<PAGE>
MORGAN STANLEY UNIVERSAL FUNDS, INC.
- --------------------------------------------------------------------------------
VALUE PORTFOLIO
SEMI-ANNUAL REPORT
JUNE 30, 1998
<PAGE>
MORGAN STANLEY UNIVERSAL FUNDS, INC.
VALUE PORTFOLIO
- --------------------------------------------------------------------------------
INVESTMENT OVERVIEW
COMPOSITION OF NET ASSETS (AT JUNE 30, 1998)
EDGAR REPRESENTATION OF DATA POINTS USED IN PRINTED GRAPHIC
<TABLE>
<S> <C>
%
Basic Resources 7.9
Beverages & Personal Products 0.6
Consumer Durables 10.3
Consumer Services 0.4
Energy 5.2
Financial Services 18.8
Food, Tobacco & Other 4.5
Health Care 4.8
Heavy Industry/Transportation 16.1
Retail 8.1
Technology 6.9
Utilities 3.7
Other 12.7
</TABLE>
PERFORMANCE COMPARED TO THE S&P 500
INDEX(1)
- ------------------------------------
<TABLE>
<CAPTION>
TOTAL RETURNS(2)
-----------------------------------------
AVERAGE ANNUAL
ONE SINCE
YTD YEAR INCEPTION(3)
---------- ---------- -----------------
<S> <C> <C> <C>
PORTFOLIO.. 5.52% 10.52% 17.80%
INDEX..... 17.71% 30.17% 35.78%
</TABLE>
1. The S&P 500 Index is an unmanaged index of common stocks.
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 January 2, 1997.
PAST PERFORMANCE IS NOT PREDICTIVE OF FUTURE
PERFORMANCE.
<TABLE>
<CAPTION>
TOP FIVE HOLDINGS
PERCENT OF
SECURITY INDUSTRY NET ASSETS
- ------------------------- ------------------ -------------
<S> <C> <C>
Ford Motor Co. Consumer Durables 3.1%
General Motors Corp. Consumer Durables 2.9%
International Business
Machines Corp. Technology 2.8%
Chase Manhattan Corp. Financial Services 2.7%
Case Corp. Heavy Industry/ 2.5%
Transportation
</TABLE>
<TABLE>
<CAPTION>
TOP FIVE SECTORS
VALUE PERCENT OF
INDUSTRY (000) NET ASSETS
- ------------------------- --------- -------------
<S> <C> <C>
Financial Services $ 3,828 18.8%
Heavy Industry/
Transportation 3,256 16.1%
Consumer Durables 2,089 10.3%
Retail 1,638 8.1%
Basic Resources 1,604 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 Value Portfolio seeks above average total return over a market cycle of
three to five years by investing primarily in a diversified portfolio of common
stocks and other equity securities that are deemed by Miller Anderson &
Sherrerd, LLP to be relatively undervalued based on various measures such as
price/earnings ratios and price/book ratios.
For the six months ended June 30, 1998, the Portfolio had a total return of
5.52% compared to 17.71% for the S&P 500 Index (the "Index"). For the one year
period ended June 30, 1998, the Portfolio had a total return of 10.52% compared
to 30.17% for the Index. From inception on January 2, 1997 to June 30, 1998, the
Portfolio had an average annual total return of 17.80% compared to 35.78% for
the Index.
In the month of June, economic and profit concerns re-emerged in the domestic
equity markets, particularly in the economically sensitive and "smaller"
sectors. Once again, the very expensive, large-cap stable sectors garnered most
of investors' attention. During the second quarter the largest fifty companies
in the S&P 500 Index, representing about 50% of the Index market value, returned
about 7% while the remaining 450 names returned about -0.16%. For the first half
of 1998, the largest 50 names have returned 22.5% versus a return of about 12%
for the remaining 450 companies.
The inability of our Portfolio to own many mega-cap stocks due to valuation
restrictions shows up in our performance as poor stock selection. Negative stock
selection was responsible for the bulk of the period's underperformance.
Individual stock performance in the technology, energy, healthcare, retail,
heavy industry and food and tobacco sectors penalized relative returns. Our top
performing stocks included Ford, Chase Manhattan, and Delta, while notable
laggards included General Motors, Goodyear, Toys R Us, Stratus Computer, Case
Corporation, and RJR Nabisco. Performance of individual companies is measured
against the S&P 500, which is a market capitalization weighted index
increasingly dominated by mega-cap, high price-earnings companies.
1
<PAGE>
MORGAN STANLEY UNIVERSAL FUNDS, INC.
VALUE PORTFOLIO
- --------------------------------------------------------------------------------
INVESTMENT OVERVIEW (CONT.)
Because performance of the average company differed so dramatically relative to
the benchmark, we felt it timely to elaborate on our Portfolio's strategy and
style and to take a different view of performance.
Our Portfolio employs a dedicated low price-earnings strategy, and, over full
market cycles, low price-earnings investing has generated consistent
outperformance. However, in periods of excessive speculation or nifty fifty
style growth stock domination, our value philosophy falls into disfavor. This
has been the case for the past quarter and for most of the year-to-date, as low
price-earnings investing has significantly underperformed the S&P 500. We do not
own (nor do we plan to own) high price-earnings stocks in our Portfolio.
Financial service stocks constitute about 40% of the individual names and market
cap of the two lowest price-earnings quintiles, our primary universe. And,
financial service stocks significantly outperformed their non-financial
counterparts in the universe. Risk control factors prevent us from holding 40%
positions in any sector of the Portfolio including financials. Therefore, most
of our holdings are low price-earnings, non-financial companies, and, as a
result, much of our relative underperformance occurred due to our commitment to
DIVERSIFIED low price-earnings investing.
The current characteristics of the Portfolio reflect our unwavering commitment
to value investing through low price/earnings, price/sales and price/cash flow
valuation metrics. The price-earnings ratio for the Portfolio is 12.8 times next
12 months' earnings as compared to a price-earnings ratio of 21.3 times for the
S&P 500. The Portfolio's price to sales ratio of 0.73 and price to cash flow
ratio of 10.1 compare favorably to the S&P 500 ratios of 1.8 times revenues and
17.0 times cash flow. These price-earnings, price-sales and price-cash flow
valuation discounts of 40%, 60% and 41%, respectively, represent the largest
discounts in our value strategy this decade. And while these valuation discounts
might be warranted if our Portfolio contained companies with poor and
deteriorating fundamentals, this is not the case. While the Portfolio does have
more economic sensitivity than usual, recent growth rates and earnings estimate
revisions still approach those of the S&P 500. Our Portfolio's last twelve month
growth rates of 5.5% for earnings per share, 8.1% for sales, and 7.0% for
dividends approach those of the S&P at 7.4%, 11.2% and 8.8%, respectively.
Earnings estimate revisions for the current and next fiscal years, frequently
good predictors of future fundamental conditions are -1.7% and -7.1% for the
Value Portfolio versus -1.0% and -8.8% for the S&P 500. So, while the Portfolio
has owned a few individual companies whose income statements were negatively
impacted by the Asian malaise, most of our businesses have not experienced major
earnings problems. Our investment philosophy is based on the concept of
valuation reconciliation, the concept that most low price-earnings stocks
ultimately achieve fair valuation by either price appreciation or earnings
deterioration. In today's very narrow stock market, valuation reconciliation has
been eclipsed by the market performance of a relatively few, large-cap "growth"
stocks. In fact, most low price-earnings stocks have suffered considerable
valuation contraction since last fall.
Strategically, there were no significant changes in the Portfolio during the
second quarter. The Portfolio remains overweighted in traditional economically
sensitive sectors such as industrial franchise, consumer durable, raw material,
and transportation sectors as well as the financial services industries. These
sectors dominate the low price-earnings investible universe and possess
compelling relative and now absolute valuations. At the margin, however, we did
attempt to expand our positions in more defensive parts of the stock market. We
initiated new positions in EDS, a large cap technology services company, Bell
Atlantic, Tenet Healthcare, a large hospital company, and Air Products &
Chemicals, the industrial gas company. We added to holdings in VF Corp., Inland
Steel, and Case Corp. We also expanded our bank holdings with new positions in
Banc One and Washington Mutual. On the sell side, we eliminated our positions in
Repsol, Seagate, Mellon, and Quantum. We trimmed positions in some consumer
cyclicals which had big moves up including Ford and AMR. Our large
underweightings remain in consumer staples and services, health care,
technology, and telephone utilities. Our avoidance of many mega-cap stable
growth or defensive stocks is driven by valuation considerations and the
discipline restrictions of our portfolio process, which we will not violate. Of
the largest fifty companies in the S&P 500 at June 30, forty-one were excluded
for valuation considerations; of the nine we could own we do own eight. Of the
eight largest companies that we in fact own, five positions are top ten holdings
including Philip Morris, IBM, Ford, First Union, and Chase Manhattan.
Our outlook for the equity market continues to reflect concern over
unsustainable valuations, deteriorating corporate fundamentals and extremely
complacent investor sentiment. The recent narrowness in the current stock market
advance is typical of an aging bull market. While not absolutely indicative of
problems to come in the equity markets, it does seem to increase the possibility
of a major market decline. The bear market of 1973-1974 and the market crash of
1987 were preceded by similar relative outperformance of large cap liquid names
combined with a faltering broad market. We also believe that a negative market
reaction could stimulate a rotation away from the mega-cap defensive names
towards the "smaller", cyclical companies in our low price-earnings universe.
Indeed, this happened after the last nifty fifty growth stock craze.
July 1998
2
<PAGE>
MORGAN STANLEY UNIVERSAL FUNDS, INC.
VALUE PORTFOLIO
- --------------------------------------------------------------------------------
STATEMENT OF NET ASSETS
JUNE 30, 1998
(UNAUDITED)
<TABLE>
<CAPTION>
VALUE
SHARES (000)
<C> <S> <C>
- ------------------------------------------------------------------------
COMMON STOCKS (87.3%)
BASIC RESOURCES (7.9%)
3,100 Air Products and Chemicals, Inc.................. $ 124
2,200 Cabot Oil & Gas Corp., Class A................... 71
2,000 Dow Chemical Co.................................. 193
2,600 E.I. DuPont de Nemours & Co...................... 194
5,100 Great Lakes Chemical Corp........................ 201
5,000 IMC Global, Inc.................................. 151
6,400 Inland Steel Industries, Inc..................... 180
3,400 Lubrizol Corp.................................... 103
2,100 Rohm & Haas Co................................... 218
5,600 W.R. Grace & Co.................................. 96
2,600 Westvaco Corp.................................... 73
-------
1,604
-------
BEVERAGES & PERSONAL PRODUCTS (0.6%)
3,900 Tupperware Corp.................................. 110
-------
CONSUMER DURABLES (10.3%)
3,600 Dana Corp........................................ 193
10,700 Ford Motor Co.................................... 631
8,800 General Motors Corp.............................. 588
6,400 Goodyear Tire & Rubber Co........................ 412
6,500 Owens Corning.................................... 265
-------
2,089
-------
CONSUMER SERVICES (0.4%)
2,100 Standard Register Co............................. 74
-------
ENERGY (5.2%)
2,600 Atlantic Richfield Co............................ 203
2,500 British Petroleum plc ADR........................ 221
(a)5,500 Nabors Industries, Inc........................... 109
3,400 Phillips Petroleum Co............................ 164
5,000 Ultramar Diamond Shamrock Corp................... 158
6,800 YPF SA ADR....................................... 204
-------
1,059
-------
FINANCIAL SERVICES (18.8%)
BANKS (9.3%)
3,600 Banc One Corp.................................... 201
7,200 Chase Manhattan Corp............................. 544
1,400 Citicorp......................................... 209
900 Crestar Financial Corp........................... 49
7,350 First Union Corp................................. 428
2,000 NationsBank Corp................................. 153
2,700 Republic New York Corp........................... 170
3,200 Washington Mutual, Inc........................... 139
-------
1,893
-------
INSURANCE (9.5%)
3,000 Allstate Corp.................................... 275
3,000 American General Corp............................ 214
4,100 CIGNA Corp....................................... 283
5,100 Everest Reinsurance Holdings, Inc................ 196
2,200 Hartford Financial Services Group, Inc........... 252
1,300 Loews Corp....................................... 113
7,150 Old Republic International Corp.................. 210
<CAPTION>
VALUE
SHARES (000)
<C> <S> <C>
- ------------------------------------------------------------------------
4,800 ReliaStar Financial Corp......................... $ 230
2,100 Transatlantic Holdings, Inc...................... 162
-------
1,935
-------
TOTAL FINANCIAL SERVICES..................................... 3,828
-------
FOOD, TOBACCO & OTHER (4.5%)
5,100 IBP, Inc......................................... 92
9,600 Philip Morris Cos., Inc.......................... 378
10,300 RJR Nabisco Holdings Corp........................ 245
9,300 Universal Foods Corp............................. 206
-------
921
-------
HEALTH CARE (4.8%)
600 Beckman Coulter, Inc............................. 35
4,700 Beckman Instruments, Inc......................... 274
7,600 Columbia/HCA Healthcare Corp..................... 221
(a)8,670 Foundation Health Corp........................... 229
2,100 Mallinckrodt, Inc................................ 62
(a)3,700 Maxicare Health Plans, Inc....................... 25
(a)3,500 Tenet Healthcare Corp............................ 109
(a)1,300 Vencor, Inc...................................... 9
800 Ventas, Inc...................................... 11
-------
975
-------
HEAVY INDUSTRY/TRANSPORTATION (16.1%)
(a)2,100 AMR Corp......................................... 175
7,300 Aeroquip-Vickers, Inc............................ 426
400 Burlington Northern Santa Fe, Inc................ 39
2,800 CSX Corp......................................... 127
10,600 Case Corp........................................ 511
2,400 Caterpillar, Inc................................. 127
6,800 Cummins Engine Co., Inc.......................... 349
1,800 Delta Air Lines, Inc............................. 233
1,000 Eaton Corp....................................... 78
(a)2,100 FMC Corp......................................... 143
8,000 Harnischfeger Industries, Inc.................... 227
4,100 Kennametal, Inc.................................. 171
11,800 Olsten Corp...................................... 132
3,850 Parker Hannifin Corp............................. 147
3,600 TRW, Inc......................................... 197
3,300 Tecumseh Products Co., Class A................... 174
-------
3,256
-------
RETAIL (8.1%)
6,400 Dillard's, Inc., Class A......................... 265
(a)2,100 Federated Department Stores, Inc................. 113
4,000 Russell Corp..................................... 121
3,800 Sears, Roebuck & Co.............................. 232
3,100 Springs Industries, Inc., Class A................ 143
(a)12,600 Toys 'R' Us, Inc................................. 297
6,300 V.F. Corp........................................ 324
(a)7,500 Venator Group, Inc............................... 143
-------
1,638
-------
TECHNOLOGY (6.9%)
(a)5,000 Arrow Electronics, Inc........................... 109
3,600 Avnet, Inc....................................... 197
</TABLE>
The accompanying notes are an integral part of the financial statements.
3
<PAGE>
MORGAN STANLEY UNIVERSAL FUNDS, INC.
VALUE PORTFOLIO
- --------------------------------------------------------------------------------
STATEMENT OF NET ASSETS (CONT.)
JUNE 30, 1998
(UNAUDITED)
<TABLE>
<CAPTION>
VALUE
SHARES (000)
- ------------------------------------------------------------------------
<C> <S> <C>
</TABLE>
TECHNOLOGY (CONT.)
<TABLE>
<C> <S> <C>
4,000 Electronic Data Systems Corp..................... $ 160
5,000 International Business Machines Corp............. 574
(a)5,300 Stratus Computer, Inc............................ 134
6,150 Tektronix, Inc................................... 218
-------
1,392
-------
UTILITIES (3.7%)
5,300 Bell Atlantic Corp............................... 242
100 Central Maine Power Co........................... 2
2,100 Cinergy Corp..................................... 74
3,500 DTE Energy Co.................................... 141
1,617 Duke Energy Corp................................. 96
3,500 Entergy Corp..................................... 101
2,800 GPU, Inc......................................... 106
-------
762
-------
TOTAL COMMON STOCKS (COST $16,941)............................. 17,708
-------
</TABLE>
<TABLE>
<CAPTION>
FACE
AMOUNT
(000)
<C> <S> <C>
- -----------
SHORT-TERM INVESTMENT (17.3%)
REPURCHASE AGREEMENT (17.3%)
$3,502 Chase Securities, Inc. 5.40%, dated 6/30/98 due
7/1/98, to be repurchased at $3,503,
collateralized by U.S. Treasury Bonds, 8.875%,
due 2/15/19, valued at $3,590 (COST $3,502).... 3,502
-------
TOTAL INVESTMENTS (104.6%) (COST $20,443)...................... 21,210
-------
</TABLE>
<TABLE>
<S> <C> <C>
OTHER ASSETS (0.5%)
Cash....................................... $ 4
Receivable for Investments Sold............ 61
Dividends Receivable....................... 23
Receivable for Portfolio Shares Sold....... 6 94
-----
LIABILITIES (-5.1%)
Payable for Investments Purchased.......... (976)
Professional Fees Payable.................. (18)
Payable for Portfolio Shares Redeemed...... (14)
Investment Advisory Fees Payable........... (9)
Custodian Fees Payable..................... (6)
Administrative Fees Payable................ (5)
Other Liabilities.......................... (2) (1,030)
----- --------
NET ASSETS (100%)................................... $ 20,274
--------
--------
</TABLE>
<TABLE>
<CAPTION>
AMOUNT
(000)
<S> <C> <C>
- --------------------------------------------------------------
NET ASSET VALUE, OFFERING AND REDEMPTION
PRICE PER SHARE
Applicable to 1,631,118 outstanding $0.001 par value
shares
(authorized 500,000,000 shares)................... $ 12.43
--------
--------
NET ASSETS CONSIST OF:
Paid in Capital..................................... $18,961
Undistributed Net Investment Income................. 140
Accumulated Net Realized Gain....................... 406
Unrealized Appreciation on Investments.............. 767
--------
NET ASSETS.......................................... $20,274
--------
--------
</TABLE>
- ---------------
(a) -- Non-income producing security
ADR -- American Depositary Receipt
- ---------------
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) APPRECIATION
(000) (000) (000) (000)
- --------- ------------- --------------- ---------------
<S> <C> <C> <C>
$ 20,443 $ 1,785 $ (1,018) $ 767
</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 $1,388,000 and $904,000,
respectively. There were no purchases and sales of 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.
VALUE PORTFOLIO
- --------------------------------------------------------------------------------
STATEMENT OF OPERATIONS
<TABLE>
<CAPTION>
SIX MONTHS
ENDED
JUNE 30,
1998
(UNAUDITED)
(000)
<S> <C>
- ----------------------------------------------------------------------
INVESTMENT INCOME:
Dividends $160
Interest 56
-----
Total Income 216
-----
EXPENSES:
Investment Advisory Fees 49
Less: Fees Waived (34)
-----
Net Investment Advisory Fees 15
Administrative Fees 24
Professional Fees 17
Custodian Fees 9
Shareholder Reports 9
Directors' Fees and Expenses 1
Other 1
-----
Net Expenses 76
-----
Net Investment Income 140
-----
NET REALIZED GAIN ON:
Investments Sold 408
-----
CHANGE IN UNREALIZED APPRECIATION/DEPRECIATION ON:
Investments 260
-----
Net Realized Gain and Change in Unrealized
Appreciation/Depreciation 668
-----
NET INCREASE IN NET ASSETS RESULTING FROM OPERATIONS $808
-----
-----
</TABLE>
- --------------------------------------------------------------------------------
STATEMENT OF CHANGES IN NET ASSETS
<TABLE>
<CAPTION>
SIX MONTHS PERIOD FROM
ENDED JANUARY 2,
JUNE 30, 1997*
1998 TO DECEMBER 31,
(UNAUDITED) 1997
(000) (000)
<S> <C> <C>
- ------------------------------------------------------------------------
INCREASE (DECREASE) IN NET ASSETS
OPERATIONS:
Net Investment Income $ 140 $ 116
Net Realized Gain 408 249
Change in Unrealized
Appreciation/Depreciation 260 507
------------ -------
Net Increase in Net Assets
Resulting from Operations 808 872
------------ -------
DISTRIBUTIONS:
Net Investment Income -- (116)
In Excess of Net Investment Income -- (3)
Net Realized Gain -- (249)
In Excess of Net Realized Gain -- (2)
------------ -------
Total Distributions -- (370)
------------ -------
CAPITAL SHARE TRANSACTIONS (1):
Subscribed 6,008 13,979
Distributions Reinvested -- 276
Redeemed (1,206) (93)
------------ -------
Net Increase in Net Assets Resulting
from Capital Share Transactions 4,802 14,162
------------ -------
Total Increase in Net Assets 5,610 14,664
NET ASSETS:
Beginning of Period 14,664 --
------------ -------
End of Period (Including
undistributed net investment
income of $140 and $0,
respectively) $20,274 $14,664
------------ -------
------------ -------
- ------------------------------------------------------------------------
(1) Capital Share Transactions:
Shares Subscribed 482 1,229
Shares Issued on Distributions
Reinvested -- 24
Shares Redeemed (96) (8)
------------ -------
Net Increase in Capital Shares
Outstanding 386 1,245
------------ -------
------------ -------
- ------------------------------------------------------------------------
</TABLE>
* Commencement of operations
The accompanying notes are an integral part of the financial statements.
5
<PAGE>
MORGAN STANLEY UNIVERSAL FUNDS, INC.
VALUE PORTFOLIO
- --------------------------------------------------------------------------------
FINANCIAL HIGHLIGHTS
<TABLE>
<CAPTION>
PERIOD FROM
JANUARY 2,
SIX MONTHS ENDED 1997*
JUNE 30, 1998 TO DECEMBER 31,
SELECTED PER SHARE DATA AND RATIOS (UNAUDITED) 1997
<S> <C> <C>
- -------------------------------------------------------------------------------
NET ASSET VALUE, BEGINNING OF PERIOD $ 11.78 $ 10.00
------- -------
INCOME FROM INVESTMENT OPERATIONS
Net Investment Income 0.09 0.10
Net Realized and Unrealized Gain 0.56 1.99
------- -------
Total From Investment Operations 0.65 2.09
------- -------
DISTRIBUTIONS
Net Investment Income -- (0.10)
In Excess of Net Investment Income -- 0.00+
Net Realized Gain -- (0.21)
In Excess of Net Realized Gain -- 0.00+
------- -------
Total Distributions -- (0.31)
------- -------
NET ASSET VALUE, END OF PERIOD $ 12.43 $ 11.78
------- -------
------- -------
TOTAL RETURN 5.52% 20.98%
------- -------
------- -------
RATIOS AND SUPPLEMENTAL DATA:
Net Assets, End of Period (000's) $20,274 $14,664
Ratio of Expenses to Average Net
Assets 0.85%** 0.85%**
Ratio of Net Investment Income to
Average Net Assets 1.58%** 1.70%**
Portfolio Turnover Rate 40% 34%
- -------------------------------------------------------------------------------
Effect of Voluntary Expense
Limitation During the Period:
Per Share Benefit to Net Investment
Income $ 0.02 $ 0.06
Ratios Before Expense Limitation:
Expenses to Average Net Assets 1.24%** 1.87%**
Net Investment Income to Average
Net Assets 1.19%** 0.68%**
</TABLE>
- --------------------------------------------------------------------------------
* Commencement of operations
** Annualized
+ Amount is less than $0.01 per share
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 Value 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 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 a Portfolio to further risk of loss in the event of a failure to
complete the transaction by the counterparty.
B. ADVISER: Miller Anderson & Sherrerd, LLP ("MAS"), a wholly-owned subsidiary
of Morgan Stanley Dean Witter & Co., provides the Value 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>
Value..................... 0.55% 0.50% 0.45%
</TABLE>
MAS 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 0.85%.
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 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
10
<PAGE>
MORGAN STANLEY UNIVERSAL FUNDS, INC.
NOTES TO FINANCIAL STATEMENTS (CONT.)
JUNE 30, 1998 (UNAUDITED)
- --------------------------------------------------------------------------------
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.
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
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
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
