized by U.S. Treasury Bonds, 11.25%,
due 2/15/15, valued at $1,118
(COST $1,089).................................. $ 1,089
-------
TOTAL INVESTMENTS (100.5%) (COST $15,512)............................................ 15,233
-------
OTHER ASSETS (1.1%)
Cash...................................................................... $ 1
Dividends Receivable...................................................... 121
Receivable for Investments Sold........................................... 35
Receivable for Portfolio Shares Sold...................................... 15
Other..................................................................... 3 175
-------
LIABILITIES ( -1.6%)
Payable for Investments Purchased......................................... (211)
Custodian Fees Payable.................................................... (13)
Professional Fees Payable................................................. (13)
Investment Advisory Fees Payable.......................................... (6)
Administrative Fees Payable............................................... (3)
Payable for Portfolio Shares Redeemed..................................... (2)
Other Liabilities......................................................... (3) (251)
------- -------
NET ASSETS (100%)........................................................... $15,157
-------
-------
NET ASSET VALUE, OFFERING AND REDEMPTION
PRICE PER SHARE
Applicable to 1,393,765 outstanding $0.001 par value Shares (authorized 500,000,000
shares)............................................................................ $10.87
-------
-------
NET ASSETS CONSIST OF:
Paid in Capital...................................................................... $14,861
Undistributed Net Investment Income.................................................. 320
Accumulated Net Realized Gain........................................................ 255
Unrealized Depreciation on Investments............................................... (279)
-------
NET ASSETS........................................................................... $15,157
-------
-------
</TABLE>
- ---------------
(a) -- Non-income producing security
(d) -- Security valued at fair value -- See note A-1 to financial statements.
REIT -- Real Estate Investment Trust
- ----------------------------------------------------------------
- ----------------------------------------------------------------
At June 30, 1998, cost and unrealized appreciation (depreciation) for U.S.
Federal income tax purposes of the investments of the Portfolio were:
<TABLE>
<CAPTION>
NET
COST APPRECIATION (DEPRECIATION) (DEPRECIATION)
(000) (000) (000) (000)
- --------- --------------- --------------- ---------------
<S> <C> <C> <C>
$ 15,512 $ 188 $ (467) $ (279)
</TABLE>
For the six months ended June 30, 1998, purchases and sales of investment
securities for the Portfolio, other than long-term U.S. Government securities
and short-term investments, were approximately $10,735,000 and $8,297,000,
respectively. There were no purchases and sales of long-term U.S. Government
securities for the six months ended June 30, 1998.
The accompanying notes are an integral part of the financial statements.
4
<PAGE>
MORGAN STANLEY UNIVERSAL FUNDS, INC.
U.S. REAL ESTATE PORTFOLIO
- --------------------------------------------------------------------------------
STATEMENT OF OPERATIONS
<TABLE>
<CAPTION>
SIX MONTHS ENDED
JUNE 30, 1998
(UNAUDITED)
(000)
<S> <C>
- -------------------------------------------------------
INVESTMENT INCOME:
Dividends $ 372
Interest 20
------
Total Income 392
------
EXPENSES:
Investment Advisory Fees 55
Less: Fees Waived (32)
------
Net Investment Advisory Fees 23
Administrative Fees 19
Shareholder Reports 14
Professional Fees 10
Custodian Fees 8
Directors' Fees and Expenses 1
Other 1
------
Net Expenses 76
------
Net Investment Income 316
------
NET REALIZED GAIN ON:
Investments Sold 164
------
CHANGE IN UNREALIZED
APPRECIATION/DEPRECIATION ON:
Investments (1,132)
------
Net Realized Gain and Change in
Unrealized
Appreciation/Depreciation (968)
------
NET DECREASE IN NET ASSETS RESULTING
FROM OPERATIONS $ (652)
------
------
</TABLE>
- --------------------------------------------------------------------------------
STATEMENT OF CHANGES IN NET ASSETS
<TABLE>
<CAPTION>
SIX MONTHS ENDED PERIOD FROM
JUNE 30, 1998 MARCH 3, 1997*
(UNAUDITED) TO DECEMBER 31, 1997
(000) (000)
<S> <C> <C>
- ------------------------------------------------------------------------------------
INCREASE (DECREASE) IN NET ASSETS
OPERATIONS:
Net Investment Income $ 316 $ 193
Net Realized Gain 164 318
Change in Unrealized
Appreciation/Depreciation (1,132) 853
------- -------
Net Increase/Decrease in Net Assets
Resulting from Operations (652) 1,364
------- -------
DISTRIBUTIONS:
Net Investment Income -- (189)
Net Realized Gain -- (227)
------- -------
Total Distributions -- (416)
------- -------
CAPITAL SHARE TRANSACTIONS (1):
Subscribed 5,902 13,434
Distributions Reinvested -- 228
Redeemed (3,148) (1,555)
------- -------
Net Increase in Net Assets Resulting
from Capital Share Transactions 2,754 12,107
------- -------
Total Increase in Net Assets 2,102 13,055
NET ASSETS:
Beginning of Period 13,055 --
------- -------
End of Period (Including
undistributed net investment
income of $320 and $4,
respectively) $15,157 $13,055
------- -------
------- -------
- ------------------------------------------------------------------------------------
(1) Capital Share Transactions:
Shares Subscribed 533 1,259
Shares Issued on Distributions
Reinvested -- 21
Shares Redeemed (284) (135)
------- -------
Net Increase in Capital Shares
Outstanding 249 1,145
------- -------
------- -------
- ------------------------------------------------------------------------------------
* Commencement of operations
</TABLE>
The accompanying notes are an integral part of the financial statements.
5
<PAGE>
MORGAN STANLEY UNIVERSAL FUNDS, INC.
U.S. REAL ESTATE PORTFOLIO
- --------------------------------------------------------------------------------
FINANCIAL HIGHLIGHTS
<TABLE>
<CAPTION>
SIX MONTHS ENDED PERIOD FROM
JUNE 30, 1998 MARCH 3, 1997*
SELECTED PER SHARE DATA AND RATIOS (UNAUDITED) TO DECEMBER 31, 1997
<S> <C> <C>
- ------------------------------------------------------------------------------
NET ASSET VALUE, BEGINNING OF PERIOD $ 11.41 $ 10.00
------- -------
INCOME FROM INVESTMENT OPERATIONS
Net Investment Income 0.23 0.17
Net Realized and Unrealized
Gain(Loss) (0.77) 1.61
------- -------
Total From Investment Operations (0.54) 1.78
------- -------
DISTRIBUTIONS
Net Investment Income -- (0.17)
Net Realized Gain -- (0.20)
------- -------
Total Distributions -- (0.37)
------- -------
NET ASSET VALUE, END OF PERIOD $ 10.87 $ 11.41
------- -------
------- -------
TOTAL RETURN (4.73)% 17.99%
------- -------
------- -------
RATIOS AND SUPPLEMENTAL DATA:
Net Assets, End of Period (000's) $15,157 $13,055
Ratio of Expenses to Average Net
Assets 1.10%** 1.10%**
Ratio of Net Investment Income to
Average Net Assets 4.57%** 3.14%**
Portfolio Turnover Rate 63% 114%
- ------------------------------------------------------------------------------
Effect of Voluntary Expense
Limitation During the Period:
Per Share Benefit to Net Investment
Income $ 0.02 $ 0.07
Ratios Before Expense Limitation:
Expenses to Average Net Assets 1.56%** 2.32%**
Net Investment Income to Average
Net Assets 4.10%** 1.92%**
</TABLE>
- --------------------------------------------------------------------------------
* Commencement of operations
** Annualized
The accompanying notes are an integral part of the financial statements.
6
<PAGE>
MORGAN STANLEY UNIVERSAL FUNDS, INC.
NOTES TO FINANCIAL STATEMENTS
JUNE 30, 1998 (UNAUDITED)
- --------------------------------------------------------------------------------
Morgan Stanley Universal Funds, Inc. (the "Fund") is registered under the
Investment Company Act of 1940, as amended, as an open-end management investment
company. As of June 30, 1998, the Fund was comprised of eleven separate active
portfolios (individually referred to as a "Portfolio", collectively as the
"Portfolios").
The accompanying financial statements cover only the U.S. Real Estate Portfolio.
The Fund is intended to be the funding vehicle for variable annuity contracts
and variable life insurance policies to be offered by the separate accounts of
certain life insurance companies.
A. ACCOUNTING POLICIES: The following significant accounting policies are in
conformity with generally accepted accounting principles for investment
companies. Such policies are consistently followed by the Fund in the
preparation of the financial statements. Generally accepted accounting
principles may require management to make estimates and assumptions that affect
the reported amounts and disclosures in the financial statements. Actual results
may differ from those estimates.
1. SECURITY VALUATION: Equity securities listed on a U.S. exchange and equity
securities traded on NASDAQ are valued at the latest quoted sales price on the
valuation date. Securities listed on a foreign exchange are valued at their
closing price. Unlisted securities and listed securities not traded on the
valuation date, for which market quotations are readily available, are valued at
the average of the mean between the current bid and asked prices obtained from
reputable brokers. Bonds and other fixed income securities may be valued
according to the broadest and most representative market. In addition, bonds and
other fixed income securities may be valued on the basis of prices provided by a
pricing service which are based primarily on institutional size trading in
similar groups of securities. The prices provided by a pricing service are
determined without regard to bid or last sale prices, but take into account
institutional size trading in similar groups of securities and any developments
related to the specific securities. Debt securities purchased with remaining
maturities of 60 days or less are valued at amortized cost, if it approximates
market value. All other securities and assets for which market values are not
readily available, including restricted securities, are valued at fair value as
determined in good faith by the Board of Directors, although the actual
calculations may be done by others.
2. INCOME TAXES: It is each Portfolio's intention to qualify as a regulated
investment company and distribute all of its taxable and tax-exempt income.
Accordingly, no provision for Federal income taxes is required in the financial
statements.
Certain Portfolios may be subject to taxes imposed by countries in which they
invest. Such taxes are generally based on income and/or capital gains earned or
repatriated. Taxes are accrued and applied to net investment income, net
realized gains and net unrealized appreciation as these amounts are earned.
Taxes may also be based on the movement of foreign currency and are accrued
based on the value of investments denominated in such currency.
3. REPURCHASE AGREEMENTS: The Portfolios of the Fund may enter into repurchase
agreements under which the Portfolio lends excess cash and takes possession of
securities with an agreement that the counterparty will repurchase such
securities. In connection with transactions in repurchase agreements, a bank as
custodian for the Fund takes possession of the underlying securities which are
held as collateral, with a market value at least equal to the amount of the
repurchase transaction, including principal and accrued interest. To the extent
that any repurchase transaction exceeds one business day, the value of the
collateral is marked-to-market on a daily basis to determine the adequacy of the
collateral. In the event of default on the obligation to repurchase, the Fund
has the right to liquidate the collateral and apply the proceeds in satisfaction
of the obligation. In the event of default or bankruptcy by the counterparty to
the agreement, realization and/or retention of the collateral or proceeds may be
subject to legal proceedings.
4. FOREIGN CURRENCY TRANSLATION AND FOREIGN INVESTMENTS: The books and records
of the Fund are maintained in U.S. dollars. Foreign currency amounts are
translated into U.S. dollars at the mean of the bid and asked prices of such
currencies against U.S. dollars last quoted by a major bank as follows:
- investments, other assets and liabilities at the prevailing rates of
exchange on the valuation date;
- investment transactions and investment income at the prevailing rates of
exchange on the dates of such transactions.
Although the net assets of the Fund are presented at the foreign exchange rates
and market values at the close of the period, the Fund does not isolate that
portion of the results of operations arising as a result of changes in the
foreign exchange rates from the fluctuations arising from changes in the market
prices of the securities held at period end. Similarly, the Fund does not
isolate the effect of changes in foreign exchange rates from the fluctuations
arising from changes in the market prices of securities sold during the period.
Accordingly, realized and unrealized foreign currency gains (losses) are
included in the reported net realized and unrealized gains (losses) on
investment transactions and balances. However, pursuant to U.S. Federal income
tax regulations, gains and losses from certain foreign currency transactions and
the foreign currency portion of gains and losses realized on sales and
maturities of foreign denominated debt securities are treated as ordinary income
for U.S. Federal income tax purposes.
7
<PAGE>
MORGAN STANLEY UNIVERSAL FUNDS, INC.
NOTES TO FINANCIAL STATEMENTS (CONT.)
JUNE 30, 1998 (UNAUDITED)
- --------------------------------------------------------------------------------
Net realized gains (losses) on foreign currency transactions represent net
foreign exchange gains (losses) from foreign currency exchange contracts,
disposition of foreign currencies, currency gains or losses realized between the
trade and settlement dates on securities transactions, and the difference
between the amount of investment income and foreign withholding taxes recorded
on the Fund's books and the U.S. dollar equivalent amounts actually received or
paid. Net unrealized currency gains (losses) from valuing foreign currency
denominated assets and liabilities at period end exchange rates are reflected as
a component of unrealized appreciation (depreciation) on the Statement of Net
Assets. The change in net unrealized currency gains (losses) for the period is
reflected on the Statement of Operations.
Foreign security and currency transactions may involve certain considerations
and risks not typically associated with those of U.S. dollar denominated
transactions as a result of, among other factors, the possibility of lower
levels of governmental supervision and regulation of foreign securities markets
and the possibility of political or economic instability.
Prior governmental approval for foreign investments may be required under
certain circumstances in some countries, and the extent of foreign investments
in domestic companies may be subject to limitation in other countries. Foreign
ownership limitations also may be imposed by the charters of individual
companies to prevent, among other concerns, violation of foreign investment
limitations. As a result, an additional class of shares (identified as "Foreign"
in the Statement of Net Assets) may be created and offered for investment. The
"local" and "foreign" shares' market values may differ. In the absence of
trading of the foreign shares in such markets, the Fund values the foreign
shares at the closing exchange price of the local shares. Such securities are
identified as fair valued in the Statement of Net Assets.
5. FOREIGN CURRENCY EXCHANGE CONTRACTS: Certain Portfolios may enter into
foreign currency exchange contracts generally to attempt to protect securities
and related receivables and payables against changes in future foreign currency
exchange rates and, in certain situations, to gain exposure to foreign
currencies. A foreign currency exchange contract is an agreement between two
parties to buy or sell currency at a set price on a future date. The market
value of the contract will fluctuate with changes in currency exchange rates.
The contract is marked-to-market daily and the change in market value is
recorded by the Portfolios as unrealized gain or loss. The Portfolios record
realized gains or losses when the contract is closed equal to the difference
between the value of the contract at the time it was opened and the value at the
time it was closed. Risk may arise upon entering into these contracts from the
potential inability of counterparties to meet the terms of their contracts and
is generally limited to the amount of the unrealized gain on the contracts, if
any, at the date of default. Risks may also arise from unanticipated movements
in the value of a foreign currency relative to the U.S. dollar.
6. FORWARD COMMITMENTS AND WHEN-ISSUED/DELAYED DELIVERY SECURITIES: The
Portfolios may make forward commitments to purchase or sell securities. Payment
and delivery for securities which have been purchased or sold on a forward
commitment basis can take place a month or more (not to exceed 120 days) after
the date of the transaction. Additionally, the Portfolio may purchase securities
on a when-issued or delayed delivery basis. Securities purchased on a
when-issued or delayed delivery basis are purchased for delivery beyond the
normal settlement date at a stated price and yield, and no income accrues to the
Portfolio on such securities prior to delivery. When the Portfolio enters into a
purchase transaction on a when-issued or delayed delivery basis, it establishes
either a segregated account in which it maintains liquid assets in an amount at
least equal in value to the Portfolio's commitments to purchase such securities
or designates such assets as segregated on the custodian's records for the
Portfolio's regular custody account. Purchasing securities on a forward
commitment or when-issued or delayed-delivery basis may involve a risk that the
market price at the time of delivery may be lower than the agreed upon purchase
price, in which case there could be an unrealized loss at the time of delivery.
7. LOAN AGREEMENTS: Certain Portfolios may invest in fixed and floating rate
loans ("Loans") arranged through private negotiations between an issuer of
sovereign debt obligations and one or more financial institutions ("Lenders")
deemed to be creditworthy by the investment adviser. The Portfolio's investments
in Loans may be in the form of participations in Loans ("Participations") or
assignments of all or a portion of Loans ("Assignments") from third parties. The
Portfolio's investment in Participations typically results in the Portfolio
having a contractual relationship with only the Lender and not with the
borrower. The Portfolio has the right to receive payments of principal, interest
and any fees to which it is entitled only upon receipt by the Lender of the
payments from the borrower. The Portfolio generally has no right to enforce
compliance by the borrower with the terms of the loan agreement. As a result,
the Portfolio may be subject to the credit risk of both the borrower and the
Lender that is selling the Participation. When the Portfolio purchases
Assignments from Lenders, it typically acquires direct rights against the
borrower on the Loan. Because Assignments are arranged through private
negotiations between potential assignees and potential assignors, the rights and
obligations acquired by the Portfolio as the purchaser of an Assignment may
differ from, and be more limited than, those held by the assigning Lender.
8. ORGANIZATIONAL COSTS: The organizational costs of the Fund are being
amortized on a straight line basis over a period of five years beginning with
the commencement of operations. Morgan Stanley Asset Management Inc. has
8
<PAGE>
MORGAN STANLEY UNIVERSAL FUNDS, INC.
NOTES TO FINANCIAL STATEMENTS (CONT.)
JUNE 30, 1998 (UNAUDITED)
- --------------------------------------------------------------------------------
agreed that in the event any of its initial shares which comprised the Fund at
inception are redeemed, the proceeds on redemption will be reduced by the
pro-rata portion of any unamortized organizational costs in the same proportion
as the number of shares redeemed bears to the initial shares held at time of
redemption.
9. SHORT SALES: Certain Portfolios may sell securities short. A short sale is a
transaction in which the Portfolio sells securities it may or may not own, but
has borrowed, in anticipation of a decline in the market price of the
securities. The Portfolio is obligated to replace the borrowed securities at the
market price at the time of replacement. The Portfolio may have to pay a premium
to borrow the securities as well as pay any dividends or interest payable on the
securities until they are replaced. The Portfolio's obligation to replace the
securities borrowed in connection with a short sale will generally be secured by
collateral deposited with the broker that consists of cash, U.S. government
securities or other liquid, high grade debt obligations. In addition, the
Portfolio will either designate on the custodian records in its regular custody
account or place in a segregated account with its Custodian an amount of cash,
U.S. government securities or other liquid high grade debt obligations equal to
the difference, if any, between (1) the market value of the securities sold and
(2) any cash, U.S. government securities or other liquid high grade debt
obligations deposited as collateral with the broker in connection with the short
sale. Short sales by the Portfolio involve certain risks and special
considerations. Possible losses from short sales differ from losses that could
be incurred from a purchase of a security, because losses from short sales may
be unlimited, whereas losses from purchases cannot exceed the total amount
invested.
10. FUTURES: Certain Portfolios may purchase and sell futures contracts. Futures
contracts provide for the sale by one party and purchase by another party of a
specified amount of a specified security, index, instrument or basket of
instruments. Futures contracts (secured by cash or government securities
deposited with brokers or custodians as "initial margin") are valued based upon
their quoted daily settlement prices; changes in initial settlement value
(represented by cash paid to or received from brokers as "variation margin") are
accounted for as unrealized appreciation (depreciation). When futures contracts
are closed, the difference between the opening value at the date of purchase and
the value at closing is recorded as realized gains or losses in the Statement of
Operations.
Certain Portfolios may use futures contracts in order to manage exposure to the
stock and bond markets, to hedge against unfavorable changes in the value of
securities or to remain fully invested and to reduce transaction costs. Futures
contracts involve market risk in excess of the amounts recognized in the
Statement of Net Assets. Risks arise from the possible movements in security
values underlying these instruments. The change in value of futures contracts
primarily corresponds with the value of their underlying instruments, which may
not correlate with the change in value of the hedged investments. In addition,
there is the risk that the Portfolios may not be able to enter into a closing
transaction because of an illiquid secondary market.
11. SWAP AGREEMENTS: The Portfolios may enter into swap agreements to exchange
one return or cash flow for another return or cash flow in order to hedge
against unfavorable changes in the value of securities or to remain fully
invested and to reduce transaction costs. The following summarizes swaps which
may be entered into by the Portfolios.
INTEREST RATE SWAPS: Interest rate swaps involve the exchange of commitments to
pay and receive interest based on a notional principal amount. Net periodic
interest payments to be received or paid are accrued daily and are recorded in
the Statement of Operations as an adjustment to interest income. Interest rate
swaps are marked-to-market daily based upon quotations from market makers and
the change, if any, is recorded as unrealized appreciation or depreciation in
the Statement of Operations.
TOTAL RETURN SWAPS: Total return swaps involve commitments to pay interest in
exchange for a market-linked return based on a notional amount. To the extent
the total return of the security, instrument or basket of instruments underlying
the transaction exceeds or falls short of the offsetting interest obligation,
the Portfolio will receive a payment from or make a payment to the counterparty,
respectively. Total return swaps are marked-to-market daily based upon
quotations from market makers and the change, if any, is recorded as unrealized
gains or losses in the Statement of Operations. Periodic payments received or
made at the end of each measurement period, but prior to termination, are
recorded as realized gains or losses in the Statement of Operations. Realized
gains or losses on maturity or termination of interest rate and total return
swaps are presented in the Statement of Operations.
Because there is no organized market for these swap agreements, the value of
open swaps reported in the Statement of Net Assets may differ from that which
would be realized in the event the Portfolio terminated its position in the
agreement. Risks may arise upon entering into these agreements from the
potential inability of the counterparties to meet the terms of the agreements
and are generally limited to the amount of net interest payments to be received
and/or favorable movements in the value of the underlying security, instrument
or basket of instruments, if any, at the date of default.
12. PURCHASED AND WRITTEN OPTIONS: Certain Portfolios may write covered call and
put options on portfolio securities and other financial instruments. Premiums
are received and are recorded as liabilities. The liabilities are subsequently
adjusted to reflect the current value of the options written. Premiums received
from writing options which expire are treated as realized gains. Premiums
received from writing
9
<PAGE>
MORGAN STANLEY UNIVERSAL FUNDS, INC.
NOTES TO FINANCIAL STATEMENTS (CONT.)
JUNE 30, 1998 (UNAUDITED)
- --------------------------------------------------------------------------------
options which are exercised or are closed are added to or offset against the
proceeds or amount paid on the transaction to determine the net realized gain or
loss. By writing a covered call option, a Portfolio, in exchange for the
premium, foregoes the opportunity for capital appreciation above the exercise
price should the market price of the underlying security increase. By writing a
covered put option, a Portfolio, in exchange for the premium, accepts the risk
of a decline in the market value of the underlying security below the exercise
price.
Certain Portfolios may purchase call and put options on portfolio securities or
other financial instruments. The Portfolio may purchase call options to protect
against an increase in the price of the security or financial instrument it
anticipates purchasing. Each Portfolio may purchase put options on securities
which it holds or other financial instruments to protect against a decline in
the value of the security or financial instrument or to close out covered
written put positions. Risks may arise from an imperfect correlation between the
change in market value of the securities held by the Portfolio and the prices of
options relating to the securities purchased or sold by the Portfolio and from
the possible lack of a liquid secondary market for an option. The maximum
exposure to loss for any purchased option is limited to the premium initially
paid for the option.
13. OTHER: Security transactions are accounted for on the date the securities
are purchased or sold. Realized gains and losses on the sale of investment
securities are determined on the specific identified cost basis. Dividend income
is recorded on the ex-dividend date (except for certain foreign dividends which
may be recorded as soon as the Fund is informed of such dividends) net of
applicable withholding taxes where recovery of such taxes is not reasonably
assured. Interest income is recognized on the accrual basis except where
collection is in doubt. Discounts and premiums on securities purchased (other
than mortgage-backed securities) are amortized according to the effective yield
method over their respective lives. Most expenses of the Fund can be directly
attributed to a particular Portfolio. Expenses which cannot be directly
attributed are apportioned among the Portfolios based upon relative net assets.
Distributions from the Portfolios are recorded on the ex-distribution date.
The U.S. Real Estate Portfolio owns shares of real estate investment trusts
("REITs") which report information on the source of their distributions
annually. A portion of distributions received from REITs during the year are
estimated to be a return of capital and is recorded as a reduction of their
cost.
The amount and character of income and capital gain distributions to be paid by
Portfolios of the Fund are determined in accordance with Federal income tax
regulations which may differ from generally accepted accounting principles.
These differences are primarily due to differing book and tax treatments for the
character and timing of the recognition of gains or losses on securities and
foreign currency exchange contracts, the timing of the deductibility of certain
foreign taxes and dividends received from real estate investment trusts.
Permanent book and tax basis differences relating to shareholder distributions
may result in reclassifications among undistributed net investment income
(loss), accumulated net realized gain (loss) and paid in capital.
Permanent book and tax differences, if any, are not included in ending
undistributed (distributions in excess of) net investment income/accumulated net
investment loss for the purpose of calculating net investment income (loss) per
share in the Financial Highlights.
Settlement and registration of foreign securities transactions may be subject to
significant risks not normally associated with investments in the United States.
In certain markets, including Russia, ownership of shares is defined according
to entries in the issuer's share register. In Russia, there currently exists no
central registration system and the share registrars may not be subject to
effective state supervision. It is possible that a Portfolio holding these
securities could lose its share registration through fraud, negligence or even
mere oversight. In addition, shares being delivered for sales and cash being
paid for purchases may be delivered before the exchange is complete. This may
subject the Portfolio to further risk of loss in the event of a failure to
complete the transaction by the counterparty.
B. ADVISER: Morgan Stanley Asset Management Inc. ("MSAM"), a wholly-owned
subsidiary of Morgan Stanley Dean Witter & Co., provides the U.S. Real Estate
Portfolio with investment advisory services for a fee, paid quarterly, at the
annual rate based on average daily net assets as follows:
<TABLE>
<CAPTION>
FROM MORE
FIRST $500 MILLION TO THAN
PORTFOLIO $500 MILLION $1 BILLION $1 BILLION
- -------------------------- --------------- --------------- -------------
<S> <C> <C> <C>
U.S. Real Estate.......... 0.80% 0.75% 0.70%
</TABLE>
MSAM has agreed to reduce fees payable to it and to reimburse the Portfolio, if
necessary, to the extent that the annual operating expenses, as defined,
expressed as a percentage of average daily net assets, exceed the maximum ratio
of 1.10%.
C. ADMINISTRATOR: MSAM (the "Administrator") also provides the Portfolio with
administrative services pursuant to an administrative agreement for a monthly
fee which on an annual basis equals 0.25% of the average daily net assets of the
Portfolio, plus reimbursement of out-of-pocket expenses. Under an agreement
between the Administrator and Chase Global Funds Services Company ("CGFSC"), a
corporate affiliate of The Chase Manhattan Bank ("Chase"), CGFSC provides
certain administrative services to the Fund. For such services, the
Administrator pays CGFSC a portion of the fee the Administrator receives from
the Fund. Certain
10
<PAGE>
MORGAN STANLEY UNIVERSAL FUNDS, INC.
NOTES TO FINANCIAL STATEMENTS (CONT.)
JUNE 30, 1998 (UNAUDITED)
- --------------------------------------------------------------------------------
employees of CGFSC are officers of the Fund. In addition, the Fund incurs local
administration fees in connection with doing business in certain emerging market
countries.
D. CUSTODIANS: Morgan Stanley Trust Company ("MSTC"), a wholly-owned subsidiary
of Morgan Stanley Dean Witter & Co., acts as custodian for the Fund's assets
held outside the United States in accordance with a custodian agreement. Chase
serves as custodian for the Fund's U.S. assets in accordance with a separate
custodian agreement. Custodian fees are computed and payable monthly based on
assets held, investment purchases and sales activity, an account maintenance
fee, plus reimbursement for certain out-of-pocket expenses.
E. OTHER: At June 30, 1998, the net assets of certain Portfolios were
substantially comprised of foreign denominated securities and currency. Changes
in currency exchange rates will affect the U.S. dollar value of and investment
income from such securities.
From time to time, a Portfolio may have shareholders that hold a significant
portion of the Portfolio's outstanding shares. Investment activities of these
shareholders could have a material impact on those Portfolios.
11
<PAGE>
MORGAN STANLEY UNIVERSAL FUNDS, INC.
- --------------------------------------------------------------------------------
DIRECTORS
Barton M. Biggs
CHAIRMAN OF THE BOARD
Chairman and Director, Morgan Stanley Asset Management Inc.
and Morgan Stanley Asset Management Limited;
Managing Director, Morgan Stanley & Co. Incorporated
Michael F. Klein
DIRECTOR AND PRESIDENT
Principal, Morgan Stanley Asset Management Inc. and
Morgan Stanley & Co. Incorporated
John D. Barrett II
Chairman and Director,
Barrett Associates, Inc.
Gerard E. Jones
Partner, Richards & O'Neil LLP
Andrew McNally IV
River Road Partners
Samuel T. Reeves
Chairman of the Board and CEO,
Pinacle L.L.C.
Fergus Reid
Chairman and Chief Executive Officer,
LumeLite Plastics Corporation
Frederick O. Robertshaw
Of Counsel, Copple, Chamberlin & Boehm, P.C.
INVESTMENT ADVISERS AND ADMINISTRATORS
Morgan Stanley Asset Management Inc.
1221 Avenue of the Americas
New York, New York 10020
Miller Anderson & Sherrerd, LLP
One Tower Bridge
West Conshohocken, PA 19428-2899
DISTRIBUTOR
Morgan Stanley & Co. Incorporated
1221 Avenue of the Americas
New York, NY 10020
CUSTODIANS
Morgan Stanley Trust Company
One Pierrepont Plaza
Brooklyn, New York 11210
The Chase Manhattan Bank
3 Chase MetroTech Center
Brooklyn, NY 11245
OFFICERS
Stefanie V. Chang
VICE PRESIDENT
James A. Gallo
VICE PRESIDENT
Harold J. Schaaff, Jr.
VICE PRESIDENT
Joseph P. Stadler
VICE PRESIDENT
Lorraine Truten
VICE PRESIDENT
Valerie Y. Lewis
SECRETARY
Joanna M. Haigney
TREASURER
Rene J. Feuerman
ASSISTANT TREASURER
Karl O. Hartmann
ASSISTANT SECRETARY
LEGAL COUNSEL
Morgan, Lewis & Bockius LLP
2000 One Logan Square
Philadelphia, Pennsylvania 19103
INDEPENDENT ACCOUNTANTS
PricewaterhouseCoopers LLP
1177 Avenue of the Americas
New York, New York 10036
- --------------------------------------------------------------------------------
THIS REPORT IS AUTHORIZED FOR DISTRIBUTION ONLY WHEN PRECEDED OR ACCOMPANIED BY
THE PROSPECTUS OF THE MORGAN STANLEY UNIVERSAL FUNDS, INC. WHICH DESCRIBES IN
DETAIL EACH INVESTMENT PORTFOLIO'S INVESTMENT POLICIES, FEES AND EXPENSES.
PLEASE READ THE PROSPECTUS CAREFULLY BEFORE YOU INVEST OR SEND MONEY.
12
