AETNA VARIABLE GROWTH PORTFOLIO
AETNA VARIABLE SMALL COMPANY PORTFOLIO
AETNA VARIABLE INDEX PLUS PORTFOLIO
AETNA VARIABLE CAPITAL APPRECIATION PORTFOLIO
AETNA VARIABLE PORTFOLIOS, INC.
151 FARMINGTON AVENUE
HARTFORD, CT 06156-8962
Prospectus dated: May 1, 1997
Aetna Variable Portfolios, Inc. (Fund) is an open-end management investment
company authorized to issue multiple series of shares, each representing a
diversified portfolio of investments (individually, a "Portfolio" and
collectively, the "Variable Portfolios"). The Fund currently has four Portfolios
authorized. The Fund's shares are offered only to insurance companies to fund
benefits under their variable annuity contracts (VA Contracts) and variable life
insurance policies (VLI Policies).
This Prospectus sets forth concisely the information that a prospective
contract holder or policy holder should know before directing an investment to a
Portfolio and should be read and kept for future reference. A Statement of
Additional Information (Statement) dated May 1, 1997 contains more information
about the Variable Portfolios. For a free copy of the Statement, call
1-800-525-4225 or write to Aetna Variable Portfolios, Inc., at the address
listed above. The Statement has been filed with the Securities and Exchange
Commission (Commission) and is incorporated into this Prospectus by reference.
This Prospectus does not constitute an offer to sell, or a solicitation of an
offer to buy, the securities of the Fund in any jurisdiction in which such sale,
offer to sell, or solicitation may not be lawfully made.
INVESTMENTS IN THE FUND ARE NOT DEPOSITS OR OBLIGATIONS OF, OR GUARANTEED OR
ENDORSED BY, ANY BANK. SHARES OF THE FUND ARE NOT FEDERALLY INSURED BY THE
FEDERAL DEPOSIT INSURANCE CORPORATION, THE FEDERAL RESERVE BOARD, OR ANY OTHER
GOVERNMENTAL AGENCY. AN INVESTMENT IN THE FUND IS SUBJECT TO RISK THAT MAY CAUSE
THE VALUE OF THE INVESTMENT TO FLUCTUATE, AND WHEN THE INVESTMENT IS REDEEMED,
THE VALUE MAY BE HIGHER OR LOWER THAN THE AMOUNT ORIGINALLY INVESTED BY THE
INVESTOR.
LIKE ALL MUTUAL FUNDS, THESE SECURITIES HAVE NOT BEEN APPROVED OR DISAPPROVED
BY THE SECURITIES AND EXCHANGE COMMISSION OR ANY STATE SECURITIES COMMISSION,
NOR HAS THE SECURITIES AND EXCHANGE COMMISSION OR ANY STATE SECURITIES
COMMISSION PASSED UPON THE ACCURACY OR ADEQUACY OF THIS PROSPECTUS. ANY
REPRESENTATION TO THE CONTRARY IS A CRIMINAL OFFENSE.
Please read this Prospectus carefully before investing and retain
for future reference.
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TABLE OF CONTENTS
Page
THE FUND 3
DESCRIPTION OF THE VARIABLE PORTFOLIOS 3
FINANCIAL HIGHLIGHTS 4
INVESTMENT TECHNIQUES 5
RISK FACTORS AND OTHER CONSIDERATIONS 7
INVESTMENT RESTRICTIONS 9
MANAGEMENT OF THE VARIABLE PORTFOLIOS 9
PURCHASE AND REDEMPTION OF SHARES 10
NET ASSET VALUE 10
GENERAL INFORMATION 11
PERFORMANCE 11
TAX MATTERS 13
APPENDIX A -- GLOSSARY OF INVESTMENT TERMS 14
APPENDIX B -- DESCRIPTION OF CORPORATE BOND RATINGS 16
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THE FUND
The Fund is an open-end, management investment company, consisting of multiple
Portfolios. It currently has authorized four Portfolios, AETNA VARIABLE GROWTH
PORTFOLIO (Growth) AETNA VARIABLE SMALL COMPANY PORTFOLIO (Small Company), AETNA
VARIABLE INDEX PLUS PORTFOLIO (Index Plus) and AETNA VARIABLE CAPITAL
APPRECIATION PORTFOLIO (Capital Appreciation). The Fund's Board of Directors
(Directors) may authorize additional Portfolios in the future. The Fund is
intended to serve as one of the funding vehicles for VA Contracts and VLI
Policies to be offered through the separate accounts of insurance companies. The
insurance companies, not retirement plan participants (Participants), are
shareholders of the Fund. See "General Information."
The Fund does not foresee any disadvantages to the Participants in funding both
VA Contracts and VLI Policies through the Variable Portfolios or in offering the
Variable Portfolios through more than one insurance company. The Fund's
Directors have agreed to monitor the Portfolios' activities to identify any
potentially material, irreconcilable conflicts and to take appropriate action if
necessary to resolve any conflicts which may arise.
DESCRIPTION OF THE VARIABLE PORTFOLIOS
Each Portfolio has an investment objective that is a fundamental policy and may
not be changed without the vote of a majority of the holders of that Portfolio's
outstanding shares. There can be no assurance that the Portfolios will meet
their investment objectives. Each Portfolio is subject to investment policies
and restrictions described in this Prospectus and in the Statement, some of
which are fundamental. No fundamental investment policy or restriction may be
changed without the approval of a majority of the outstanding shares of that
Portfolio. A glossary describing various investment terms relating to securities
that may be held by the Portfolios is contained in Appendix A.
AETNA VARIABLE GROWTH PORTFOLIO
Investment Objective
Growth seeks growth of capital through investment in a diversified portfolio
of common stocks and securities convertible into common stocks believed to
offer growth potential.
Investment Policy
Growth will normally invest at least 65% of its total assets in common stocks
which have potential for capital growth. It may also invest in convertible and
non-convertible preferred stocks.
Additionally, Growth may lend portfolio securities, buy and sell put and call
options and stock index futures and options. Growth may also enter into
repurchase agreements, invest up to 25% of its assets in foreign securities,
engage in currency hedging and purchase securities on a when-issued,
delayed-delivery or forward-commitment basis. The Growth Portfolio will not
invest more than 15% of the total value of its assets in high-risk, high-yield
securities or "junk bonds".
AETNA VARIABLE SMALL COMPANY PORTFOLIO
Investment Objective
Small Company seeks growth of capital primarily through investment in a
diversified portfolio of common stocks and securities convertible into common
stocks of companies with smaller market capitalizations.
Investment Policy
Small Company will normally invest at least 65% of its total assets in the
common stock of companies with equity market capitalizations at the time of
purchase of $1 billion or less. Small Company may also invest in convertible and
non-convertible preferred stocks.
Additionally, Small Company may lend portfolio securities, buy and sell put and
call options and stock index futures and options. Small Company may also enter
into repurchase agreements, invest up to 25% of its assets in foreign
securities, engage in currency hedging and purchase securities on a when-issued,
delayed-delivery or forward-commitment basis. Small Company will not invest more
than 15% of the total value of its assets in high-risk, high-yield securities or
"junk bonds".
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AETNA VARIABLE INDEX PLUS PORTFOLIO
Investment Objective
Index Plus will attempt to outperform the total return performance of publicly
traded common stocks represented by the S&P 500 Composite Stock Price Index (S&P
500), a stock market index composed of 500 common stocks selected by the
Standard & Poor's Corporation.
Investment Policy
Index Plus will attempt to be fully invested in common stocks. Under normal
circumstances, Index Plus will invest at least 90% of its assets in common
stocks represented in the S&P 500. Inclusion of a stock in the S&P 500 in no way
implies an opinion by Standard & Poor's Corporation as to the stock's
attractiveness as an investment. Index Plus is neither sponsored by nor
affiliated with Standard & Poor's Corporation. AN INVESTMENT IN THE PORTFOLIO
INVOLVES RISKS SIMILAR TO THOSE OF INVESTING IN COMMON STOCKS GENERALLY. As
Index Plus invests primarily in common stocks, the Portfolio is subject to
market risk -- i.e. the possibility that common stock prices will decline over
short or even extended periods. The U.S. stock market tends to be cyclical, with
periods when stock prices generally rise and periods when prices generally
decline.
Under normal circumstances, Index Plus will generally include approximately 400
stocks included in the S&P 500. Index Plus intends, under normal circumstances,
to exclude common stocks which are not part of the S&P 500 and to exclude Aetna
Inc. common stock.
The weightings of stocks in the S&P 500 are based on each stock's relative total
market capitalization, that is, its market price per share multiplied by the
number of common shares outstanding. The investment adviser will attempt to
outperform the investment results of the S&P 500 by creating a portfolio that
has similar market risk characteristics to the S&P 500, but will use a
disciplined analysis to identify those stocks having the greatest likelihood of
either outperforming or underperforming the market.
AETNA VARIABLE CAPITAL APPRECIATION PORTFOLIO
Investment Objective
Capital Appreciation seeks growth of capital primarily through investment in a
diversified portfolio of common stocks and securities convertible into common
stock. Capital Appreciation will use a value-oriented approach in an attempt to
outperform the total return performance of publicly traded common stocks
represented by the S&P 500.
Investment Policy
Capital Appreciation will normally invest at least 65% of the Portfolio's net
assets in common stocks.
Capital Appreciation may also purchase securities aside from common stocks. The
value of all non-common stock investments may normally represent no more than
35% of Capital Appreciation's total assets.
Capital Appreciation may lend portfolio securities, invest up to 25% of its
assets in foreign securities, buy and sell put and call options on stock indices
and on individual stocks, purchase futures contracts, options contracts
(including options on futures contracts), equity index participations and index
participation contracts, engage in currency hedging and purchase securities on a
when-issued, delayed-delivery or forward-commitment basis.
FINANCIAL HIGHLIGHTS
The selected data presented below for the period ended December 31, 1996 are
derived from the financial statements of the Portfolios, which statements have
been audited by KPMG Peat Marwick LLP, independent auditors.
<TABLE>
<CAPTION>
Capital(1) Index(2) Small(3)
Appreciation Growth(1) Plus Company
------------- --------- -------- --------
<S> <C> <C> <C> <C>
Net asset value per share, beginning of period $10.000 $10.000 $10.000 $10.000
------- ------- ------- -------
Income From Investment Operations
Net investment income 0.015 0.011 0.047 0.008
Net realized and unrealized gain on
investments 0.200 0.147 0.919 0.115
------- ------- ------- -------
Total from investment operations 0.215 0.158 0.966 0.123
------- ------- ------- -------
</TABLE>
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<TABLE>
<CAPTION>
Capital(1) Index(2) Small(3)
Appreciation Growth(1) Plus Company
------------- --------- -------- --------
<S> <C> <C> <C> <C>
Less Distributions
Dividends from net investment income (0.016) (0.012) (0.047) (0.010)
Distribution from net realized gains on
investments -0- -0- (0.013) -0-
------- ------- ------- -------
Total distributions (0.016) (0.012) (0.060) (0.010)
------- ------- ------- -------
Net asset value per share, end of year $10.199 $10.146 $10.906 $10.113
======= ======= ======= =======
Total Return* 2.15% 1.57% 9.64% 1.23%
Net assets, end of year (millions) $ 5.2 $ 5.2 $ 19.4 $ 5.2
Ratio of total expenses to average net assets** 0.67% 0.67% 0.50% 0.55%
Ratio of net investment income to average net
assets** 2.73% 1.99% 1.89% 5.96%
Portfolio turnover rate -- 1.97% 5.18% --
Average Commission rate paid per share $0.0300 $0.0364 $0.0358 --
</TABLE>
(1) Date of initial capitalization was December 13, 1996
(2) Date of initial capitalization was September 16, 1996
(3) Date of initial capitalization was December 27, 1996
* The total return percentage does not reflect any separate account charges
under VA contracts and VLI policies.
** Annualized.
Additional information about the performance of the Portfolios are contained in
each Portfolio's Annual Report dated December 31, 1996. The Annual Reports and
independent auditors' reports thereon are incorporated herein by reference and
are available, without charge, by writing to the Fund at the address listed on
the cover of this Prospectus or by calling 1-800-525-4225.
INVESTMENT TECHNIQUES
The Variable Portfolios may use the following investment techniques (see
Appendix A for the definition of certain terms used below):
Borrowing
Each Portfolio may borrow money from banks for temporary or emergency purposes
in an amount up to 5% of the value of the Portfolio's total assets (including
the amount borrowed), valued at the lesser of cost or market, less liabilities
(not including the amount borrowed), at the time the borrowing is made.
The Portfolios do not intend to borrow for leveraging purposes. Each Portfolio
has the authority to do so, but only if, after the borrowing, the value of the
Portfolio's net assets, including proceeds from the borrowings, is equal to at
least 300% of all outstanding borrowings. Leveraging can increase the volatility
of a Portfolio because it exaggerates the effects of changes in the value of the
securities purchased with the borrowed funds.
Securities Lending
A Portfolio may lend its portfolio securities; however, the value of the loaned
securities (together with all other assets that are loaned, including those
subject to repurchase agreements) may not exceed one-third of the Portfolio's
total assets. A Portfolio will not lend portfolio securities to affiliates.
Though fully collateralized, lending portfolio securities involves certain
risks, including the possibility that the Portfolio may incur costs in
liquidating the collateral or a loss if the collateral declines in value. In the
event of a disparity between the value of the loaned security and the
collateral, there is the additional risk that the borrower may fail to return
the securities or provide additional collateral.
Repurchase Agreements
Under a repurchase agreement, a Portfolio may acquire a debt instrument for a
relatively short period subject to an obligation by the seller to repurchase and
by the Portfolio to resell the instrument at a fixed price and time.
The Portfolios may enter into repurchase agreements with domestic banks and
broker-dealers. Such agreements, although fully collateralized, involve the risk
that the seller of the securities may fail to repurchase them. In that event, a
Portfolio may incur costs in liquidating the security (or other collateral) or a
loss if the security or other collateral declines in value. If the default on
the part of the seller is due to insolvency and the seller initiates bankruptcy
proceedings, the ability of a Portfolio to liquidate the collateral may be
delayed or limited.
The Board of Directors has established credit standards for repurchase
transactions entered into by the Variable Portfolios.
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Asset-Backed Securities
Each Portfolio may purchase securities collateralized by a specified pool of
assets, including, but not limited to, credit card receivables, automobile
loans, home equity loans, mobile home loans, or recreational vehicle loans.
These securities are subject to prepayment risk. In periods of declining
interest rates, reinvestment of prepayment proceeds would be made at lower and
less attractive interest rates.
Zero Coupon and Pay-in-Kind Bonds
Each Portfolio may invest in zero coupon securities and pay-in-kind bonds. Zero
coupon securities are debt securities that pay no cash income but are sold at
substantial discounts to their value at maturity. Some zero coupon securities
call for the commencement of regular interest payments at a deferred date.
Pay-in-kind bonds pay all or a portion of their interest in the form of
additional debt or equity securities. Zero coupon securities and pay-in-kind
bonds are subject to greater price fluctuations in response to changes in
interest rates than are ordinary interest-paying instruments with similar
maturities; the value of zero coupon securities and pay-in-kind bonds
appreciates more during periods of declining interest rates and depreciates more
during periods of rising interest rates.
Bank Obligations
Each Portfolio may invest in obligations (including banker's acceptances,
commercial paper, bank notes, time deposits and certificates of deposit) issued
by domestic or foreign banks, provided the issuing bank has a minimum of $5
billion in assets and a primary capital ratio of at least 4.25%.
Options, Futures and Other Derivative Instruments
A derivative is a financial instrument, the value of which is "derived" from the
performance of an underlying asset (such as a security or an index of
securities). In addition to futures and options, derivatives include, but are
not limited to, forward contracts, swaps, structured notes, and collateralized
mortgage obligations (CMOs).
A Portfolio may engage in various strategies using derivatives including
managing its exposure to changing interest rates, securities prices and currency
exchange rates (collectively known as hedging strategies), or increasing its
investment return. For purposes other than hedging, a Portfolio will invest no
more than 5% of its total assets in derivatives which at the time of purchase
are considered by management to involve high risk to the Portfolio. These would
include inverse floaters, interest-only and principal-only securities.
Each Portfolio may purchase call options, write (sell) covered call options, and
purchase and write (sell) put options, including options on securities, indices
and futures. There is no limit on the amount of a Portfolio's total assets that
may be subject to call options; however, writing a put option requires the
segregation of liquid assets to cover the contract. A Portfolio will not write a
put option if it will require more than 50% of the Portfolio's net assets to be
segregated to cover the put obligation nor will it write a put option if, after
it is written, more than 3% of the Portfolio's assets would consist of put
options.
As with all derivatives, the use of call options involves certain risks, which
are described in detail under "Risk Factors and Other Considerations" and in the
Statement. In that there is no limit on the amount of a Portfolio's total assets
that may be subject to call options, these risks may be heightened should a
Portfolio choose to engage extensively in such transactions.
Investments in futures contracts and related options with respect to foreign
currencies, fixed income securities and foreign stock indices may also be made
by a Portfolio. Although these investments are primarily made to hedge against
price fluctuations, in some cases, a Portfolio may buy a futures contract for
the purpose of increasing its exposure in a particular asset class or market
segment, which strategy may be considered speculative. This strategy is
typically used to better manage portfolio transaction costs. With respect to
futures contracts or related options that may be entered into for speculative
purposes, the aggregate initial margin for futures contracts and premiums for
options will not exceed 5% of a Portfolio's net assets, after taking into
account realized profits and unrealized losses on such futures contracts.
A Portfolio may invest in forward contracts on foreign currency (forward
exchange contracts). These contracts may involve "cross-hedging," a technique in
which a Portfolio hedges with currencies that differ from the currency in which
the underlying asset is denominated.
A Portfolio may also invest in interest rate swap transactions. Interest rate
swaps are subject to credit risks (if the other party fails to meet its
obligations) and also to interest rate risks, because a Portfolio could be
obligated to pay more under its swap agreements than it receives under them as a
result of interest rate changes.
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U.S. Government Derivatives
Each Portfolio may purchase separately traded principal and interest components
of certain U.S. Government securities ("STRIPS"). In addition, a Portfolio may
acquire custodial receipts that represent ownership in a U.S. Government
security's future interest or principal payments. These securities are known by
such exotic names as TIGRS and CATS and may be issued at a discount to face
value. They are generally more volatile than normal fixed income securities
because interest payments are accrued rather than paid out in regular
installments.
Supranational Agencies
Each Portfolio may invest up to 10% of its net assets in securities of
supranational agencies such as: the International Bank for Reconstruction and
Development (commonly referred to as the "World Bank"), which was chartered to
finance development projects in developing member countries; the European
Community, which is a twelve-nation organization engaged in cooperative economic
activities; the European Coal and Steel Community, which is an economic union of
various European nations' steel and coal industries; and the Asian Development
Bank, which is an international development bank established to lend funds,
promote investment and provide technical assistance to member nations in the
Asian and Pacific regions. Securities of supranational agencies are not
considered government securities and are not supported directly or indirectly by
the U.S. Government.
Illiquid and Restricted Securities
Each Portfolio may invest up to 15% of its total assets in illiquid securities
(except up to 10%, under normal circumstances, with respect to the Index Plus
Portfolio). Illiquid securities are securities that are not readily marketable
or cannot be disposed of promptly within seven days and in the ordinary course
of business without taking a materially reduced price. In addition, a Portfolio
may invest in securities that are subject to legal or contractual restrictions
on resale, including securities purchased under Rule 144A and Section 4(2) of
the Securities Act of 1933.
Because of the absence of a trading market for illiquid and certain restricted
securities, it may take longer to liquidate these securities than it would
unrestricted, liquid securities. A Portfolio may realize less than the amount
originally paid by the Portfolio for the security. The Board of Directors has
established a policy to monitor the liquidity of such securities.
Cash or Cash Equivalents
Each Portfolio reserves the right to depart from its investment objectives
temporarily by investing up to 100% of its assets in cash or cash equivalents
for defense against potential market declines and to accommodate cash flows from
the purchase and sale of Portfolio shares.
Other Investments
Each Portfolio may use other investment techniques, including the purchase of
variable rate instruments. These techniques are described in Appendix A and
the Statement.
RISK FACTORS AND OTHER CONSIDERATIONS
General Considerations
The different types of securities purchased and investment techniques used by a
Portfolio involve varying amounts of risk. For example, equity securities are
subject to a decline in the stock market or in the value of the issuer, and
preferred stocks have price risk and some interest rate and credit risk. The
value of debt securities may be affected by changes in general interest rates
and in the creditworthiness of the issuer. Debt securities with longer
maturities (for example, over ten years) are generally more affected by changes
in interest rates and provide less price stability than securities with short
term maturities (for example, one to ten years). Also, on each debt security,
the risk of principal and interest default is greater with higher-yielding,
lower-grade securities. High-risk, high-yield securities may provide a higher
return but with added risk. In addition, foreign securities have currency risk.
Some of the risks involved in the securities acquired by the Variable Portfolios
are discussed in this section. Additional discussion is contained above under
"Investment Techniques" and in the Statement.
Portfolio Turnover
Portfolio turnover refers to the frequency of portfolio transactions and the
percentage of portfolio assets being bought and sold in the aggregate during the
year. Although the Variable Portfolios do not purchase securities with the
intention of profiting from short-term trading, each Portfolio may buy and sell
securities when the investment adviser or subadviser believes such action is
advisable. It is anticipated that the average annual turnover rate of each of
the Portfolios may exceed 125%. Turnover
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rates in excess of 125% may result in higher transaction costs (which are borne
directly by the respective Portfolio) and a possible increase in short-term
capital gains (or losses). See "Tax Status" in the Statement.
Foreign Securities
Investments in securities of foreign issuers or securities denominated in
foreign currencies involve risks not present in domestic markets. These risks
include: currency fluctuations and related currency conversion costs; less
liquidity; price or income volatility; less government supervision and
regulation of foreign stock exchanges, brokers and listed companies; possible
difficulty in obtaining and enforcing judgments against foreign entities;
adverse foreign political and economic developments; different accounting
procedures and auditing standards; the possible imposition of withholding taxes
on interest income payable on securities; the possible seizure or
nationalization of foreign assets; the possible establishment of exchange
controls or other foreign laws or restrictions which might adversely affect the
payment and transferability of principal, interest and dividends on securities;
higher transaction costs; possible settlement delays; and less publicly
available information about foreign issuers.
Depositary Receipts
The Portfolios can invest in both sponsored and unsponsored depositary receipts.
Unsponsored depositary receipts, which are typically traded in the
over-the-counter market, may be less liquid than sponsored depositary receipts
and therefore may involve more risk. In addition, there may be less information
available about issuers of unsponsored depositary receipts.
The Portfolios will generally acquire American Depositary Receipts (ADRs) which
are dollar denominated, although their market price is subject to fluctuations
of the foreign currency in which the underlying securities are denominated. All
depositary receipts will be considered foreign securities for purposes of a
Portfolio's investment limitation concerning investment in foreign securities.
See Appendix A and the Statement for more information.
High-Risk, High-Yield Securities
A Portfolio may invest in high-risk, high-yield securities, often called "junk
bonds". These securities tend to offer higher yields than investment-grade bonds
because of the additional risks associated with them. These risks include: a
lack of liquidity; an unpredictable secondary market; a greater likelihood of
default; increased sensitivity to difficult economic and corporate developments;
call provisions which may adversely affect investment returns; and loss of the
entire principal and interest. Although junk bonds are high-risk investments,
the investment adviser may purchase these securities if they are thought to
offer good value. This may happen if, for example, the rating agencies have, in
the investment adviser's opinion, misclassified the bonds or overlooked the
potential for the issuer's enhanced creditworthiness.
Derivatives
The Portfolios may use derivative instruments as described above under
"Investment Techniques -- Options, Futures and Other Derivative Instruments."
Derivatives can be volatile investments and involve certain risks. A Portfolio
may be unable to limit its losses by closing a position due to lack of a liquid
market or similar factors. Losses may also occur if there is not a perfect
correlation between the value of futures or forward contracts and the related
securities. The use of futures may involve a high degree of leverage because of
low margin requirements. As a result, small price movements in futures contracts
may result in immediate and potentially unlimited gains or losses to a
Portfolio. Leverage may exaggerate losses of principal. The amount of gains or
losses on investments in futures contracts depends on the investment adviser's
ability to predict correctly the direction of stock prices, interest rates and
other economic factors.
The use of forward-exchange contracts may reduce the gain that would otherwise
result from a change in the relationship between the U.S. dollar and a foreign
currency. In an attempt to limit their risk in forward-exchange contracts, the
Variable Portfolios limit their exposure to the amount of their respective
assets denominated in the foreign currency being cross- hedged. Cross-hedging
entails a risk of loss on both the value of the security that is the basis of
the hedge and the currency contract that was used in the hedge. These risks are
described in greater detail in the Statement.
Variable-Rate Instruments, When-Issued and Delayed-Delivery Transactions
When-issued, delayed-delivery and variable-rate instruments may be subject to
liquidity risks and risks of loss of principal due to market fluctuations.
Liquid assets in an amount at least equal to the Portfolio's commitments to
purchase securities on a when-issued or delayed-delivery basis will be
segregated at the Portfolio's custodian. For more information about these
securities, see Appendix A and the Statement.
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Small Capitalization Companies
The Variable Portfolios may invest in small capitalization companies. These
companies may be in an early developmental stage or older companies entering a
new stage of growth due to management changes, new technology, products or
markets. The securities of small capitalization companies may also be
undervalued due to poor economic conditions, market decline or actual or
anticipated unfavorable developments affecting the issuer of the security or its
industry.
Securities of small capitalization companies tend to offer greater potential for
growth than securities of larger, more established issuers but there are
additional risks associated with them. These risks include: limited
marketability; more abrupt or erratic market movements than securities of larger
capitalization companies; and less publicly available information about the
issuer. In addition, these companies may be dependent on relatively few products
or services, have limited financial resources and lack of management depth, and
may have less of a track record or historical pattern of performance.
INVESTMENT RESTRICTIONS
In addition to the restrictions discussed under "Investment Techniques," a
Portfolio will not invest more than 25% of its total assets in securities issued
by companies principally engaged in any one industry. For purposes of this
restriction, finance companies will be classified as separate industries
according to the end users of their services, such as automobile finance,
computer finance and consumer finance. The 25% limitation does not apply to
securities issued or guaranteed by the U.S. Government, its agencies or
instrumentalities.
A Portfolio will not invest more than 5% of its total assets in the securities
of any one issuer (excluding securities issued or guaranteed by the U.S.
Government, its agencies or instrumentalities) or purchase more than 10% of the
outstanding voting securities of any one issuer. These latter restrictions apply
only to 75% of a Portfolio's total assets. In addition, the Small Company,
Growth and Capital Appreciation Portfolios do not invest in the securities of
companies determined by the Adviser to be primarily involved in the production
or distribution of tobacco products. See the Statement for additional investment
restrictions.
MANAGEMENT OF THE VARIABLE PORTFOLIOS
Directors
The operations of each Portfolio are managed under the supervision of the
Directors. The Directors set broad policies for the Fund and each Portfolio.
Information about the Directors is found in the Statement.
Investment Adviser
Aetna Life Insurance and Annuity Company (Aetna), serves as the investment
adviser for each of the Variable Portfolios. Aetna is a Connecticut insurance
corporation with its principal offices at 151 Farmington Avenue, Hartford,
Connecticut 06156, and is registered with the Commission as an investment
adviser. Aetna is an indirect, wholly-owned subsidiary of Aetna Retirement
Services, Inc., which is in turn an indirect, wholly-owned subsidiary of Aetna
Inc.
Under the terms of the Investment Advisory Agreement between the Fund and Aetna
with respect to each of the Portfolios, Aetna, subject to the supervision of the
Directors, is obligated to manage and oversee the Fund's day-to-day operations
and to manage the investments of each Portfolio.
The Investment Advisory Agreement gives Aetna broad latitude in selecting
securities for each Portfolio subject to the Directors' oversight. Under the
Investment Advisory Agreement, Aetna may delegate to a subadviser its functions
in managing the investments of each Portfolio, subject to Aetna's oversight. The
Investment Advisory Agreement allows Aetna to place trades through brokers of
its choosing and to take into consideration the quality of the brokers' services
and execution, as well as services such as research, providing equipment to the
Fund, or paying Fund expenses, in setting the amount of commissions paid to a
broker. Aetna will only use these commissions for services and expenses to the
extent authorized by applicable law and by the rules and regulations of the SEC.
Aetna receives a monthly fee from each Portfolio at an annual rate based on the
average daily net assets of each Portfolio as follows:
Portfolio Fee
--------- ---
Growth 0.600%
Small Company 0.750%
Index Plus 0.350%
Capital Appreciation 0.600%
Aetna is not obligated to reimburse a Portfolio for any expenses that exceed the
amount of its advisory fee for that year. The Investment Advisory Agreement also
provides that Aetna is responsible for all of its own costs including costs of
Aetna's personnel required to carry out its investment advisory duties.
9
<PAGE>
Subadviser
Aetna has engaged Aeltus Investment Management, Inc. (Aeltus), organized in 1972
under the name Aetna Capital Management, Inc., as a subadviser to each of the
Variable Portfolios. Aeltus is a Connecticut corporation located at 242 Trumbull
Street, Hartford, Connecticut 06103-1205. Aeltus is registered as an investment
adviser with the Commission. Aeltus is a part of the Aetna organization, and is
an indirect, wholly-owned subsidiary of Aetna Retirement Services, Inc., which
is in turn an indirect, wholly-owned subsidiary of Aetna Inc. John Y. Kim
currently serves as the President, Chief Executive Officer and Chief Investment
Officer of Aeltus. Under a Subadvisory Agreement with Aetna, Aeltus, subject to
the supervision of Aetna and the Directors, is responsible for managing the
assets of each respective Portfolio in accordance with its investment objective
and policies. Aeltus pays the salaries and other related costs of personnel
engaged in providing investment advice including office space, facilities and
equipment.
Aetna has overall responsibility for monitoring the investment program
maintained by Aeltus for compliance with applicable laws and regulations and the
respective Portfolio's investment objective.
The Subadvisory Agreement gives Aeltus broad latitude in selecting securities
for each Portfolio subject to Aetna's oversight. The Subadvisory Agreement also
allows Aeltus to place trades through brokers of its choosing and to take into
consideration the quality of the brokers' services and execution, as well as
services such as research and providing equipment or paying Fund expenses, in
setting the amount of commissions paid to a broker. The use of research and
expense reimbursements in determining and paying commissions is referred to as
"soft dollar" practices. Aeltus will only use soft dollars for services and
expenses to the extent authorized under the Investment Advisory Agreement, but
only as authorized by applicable law and the rules and regulations of the
Commission.
The Subadvisory Agreement provides that Aetna will pay Aeltus a fee at an annual
rate up to 0.45% of the average daily net assets of each Portfolio. This fee is
not charged back to, or paid by, the Portfolios; it is paid by Aetna out of its
own resources, including fees and charges it receives from or in connection with
each Portfolio.
The Subadvisory Agreement requires Aeltus to reduce its fee if Aetna is required
to reduce its fee under the Investment Advisory Agreement. Aetna would not be
obligated to reimburse a Portfolio for any expenses that exceed the amount of
its advisory fee for that year. The Subadvisory Agreement obligates Aeltus to
reduce its fee by approximately 60% of the amount of Aetna's fee reduction.
Portfolio Management
The following individuals are primarily responsible for the day-to-day
management of the Portfolios, as indicated below. All of the following
individuals may also decide as a group what strategy may benefit all of the
Portfolios.
Growth and Capital Appreciation
Peter B. Canoni, Managing Director, Aeltus. Mr. Canoni has been with the
Aetna organization since 1980 and has over 20 years of investment experience.
Small Company
Thomas J. DiBella, Vice President, Aeltus. Before joining Aeltus, Mr. DiBella
was Investment Officer at Bethlehem Steel from 1989 to 1991. Mr. DiBella has
over 10 years of investment experience.
Index Plus
Geoffrey A. Brod, Vice President, Aeltus. Mr. Brod has over 30 years of
experience in quantitative applications and has over 9 years of experience in
equity investments. Mr. Brod has been with the Aetna organization since 1966.
Expenses and Fund Administration
Under an Administrative Services Agreement with the Fund, Aetna provides all
administrative services necessary for the Fund's operations and is responsible
for the supervision of the Fund's other service providers. Aetna also assumes
all ordinary recurring direct costs of the Fund, such as custodian fees,
directors fees, transfer agency costs and accounting expenses. For the services
provided under the Administrative Services Agreement, Aetna receives an annual
fee, payable monthly, at a rate of 0.15% of the average daily net assets of the
Fund.
PURCHASE AND REDEMPTION OF SHARES
Purchases and redemptions of shares may be made only by insurance companies for
their separate accounts at the direction of Participants. Please refer to the
prospectus for your contract or policy for information on how to direct
investments in or redemptions from a Portfolio and any fees that may apply.
Orders for the purchase or redemption of shares of each Portfolio
10
<PAGE>
that are received before the close of regular trading on the New York Stock
Exchange (normally 4 p.m. eastern time) are effected at the respective net asset
value per share determined that day, as described below (see Net Asset Value).
The Portfolios reserve the right to suspend the offering of shares, or to reject
any specific purchase order. The Portfolios may suspend redemptions or postpone
payments when the New York Stock Exchange is closed or when trading is
restricted for any reason (other than weekends or holidays) or under emergency
circumstances as determined by the Commission.
NET ASSET VALUE
The net asset value per share (NAV) of each Portfolio is determined as of the
earlier of 15 minutes after the close of the New York Stock Exchange (NYSE) or
4:15 p.m. eastern time on each day that NYSE is open for trading. Each
Portfolio's NAV is computed by taking the total value of a Portfolio's
securities, plus any cash or other assets (including dividends and interest
accrued but not collected) and subtracting all liabilities (including accrued
expenses), and dividing the total by the number of shares outstanding. Portfolio
securities are valued primarily by independent pricing services, based on market
quotations. Short-term debt instruments maturing in less than 60 days are valued
at amortized cost. Securities for which market quotations are not readily
available are valued at their fair value in such manner as may be determined,
from time to time, in good faith, by or under the authority of, the Directors.
GENERAL INFORMATION
Incorporation
The Fund was incorporated under the laws of Maryland on June 4, 1996.
Capital Stock
The Fund is authorized to issue one billion shares of capital stock, par value
$0.001 per share. All shares are nonassessable, transferable and redeemable.
There are no preemptive rights.
Shareholder Meetings
The Fund is not required and does not intend to hold annual shareholder
meetings. The Fund's Articles of Incorporation provide for meetings of
shareholders to elect Directors at such times as may be determined by the
Directors or as required by the 1940 Act. If requested by the holders of at
least 10% of the Fund's outstanding shares, the Fund will hold a shareholder
meeting for the purpose of voting on the removal of one or more Directors and
will assist with communication concerning that shareholder meeting.
Voting Rights
Each share of the Fund is entitled to one vote for each full share and
fractional votes for fractional shares. Separate votes are taken by Portfolio
only if the matter affects or requires the vote of only that Portfolio. The
insurance companies holding the shares in their separate accounts will generally
request voting instructions from the Participants and generally must vote the
shares in proportion to the voting instructions received. Voting rights for VA
Contracts and VLI Policies are discussed in the prospectus for the applicable
contract or policy.
PERFORMANCE
From time to time advertisements and other sales materials for the Fund may
include information concerning the historical performance of each Portfolio.
Such advertisements will also describe the performance of the relevant insurance
company separate accounts. Any such information will include the average annual
total return of the Portfolio calculated on a compounded basis for specified
periods of time. Total return information will be calculated pursuant to rules
established by the Commission. In lieu of or in addition to total return
calculations, such information may include performance rankings and similar
information from independent organizations such as Lipper Analytical Services,
Inc., Morningstar, Business Week, Forbes or other industry publications.
Each Portfolio calculates average annual total return by determining the
redemption value at the end of specified periods (assuming reinvestment of all
dividends and distributions) of a $1,000 investment in the Portfolio at the
beginning of the period, deducting the initial $1,000 investment, annualizing
the increase or decrease over the specified period and expressing the result as
a percentage.
Total return figures utilized by the Fund are based on historical performance
and are not intended to indicate future performance. Total return and NAV per
share can be expected to fluctuate over time, and accordingly, upon redemption,
shares may be worth more or less than their original cost.
11
<PAGE>
Public Fund Performance
Small Company is recently organized and does not yet have a long term
performance record. However, Small Company has the same investment objective and
follows substantially the same investment strategies as a series of a mutual
fund (public fund) whose shares are currently sold to the public and managed by
Aetna and Aeltus.
Set forth below is the historical performance of the comparable series of the
public fund. Investors should not consider the performance data of the series of
the public fund as an indication of the future performance of the Portfolio. The
performance figures shown below reflect the deduction of the historical fees and
expenses paid by the series of the public fund, and not those paid by the
Portfolio. The figures also do not reflect the deduction of any insurance fees
or charges that are imposed by the insurance company in connection with its sale
of the VA Contracts and VLI Policies. Investors should refer to the separate
account prospectuses describing the VA Contracts and VLI Policies for
information pertaining to these insurance fees and charges. The insurance
separate account fees will have a detrimental effect on the performance of the
Portfolio. The results shown reflect the reinvestment of dividends and
distributions, and were calculated in the same manner that will be used by the
Portfolio to calculate its own performance.
The following table shows average annualized total returns for the time periods
shown for the Select Class shares of the series of the public fund, as well as a
comparison with the Russell 2000 Growth Index, a small cap stock benchmark.
SMALL COMPANY
1 YEAR SINCE INCEPTION
------ ---------------
Aetna Series Fund, Inc.
Aetna Small Company 13.62% 19.53%
Russell 2000 Growth Index 11.26% 12.47%
Results shown are through the period ended December 31, 1996. The inception date
is January 1, 1994.
Private Account Performance
Index Plus, Capital Appreciation and Growth are recently organized and do not
yet have long term performance records. However, each of these Portfolios has an
investment objective, policy and strategy substantially similar to those
employed by Aeltus with respect to certain noninvestment company advisory
accounts (Private Accounts).
Thus, the performance information derived from these Private Accounts is deemed
relevant to the investor. The performance of the Portfolios may vary from the
Private Account composite information because each Portfolio will be actively
managed and its investments will vary from time to time and will not be
identical to the past portfolio investments of the Private Accounts. Moreover,
the Private Accounts are not registered under the 1940 Act and, therefore, are
not subject to certain investment restrictions that are imposed by the 1940 Act,
which, if imposed, could have adversely affected the Private Accounts'
performance.
The chart below shows hypothetical performance information derived from
historical composite performance of the Private Accounts included in the Index
Plus Composite, Capital Appreciation Composite and Growth Composite. The
performance figures represent the actual performance results of the composites
of comparable Private Accounts, adjusted to reflect the deduction of the fees
and expenses paid by each Portfolio. The Private Account composite performance
figures are time- weighted rates of return which include all income and accrued
income and realized and unrealized gains or losses, but do not reflect the
deduction of investment advisory fees actually charged to the Private Accounts.
Investors should not consider the performance data of these Private Accounts as
an indication of the future performance of the respective Portfolios. The
figures also do not reflect the deduction of any insurance fees or charges that
are imposed by the insurance company in connection with its sale of VA Contracts
and VLI Policies. Investors should refer to the separate account prospectuses
describing the VA Contracts and VLI Policies for information pertaining to these
insurance fees and charges. The insurance fees and charges will have a
detrimental effect on the performance of a Portfolio.
The following tables show performance information derived from private account
composite performance reduced by actual Portfolio fees and expenses, as well as
comparisons with the S&P 500, an unmanaged index generally considered to be
representative of the stock market.
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PRIVATE ACCOUNT COMPOSITE PERFORMANCE
INDEX PLUS 1 YEAR 5 YEARS SINCE INCEPTION
------ ------- ---------------
Index Plus Composite* 24.92% 15.49% 16.72%
S&P 500 Stock Index 22.95% 15.22% 16.22%
CAPITAL APPRECIATION 1 YEAR 5 YEARS SINCE INCEPTION
------ ------- ---------------
Capital Appreciation Composite* 27.69% 17.84% 22.67%
S&P 500 Stock Index 22.95% 15.22% 18.49%
GROWTH 1 YEAR 5 YEARS 10 YEARS
------ ------- --------
Growth Composite* 27.77% 13.79% 16.04%
S&P 500 Stock Index 22.95% 15.22% 15.29%
* The Composite reflects the Aeltus "Quantitative Equity" Composite.
Results shown are through the period ended December 31, 1996. The inception
dates are October 1, 1991 for the Index Plus Composite, October 1, 1990 for the
Capital Appreciation Composite and January 1, 1983 for the Growth Composite.
TAX MATTERS
Each Portfolio intends to qualify as a regulated investment company by
satisfying the requirements under Subchapter M of the Internal Revenue Code of
1986, as amended (Code), including requirements with respect to diversification
of assets, distribution of income and sources of income. As a regulated
investment company, a Portfolio generally will not be subject to tax on its
ordinary income and net realized capital gains.
Each Portfolio also intends to comply with the diversification requirements of
Section 817(h) of the Code for variable annuity contracts and variable life
insurance policies so that the VA Contract owners and VLI Policy owners should
not be subject to federal tax on distributions of dividends and income from a
Portfolio to the insurance company separate accounts. Contract owners and policy
owners should review the prospectus for their VA Contract or VLI Policy for
information regarding the personal tax consequences of purchasing a contract or
policy.
13
<PAGE>
APPENDIX A
GLOSSARY OF INVESTMENT TERMS
BANKER'S ACCEPTANCE. A time draft drawn on and accepted by a bank, customarily
used by corporations as a means of financing payment for traded goods. When a
draft is accepted by a bank, the bank guarantees to pay the face value of the
debt at maturity.
CALL OPTION. The right to buy a security, currency or stock index at a stated
price, or strike price, within a fixed period. A call option will be exercised
if the market price rises above the strike price; if not, the option expires
worthless.
CERTIFICATES OF DEPOSIT. For large deposits not withdrawable on demand, banks
issue certificates of deposit ("CDs") as evidence of ownership. CDs are usually
negotiable and traded among investors such as mutual funds and banks.
COLLATERALIZED MORTGAGE OBLIGATIONS (CMOS). Mortgage-backed bonds that separate
mortgage pools into various classes or tranches in a predetermined, specified
order such as short-, medium-, and long-term portions.
COMMERCIAL PAPER. Unsecured short-term debt instruments issued by banks,
corporations or other borrowers with a maturity ranging from two to 270 days.
CONVERTIBLE SECURITIES. Corporate securities (usually bonds or preferred stock)
that can be exchanged for a set number of shares of another security, usually
common stock.
COVERED CALL OPTIONS. A call option backed by the securities underlying the
option. The owner of a security will normally sell covered call options to
collect premium income or to reduce price fluctuations of the security. A
covered call option limits the capital appreciation of the underlying security.
EURODOLLARS. Eurodollars are U.S. dollars held in banks outside the United
States, mainly in Europe but also in other countries, and are commonly used for
the settlement of international transactions. There are many types of Eurodollar
securities including Eurodollar CDS and bonds; these securities are not
registered with the Commission. Certain Eurodollar deposits are not FDIC insured
and may be subject to future political and economic developments and
governmental restrictions.
DEPOSITARY RECEIPTS. Negotiable certificates evidencing ownership of shares of a
non-U.S. corporation, government, or foreign subsidiary of a U.S. corporation. A
U.S. bank typically issues depositary receipts, which are backed by ordinary
shares that remain on deposit with a custodian bank in the issuer's home market.
A depositary receipt can either be "sponsored" by the issuing company or
established without the involvement of the company, which is referred to as
"unsponsored."
FORWARD CONTRACTS. A purchase or sale of a specific quantity of a government
security, foreign currency, or other financial instrument at the current price,
with delivery and settlement at a specified future date.
FUTURES CONTRACTS. An agreement to buy or sell a specific amount of a financial
instrument at a particular price on a stipulated future date. A futures contract
obligates the buyer to purchase and the seller to sell, unlike an option where
one party can choose whether or not to exercise the option.
HIGH-RISK, HIGH-YIELD SECURITIES. Debt instruments rated BB or below by Standard
& Poor's Corporation or Ba or below by Moody's Investors Services Inc., or
securities of comparable ratings by other agencies or, if unrated, considered by
ALIAC to be of comparable quality. These securities are often called "junk
bonds" because of the greater possibility of default.
PREFERRED STOCK. Stock which has a preference over common stock, whether as to
payment of dividends or to assets on liquidation. It ordinarily pays a fixed
dividend.
PRIMARY CAPITAL RATIO. The ratio used to evaluate the creditworthiness of
foreign banks which is based on the ratio of total assets to the common and
preferred stock, loan loss reserves, minority interests and mandatory
convertibles.
PUT OPTION. The right to sell a security, currency or stock index at a stated
price, or strike price, within a fixed period. A put option will be exercised if
the market price falls below the strike price; if not, the option expires
worthless.
SWAP. An exchange of one security for another. A swap may be executed to change
the maturities of a bond portfolio or the quality of the issues in a stock or
bond portfolio.
U.S. GOVERNMENT SECURITIES. Securities issued by the U.S. Government or its
agencies.
14
<PAGE>
Direct Obligations of the U.S. Government are:
TREASURY BILLS -- issued with short maturities (one year or less) and priced
at a discount to face value. The income for investors is the difference between
the purchase price and the face value.
TREASURY NOTES -- intermediate-term securities with maturities of between
one to ten years. Income to investors is paid in semiannual interest payments.
TREASURY BONDS -- long-term securities with maturities from ten years to up
to thirty years. Income is paid to investors on a semiannual basis.
In addition, U.S. Government Agencies issue debt securities to finance
activities for the U.S. Government. These agencies include among others the
Federal Home Loan Bank, Federal National Mortgage Association ("FNMA" or "Fannie
Mae"), Government National Mortgage Association ("GNMA" or "Ginnie Mae"),
Export-Import Bank and the Tennessee Valley Authority.
Not all agencies are backed by the full faith and credit of the United States;
for example, the FNMA may borrow money from the U.S. Treasury only under certain
circumstances. There is no guarantee that the government will support these
types of securities and they therefore involve more risk than direct government
obligations.
VARIABLE-RATE INSTRUMENTS. An instrument the terms of which provide for the
adjustment of its interest rate on set dates and which can reasonably be
expected to have a market value close to par value.
WARRANTS. A security, normally offered with bonds or preferred stock, that
entitles the holder to buy shares of stock at a prescribed price within a named
or stated period, or to perpetuity. The time period is usually longer than that
of a call option.
WHEN-ISSUED AND DELAYED-DELIVERY TRANSACTIONS. When-issued is a transaction that
is made as of a current date, but conditioned on the actual issuance of a
security that is authorized but not yet issued. A delayed-delivery transaction
is one where both parties agree that the security will be delivered and the
transaction completed at a future date.
YANKEE BONDS. A dollar denominated bond issued in the United States by foreign
corporations and banks. Similarly, Yankee CDS are issued in the U.S. by branches
and agencies of foreign banks.
15
<PAGE>
APPENDIX B
DESCRIPTION OF CORPORATE BOND RATINGS
MOODY'S INVESTORS SERVICE, INC.
Aaa -- Bonds which are rated Aaa are judged to be of the best quality. They
carry the smallest degree of investment risk and are generally referred to as
"gilt-edge." Interest payments are protected by a large or by an exceptionally
stable margin and principal is secure. While the various protective elements are
likely to change, such changes as can be visualized are most unlikely to impair
the fundamentally strong position of such issues.
Aa -- Bonds which are rated Aa are judged to be of high quality by all
standards. Together with the Aaa group they comprise what are generally known as
high grade bonds. They are rated lower than the best bonds because margins of
protection may not be as large as in Aaa securities or fluctuation of protective
elements may be of greater amplitude or there may be other elements present
which make the long term risks appear somewhat larger than in Aaa securities.
A -- Bonds which are rated A possess many favorable investment attributes and
are to be considered as upper medium grade obligations. Factors giving security
to principal and interest are considered adequate but elements may be present
which suggest a susceptibility to impairment sometime in the future.
Baa -- Bonds which are rated Baa are considered as medium grade obligations,
i.e., they are neither highly protected nor poorly secured. Interest payments
and principal security appear adequate for the present, but certain protective
elements may be lacking or may be characteristically unreliable over any great
length of time. Such bonds lack outstanding investment characteristics and in
fact have speculative characteristics as well.
Ba -- Bonds which are rated Ba are judged to have speculative elements; their
future cannot be considered as well assured. Often the protection of interest
and principal payments may be very moderate and thereby not well safeguarded
during both good and bad times over the future. Uncertainty of position
characterizes bonds in this class.
B -- Bonds which are rated B generally lack characteristics of the desirable
investment. Assurance of interest and principal payments or of maintenance of
other terms of the contract over any long period of time may be small.
The modifier 1 indicates that the bond ranks in the higher end of its generic
rating category; the modifier 2 indicates a mid-range ranking; and the modifier
3 indicates the issuer ranks in the lower end of its rating category.
STANDARD & POOR'S CORPORATION
AAA -- Bonds rated AAA have the highest rating assigned by Standard & Poor's
to a debt obligation. Capacity to pay interest and repay principal is extremely
strong.
AA -- Bonds rated AA have a very strong capacity to pay interest and repay
principal and differ from the highest rated issues only in small degree.
A -- Bonds rated A have a strong capacity to pay interest and repay principal
although they are somewhat more susceptible to the adverse effects of changes in
circumstances and economic conditions than bonds in higher rated categories.
BBB -- Bonds rated BBB are regarded as having an adequate capacity to pay
interest and repay principal. Whereas they normally exhibit adequate protection
parameters, adverse economic conditions or changing circumstances are more
likely to lead to a weakened capacity to pay interest and repay principal for
bonds in this category than for bonds in higher rated categories.
BB -- Bonds rated BB have less near-term vulnerability to default than other
speculative issues. However, the bonds face major uncertainties or exposure to
adverse business, financial, or economic conditions which could lead to
inadequate capacity to meet timely interest and principal payments.
B -- Bonds rated B have a greater vulnerability to default but currently have
the capacity to meet interest payments and principal repayments. Adverse
business, financial, or economic conditions will likely impair capacity or
willingness to pay interest and repay principal.
The ratings from "AA" to "B" may be modified by the addition of a plus (+) or
minus (-) sign to show relative standing within the major rating categories.
16
<PAGE>
AETNA VARIABLE PORTFOLIOS, INC.
151 Farmington Avenue
Hartford, Connecticut 06156-8962
Statement of Additional Information Dated: May 1, 1997
This Statement of Additional Information is not a prospectus and should be
read in conjunction with the current prospectus for Aetna Variable
Portfolios, Inc. dated May 1, 1997. A free prospectus is available upon
request by writing to Aetna Variable Portfolios, Inc. at the address listed
above or calling 1-800-525-4225.
Read the prospectus before you invest.
<PAGE>
TABLE OF CONTENTS
<TABLE>
<CAPTION>
Page
----
<S> <C>
GENERAL INFORMATION AND HISTORY 3
ADDITIONAL INVESTMENT RESTRICTIONS AND POLICIES OF THE VARIABLE PORTFOLIOS 3
DESCRIPTION OF VARIOUS SECURITIES AND INVESTMENT TECHNIQUES 4
DIRECTORS AND OFFICERS OF THE FUND 14
CONTROL PERSONS AND PRINCIPAL SHAREHOLDERS 17
THE INVESTMENT ADVISORY AGREEMENT 17
THE SUBADVISORY AGREEMENT 17
THE ADMINISTRATIVE SERVICES AGREEMENT 18
CUSTODIAN 18
INDEPENDENT AUDITORS 18
PRINCIPAL UNDERWRITER 18
BROKERAGE ALLOCATION AND TRADING POLICIES 18
DESCRIPTION OF SHARES 19
PURCHASE AND REDEMPTION OF SHARES 20
NET ASSET VALUE 20
PERFORMANCE INFORMATION 20
TAX STATUS 21
VOTING RIGHTS 25
FINANCIAL STATEMENTS 26
</TABLE>
2
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GENERAL INFORMATION AND HISTORY
Aetna Variable Portfolios, Inc. (Fund) was incorporated in 1996 in Maryland. The
Fund is an open-end management investment company. The Fund is authorized to
issue multiple series of shares, each representing a diversified portfolio of
investments with different investment objectives, policies and restrictions
(individually, a "Portfolio" and collectively, the "Variable Portfolios"). The
Fund currently has authorized four Portfolios: Aetna Variable Growth Portfolio
(Growth); Aetna Variable Small Company Portfolio (Small Company); Aetna Variable
Index Plus Portfolio (Index Plus); and Aetna Variable Capital Appreciation
Portfolio (Capital Appreciation).
The investment objective and general investment policies of each Portfolio are
described in the Prospectus.
ADDITIONAL INVESTMENT RESTRICTIONS AND POLICIES OF THE VARIABLE PORTFOLIOS
The investment policies and restrictions of the Variable Portfolios, set forth
below, are matters of fundamental policy for purposes of the Investment Company
Act of 1940 (1940 Act) and therefore cannot be changed, with regard to a
particular Portfolio, without the approval of a majority of the outstanding
voting securities of that Portfolio as defined by the 1940 Act. This means the
lesser of: (i) 67% of the shares of a Portfolio present at a shareholders'
meeting if the holders of more than 50% of the shares of that Portfolio then
outstanding are present in person or by proxy; or (ii) more than 50% of the
outstanding voting securities of a Portfolio.
As a matter of fundamental policy, none of the Variable Portfolios will:
(1) with respect to 75% of the value of a Portfolio's total assets, hold more
than 5% of the value of its total assets in the securities of any one issuer
or hold more than 10% of the outstanding voting securities of any one
issuer. Securities issued or guaranteed by the U.S. Government, its agencies
or instrumentalities are excluded from these restrictions;
(2) concentrate its investments in any one industry, except that a Portfolio may
invest up to 25% of its total assets in securities issued by companies
principally engaged in any one industry. For purposes of this restriction,
finance companies will be classified as separate industries according to the
end user of their services, such as automobile finance, computer finance and
consumer finance. This limitation will not, however, apply to securities
issued or guaranteed by the U.S. Government, its agencies or
instrumentalities;
(3) make loans, except that, to the extent appropriate under its investment
program, a Portfolio may (a) purchase bonds, debentures or other debt
securities, including short-term obligations; (b) enter into repurchase
transactions; and (c) lend portfolio securities provided that the value of
such loaned securities does not exceed one-third of the Portfolio's total
assets;
(4) issue any senior security (as defined in the 1940 Act), except that (a) a
Portfolio may enter into commitments to purchase securities in accordance
with that Portfolio's investment program, including reverse repurchase
agreements, delayed delivery and when-issued securities, which may be
considered the issuance of senior securities; (b) a Portfolio may engage in
transactions that may result in the issuance of a senior security to the
extent permitted under applicable regulations, interpretations of the 1940
Act or an exemptive order; (c) a Portfolio may engage in short sales of
securities to the extent permitted in its investment program and other
restrictions; (d) the purchase or sale of futures contracts or related
options shall not be considered to involve the issuance of a senior
security; and (e) subject to fundamental restrictions, a Portfolio may
borrow money as authorized by the 1940 Act;
(5) purchase real estate, interests in real estate or real estate limited
partnership interests except that to the extent appropriate under its
investment program, a Portfolio may invest in securities secured by real
estate or interests therein or issued by companies, including real estate
investment trusts, which deal in real estate or interests therein;
(6) invest in commodity contracts, except that a Portfolio may, to the extent
appropriate under its investment program, purchase securities of companies
engaged in such activities; may enter into transactions in financial and
index futures contracts and related options; may engage in transactions on a
when-issued or forward commitment basis; and may enter into forward currency
contracts;
(7) borrow money, except that (a) a Portfolio may enter into certain futures
contracts or options related thereto; (b) a Portfolio may enter into
commitments to purchase securities in accordance with that Portfolio's
investment program, including delayed delivery and when-issued securities
and reverse repurchase agreements; (c) for temporary or emergency purposes,
a Portfolio may borrow money in amounts not exceeding 5% of the value of its
total assets at the time the loan is made; and (d) for purposes of
leveraging, a Portfolio may borrow money from banks (including its custodian
bank) only if, immediately after such borrowing, the value of that
Portfolio's assets, including the amount borrowed, less its liabilities,
is equal to at least 300% of the amount borrowed, plus all outstanding
borrowings. If, at any time, the value of that Portfolio's assets fails to
meet the 300% asset coverage requirement relative only to leveraging, that
Portfolio will, within three days (not including Sundays and holidays),
reduce its borrowings to the extent necessary to meet the 300% test; or
(8) act as an underwriter of securities except to the extent that, in connection
with the disposition of portfolio securities by a Portfolio, that Portfolio
may be deemed to be an underwriter under the provisions of the Securities
Act of 1933 (1933 Act).
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The Fund has also adopted certain other investment restrictions reflecting the
current investment practices of the Variable Portfolios that may be changed by
the Fund's Board of Directors (Directors) and without shareholder vote. Some of
these restrictions are described in the Prospectus. In addition, none of the
Portfolios will:
(1) make short sales of securities, other than short sales "against the box," or
purchase securities on margin except for short-term credits necessary for
clearance of portfolio transactions, provided that this restriction will not
be applied to limit the use of options, futures contracts and related
options, in the manner otherwise permitted by the investment restrictions,
policies and investment programs of each Portfolio, as described here and in
the prospectus;
(2) invest more than 25% of its total assets in securities or obligations of
foreign issuers, including marketable securities of, or guaranteed by,
foreign governments (or any instrumentality or subdivision thereof). A
Portfolio will invest in securities or obligations of foreign banks only if
such banks have a minimum of $5 billion in assets and a primary capital
ratio of at least 4.25%.
(3) invest in companies for the purpose of exercising control or management;
(4) purchase the securities of any other investment company, except as
permitted under the 1940 Act or by Order of the Commission;
(5) purchase interests in oil, gas or other mineral exploration programs;
however, this limitation will not prohibit the acquisition of securities of
companies engaged in the production or transmission of oil, gas, or other
minerals; or
(6) invest more than 25% of the total value of its assets in high-risk,
high-yield securities or "junk bonds" (securities rated BB/Ba or lower by
Standard & Poor's Corporation or Moody's Investors Service, Inc., or if
unrated, considered by the investment adviser to be of comparable quality).
(7) invest more than 15% of its total assets in illiquid securities. Illiquid
securities are securities that are not readily marketable or cannot be
disposed of promptly within seven days and in the usual course of business
without taking a materially reduced price. Such securities include, but are
not limited to time deposits and repurchase agreements with maturities
longer than seven days. Securities that may be resold under Rule 144A or
securities offered pursuant to Section 4(2) of the 1933 Act, as amended,
shall not be deemed illiquid solely by reason of being unregistered. The
investment adviser shall determine whether a particular security is deemed
to be liquid based on the trading markets for the specific security and
other factors.
Where a Portfolio's investment objective or policies restrict it to a specified
percentage of its total assets in any type of instrument, that percentage is
measured at the time of purchase. There will be no violation of any investment
policy or restriction if that restriction is complied with at the time of
purchase, notwithstanding a later change in the market value of an investment,
in net or total assets, in the securities rating of the investment, or any other
change.
DESCRIPTION OF VARIOUS SECURITIES AND INVESTMENT TECHNIQUES
Options, Futures and Other Derivative Instruments
The Variable Portfolios may use derivative instruments as described in the
prospectus under "Investment Techniques." The following provides additional
information about these instruments.
Futures Contracts--Each Portfolio may enter into futures contracts as described
in the prospectus. A Portfolio may enter into futures contracts that are traded
on national futures exchanges and are standardized as to maturity date and
underlying financial instrument. The futures exchanges and trading in the United
States are regulated under the Commodity Exchange Act by the Commodity Futures
Trading Commission (CFTC).
A futures contract provides for the future sale by one party and purchase by
another party of a specified amount of a specific financial instrument(s) or a
specific stock market index for a specified price at a designated date and time.
Brokerage fees are incurred when a futures contract is bought or sold and at
expiration, and margin deposits must be maintained. Although certain futures
contracts require actual future delivery of and payment for the underlying
instruments, those contracts are usually closed out before the delivery date.
Stock index futures contracts do not contemplate actual future delivery and will
be settled in cash at expiration or closed out prior to expiration. Closing out
an open futures contract sale or purchase is effected by entering into an
offsetting futures contract purchase or sale, respectively, for the same
aggregate amount of the identical type of underlying instrument and the same
delivery date. There can be no assurance, however, that a Portfolio will be able
to enter into an offsetting transaction with respect to a particular contract at
a particular time. If a Portfolio is not able to enter into an offsetting
transaction, it will continue to be required to maintain the margin deposits on
the contract and continue to bear the risk of market improvement.
The prices of futures contracts are volatile and are influenced, among other
things, by actual and anticipated changes in interest rates and equities prices,
which in turn are affected by fiscal and monetary policies and national and
international political and economic events.
When using futures contracts as a hedging technique, at best, the correlation
between changes in prices of futures contracts and of the securities being
hedged can be only approximate. The degree of imperfection of correlation
depends upon circumstances such as:
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variations in speculative market demand for futures and for securities,
including technical influences in futures trading, and differences between the
financial instruments being hedged and the instruments underlying the standard
futures contracts available for trading. Even a well-conceived hedge may be
unsuccessful to some degree because of unexpected market behavior or stock
market or interest rate trends. Most United States futures exchanges limit the
amount of fluctuation permitted in interest rates futures contract prices during
a single trading day, and temporary regulations limiting price fluctuations for
stock index futures contracts are also now in effect. The daily limits
establishes the maximum amount that the price of a futures contract may vary
either up or down from the previous day's settlement price at the end of a
trading session. Once the daily limit has been reached in a particular type of
contract, no trades may be made on that day at a price beyond that limit. The
daily limit governs only price movement during a particular trading day and
therefore does not limit potential losses, because the limit may prevent the
liquidation of unfavorable positions. Futures contract prices have occasionally
moved to the daily limit for several consecutive trading days with little or no
trading, thereby preventing prompt liquidation of futures positions and
subjecting some persons engaging in futures transactions to substantial losses.
Sales of futures contracts which are intended to hedge against a change in the
value of securities held by a Portfolio may affect the holding period of such
securities and, consequently, the nature of the gain or loss on such securities
upon disposition.
"Margin" is the amount of funds that must be deposited by a Portfolio with a
commodities broker in a custodian account in order to initiate futures trading
and to maintain open positions in a Portfolio's futures contracts. A margin
deposit is intended to assure the Portfolio's performance of the futures
contract. The margin required for a particular futures contract is set by the
exchange on which the contract is traded and may be significantly modified from
time to time by the exchange during the term of the contract. If the price of an
open futures contract changes (by increase in the case of a sale or by decrease
in the case of a purchase) so that the loss on the futures contract reaches a
point at which the margin on deposit does not satisfy margin requirements, the
broker will require an increase in the margin. However, if the value of a
position increases because of favorable price changes in the futures contract so
that the margin deposit exceeds the required margin, the broker will promptly
pay the excess to a Portfolio. These daily payments to and from a Portfolio are
called variation margin. At times of extreme price volatility such as occurred
during the week of October 19, 1987, intra-day variation margin payments may be
required. In computing daily net asset values, each Portfolio will
mark-to-market the current value of its open futures contracts. Each Portfolio
expects to earn interest income on its initial margin deposits. Furthermore, in
the case of a futures contract purchase, each Portfolio has deposited in a
segregated account money market instruments sufficient to meet all futures
contract initial margin requirements.
Because of the low margin deposits required, futures trading involves an
extremely high degree of leverage. As a result, small price movements in futures
contracts may result in immediate and potentially unlimited loss or gain to a
Portfolio relative to the size of the margin commitment. For example, if at the
time of purchase 10% of the value of the futures contract is deposited as
margin, a subsequent 10% decrease in the value of the futures contract would
result in a total loss of the margin deposit before any deduction for the
transaction costs, if the contract were then closed out. A 15% decrease in the
value of the futures contract would result in a loss equal to 150% of the
original margin deposit, if the contract were closed out. Thus, a purchase or
sale of a futures contract may result in losses in excess of the amount
initially invested in the futures contract. However, a Portfolio would
presumably have sustained comparable losses if, instead of the futures contract,
it had invested in the underlying financial instrument and sold it after the
decline. With regard to transactions involving futures contracts, the Fund
maintains a segregated account holding liquid assets in accordance with
applicable Commission staff positions.
A Portfolio can enter into options on futures contacts. See "Covered Call and
Put Options" below. The risk involved in writing options on futures contracts or
market indices is that there could be an increase in the market value of such
contracts or indices. If that occurred, the option would be exercised and the
Portfolio involved would not benefit from any increase in value above the
exercise price. Usually, this risk can be eliminated by entering into an
offsetting transaction. However, the cost to do an offsetting transaction and
terminate the Portfolio's obligation might be more or less than the premium
received when it originally wrote the option. Further, the Portfolio might
occasionally not be able to close the option because of insufficient activity in
the options market.
Call and Put Options--Each Variable Portfolio may write (sell) covered call
options (Call Options) and purchase put options (Put Options) and may purchase
call and sell put options including options on securities, indices and futures
as discussed in the prospectus and in this Section. A call option gives the
holder (buyer) the right to buy and obligates the writer (seller) to sell a
security or financial instrument at a stated price (strike price) at any time
until a designated future date when the option expires (expiration date). A put
option gives the holder (buyer) the right to sell and obligates the writer
(seller) to purchase a security or financial instrument at a stated price at any
time until the expiration date. A Portfolio may write or purchase put or call
options listed on national securities exchanges in standard contracts or may
write or purchase put or call options with or directly from investment dealers
meeting the creditworthiness criteria of Aetna.
So long as the obligation of the writer of a call option continues, the writer
may be assigned an exercise notice by the broker-dealer through which such
option was settled, requiring the writer to deliver the underlying security
against payment of the exercise price. This obligation terminates upon the
expiration of the call option, by the exercise of the call option, or by
entering into an offsetting transaction. To secure the writer's obligation to
deliver the underlying security, a writer of a call option is required to
deposit in escrow
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the underlying security or other assets in accordance with the rules of the
clearing corporations and of the exchanges. A Portfolio will only write a call
option on a security that it already owns and will not write call options on
when-issued securities.
When writing a call option, in return for the premium, the writer gives up the
opportunity to profit from the price increase in the underlying security above
the exercise price, but conversely retains the risk of loss should the price of
the security decline. If a call option expires unexercised, the writer will
realize a gain in the amount of the premium; however, such gain may be offset by
a decline in the market value of the underlying security during the option
period. If the call option is exercised, the writer would realize a gain or loss
from the transaction depending on what it received from the call and what it
paid for the underlying security.
A Portfolio may purchase and write call options on stock indices, including the
S&P 500, as well as on any individual stock, as described below. The Portfolio
will use these techniques primarily as a temporary substitute for taking
positions in certain securities or in the securities that comprise the index,
particularly if Aetna considers these instruments to be undervalued relative to
the prices of particular securities or of the securities that comprise the
index.
An option on an index (or a particular security) is a contract that gives the
purchaser of the option, in return for the premium paid, the right to receive
from the writer of the option cash equal to the difference between the closing
price of the index (or security) and the exercise price of the option, expressed
in dollars, times a specified multiple (multiplier). A Portfolio may, in
particular, purchase call options on an index (or a particular security) to
protect against increases in the price of securities underlying that index (or
individual securities) that the Portfolio intends to purchase pending its
ability to invest in such securities in an orderly manner.
In the case of a put option, as long as the obligation of the put writer
continues, it may be assigned an exercise notice by the broker-dealer through
which such option was sold, requiring the writer to take delivery of the
underlying security against payment of the exercise price. A writer has no
control over when it may be required to purchase the underlying security, since
it may be assigned an exercise notice at any time prior to the expiration date.
This obligation terminates earlier if the writer effects a closing purchase
transaction by purchasing a put of the same series as that previously sold.
To secure its obligation to pay for the underlying security, the writer of a put
generally must deposit in escrow liquid assets with a value equal to or greater
than the exercise price of the put option. The writer therefore foregoes the
opportunity of investing the segregated assets or writing calls against those
assets. A Portfolio may write put options on debt securities or futures, only if
such puts are covered by segregated liquid assets.
In writing puts, there is the risk that a writer may be required to buy the
underlying security at a disadvantageous price. Writing a put covered by
segregated liquid assets equal to the exercise of the put has the same economic
effect as writing a covered call option. The premium the writer receives from
writing a put option represents a profit, as long as the price of the underlying
instrument remains above the exercise price; however, if the put is exercised,
the writer is obligated during the option period to buy the underlying
instrument from the buyer of the put at the exercise price, even though the
value of the investment may have fallen below the exercise price. If the put
lapses unexercised, the writer realizes a gain in the amount of the premium. If
the put is exercised, the writer may incur a loss, equal to the difference
between the exercise price and the current market value of the underlying
instrument.
A Portfolio may purchase put options when Aetna believes that a temporary
defensive position is desirable in light of market conditions, but does not
desire to sell a portfolio security. The purchase of put options for these
purposes may be used to protect a Portfolio's holdings in an underlying security
against a substantial decline in market value. Such protection is, of course,
only provided during the life of the put option when a Portfolio, as the holder
of the put option, is able to sell the underlying security at the put exercise
price regardless of any decline in the underlying security's market price. By
using put options in this manner, a Portfolio will reduce any profit it might
otherwise have realized in its underlying security by the premium paid for the
put option and by transaction costs. The security covering the call or put
option will be segregated at the Portfolio's custodian.
The premium received from writing a call or put option, or paid for purchasing a
call or put option will reflect, among other things, the current market price of
the underlying security, the relationship of the exercise price to such market
price, the historical price volatility of the underlying security, the length of
the option period, and the general interest rate environment. The premium
received by a Portfolio for writing call options will be recorded as a liability
in the statement of assets and liabilities of that Portfolio. This liability
will be adjusted daily to the option's current market value. The liability will
be extinguished upon expiration of the option, by the exercise of the option, or
by entering into an offsetting transaction. Similarly, the premium paid by a
Portfolio when purchasing a put option will be recorded as an asset in the
statement of assets and liabilities of that Portfolio. This asset will be
adjusted daily to the option's current market value. The asset will be
extinguished upon expiration of the option, by selling an identical option in a
closing transaction, or by exercising the option.
Closing transactions will be effected in order to realize a profit on an
outstanding call or put option, to prevent an underlying security from being
called or put, or to permit the exchange or tender of the underlying security.
Furthermore, effecting a closing transaction will permit a Portfolio to write
another call option, or purchase another put option, on the underlying security
with either a different exercise price or expiration date or both. If a
Portfolio desires to sell a particular security from its portfolio on which it
has written a call option, or purchased a put option, it will seek to effect a
closing transaction prior to, or concurrently with, the sale of the security.
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There is, of course, no assurance that a Portfolio will be able to effect a
closing transaction at a favorable price. If a Portfolio cannot enter into such
a transaction, it may be required to hold a security that it might otherwise
have sold, in which case it would continue to be at market risk on the security.
A Portfolio will pay brokerage commissions in connection with the sale or
purchase of options to close out previously established option positions. Such
brokerage commissions are normally higher as a percentage of underlying asset
values than those applicable to purchases and sales of portfolio securities. The
exercise price of an option may be below, equal to, or above the current market
value of the underlying security at the time the option is written. From time to
time, a Portfolio may purchase an underlying security for delivery in accordance
with an exercise notice of a call option assignment, rather than delivering such
security from its portfolio. In such cases additional brokerage commissions will
be incurred.
A Portfolio will realize a profit or loss from a closing purchase transaction if
the cost of the transaction is less or more than the premium received from the
writing of the option; however, any loss so incurred in a closing purchase
transaction may be partially or entirely offset by the premium received from a
simultaneous or subsequent sale of a different option. Also, because increases
in the market price of a call option will generally reflect increases in the
market price of the underlying security, any loss resulting from the repurchase
of a call option is likely to be offset in whole or in part by appreciation of
the underlying security owned by a Portfolio. Any profits from writing covered
call options are considered short-term gain for federal income tax purposes and,
when distributed by a Portfolio, are taxable as ordinary income.
Foreign Futures Contracts and Foreign Options--The Variable Portfolios may
engage in transactions in foreign futures contracts and foreign options.
Participation in foreign futures contracts and foreign options transactions
involves the execution and clearing of trades on or subject to the rules of a
foreign board of trade. Neither the CFTC, the National Futures Association (NFA)
nor any domestic exchange regulates activities of any foreign boards of trade
including the execution, delivery and clearing of transactions, or has the power
to compel enforcement of the rules of a foreign board of trade or any applicable
foreign laws. Generally, the foreign transaction will be governed by applicable
foreign law. This is true even if the exchange is formally linked to a domestic
market so that a position taken on the market may be liquidated by a transaction
on another market. Moreover, such laws or regulations will vary depending on the
foreign country in which the foreign futures contract or foreign options
transaction occurs. Investors which trade foreign futures contracts or foreign
options contracts may not be afforded certain of the protective measures
provided by domestic exchanges, including the right to use reparations
proceedings before the CFTC and arbitration proceedings provided by the NFA. In
particular, funds received from customers for foreign futures contracts or
foreign options transactions may not be provided the same protections as funds
received for transactions on United States futures exchanges. The price of any
foreign futures contracts or foreign options contract and, therefore, the
potential profit and loss thereon, may be affected by an variance in the foreign
exchange rate between the time an order is placed and the time it is liquidated,
offset or exercised.
Options on Foreign Currencies--Each Variable Portfolio may write and purchase
calls on foreign currencies. A Portfolio may purchase and write puts and calls
on foreign currencies that are traded on a securities or commodities exchange or
quoted by major recognized dealers in such options for the purposes of
protecting against declines in the dollar value of foreign securities and
against increases in the dollar cost of foreign securities to be acquired. If a
rise is anticipated in the dollar value of a foreign currency in which
securities to be required are denominated, the increased cost of such securities
may be partially offset by purchasing calls or writing puts on that foreign
currency. If a decline in the dollar value of a foreign currency is anticipated,
the decline in value of portfolio securities denominated in that currency may be
partially offset by writing calls or purchasing puts on that foreign currency.
In the event of rate fluctuations adverse to a Portfolio's position, it would
lose the premium it paid and transaction costs. A call written on a foreign
currency by a Portfolio is covered if the Portfolio owns the underlying foreign
currency covered by the call or has an absolute and immediate right to acquire
that foreign currency without additional cash consideration (or for additional
cash consideration held in a segregated account by its custodian) upon
conversion or exchange of other foreign currency held in its portfolio. A call
may be written by a Portfolio on a foreign currency to provide a hedge against a
decline due to an expected adverse change in the exchange rate in the U.S.
dollar value of a security which the Portfolio owns or has the right to acquire
and which is denominated in the currency underlying the option. This is a
"cross-hedging" strategy. In such circumstances, the Portfolio collateralizes
the position by maintaining in a segregated account with the Portfolio's
custodian cash or U.S. Government securities in an amount not less than the
value of the underlying foreign currency in U.S. dollars marked-to-market daily.
Forward Exchange Contracts--Each Variable Portfolio may enter into forward
contracts for foreign currency (forward exchange contracts), which obligate the
seller to deliver and the purchaser to take a specific amount of a specified
foreign currency at a future date at a price set at the time of the contract.
These contracts are generally traded in the interbank market conducted directly
between currency traders and their customers. A Portfolio may enter into a
forward exchange contract in order to "lock in" the U.S. dollar price of a
security denominated in a foreign currency which it has purchased or sold but
which has not yet settled (transaction hedge); or to lock in the value of an
existing portfolio security (position hedge); or to protect against a possible
loss resulting from an adverse change in the relationship between the U.S.
dollar and a foreign currency. There is a risk that use of forward exchange
contracts may reduce the gain that would otherwise result from a change in the
relationship between the U.S. dollar and a foreign currency. Forward exchange
contracts include standardized foreign currency futures contracts which are
traded on exchanges and are subject to procedures and regulations applicable to
futures. Each Portfolio may also enter into a forward exchange contract to sell
a foreign currency which
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differs from the currency in which the underlying security is denominated. This
is done in the expectation that there is a greater correlation between the
foreign currency of the forward exchange contract and the foreign currency of
the underlying investment than between the U.S. dollar and the foreign currency
of the underlying investment. This technique is referred to as "cross-hedging."
The success of cross-hedging is dependent on many factors, including the ability
of Aetna to correctly identify and monitor the correlation between foreign
currencies and the U.S. dollar. To the extent that the correlation is not
identical, a Portfolio may experience losses or gains on both the underlying
security and the cross currency hedge.
Each Portfolio may use forward exchange contracts to protect against uncertainty
in the level of future exchange rates. The use of forward exchange contracts
does not eliminate fluctuations in the prices of the underlying securities the
Portfolio owns or intends to acquire, but it does fix a rate of exchange in
advance. In addition, although forward exchange contracts limit the risk of loss
due to a decline in the value of the hedged currencies, at the same time they
limit any potential gain that might result should the value of the currencies
increase.
There is no limitation as to the percentage of a Portfolio's assets that may be
committed to forward exchange contracts. The Portfolios will not enter into a
"cross-hedge," unless it is denominated in a currency or currencies that Aetna
believes will have price movements that tend to correlate closely with the
currency in which the investment being hedged is denominated.
The Variable Portfolios' custodian will place cash or U.S. Government securities
or other liquid high-quality debt securities in a separate account of each
Portfolio having a value equal to the aggregate amount of that Portfolio's
commitments under forward contracts entered into with respect to position hedges
and cross-hedges. If the value of the securities placed in the separate account
declines, additional cash or securities will be placed in the account on a daily
basis so that the value of the account will equal the amount of the Portfolio's
commitments with respect to such contracts. As an alternative to maintaining all
or part of the separate account, a Portfolio may purchase a call option
permitting the Portfolio to purchase the amount of foreign currency being hedged
by a forward sale contract at a price no higher than the forward contract price,
or a Portfolio may purchase a put option permitting the Portfolio to sell the
amount of foreign currency subject to a forward purchase contract at a price as
high or higher than the forward contract price. Unanticipated changes in
currency prices may result in poorer overall performance for a Portfolio than if
it had not entered into such contracts.
The precise matching of the forward contract amounts and the value of the
securities involved will not generally be possible because the future value of
such securities in foreign currencies will change as a consequence of market
movements in the value of these securities between the date the forward contract
is entered into and the date it is sold. Accordingly, it may be necessary for a
Portfolio to purchase additional foreign currency on the spot (i.e., cash)
market (and bear the expense of such purchase), if the market value of the
security is less than the amount of foreign currency the Portfolio is obligated
to deliver and if a decision is made to sell the security and make delivery of
the foreign currency. Conversely, it may be necessary to sell on the spot market
some of the foreign currency received upon the sale of the portfolio security if
its market value exceeds the amount of foreign currency the Portfolio is
obligated to deliver. The projection of short-term currency market movements is
extremely difficult, and the successful execution of a short-term hedging
strategy is highly uncertain. Forward contracts involve the risk that
anticipated currency movements will not be accurately predicted, causing the
Portfolio to sustain losses on these contracts and transactions costs.
At or before the maturity of a forward exchange contract requiring a Portfolio
to sell a currency, the Portfolio may either sell a portfolio security and use
the sale proceeds to make delivery of the currency or retain the security and
offset its contractual obligation to deliver the currency by purchasing a second
contract pursuant to which the Portfolio will obtain, on the same maturity date,
the same amount of the currency that it is obligated to deliver. Similarly, a
Portfolio may close out a forward contract requiring it to purchase a specified
currency by entering into a second contract entitling it to sell the same amount
of the same currency on the maturity date of the first contract. The Portfolio
would realize a gain or loss as a result of entering into such an offsetting
forward contract under either circumstance to the extent the exchange rate(s)
between the currencies involved moved between the execution dates of the first
contract and the offsetting contract.
The cost to a Portfolio of engaging in forward exchange contracts varies with
factors such as the currencies involved, the length of the contract period and
the market conditions then prevailing. Because forward contracts are usually
entered into on a principal basis, no fees or commissions are involved. Because
such contracts are not traded on an exchange, a Portfolio must evaluate the
credit and performance risk of each particular counterparty under a forward
contract.
Although the Variable Portfolios value their assets daily in terms of U.S.
dollars, they do not intend to convert their holdings of foreign currencies
into U.S. dollars on a daily basis. The Portfolios may convert foreign
currency from time to time, and investors should be aware of the costs of
currency conversion. Foreign exchange dealers do not charge a fee for
conversion, but they do seek to realize a profit based on the difference between
the prices at which they buy and sell various currencies. Thus, a dealer may
offer to sell a foreign currency to the Portfolio at one rate, while offering a
lesser rate of exchange should the Portfolio desire to resell that currency to
the dealer.
Restrictions on the Use of Futures and Option Contracts--CFTC regulations
require that all short futures positions be entered into for the purpose of
hedging the value of securities held, and that all long futures positions either
constitute bona fide hedging transactions,
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as defined in such regulations, or have a total value not in excess of an amount
determined by reference to certain cash and securities positions maintained, and
accrued profits on such positions. With respect to futures contracts or related
options that are entered into for purposes that may be considered speculative,
the aggregate initial margin for future contracts and premiums for options will
not exceed 5% of a Portfolio's net assets, after taking into account realized
profits and unrealized losses on such futures contracts.
A Portfolio's ability to engage in the hedging transactions described herein may
be limited by the current federal income tax requirement that a Portfolio derive
less than 30% of its gross income from the sale or other disposition of stock or
securities held for less than three months.
Interest Rate Swap Transactions--Swap agreements entail both interest rate risk
and credit risk. There is a risk that, based on movements of interest rates in
the future, the payments made by a Portfolio under a swap agreement will have
been greater than those received by it. Credit risk arises from the possibility
that the counterparty will default. If the counterparty to an interest rate swap
defaults, a Portfolio's loss will consist of the net amount of contractual
interest payments that a Portfolio has not yet received. Aetna will monitor the
creditworthiness of counterparties to a Portfolio's interest rate swap
transactions on an ongoing basis. A Portfolio will enter into swap transactions
with appropriate counterparties pursuant to master netting agreements. A master
netting agreement provides that all swaps done between a Portfolio and that
counterparty under that master agreement shall be regarded as parts of an
integral agreement. If on any date amounts are payable in the same currency in
respect of one or more swap transactions, the net amount payable on that date in
that currency shall be paid. In addition, the master netting agreement may
provide that if one party defaults generally or on one swap, the counterparty
may terminate the swaps with that party. Under such agreements, if there is a
default resulting in a loss to one party, the measure of that party's damages is
calculated by reference to the average cost of a replacement swap with respect
to each swap (i.e., the mark-to-market value at the time of the termination of
each swap). The gains and losses on all swaps are then netted, and the result is
the counterparty's gain or loss on termination. The termination of all swaps and
the netting of gains and losses on termination is generally referred to as
"aggregation."
Additional Risk Factors in Using Derivatives--In addition to any risk factors
described elsewhere in this section, or in the prospectus under "Investment
Techniques" and "Risk Factors and Other Considerations," the following sets
forth certain information regarding the potential risks associated with the
Portfolio's transactions in derivatives.
Risk of Imperfect Correlation--A Portfolio's ability to hedge effectively all or
a portion of its portfolio through transactions in futures, options on futures
or options on securities and indexes depends on the degree to which movements in
the value of the securities or index underlying such hedging instrument
correlate with movements in the value of the assets being hedged. If the values
of the assets being hedged do not move in the same amount or direction as the
underlying security or index, the hedging strategy for a Portfolio might not be
successful and the Portfolio could sustain losses on its hedging transactions
which would not be offset by gains on its portfolio. It is also possible that
there may be a negative correlation between the security or index underlying a
futures or option contract and the portfolio securities being hedged, which
could result in losses both on the hedging transaction and the portfolio
securities. In such instances, the Portfolio's overall return could be less than
if the hedging transactions had not been undertaken. Stock index futures or
options based on a narrower index of securities may present greater risk than
options or futures based on a broad market index, as a narrower index is more
susceptible to rapid and extreme fluctuations resulting from changes in the
value of a small number of securities. The Portfolio would, however, effect
transactions in such futures or options only for hedging purposes (or to close
out open positions).
The trading of futures and options on indices involves the additional risk of
imperfect correlation between movements in the futures or option price and the
value of the underlying index. The anticipated spread between the prices may be
distorted due to differences in the nature of the markets, such as differences
in margin requirements, the liquidity of such markets and the participation of
speculators in the futures and options market. The purchase of an option on a
futures contract also involves the risk that changes in the value of the
underlying futures contract will not be fully reflected in the value of the
option purchased. The risk of imperfect correlation, however, generally tends to
diminish as the maturity date of the futures contract or termination date of the
option approaches. The risk incurred in purchasing an option on a futures
contract is limited to the amount of the premium plus related transaction costs,
although it may be necessary under certain circumstances to exercise the option
and enter into the underlying futures contract in order to realize a profit.
Under certain extreme market conditions, it is possible that a Portfolio will
not be able to establish hedging positions, or that any hedging strategy adopted
will be insufficient to completely protect the Portfolio.
The Variable Portfolios will purchase or sell futures contracts or options for
hedging purposes, only if, in Aetna's judgment, there is expected to be a
sufficient degree of correlation between movements in the value of such
instruments and changes in the value of the assets being hedged for the hedge
to be effective. There can be no assurance that Aetna's judgment will be
accurate.
Potential Lack of a Liquid Secondary Market--The ordinary spreads between prices
in the cash and futures markets, due to differences in the natures of those
markets, are subject to distortions. First, all participants in the futures
markets are subject to initial deposit and variation margin requirements. This
could require a Portfolio to post additional cash or cash equivalents as the
value of the position fluctuates. Rather than meeting additional variation
margin requirements, investors may close futures contracts through offsetting
transactions which could distort the normal relationship between the cash and
futures markets. Second, the liquidity of the futures or options
9
<PAGE>
market may be lacking. Prior to exercise or expiration, a futures or option
position may be terminated only by entering into a closing purchase or sale
transaction, which requires a secondary market on the exchange on which the
position was originally established. While a Portfolio will establish a futures
or option position only if there appears to be a liquid secondary market
therefor, there can be no assurance that such a market will exist for any
particular futures or option contract at any specific time. In such event, it
may not be possible to close out a position held by the Portfolio, which could
require the Portfolio to purchase or sell the instrument underlying the
position, make or receive a cash settlement, or meet ongoing variation margin
requirements. The inability to close out futures or option positions also could
have an adverse impact on the Portfolio's ability effectively to hedge its
portfolio, or the relevant portion thereof.
The liquidity of a secondary market in a futures contract or an option on a
futures contract may be adversely affected by "daily price fluctuation limits"
established by the exchanges, which limit the amount of fluctuation in the price
of a contract during a single trading day and prohibit trading beyond such
limits once they have been reached. The trading of futures and options contracts
also is subject to the risk of trading halts, suspensions, exchange or clearing
house equipment failures, government intervention, insolvency of the brokerage
firm or clearing house or other disruptions of normal trading activity, which
could at times make it difficult or impossible to liquidate existing positions
or to recover excess variation margin payments.
Risk of Predicting Interest Rate Movements--Investments in futures contracts on
fixed income securities and related indices involve the risk that if Aetna's
judgment concerning the general direction of interest rates is incorrect, a
Portfolio's overall performance may be poorer than if it had not entered into
any such contract. For example, if a Portfolio has been hedged against the
possibility of an increase in interest rates which would adversely affect the
price of bonds held in its portfolio and interest rates decrease instead, the
Portfolio will lose part or all of the benefit of the increased value of its
bonds which have been hedged because it will have offsetting losses in its
futures positions. In addition, in such situations, if the Portfolio has
insufficient cash, it may have to sell bonds from its portfolio to meet daily
variation margin requirements, possibly at a time when it may be disadvantageous
to do so. Such sale of bonds may be, but will not necessarily be, at increased
prices that reflect the rising market.
Trading and Position Limits--Each contract market on which futures and option
contracts are traded has established a number of limitations governing the
maximum number of positions which may be held by a trader, whether acting alone
or in concert with others. The Fund does not believe that these trading and
position limits will have an adverse impact on the hedging strategies regarding
the Variable Portfolios.
Repurchase Agreements
Each Portfolio may enter into repurchase agreements with domestic banks and
broker-dealers meeting certain size and creditworthiness standards established
by the Directors. A repurchase agreement allows a Portfolio to determine the
yield during the Portfolio's holding period. This results in a fixed rate of
return insulated from market fluctuations during such period. Such underlying
debt instruments serving as collateral will meet the quality standards of a
Portfolio. The market value of the underlying debt instruments will, at all
times, be equal to the dollar amount invested. Repurchase agreements, although
fully collateralized, involve the risk that the seller of the securities may
fail to repurchase them from a Portfolio. In that event, a Portfolio may incur
(a) disposition costs in connection with liquidating the collateral, or (b) a
loss if the collateral declines in value. Also, if the default on the part of
the seller is due to insolvency and the seller initiates bankruptcy proceedings,
a Portfolio's ability to liquidate the collateral may be delayed or limited.
Under the 1940 Act, repurchase agreements are considered loans by a Portfolio.
Repurchase agreements maturing in more than seven days will not exceed 15
percent of the total assets of a Portfolio.
Variable Rate Demand Instruments
Variable rate demand instruments (including floating rate instruments) held by a
Portfolio may have maturities of more than one year, provided: (i) the Portfolio
is entitled to the payment of principal at any time, or during specified
intervals not exceeding one year, upon giving the prescribed notice (which may
not exceed 30 days), and (ii) the rate of interest on such instruments is
adjusted at periodic intervals not to exceed one year. In determining whether a
variable rate demand instrument has a remaining maturity of one year or less,
each instrument will be deemed to have a maturity equal to the longer of the
period remaining until its next interest rate adjustment or the period remaining
until the principal amount can be recovered through demand. A Portfolio will be
able (at any time or during specified periods not exceeding one year, depending
upon the note involved) to demand payment of the principal of a note. If an
issuer of a variable rate demand note defaulted on its payment obligation, a
Portfolio might be unable to dispose of the note and a loss would be incurred to
the extent of the default. A Portfolio may invest in variable rate demand notes
only when the investment is deemed to involve minimal credit risk. The
continuing creditworthiness of issuers of variable rate demand notes held by a
Portfolio will also be monitored to determine whether such notes should continue
to be held. Variable and floating rate instruments with demand periods in excess
of seven days and which cannot be disposed of promptly within seven business
days and in the usual course of business without taking a reduced price will be
treated as illiquid securities that are subject to the Portfolio's policies and
restrictions on illiquid securities.
Securities Lending
The Variable Portfolios can lend securities in its portfolio subject to the
following conditions: (a) the borrower will provide collateral equal to an
amount of at least 100% of the then current market value of the loaned
securities throughout the life of the loan; (b) loans
10
<PAGE>
will be made subject to the rules of the New York Stock Exchange; (c) the loan
collateral will be either cash, direct obligations of the U.S. government or
agencies thereof or irrevocable letters of credit; (d) cash collateral will be
invested only in highly liquid short- term investments; (e) during the existence
of a loan, a Portfolio will continue to receive any distributions paid on the
borrowed securities or amounts equivalent thereto; and (f) no more than
one-third of the net assets of a Portfolio will be on loan at any one time. A
loan may be terminated at any time by the borrower or lender upon proper notice.
In Aetna's opinion, lending portfolio securities to qualified broker-dealers
affords a Portfolio a means of increasing the yield on its portfolio. A
Portfolio will be entitled either to receive a fee from the borrower or to
retain some or all of the income derived from its investment of cash collateral.
A Portfolio will continue to receive the interest or dividends paid on any
securities loaned, or amounts equivalent thereto. Although voting rights will
pass to the borrower of the securities, whenever a material event affecting the
borrowed securities is to be voted on, Aetna will regain or direct the vote with
respect to loaned securities.
The primary risk a Portfolio assumes in loaning securities is that the borrower
may become insolvent on a day on which the loaned security is rapidly increasing
in price. In such event, if the borrower fails to return the loaned securities,
the existing collateral might be insufficient to purchase back the full amount
of the security loaned, and the borrower would be unable to furnish additional
collateral. The borrower would be liable for any shortage, but a Portfolio would
be an unsecured creditor as to such shortage and might not be able to recover
all or any of it.
Foreign Securities
Investments in foreign securities, including futures and options contracts,
offer potential benefits not available solely through investment in securities
of domestic issuers. Foreign securities offer the opportunity to invest in
foreign issuers that appear to offer growth potential, or in foreign countries
with economic policies or business cycles different from those of the United
States, or to reduce fluctuations in portfolio value by taking advantage of
foreign stock markets that may not move in a manner parallel to U.S. markets.
Investments in securities of foreign issuers involve certain risks not
ordinarily associated with investments in securities of domestic issuers. Such
risks include fluctuations in exchange rates, adverse foreign political and
economic developments, and the possible imposition of exchange controls or other
foreign governmental laws or restrictions. Since the Variable Portfolios may
invest in securities denominated or quoted in currencies other than the U.S.
dollar, changes in foreign currency exchange rates will affect the value of
securities in the portfolio and the unrealized appreciation or depreciation of
investments so far as U.S. investors are concerned. In addition, with respect to
certain countries, there is the possibility of expropriation of assets,
confiscatory taxation, political or social instability, or diplomatic
developments that could adversely affect investments in those countries.
There may be less publicly available information about a foreign issuer than
about a U.S. issuer, and foreign issuers may not be subject to accounting,
auditing, and financial reporting standards and requirements comparable to or as
uniform as those of U.S. issuers. Foreign securities markets, while growing in
volume, have, for the most part, substantially less volume than U.S. markets.
Securities of many foreign issuers are less liquid and their prices more
volatile than securities of comparable U.S. issuers. Transactional costs in
non-U.S. securities markets are generally higher than in U.S. securities
markets. There is generally less government supervision and regulation of
exchanges, brokers, and issuers than there is in the U.S. The Fund might have
greater difficulty taking appropriate legal action with respect to foreign
investments in non-U.S. courts than with respect to domestic issuers in U.S.
courts. In addition, transactions in foreign securities may involve greater time
from the trade date until settlement than domestic securities transactions and
involve the risk of possible losses through the holding of securities by
custodians and securities depositories in foreign countries.
Currently, direct investment in equity securities in China and Taiwan is
restricted, and investments may be made only through a limited number of
approved vehicles. At present this includes investment in listed and unlisted
investment companies, subject to limitations under the 1940 Act. Investment in
these closed-end funds may involve the payment of additional premiums to acquire
shares in the open-market and the yield of these securities will be reduced by
the operating expenses of such companies. In addition, an investor should
recognize that he will bear not only his proportionate share of the expenses of
the Portfolio, but also indirectly bear similar expenses of the underlying
closed-end fund. Also, as a result of a Portfolio's policy of investing in
closed-end mutual funds, investors in the Portfolio may receive taxable capital
gains distributions to a greater extent than if he or she had invested directly
in the underlying closed-end fund.
Dividend and interest income from foreign securities may generally be subject to
withholding taxes by the country in which the issuer is located and may not be
recoverable by a Portfolio or its investors.
Depositary receipts are typically dollar denominated, although their market
price is subject to fluctuations of the foreign currency in which the underlying
securities are denominated. Depositary receipts include: (a) American Depositary
Receipts (ADRs), which are typically designed for U.S. investors and held either
in physical form or in book entry form; (b) European Depositary Receipts (EDRs),
which are similar to ADRs but may be listed and traded on a European exchange
(typically Luxembourg) as well as in the United States; and (c) Global
Depositary Receipts (GDRS), which are similar to EDRS although they may be held
through foreign clearing agents such as Euroclear and other foreign
depositories. Depositary receipts are not considered foreign securities for
purposes of a Portfolio's investment limitation concerning investment in foreign
securities.
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<PAGE>
Mortgage-Related Debt Securities
Federal mortgage-related securities include obligations issued or guaranteed by
the Government National Mortgage Association (GNMA), the Federal National
Mortgage Association (FNMA) and the Federal Home Loan Mortgage Corporation
(FHLMC). GNMA is a wholly owned corporate instrumentality of the United States,
the securities and guarantees of which are backed by the full faith and credit
of the United States. FNMA, a federally chartered and privately owned
corporation, and FHLMC, a federal corporation, are instrumentalities of the
United States with Presidentially-appointed board members. The obligations of
FNMA and FHLMC are not explicitly guaranteed by the full faith and credit of the
federal government.
Pass-through, mortgage-related securities are characterized by monthly payments
to the holder, reflecting the monthly payments made by the borrowers who
received the underlying mortgage loans. The payments to the security holders,
like the payments on the underlying loans, represent both principal and
interest. Although the underlying mortgage loans are for specified periods of
time, often twenty or thirty years, the borrowers can repay such loans sooner.
Thus, the security holders frequently receive repayments of principal, in
addition to the principal that is part of the regular monthly payment. A
borrower is more likely to repay a mortgage that bears a relatively high rate of
interest. This means that in times of declining interest rates, some higher
yielding securities held by a Portfolio might be converted to cash, and the
Portfolio could be expected to reinvest such cash at the then prevailing lower
rates. The increased likelihood of prepayment when interest rates decline also
limits market price appreciation of mortgage-related securities. If a Portfolio
buys mortgage-related securities at a premium, mortgage foreclosures or mortgage
prepayments may result in losses of up to the amount of the premium paid since
only timely payment of principal and interest is guaranteed.
As noted in the Prospectus, the Variable Portfolios may also invest in
collateralized mortgage obligations (CMOs). CMOs are securities that are
collateralized by mortgage pass-through securities. Cash flows from underlying
mortgages are allocated to various classes or tranches in a predetermined,
specified order. Each sequential tranche has a "stated maturity"--the latest
date by which the tranche can be completely repaid, assuming no repayments--and
has an "average life"--the average time to receipt of a principal payment
weighted by the size of the principal payment. The average life is typically
used as a proxy for maturity because the debt is amortized, rather than being
paid off entirely at maturity, as would be the case in a straight debt
instrument.
CMOs are typically structured as "pass-through" securities. In these
arrangements, the underlying mortgages are held by the issuer, which then issues
debt collateralized by the underlying mortgage assets. The security holder thus
owns an obligation of the issuer and payment of interest and principal on such
obligations is made from payments generated by the underlying mortgage assets.
The underlying mortgages may be guaranteed as to payment of principal and
interest by an agency or instrumentality of the U.S. Government such as GNMA or
otherwise backed by FNMA or FHLMC. Alternatively, such securities may be backed
by mortgage insurance, letters of credit or other credit enhancing features.
CMOs are issued by private entities. They are not directly guaranteed by any
government agency and are secured by the collateral held by the issuer.
Asset-Backed Securities
Asset-backed securities are collateralized by short-term loans such as
automobile loans, home equity loans, or credit card receivables. The payments
from the collateral are passed through to the security holder. As noted above
with respect to CMOs, the average life for these securities is the conventional
proxy for maturity. Asset-backed securities may pay all interest and principal
to the holder, or they may pay a fixed rate of interest, with any excess over
that required to pay interest going either into a reserve account or to a
subordinate class of securities, which may be retained by the originator. The
originator may guarantee interest and principal payments. These guarantees often
do not extend to the whole amount of principal, but rather to an amount equal to
a multiple of the historical loss experience of similar portfolios.
Two varieties of asset-backed securities are CARs and CARDs. CARs are
securities, representing either ownership interests in fixed pools of automobile
receivables, or debt instruments supported by the cash flows from such a pool.
CARDs are participations in fixed pools of credit accounts. These securities
have varying terms and degrees of liquidity.
Asset-backed securities may be subject to the type of prepayment risk discussed
above due to the possibility that prepayments on the underlying assets will
alter the cash flow. Faster prepayments will shorten the average life and slower
prepayments will lengthen it.
The coupon rate of interest on mortgage-related and asset-backed securities is
lower than the interest rates paid on the mortgages included in the underlying
pool, by the amount of the fees paid to the mortgage pooler, issuer, and/or
guarantor. Actual yield may vary from the coupon rate, however, if such
securities are purchased at a premium or discount, trade in the secondary market
at a premium or discount, or to the extent that the underlying assets are
prepaid as noted above.
High-Risk, High-Yield Securities
The Variable Portfolios may invest in high-risk, high-yield securities (junk
bonds), which are fixed income securities that offer a current yield above that
generally available on higher quality debt securities. These securities are
regarded as speculative and generally involve more risk of loss of principal and
income than higher-rated securities. Also their yields and market values tend to
fluctuate more. Fluctuations in value do not affect the cash income from the
securities but are reflected in a Portfolio's net asset value. The greater risks
and fluctuations in yield and value occur, in part, because investors generally
perceive issuers of lower-rated and unrated securities
12
<PAGE>
to be less creditworthy. Lower ratings, however, may not necessarily indicate
higher risks. In pursuing a Portfolio's objectives, Aetna seeks to identify
situations in which the rating agencies have not fully perceived the value of
the security or in which Aetna believes that future developments will enhance
the creditworthiness and the ratings of the issuer.
The yields earned on high-risk, high-yield securities (junk bonds) generally are
higher than those of higher quality securities with the same maturities because
of the additional risks associated with them. These risks include:
(1) Sensitivity to Interest Rate and Economic Changes. High-risk, high-yield
securities (junk bonds) are more sensitive to adverse economic changes or
individual corporate developments but less sensitive to interest rate
changes than are investment grade bonds. As a result, when interest rates
rise, causing bond prices to fall, the value of these securities may not
fall as much as investment grade corporate bonds. Conversely, when interest
rates fall, these securities may underperform investment grade corporate
bonds because the prices of high-risk, high-yield securities (junk bonds)
tend not to rise as much as the prices of those other bonds. Also, the
financial stress resulting from an economic downturn or adverse corporate
developments could have a greater negative effect on the ability of issuers
of these securities to service their principal and interest payments, to
meet projected business goals and to obtain additional financing, than on
more creditworthy issuers. Holders of these securities could also be at
greater risk because these securities are generally unsecured and
subordinated to senior debt holders and secured creditors. If the issuer of
a high-risk, high-yield security (junk bonds) owned by a Portfolio defaults,
the Portfolio may incur additional expenses to seek recovery. In addition,
periods of economic uncertainty and changes can be expected to result in
increased volatility of market prices of these securities and a Portfolio's
net asset value. Furthermore, in the case of high-risk, high-yield
securities (junk bonds) structured as zero coupon or pay-in-kind securities,
their market prices are affected to a greater extent by interest rate
changes and thereby tend to be more speculative and volatile than securities
which pay interest periodically and in cash.
(2) Payment Expectations. High-risk, high-yield securities (junk bonds), like
other debt instruments, present risks based on payment expectations. For
example, these securities may contain redemption or call provisions. If an
issuer exercises these provisions in a declining interest rate market, the
Portfolio may have to replace the securities with a lower yielding security,
resulting in a decreased return for investors. Also, the value of these
securities may decrease in a rising interest rate market. In addition, there
is a higher risk of non-payment of interest and/or principal by issuers of
these securities than in the case of investment grade bonds.
(3) Liquidity and Valuation Risks. Some high-risk, high-yield securities (junk
bonds) are traded among a small number of broker- dealers rather than in a
broad secondary market. Many of these securities may not be as liquid as
investment grade bonds. The ability to value or sell these securities will
be adversely affected to the extent that such securities are thinly traded
or illiquid. Adverse publicity and investor perceptions, whether or not
based on fundamental analysis, may decrease or increase the value and
liquidity of these securities more than other securities, especially in a
thinly-traded market.
(4) Limitations of Credit Ratings. The credit ratings assigned to high-risk,
high-yield securities (junk bonds) may not accurately reflect the true risks
of an investment. Credit ratings typically evaluate the safety of principal
and interest payments rather than the market value risk of such securities.
In addition, credit agencies may fail to adjust credit ratings to reflect
rapid changes in economic or company conditions that affect a security's
market value. Although the ratings of recognized rating services such as
Moody's Investors Service, Inc. and Standard & Poor's Corporation are
considered, Aetna primarily relies on its own credit analysis which includes
a study of existing debt, capital structure, ability to service debts and to
pay dividends, the issuer's sensitivity to economic conditions, its
operating history and the current trend of earnings. Thus the achievement of
a Portfolio's investment objective may be more dependent on Aetna's own
credit analysis than might be the case for a fund which does not invest in
these securities.
(5) Legislation. Legislation may have a negative impact on the market for
high-risk, high-yield securities (junk bonds), such as legislation requiring
federally insured savings and loan associations to divest themselves of
their investments in these securities.
Zero Coupon and Pay-in-Kind Securities
The Variable Portfolios may invest in zero coupon securities and pay-in-kind
securities. In addition, the Portfolios may invest in STRIPS (Separate Trading
of Registered Interest and Principal of Securities). Zero coupon or deferred
interest securities are debt obligations that do not entitle the holder to any
periodic payment of interest prior to maturity or a specified date when the
securities begin paying current interest (the "cash payment date") and therefore
are issued and traded at a discount from their face amounts or par value. The
discount varies, depending on the time remaining until maturity or cash payment
date, prevailing interest rates, liquidity of the security and the perceived
credit quality of the issuer. The discount, in the absence of financial
difficulties of the issuer, decreases as the final maturity or cash payment date
of the security approaches. STRIPS are created by the Federal Reserve Bank by
separating the interest and principal components of an outstanding U.S. Treasury
bond and selling them as individual securities. The market prices of zero
coupon, STRIPS and deferred interest securities generally are more volatile than
the market prices of securities with similar maturities that pay interest
periodically and are likely to respond to changes in interest rates to a greater
degree than do non-zero coupon securities having similar maturities and credit
quality.
The risks associated with lower-rated debt securities apply to these securities.
Zero coupon and pay-in-kind securities are also subject to the risk that in the
event of a default, a Portfolio may realize no return on its investment, because
these securities do not pay cash interest.
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Convertibles
A convertible bond or convertible preferred stock gives the holder the option of
converting these securities into common stock. Some convertible securities
contain a call feature whereby the issuer may redeem the security at a
stipulated price, thereby limiting the possible appreciation.
Warrants
Warrants allow the holder to subscribe for new shares in the issuing company
within a specified time period, according to a predetermined formula governing
the number of shares per warrant and the price to be paid for those shares.
Warrants may be issued separately or in association with a new issue of bonds,
preferred stock, common stock or other securities.
Covered warrants allow the holder to purchase existing shares in the issuing
company, or in a company associated with the issuer, or in a company in which
the issuer has or may have a share stake which covers all or part of the
warrants' subscription rights.
When-Issued or Delayed-Delivery Securities
During any period that a Portfolio has outstanding a commitment to purchase
securities on a when-issued or delayed-delivery basis, that Portfolio will
maintain a segregated account consisting of cash, U.S. Government securities or
other high-quality debt obligations with its custodian bank. To the extent that
the market value of securities held in this segregated account falls below the
amount that the Portfolio will be required to pay on settlement, additional
assets may be required to be added to the segregated account. Such segregated
accounts could affect the Portfolio's liquidity and ability to manage its
portfolio. When a Portfolio engages in when-issued or delayed-delivery
transactions, it is effectively relying on the seller of such securities to
consummate the trade; failure of the seller to do so may result in the
Portfolio's incurring a loss or missing an opportunity to invest securities held
in the segregated account more advantageously. A Portfolio will not pay for
securities purchased on a when-issued or delayed-delivery basis, or start
earning interest on such securities, until the securities are actually received.
However, any security so purchased will be recorded as an asset of the
purchasing Portfolio at the time the commitment is made. Because the market
value of securities purchased on a when-issued or delayed-delivery basis may
increase or decrease prior to settlement as a result of changes in interest
rates or other factors, such securities will be subject to changes in market
value prior to settlement and a loss may be incurred if the value of the
security to be purchased declines prior to settlement.
Portfolio Turnover
The Variable Portfolios' policies on portfolio turnover are discussed in the
prospectus.
DIRECTORS AND OFFICERS OF THE FUND
The investments and administration of the Fund are under the supervision of the
Directors. The Directors and executive officers of the Fund and their principal
occupations for the past five years are listed below. Those Directors who are
"interested persons," as defined in the 1940 Act, are indicated by an asterisk
(*). All Directors and officers hold similar positions with other investment
companies in the same Fund Complex managed by Aetna as the investment adviser.
The Fund Complex presently consists of Aetna Series Fund, Inc., Aetna Variable
Fund, Aetna Income Shares, Aetna Variable Encore Fund, Aetna Investment Advisers
Fund, Inc., Aetna GET Fund (Series B and Series C), Aetna Generation Portfolios,
Inc. and Aetna Variable Portfolios, Inc.
<TABLE>
<CAPTION>
Principal Occupation During Past Five Years
Position(s) Held (and Positions held with Affiliated Persons or
Name, Address and Age with Registrant Principal Underwriters of the Registrant)
- ------------------------------------------------------------------------------------------------------------------
<S> <C> <C>
Shaun P. Mathews* Director and President Vice President/Senior Vice President, Aetna, March
151 Farmington Avenue 1991 to present and Vice President, Aetna Life
Hartford, Connecticut Insurance Company, 1991 to present. Director and
Age 41 President, Aetna Investment Services, Inc.; and
Director and Senior
Vice President, Aetna
Insurance Company of
America, March 1991 to
present.
- ------------------------------------------------------------------------------------------------------------------
Wayne F. Baltzer Vice President Assistant Vice President, Aetna, May 1991 to present;
151 Farmington Avenue Vice President, Aetna Investment Services, Inc. July
Hartford, Connecticut 1993 to present.
Age 53
- ------------------------------------------------------------------------------------------------------------------
Martin T. Conroy Vice President Assistant Treasurer, Aetna, October 1991 to present;
151 Farmington Avenue
Hartford, Connecticut
Age 57
- ------------------------------------------------------------------------------------------------------------------
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Principal Occupation During Past Five Years
Position(s) Held (and Positions held with Affiliated Persons or
Name, Address and Age with Registrant Principal Underwriters of the Registrant)
- ------------------------------------------------------------------------------------------------------------------
J. Scott Fox Vice President and Director, Managing Director, Chief Operating Officer,
242 Trumbull Street Treasurer Chief Financial Officer and Treasurer, Aeltus
Hartford, Connecticut Investment Management, Inc. (Aeltus), April 1994 to
Age 42 present; Managing Director and Treasurer, Equitable
Capital Management Corp., March 1987 to September
1993. Director and Chief Financial Officer, Aeltus
Capital, Inc. and Aeltus Trust Company, Inc.;
Director, President and Chief Executive Officer, Aetna
Investment Management, (Bermuda) Holding, Ltd.
- ------------------------------------------------------------------------------------------------------------------
Susan E. Bryant Secretary Counsel, Aetna Inc. (formerly Aetna Life and Casualty
151 Farmington Avenue Company) March 1993 to present; General Counsel and
Hartford, Connecticut Corporate Secretary, First Investors Corporation,
Age 49 April 1991 to March 1993. Secretary, Aetna Investment
Services, Inc. and Vice President and Senior Counsel,
Aetna Financial Services, Inc.
- ------------------------------------------------------------------------------------------------------------------
Morton Ehrlich Director Chairman and Chief Executive Officer, Integrated
1000 Venetian Way Management Corp. (an entrepreneurial company) and
Miami, Florida Universal Research Technologies, 1992 to present;
Age 62 Director and Chairman, Audit Committee, National
Bureau of Economic Research, 1985 to 1992.
- ------------------------------------------------------------------------------------------------------------------
Maria T. Fighetti Director Manager/Attorney, Health Services, New York City
325 Piermont Road Department of Mental Health, Mental Retardation and
Closter, New Jersey Alcohol Services, 1973 to present.
Age 53
- ------------------------------------------------------------------------------------------------------------------
David L. Grove Director Private Investor; Economic/Financial Consultant,
5 The Knoll December 1985 to present.
Armonk, New York
Age 78
- ------------------------------------------------------------------------------------------------------------------
Timothy A. Holt* Director Director, Senior Vice President and Chief Financial
151 Farmington Avenue Officer, Aetna, February 1996 to present; Vice
Hartford, Connecticut President, Portfolio Management/Investment Group,
Age 43 Aetna Inc. (formerly Aetna Life and Casualty Company),
June 1991 to February 1996. Director March 1996 to present
and Vice President September 1996 to present Aetna
Retirement Holdings, Inc.
- ------------------------------------------------------------------------------------------------------------------
Daniel P. Kearney* Director Director, President, and Chief Executive Officer,
151 Farmington Avenue Aetna, December 1993 to present; Executive Vice
Hartford, Connecticut President, Aetna Inc. (formerly Aetna Life and
Age 57 Casualty Company), December 1993 to present; Group
Executive, Aetna Inc. (formerly Aetna Life and
Casualty Company), 1991 to 1993; Director, Aetna
Investment Services, Inc., November 1994 to present;
Director, Aetna Insurance Company of America, May 1994
to present.
- ------------------------------------------------------------------------------------------------------------------
Sidney Koch Director Financial Adviser, self-employed, January 1993 to
455 East 86th Street present; Senior Adviser, Daiwa Securities America,
New York, New York Inc., January 1992 to January 1993; Executive Vice
Age 61 President, Member of Executive Committee, Daiwa
Securities America, Inc., January 1986 to January
1992.
15
<PAGE>
Principal Occupation During Past Five Years
Position(s) Held (and Positions held with Affiliated Persons or
Name, Address and Age with Registrant Principal Underwriters of the Registrant)
- ------------------------------------------------------------------------------------------------------------------
Corine T. Norgaard Director, Chair Audit Dean of the Barney School of Business, University of
556 Wormwood Hill Committee and Contract Hartford, (West Hartford, CT), August 1996 to present;
Mansfield Center, Committee Professor, Accounting and Dean of the School of
Connecticut Management, Binghamton University, (Binghamton, NY),
Age 59 August 1993 to August 1996; Professor, Accounting,
University of Connecticut, (Storrs, Connecticut),
September 1969 to June 1993; Director, The Advest Group
(holding company for brokerage firm) through September
1996.
- ------------------------------------------------------------------------------------------------------------------
Richard G. Scheide Director Trust and Private Banking Consultant, David Ross
11 Lily Street Palmer Consultants, July 1991 to present.
Nantucket, Massachusetts
Age 67
- ------------------------------------------------------------------------------------------------------------------
</TABLE>
* Interested persons as defined in the 1940 Act.
During the year ended December 31, 1996, members of the Boards of the Funds
within the Aetna Fund Complex who are also directors, officers or employees of
Aetna Inc. and its affiliates were not entitled to any compensation from the
Funds. Effective November 1, 1995, members of the Boards who are not affiliated
as employees of Aetna or its subsidiaries are entitled to receive an annual
retainer of $30,000 for service on the Boards of the Funds within the Aetna Fund
Complex. In addition, each such member will receive a fee of $5,000 per meeting
for each regularly scheduled Board meeting; $5,000 for each Contract Committee
meeting which is held on any day on which a regular Board meeting is not
scheduled; and $3,000 for each committee meeting other than for a Contract
Committee meeting on any day on which a regular Board meeting is not scheduled.
A Committee Chairperson fee of $2,000 each will be paid to the Chairperson of
the Contract and Audit Committees. All of the above fees are to be allocated
proportionately to each Fund within the Aetna Fund Complex based on the net
assets of the Fund as of the date compensation is earned.
As of December 31, 1996, the unaffiliated members of the Board of Directors were
compensated as follows:
<TABLE>
<CAPTION>
Aggregate
Compensation Total Compensation from Registrant
Name of Person, Position from Registrant and Fund Complex Paid to Directors
- --------------------------------------------------------------------------------------------
<S> <C> <C>
Corine Norgaard $37.00 $72,950.00
Director and Chairman,
Audit and Contract Committees
- --------------------------------------------------------------------------------------------
Sidney Koch $37.00 $72,950.00
Director and Member,
Audit and Contract Committees
- --------------------------------------------------------------------------------------------
Maria T. Fighetti $33.00 $63,950.00
Director and Member,
Audit and Contract Committees
- --------------------------------------------------------------------------------------------
Morton Ehrlich $33.00 $63,950.00
Director and Member,
Audit and Contract Committees
- --------------------------------------------------------------------------------------------
Richard G. Scheide $35.00 $68,950.00
Director and Member,
Audit and Contract Committees
- --------------------------------------------------------------------------------------------
David L. Grove $35.00 $68,950.00
Director and Member,
Audit and Contract Committees
- --------------------------------------------------------------------------------------------
</TABLE>
* Mr. Grove elected to defer all such compensation under an existing deferred
compensation plan.
The Fund has applied for an order by the Securities and Exchange Commission to
allow the Members of the Board of Directors who are not affiliated with Aetna
Inc. or any of its subsidiaries to defer all or a portion of their compensation
in accordance with the terms of a new Deferred Compensation Plan (the "Plan").
Under the Plan, compensation deferred by an unaffiliated Director is
periodically adjusted as though an equivalent amount had been invested and
reinvested in shares of one or more series of Aetna Series Fund, Inc. designated
by the Director. The amount paid to the unaffiliated Director under the Plan
will be based upon the performance of such investments. Deferral of compensation
in accordance with the Plan will have a negligible effect on the assets,
liabilities, and net income per share, and will not obligate the Fund to retain
the services of any Director or to pay any particular level of compensation to
the Director.
16
<PAGE>
CONTROL PERSONS AND PRINCIPAL SHAREHOLDERS
Shares of the Variable Portfolios may be owned by insurance companies as
depositors of separate accounts which are used to fund variable annuity
contracts (VA Contracts) and variable life insurance policies (VLI Policies).
All shares are currently held by separate accounts of Aetna and its subsidiary,
Aetna Insurance Company of America, Inc., on behalf of their respective separate
accounts. See "Voting Rights" below.
Aetna is an indirect wholly-owned subsidiary of Aetna Retirement Services, Inc.,
which is in turn an indirect wholly-owned subsidiary of Aetna Inc. Aetna's
principal office is located at 151 Farmington Avenue, Hartford, Connecticut
06156. Aetna is registered with the Commission as an investment adviser.
THE INVESTMENT ADVISORY AGREEMENT
On June 18, 1996, the Directors approved an investment advisory agreement
(Investment Advisory Agreement) between the Fund and Aetna for each of the
Variable Portfolios to continue through December 31, 1997.
Under the Investment Advisory Agreement and subject to the supervision of the
Directors, Aetna has responsibility for (i) supervising all aspects of the
operations of each Portfolio; (ii) selecting the securities to be purchased,
sold or exchanged by each Portfolio or otherwise represented in its investment
portfolio, placing trades for all such securities and regulatory reporting
thereon to the Directors; (iii) formulating and implementing continuing programs
for the purchase and sale of securities; (iv) obtaining and evaluating pertinent
information about significant developments and economic, statistical and
financial data, domestic foreign or otherwise, whether affecting the economy
generally, the Portfolios, securities held by or under consideration for each
Portfolio, or the issuers of those securities; (v) providing economic research
and securities analyses as Aetna considers necessary or advisable in connection
with Aetna's performance of its duties thereunder; (vi) obtaining the services
of, contracting with, and providing instructions to custodians and/or sub-
custodians of each Portfolio's securities, transfer agents, dividend paying
agents, pricing services and other service providers as are necessary to carry
out the terms of the Agreement; (vii) preparing financial and performance
reports, calculating and reporting daily net asset values, and preparing any
other financial data or reports, as Aetna from time to time, deems necessary or
as is requested by the Directors; and (viii) taking any other actions which
appear to Aetna and the Directors to be necessary.
The Investment Advisory Agreement provides that Aetna shall pay (a) the
salaries, employment benefits and other related costs of those of its personnel
engaged in providing investment advice to the Fund, including, without
limitation, office space, office equipment, telephone and postage costs and (b)
any fees and expenses of all Directors, officers and employees, if any, of the
Fund who are employees of Aetna or an affiliated entity and any salaries and
employment benefits payable to those persons. The Investment Advisory Agreement
provides that each Portfolio will pay (i) investment advisory fees; (ii)
brokers' commissions and certain other transaction fees including the portion of
such fees, if any, which is attributable to brokerage research services; (iii)
fees and expenses of the Portfolio's independent auditors and legal counsel;
(iv) expenses of printing and distributing proxies, proxy statements,
prospectuses and reports to shareholders of each Portfolio, except as such
expenses may be borne by the distributor; (v) interest and taxes; (vi) fees and
expenses of those of the Directors who are not "interested persons" (as defined
by the 1940 Act) of the Fund or Aetna; (vii) costs and expenses of promoting the
sale of shares in each Portfolio, including preparing prospectuses and reports
to shareholders of each Portfolio; (viii) administrator, transfer agent,
custodian and dividend disbursing agent fees and expenses; (ix) fees of
dividend, accounting and pricing agents appointed by each Portfolio; (x) fees
payable to the Commission or in connection with the registration of shares of
each Portfolio under the laws of any state or territory of the United States or
the District of Columbia; (xi) fees and assessments of the Investment Company
Institute or other association memberships approved by the Board of Directors;
(xii) such nonrecurring or extraordinary expenses as may arise; (xiii) all other
ordinary business expenses incurred in the operations of each Portfolio, unless
specifically allocable otherwise by the Investment Advisory Agreement; (xiv)
costs attributable to investor services, administering shareholder accounts and
handling shareholder relations; (xv) all expenses incident to the payment of any
dividend, distribution, withdrawal or redemption; and (xvi) insurance premiums
on property or personnel (including officers and Directors) of the Fund which
benefit the Fund. Some of the costs payable by each Portfolio under the
Investment Advisory Agreement are being assumed by Aetna under the terms of the
Administrative Services Agreement (see "Administrative Services Agreement").
The Investment Advisory Agreement provides that it will remain in effect from
year-to-year if approved annually by a majority vote of the Directors, including
a majority of the Directors who are not "interested persons," in person at a
meeting called for that purpose. The Investment Advisory Agreement may be
terminated as to a particular Portfolio without penalty at any time on sixty
days' written notice by (i) the Directors, (ii) a majority vote of the
outstanding voting securities of that Portfolio, or (iii) Aetna.
The Investment Advisory Agreement terminates automatically in the event of
assignment.
The service mark of the Variable Portfolios and the name "Aetna" have been
adopted by the Fund with the permission of Aetna Inc. and their continued use is
subject to the right of Aetna Inc. to withdraw this permission in the event
Aetna or another subsidiary or affiliated corporation of Aetna Inc. should not
be the investment adviser of the Variable Portfolios.
THE SUBADVISORY AGREEMENT
On June 18, 1996, the Directors approved a subadvisory agreement (Subadvisory
Agreement) between Aetna and Aeltus Investment Management, Inc. (Aeltus) with
respect to each of the Variable Portfolios to continue through December 31,
1997. The Subadvisory
17
<PAGE>
Agreement remains in effect from year-to-year if approved annually by a majority
vote of the Directors, including a majority of the Directors who are not
"interested persons," in person, at a meeting called for that purpose. The
Subadvisory Agreement may be terminated without penalty at any time on sixty
days' written notice by (i) the Directors, (ii) a majority vote of the
outstanding voting securities of the respective Portfolios, (iii) Aetna, or (iv)
Aeltus. The Subadvisory Agreement terminates automatically in the event of its
assignment or in the event of the termination of the Investment Advisory
Agreement with Aetna.
Under the Subadvisory Agreement, Aeltus supervises the investment and
reinvestment of cash and securities comprising the assets of the Portfolios. The
Subadvisory Agreement also directs Aeltus to (a) determine the securities to be
purchased or sold by the Portfolios, and (b) take any actions necessary to carry
out its investment subadvisory responsibilities.
Aeltus pays the salaries, employment benefits and other related costs of
personnel engaged in providing investment advice including office space,
facilities and equipment.
As compensation, Aetna pays the subadviser a monthly fee as described in the
prospectus.
Aetna has certain obligations under the Subadvisory Agreement and retains
overall responsibility for monitoring the investment program maintained by
Aeltus for compliance with applicable laws and regulations and each Portfolio's
respective investment objectives. Aetna will also obtain and evaluate data
regarding economic trends in the United States and industries in which the
Portfolios invest and consult with the subadviser on such data and trends. In
addition, Aetna will consult with and assist the subadviser in maintaining
appropriate policies, procedures and records and oversee matters relating to
promotion, marketing materials and reports by the subadviser to the Directors.
THE ADMINISTRATIVE SERVICES AGREEMENT
Pursuant to an Administrative Services Agreement, between the Fund and Aetna,
Aetna has agreed to provide all administrative services in support of the
Portfolios. In addition, Aetna has agreed to pay on behalf of each Portfolio,
all ordinary recurring direct costs of the Portfolio that it would otherwise be
required to pay under the terms of the Investment Advisory Agreement except
brokerage costs and other transaction costs in connection with the purchase and
sale of securities for its portfolios (Transaction Costs). As a result, the
Portfolios' costs and fees are limited to its advisory fee, the administrative
services charge and Transaction Costs. For the services under the Administrative
Services Agreement, Aetna will receive an annual fee, payable monthly, at a rate
of 0.15% of the average daily net assets of the Portfolio.
The Administrative Services Agreement will remain in effect until December 31,
1997. It will then remain in effect from year-to-year if approved annually by a
majority of the Directors. It may be terminated by either party on sixty days'
written notice.
CUSTODIAN
Mellon Bank, N.A., One Mellon Bank Center, Pittsburgh, PA, 15258 serves as
custodian for the assets of the Variable Portfolios. The custodian does not
participate in determining the investment policies of a Portfolio or in deciding
which securities are purchased or sold by a Portfolio. A Portfolio, however, may
invest in obligations of the custodian and may purchase or sell securities from
or to the custodian.
INDEPENDENT AUDITORS
KPMG Peat Marwick LLP, Hartford, Connecticut 06103-4103 serves as independent
auditors to the Variable Portfolios. KPMG Peat Marwick LLP provides audit
services, assistance and consultation in connection with Commission filings.
PRINCIPAL UNDERWRITER
Shares of the Variable Portfolios are offered on a continuous basis. Aetna has
agreed to use its best efforts to distribute the shares as the principal
underwriter of the Portfolios pursuant to an Underwriting Agreement between it
and the Fund. The Agreement was approved on June 18, 1996 to continue through
December 31, 1997. The Underwriting Agreement may be continued from year to year
if approved annually by the Directors or by a vote of holders of a majority of
each Variable Portfolio's shares, and by a vote of a majority of the Directors
who are not "interested persons," as that term is defined in the 1940 Act, of
Aetna, and who are not interested persons of the Fund, appearing in person at a
meeting called for the purpose of approving such Agreement. This Agreement
terminates automatically upon assignment, and may be terminated at any time on
sixty (60) days' written notice by the Directors or Aetna or by vote of holders
of a majority of a Variable Portfolio's shares without the payment of any
penalty.
BROKERAGE ALLOCATION AND TRADING POLICIES
Subject to the supervision of the Directors, Aetna and Aeltus have
responsibility for making the Variable Portfolios' investment decisions, for
effecting the execution of trades for the Variable Portfolios and for
negotiating any brokerage commissions thereof. It is the policy of Aetna and
Aeltus to obtain the best quality of execution available, giving attention to
net price (including commissions
18
<PAGE>
where applicable), execution capability (including the adequacy of a brokerage
firm's capital position), research and other services related to execution; the
relative priority given to these factors will depend on all of the circumstances
regarding a specific trade.
In implementing their trading policy, Aetna and Aeltus may place a Portfolio's
transactions with such brokers or dealers and for execution in such markets as,
in the opinion of the Fund, will lead to the best overall quality of execution
for the Portfolio.
Aetna and Aeltus currently receive a variety of brokerage and research services
from brokerage firms in return for the execution by such brokerage firms of
trades in securities held by the Portfolios. These brokerage and research
services include, but are not limited to, quantitative and qualitative research
information and purchase and sale recommendations regarding securities and
industries, analyses and reports covering a broad range of economic factors and
trends, statistical data relating to the strategy and performance of the
Portfolio and other investment companies and accounts, services related to the
execution of trades in a Portfolio's securities and advice as to the valuation
of securities. Aetna and Aeltus consider the quantity and quality of such
brokerage and research services provided by a brokerage firm along with the
nature and difficulty of the specific transaction in negotiating commissions for
trades in a Portfolio's securities and may pay higher commission rates than the
lowest available when it is reasonable to do so in light of the value of the
brokerage and research services received generally or in connection with a
particular transaction. Aetna's and Aeltus' policy in selecting a broker to
effect a particular transaction is to seek to obtain "best execution," which
means prompt and efficient execution of the transaction at the best obtainable
price with payment of commissions which are reasonable in relation to the value
of the services provided by the broker, taking into consideration research and
other services provided. When either Aetna or Aeltus believes that more than one
broker can provide best execution, preference may be given to brokers who
provide additional services to Aetna or Aeltus.
Consistent with securities laws and regulations, Aetna and Aeltus may obtain
such brokerage and research services regardless of whether they are paid for (1)
by means of commissions; or (2) by means of separate, non-commission payments.
Aetna's and Aeltus' judgment as to whether and how they will obtain the specific
brokerage and research services will be based upon their analysis of the quality
of such services and the cost (depending upon the various methods of payment
which may be offered by brokerage firms) and will reflect Aetna's and Aeltus'
opinion as to which services and which means of payment are in the long-term
best interests of a Portfolio. The Variable Portfolios have no present intention
to effect any brokerage transactions in portfolio securities with Aetna or any
affiliate of the Variable Portfolios or Aetna except in accordance with
applicable Commission rules. All transactions will comply with Rule 17e-1 under
the 1940 Act.
Certain officers of Aetna and Aeltus also manage the securities portfolios of
Aetna's own accounts. Further, Aetna and Aeltus also act as investment adviser
to other investment companies registered under the 1940 Act and other client
accounts. Aetna and Aeltus have adopted policies designed to prevent
disadvantaging the Variable Portfolios in placing orders for the purchase and
sale of securities for the Variable Portfolios.
To the extent Aetna or Aeltus desires to buy or sell the same security at or
about the same time for more than one client, the purchases or sales will
normally be allocated as nearly as practicable on a pro rata basis in proportion
to the amounts to be purchased or sold by each, taking into consideration the
respective investment objectives of the clients, the relative size of portfolio
holdings of the same or comparable securities, availability of cash for
investment, and the size of their respective investment commitments. Orders for
different clients received at approximately the same time may be bunched for
purposes of placing trades, as authorized by regulatory directives. Prices are
averaged for those transactions. In some cases, this procedure may adversely
affect the size of the position obtained for or disposed of by a Portfolio or
the price paid or received by a Portfolio.
The Directors have adopted a policy allowing trades to be made between
registered investment companies provided they meet the terms of Rule 17a-7 under
the 1940 Act. Pursuant to this policy, a Portfolio may buy a security from or
sell another security to another registered investment company advised by Aetna.
For 1996, the Fund paid brokerage commissions of $3,292, $11,234 and $2,562 for
Growth, Index Plus and Capital Appreciation, respectively.
For the fiscal year ended December 31, 1996, no portfolio transactions were
directed to any brokers because of research services. No brokerage business was
placed with any brokers affiliated with Aetna during 1996.
The Directors have also adopted a Code of Ethics governing personal trading by
persons who manage, or who have access to trading activity by, a Portfolio. The
Code allows trades to be made in securities that may be held by a Portfolio,
however, it prohibits a person from taking advantage of Portfolio trades or from
acting on inside information. Aetna and Aeltus have adopted Codes of Ethics
which the Directors review annually.
DESCRIPTION OF SHARES
The Articles of Incorporation authorize the Fund to issue one billion shares of
common stock with a par value of $.001 per share. The shares are nonassessable,
transferable, redeemable and do not have pre-emptive rights or cumulative voting
rights. The shares may be issued as whole or fractional shares and are
uncertificated.
19
<PAGE>
The shares may be issued in series or portfolios having separate assets and
separate investment objectives and policies. Upon liquidation of a portfolio,
its shareholders are entitled to share pro rata in the net assets of that
portfolio available for distribution to shareholders. Shares, when issued, will
be fully paid and nonassessable.
PURCHASE AND REDEMPTION OF SHARES
Shares of a Portfolio are purchased and redeemed at the net asset value next
determined after receipt of a purchase or redemption order in acceptable form as
described in the Prospectus under "Purchase and Redemption of Shares" and "Net
Asset Value."
The value of shares redeemed may be more or less than the shareholder's costs,
depending upon the market value of the portfolio securities at the time of
redemption. Payment for shares redeemed will be made to the Company by the Fund
within seven days or the maximum period allowed by law, if shorter, after the
redemption request is received by the Company acting as the transfer agent for
the Fund. The right to redeem shares of the Fund may be suspended or payment
therefore postponed for any period during which (a) trading on the New York
Stock Exchange is restricted as determined by the Commission or such exchange is
closed for other than weekends and holidays; (b) an emergency exists, as
determined by the Commission, as a result of which (i) disposal by the Fund of
portfolio securities owned by it is not reasonably practicable, or (ii) it is
not reasonably practicable for the Fund to determine fairly the value of its net
assets; or (c) the Commission by order so permits, for the protection of
shareholders of the Fund.
NET ASSET VALUE
Securities of the Variable Portfolios are generally valued by independent
pricing services. The values for equity securities traded on registered
securities exchanges are based on the last sale price or, if there has been no
sale that day, at the mean of the last bid and asked price on the exchange where
the security is principally traded. Securities traded over the counter are
valued at the mean of the last bid and asked price if current market quotations
are not readily available. Short-term debt securities which have a maturity date
of more than sixty days will be valued at the mean of the last bid and asked
price obtained from principal market makers. Short-term debt securities maturing
in sixty days or less at the date of purchase will be valued using the
"amortized cost" method of valuation. This involves valuing an instrument at its
cost and thereafter assuming a constant amortization of premium or increase of
discount. Long-term debt securities are valued at the mean of the last bid and
asked price of such securities obtained from a broker who is a market-maker in
the securities or a service providing quotations based upon the assessment of
market-makers in those securities.
Call options written by the Fund and put options are valued at the mean of the
last bid and asked price on the principal exchange where the option is traded.
Stock index futures contracts and interest rate futures contracts are valued
daily at a settlement price based on rules of the exchange where the futures
contract is primarily traded.
PERFORMANCE INFORMATION
Total return of a Portfolio for periods longer than one year is determined by
calculating the actual dollar amount of investment return on a $1,000 investment
in the Portfolio made at the beginning of each period, then calculating the
average annual compounded rate of return which would produce the same investment
return on the $1,000 investment over the same period. Total return for a period
of one year or less is equal to the actual investment return on a $1,000
investment in the Portfolio during that period. Total return calculations assume
that all Portfolio distributions are reinvested at net asset value on their
respective reinvestment dates.
From time to time, Aetna may reduce its compensation or assume expenses in
respect of the operations of a Portfolio in order to reduce the Portfolio's
expenses. Any such waiver or assumption would increase a Portfolio's yield and
total return during the period of the waiver or assumption.
The performance of the Portfolios may, from time to time, be compared to that of
other mutual funds tracked by mutual fund rating services, to broad groups of
comparable mutual funds, or to unmanaged indices which may assume investment of
dividends but generally do not reflect deductions for administrative and
management costs.
The Prospectus contains historical performance information of the Aetna Small
Company Growth Fund which is a series of a public mutual fund which has the same
investment objective and follows substantially the same investment strategies as
the Small Company Portfolio.
The performance of this series of Aetna Series Fund, Inc. is commonly measured
as total return. An average annual compounded rate of return ("T") may be
computed by using the redeemable value at the end of a specified period ("ERV")
of a hypothetical initial investment of $1,000 ("P") over a period of time ["n"]
according to the formula:
n
P(1 + T) = ERV
The total returns of the Portfolios calculated on the basis described above are
9.64% for Index Plus for the period from September 16, 1996 to December 31,
1996; 1.23% for Small Company for the period from December 27, 1996 to December
31, 1996; and 1.57% for Growth and 2.15% for Capital Appreciation, each for the
period from December 13, 1996 to December 31, 1996.
20
<PAGE>
Investors should not consider this performance data as an indication of the
future performance of any of the Portfolios of the Fund.
A Portfolio's investment results will vary from time to time depending upon
market conditions, the composition of its investment portfolio and its operating
expenses. Performance information of any Portfolio will not be compared in
advertisements with such information for funds that offer their shares directly
to the public, because Portfolio performance data does not reflect charges
imposed by the insurance company on the VA Contracts and VLI Policies. The total
return for a Portfolio should be distinguished from the rate of return of a
corresponding division of the insurance company's separate account, which rate
will reflect the deduction of additional insurance charges, including mortality
and expense risk charges, and will therefore be lower. Accordingly, performance
figures for a Portfolio will only be advertised if comparable performance
figures for the corresponding division of the separate account are included in
the advertisements. VA Contract owners and VLI Policy owners should consult
their contract and policy prospectuses, respectively, for further information.
Each Portfolio's results also should be considered relative to the risks
associated with its investment objectives and policies.
TAX STATUS
The following is only a summary of certain additional tax considerations
generally affecting each Variable Portfolio and its shareholders which are not
described in the Prospectus. No attempt is made to present a detailed
explanation of the tax treatment of each Portfolio or its shareholders, and the
discussions here and in the Prospectus are not intended as substitutes for
careful tax planning.
Qualification as a Regulated Investment Company
Each Variable Portfolio has elected to be taxed as a regulated investment
company under Subchapter M of the Internal Revenue Code of 1986, (Code). As a
regulated investment company, a Portfolio is not subject to federal income tax
on the portion of its net investment income (i.e., taxable interest, dividends
and other taxable ordinary income, net of expenses) and capital gain net income
(i.e., the excess of capital gains over capital losses) that it distributes to
shareholders, provided that it distributes at least 90% of its investment
company taxable income (i.e., net investment income and the excess of net
short-term capital gain over net long-term capital loss) and at least 90% of its
tax-exempt income (net of expenses allocable thereto) for the taxable year
(Distribution Requirement), and satisfies certain other requirements of the Code
that are described in this section. Distributions by a Portfolio made during the
taxable year or, under specified circumstances, within twelve months after the
close of the taxable year, will be considered distributions of income and gains
of the taxable year and can therefore satisfy the Distribution Requirement.
In addition to satisfying the Distribution Requirement, a regulated investment
company must (1) derive at least 90% of its gross income from dividends,
interest, certain payments with respect to securities loans, gains from the sale
or other disposition of stock or securities or foreign currencies (to the extent
such currency gains are directly related to the regulated investment company's
principal business of investing in stock or securities) and other income
(including but not limited to gains from options, futures or forward contracts)
derived with respect to its business of investing in such stock, securities or
currencies (Income Requirement); and (2) derive less than 30% of its gross
income (exclusive of certain gains on designated hedging transactions that are
offset by realized or unrealized losses on offsetting positions) from the sale
or other disposition of stock, securities or foreign currencies (or options,
futures or forward contracts thereon) held for less than three months (the
"Short-Short Gain Test"). For purposes of these calculations, gross income
includes tax-exempt income. However, foreign currency gains, including those
derived from options, futures and forwards, will not in any event be
characterized as Short-Short Gain if they are directly related to the regulated
investment company's investments in stock or securities (or options or futures
thereon). Because of the Short-Short Gain Test, a Portfolio may have to limit
the sale of appreciated securities that it has held for less than three months.
However, the Short-Short Gain Test will not prevent a Portfolio from disposing
of investments at a loss, since the recognition of a loss before the expiration
of the three-month holding period is disregarded for this purpose. Interest
(including original issue discount) received by a Portfolio at maturity or upon
the disposition of a security held for less than three months will not be
treated as gross income derived from the sale or other disposition of such
security within the meaning of the Short- Short Gain Test. However, income that
is attributable to realized market appreciation will be treated as gross income
from the sale or other disposition of securities for this purpose.
In general, gain or loss recognized by a Portfolio on the disposition of an
asset will be a capital gain or loss. However, gain recognized on the
disposition of a debt obligation (including municipal obligations) purchased by
a Portfolio at a market discount (generally, at a price less than its principal
amount) will be treated as ordinary income to the extent of the portion of the
market discount which accrued during the period of time the Portfolio held the
debt obligation. In addition, under the rules of Code Section 988, gain or loss
recognized on the disposition of a debt obligation denominated in a foreign
currency or an option with respect thereto (but only to the extent attributable
to changes in foreign currency exchange rates), and gain or loss recognized on
the disposition of a foreign currency forward contract, futures contract, option
or similar financial instrument, or of foreign currency itself, except for
regulated futures contracts or non-equity options subject to Code Section 1256
(unless the Portfolio elects otherwise), will generally be treated as ordinary
income or loss.
For purposes of determining whether capital gain or loss recognized by a
Portfolio on the disposition of an asset is long-term or short- term, the
holding period of the asset may be affected if (1) the asset is used to close a
"short sale" (which includes for certain purposes
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the acquisition of a put option ) or is substantially identical to another asset
so used, (2) the asset is otherwise held by the Portfolio as part of a
"straddle" (which term generally excludes a situation where the asset is stock
and the Portfolio grants a qualified covered call option (which, among other
things, must not be deep-in-the-money) with respect thereto) or (3) the asset is
stock and the Portfolio grants an in-the-money qualified covered call option
with respect thereto. However, for purposes of the Short-Short Gain Test, the
holding period of the asset disposed of may be reduced only in the case of
clause (1) above. In addition, a Portfolio may be required to defer the
recognition of a loss on the disposition of an asset held as part of a straddle
to the extent of any unrecognized gain on the offsetting position.
Any gain recognized by a Portfolio on the lapse of, or any gain or loss
recognized by a Portfolio from a closing transaction with respect to, an option
written by the Portfolio will be treated as a short-term capital gain or loss.
For purposes of the Short-Short Gain Test, the holding period of an option
written by a Portfolio will commence on the date it is written and end on the
date it lapses or the date a closing transaction is entered into. Accordingly, a
Portfolio may be limited in its ability to write options which expire within
three months and to enter into closing transactions at a gain within three
months of the writing of options.
Transactions that may be engaged in by a Portfolio (such as regulated futures
contracts, certain foreign currency contracts, and options on stock indexes and
futures contracts) will be subject to special tax treatment as "Section 1256
contracts." Section 1256 contracts are treated as if they are sold for their
fair market value on the last day of the taxable year, even though a taxpayer's
obligations (or rights) under such contracts have not terminated (by delivery,
exercise, entering into a closing transaction or otherwise) as of such date. Any
gain or loss recognized as a consequence of the year-end deemed disposition of
Section 1256 contracts is taken into account for the taxable year together with
any other gain or loss that was previously recognized upon the termination of
Section 1256 contracts during that taxable year. Any capital gain or loss for
the taxable year with respect to Section 1256 contracts (including any capital
gain or loss arising as a consequence of the year-end deemed sale of such
contracts) is generally treated as 60% long-term capital gain or loss and 40%
short-term capital gain or loss. A Portfolio, however, may elect not to have
this special tax treatment apply to Section 1256 contracts that are part of a
"mixed straddle" with other investments of the Portfolio that are not Section
1256 contracts. The IRS has held in several private rulings that gains arising
from Section 1256 contracts will be treated for purposes of the Short-Short Gain
Test as being derived from securities held for not less than three months if the
gains arise as a result of a constructive sale under Code Section 1256, provided
that the contract is actually held by the Portfolio uninterrupted for a total of
at least three months.
Because only a few regulations regarding the treatment of swap agreements and
other financial derivatives have been issued, the tax consequences of
transactions in these types of instruments are not always entirely clear. The
Fund intends to account for derivatives transactions in a manner deemed by it to
be appropriate, but the Internal Revenue Service might not necessarily accept
such treatment. If it did not, the status of a Portfolio as a regulated
investment company and/or its compliance with the diversification requirement
under Code Section 817(h) might be affected. The Fund intends to monitor
developments in this area. Certain requirements that must be met under the Code
in order for a Portfolio to qualify as a regulated investment company may limit
the extent to which a Portfolio will be able to engage in swap agreements.
A Portfolio may purchase securities of certain foreign investment funds or
trusts which constitute passive foreign investment companies (PFICS) for federal
income tax purposes. If a Portfolio invests in a PFIC, it may elect to treat the
PFIC as a qualifying electing portfolio (QEP) in which event the Portfolio will
each year have ordinary income equal to its pro rata share of the PFIC's
ordinary earnings for the year and long-term capital gain equal to its pro rata
share of the PFIC's net capital gain for the year, regardless of whether the
Portfolio receives distributions of any such ordinary earnings or capital gain
from the PFIC. If a Portfolio does not (because it is unable to, chooses not to
or otherwise) elect to treat the PFIC as a QEP, then in general (1) any gain
recognized by the Portfolio upon sale or other disposition of its interest in
the PFIC or any excess distribution received by the Portfolio from the PFIC will
be allocated ratably over the Portfolio's holding period of its interest in the
PFIC, (2) the portion of such gain or excess distribution so allocated to the
year in which the gain is recognized or the excess distribution is received
shall be included in the Portfolio's gross income for such year as ordinary
income (and the distribution of such portion by the Portfolio to shareholders
will be taxable as an ordinary income dividend, but such portion will not be
subject to tax at the Portfolio level), (3) the Portfolio shall be liable for
tax on the portions of such gain or excess distribution so allocated to prior
years in an amount equal to, for each such prior year, (i) the amount of gain or
excess distribution allocated to such prior year multiplied by the highest tax
rate (individual or corporate) in effect for such prior year plus (ii) interest
on the amount determined under clause (i) for the period from the due date for
filing a return for such prior year until the date for filing a return for the
year in which the gain is recognized or the excess distribution is received at
the rates and methods applicable to underpayments of tax for such period, and
(4) the distribution by the portfolio to shareholders of the portions of such
gain or excess distribution so allocated to prior years (net of the tax payable
by the Portfolio thereon) will again be taxable to the shareholders as an
ordinary income dividend.
Under recently proposed Treasury Regulations a Portfolio can elect to recognize
as gain the excess, as of the last day of its taxable year, of the fair market
value of each share of PFIC stock over the Portfolio's adjusted tax basis in
that share ("mark to market gain"). Such mark to market gain will be included by
the Portfolio as ordinary income, such gain will not be subject to the
Short-Short Gain Test, and the Portfolio's holding period with respect to such
PFIC stock commences on the first day of the next taxable year. If a Portfolio
makes such election in the first taxable year it holds PFIC stock, the Portfolio
will include ordinary income from any mark to market gain, if any, and will not
incur the tax described in the previous paragraph.
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Treasury Regulations permit a regulated investment company, in determining its
investment company taxable income and net capital gain (i.e., the excess of net
long-term capital gain over net short-term capital loss) for any taxable year,
to elect (unless it has made a taxable year election for excise tax purposes as
discussed below) to treat all or any part of any net capital loss, any net
long-term capital loss or any net foreign currency loss incurred after October
31 as if it had been incurred in the succeeding year.
In addition to satisfying the requirements described above, each Portfolio must
satisfy an asset diversification test in order to qualify as a regulated
investment company. Under this test, at the close of each quarter of a
Portfolio's taxable year, at least 50% of the value of the Portfolio's assets
must consist of cash and cash items, U.S. Government securities, securities of
other regulated investment companies, and securities of other issuers (as to
which the Portfolio has not invested more than 5% of the value of the
Portfolio's total assets in securities of such issuer and as to which the
Portfolio does not hold more than 10% of the outstanding voting securities of
such issuer), and no more than 25% of the value of its total assets may be
invested in the securities of any one issuer (other than U.S. Government
securities and securities of other regulated investment companies), or of two or
more issuers which the Portfolio controls and which are engaged in the same or
similar trades or businesses or related trades or businesses. Generally, an
option (call or put) with respect to a security is treated as issued by the
issuer of the security not the issuer of the option. However, with regard to
forward currency contracts, there does not appear to be any formal or informal
authority which identifies the issuer of such instrument. For purposes of asset
diversification testing, obligations issued or guaranteed by agencies or
instrumentalities of the U.S. Government such as the Federal Agricultural
Mortgage Corporation, the Farm Credit System Financial Assistance Corporation, a
Federal Home Loan Bank, the Federal Home Loan Mortgage Corporation, the Federal
National Mortgage Association, the Government National Mortgage Corporation, and
the Student Loan Marketing Association are treated as U.S. Government
securities.
If for any taxable year a Portfolio does not qualify as a regulated investment
company, all of its taxable income (including its net capital gain) will be
subject to tax at regular corporate rates without any deduction for
distributions to shareholders, and such distributions will be taxable to the
shareholders as ordinary dividends to the extent of the Portfolio's current and
accumulated earnings and profits. Such distributions generally will be eligible
for the dividends-received deduction in the case of corporate shareholders.
Qualification of Segregated Asset Accounts
Under Code Section 817(h), a segregated asset account upon which a variable
annuity contract or variable life insurance policy is based must be "adequately
diversified." A segregated asset account will be adequately diversified if it
satisfies one of two alternative tests set forth in the Treasury Regulations.
Specifically, the Treasury Regulations provide, that except as permitted by the
"safe harbor" discussed below, as of the end of each calendar quarter (or within
30 days thereafter) no more than 55% of a Portfolio's total assets may be
represented by any one investment, no more than 70% by any two investments, no
more than 80% by any three investments and no more than 90% by any four
investments. For this purpose, all securities of the same issuer are considered
a single investment, and while each U.S. Government agency and instrumentality
is considered a separate issuer, a particular foreign government and its
agencies, instrumentalities and political subdivisions may be considered the
same issuer. As a safe harbor, a separate account will be treated as being
adequately diversified if the diversification requirements under Subchapter M
are satisfied and no more than 55% of the value of the account's total assets
are cash and cash items, U.S. government securities and securities of other
regulated investment companies.
For purposes of these alternative diversification tests, a segregated asset
account investing in shares of a regulated investment company will be entitled
to "look through" the regulated investment company to its pro rata portion of
the regulated investment company's assets, provided the regulated investment
company satisfies certain conditions relating to the ownership of the shares.
Excise Tax on Regulated Investment Companies
A 4% non-deductible excise tax is imposed on a regulated investment company that
fails to distribute in each calendar year an amount equal to 98% of ordinary
taxable income for the calendar year and 98% of capital gain net income for the
one-year period ended on October 31 of such calendar year (or, at the election
of a regulated investment company having a taxable year ending November 30 or
December 31, for its taxable year (a "taxable year election")). Tax-exempt
interest on municipal obligations is not subject to the excise tax. The balance
of such income must be distributed during the next calendar year. For the
foregoing purposes, a regulated investment company is treated as having
distributed any amount on which it is subject to income tax for any taxable year
ending in such calendar year.
For purposes of the excise tax, a regulated investment company shall (1) reduce
its capital gain net income (but not below its net capital gain) by the amount
of any net ordinary loss for the calendar year; and (2) exclude foreign currency
gains and losses from Section 998 transactions incurred after October 31 of any
year (or after the end of its taxable year if it has made a taxable year
election) in determining the amount of ordinary taxable income for the current
calendar year (and, instead, include such gains and losses in determining
ordinary taxable income for the succeeding calendar year).
Each Portfolio intends to make sufficient distributions or deemed distributions
of its ordinary taxable income and capital gain net income prior to the end of
each calendar year to avoid liability for the excise tax. However, investors
should note that a Portfolio may in certain circumstances be required to
liquidate portfolio investments to make sufficient distributions to avoid excise
tax liability.
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Portfolio Distributions
Each Portfolio anticipates distributing substantially all of its investment
company taxable income for each taxable year. Such distributions will be taxable
to the shareholders as ordinary income and treated as dividends for federal
income tax purposes, but they may qualify for the dividends-received deduction
for corporate shareholders to the extent discussed below.
Each Portfolio may either retain or distribute to the shareholders its net
capital gain for each taxable year. Each Portfolio currently intends to
distribute any such amounts. If net capital gain is distributed and designated
as a capital gain dividend, it will be taxable to the shareholders as long-term
capital gain, regardless of the length of time the shareholders have held shares
or whether such gain was recognized by the Variable Portfolio prior to the date
on which the shareholder acquired the shares.
If a Portfolio elects to retain its net capital gain, the Portfolio will be
taxed thereon (except to the extent of any available capital loss carryovers) at
the 35% corporate tax rate. Where a Portfolio elects to retain its net capital
gain, it is expected that the Portfolio also will elect to have shareholders of
record on the last day of its taxable year treated as if each received a
distribution of its pro rata share of such gain, with the result that each
shareholder will be required to report its pro rata share of such gain on its
tax return as long-term capital gain, will receive a refundable tax credit for
its pro rata share of tax paid by the Portfolio on the gain, and will increase
the tax basis for its shares by an amount equal to the deemed distribution less
the tax credit. All distributions paid to Aetna, whether characterized as
ordinary income or capital gain, are not taxable to VA Contract or VLI Policy
holders.
Ordinary income dividends paid by a Portfolio with respect to a taxable year may
qualify for the dividends-received deduction generally available to corporations
(other than corporations, such as S corporations, which are not eligible for the
deduction because of their special characteristics and other than for purposes
of special taxes such as the accumulated earnings tax and the personal holding
company tax) to the extent of the amount of qualifying dividends received by a
Portfolio from domestic corporations for the taxable year and if the shareholder
meets eligibility requirements in the Code. A dividend received by the Portfolio
will not be treated as a qualifying dividend (1) if it has been received with
respect to any share of stock that the Portfolio has held for less than 46 days
(91 days in the case of certain preferred stock), excluding for this purpose
under the rules of Code Section 246(c)(3) and (4): (i) any day more than 45 days
(or 90 days in the case of certain preferred stock) after the date on which the
stock becomes ex-dividend and (ii) any period during which the Portfolio has an
option to sell, is under a contractual obligation to sell, has made and not
closed a short sale of, is the grantor of a deep-in-the-money or otherwise
nonqualified option to buy, or has otherwise diminished its risk of loss by
holding other positions with respect to, such (or substantially identical)
stock; (2) to the extent that the Portfolio is under an obligation (pursuant to
a short sale or otherwise) to make related payments with respect to positions in
substantially similar or related property; or (3) to the extent the stock on
which the dividend is paid is treated as debt-financed under the rules of Code
Section 246(a). Moreover, the dividends-received deduction for a corporate
shareholder may be disallowed or reduced (i) if the corporate shareholder fails
to satisfy the foregoing requirements with respect to its shares of the
Portfolio or (ii) by application of Code Section 246(b) which in general limits
the dividends-received deduction.
Alternative Minimum Tax (AMT) is imposed in addition to, but only to the extent
it exceeds, the regular tax and is computed at a maximum marginal rate of 28%
for noncorporate taxpayers and 20% for corporate taxpayers on the excess of the
taxpayer's alternative minimum taxable income ("AMTI") over an exemption amount.
In addition, under the Superfund Amendments and Reauthorization Act of 1986, a
tax is imposed for taxable years beginning after 1986 and before 1996 at the
rate of 0.12% on the excess of a corporate taxpayer's AMTI (determined without
regard to the deduction for this tax and the AMT net operating loss deduction)
over $2 million. For purposes of the corporate AMT and the environmental
super-fund tax (which are discussed above), the corporate dividends-received
deduction is not itself an item of tax preference that must be added back to
taxable income or is otherwise disallowed in determining a corporation's AMTI.
However, corporate shareholders will generally be required to take the full
amount of any dividend received from a Variable Portfolio into account (without
a dividends-received deduction) in determining its adjusted current earnings,
which are used in computing an additional corporate preference item (i.e., 75%
of the excess of a corporate taxpayer's adjusted current earnings over its AMTI
(determined without regard to this item and the AMT net operating loss
deduction)) includable in AMTI.
Investment income that may be received by a Portfolio from sources within
foreign countries may be subject to foreign taxes withheld at the source. The
United States has entered into tax treaties with many foreign countries which
entitle a Portfolio to a reduced rate of, or exemption from, taxes on such
income. It is impossible to determine the effective rate of foreign tax in
advance since the amount of a Portfolio's assets to be invested in various
countries is not known.
Distributions by a Portfolio that do not constitute ordinary income dividends or
capital gain dividends will be treated as a return of capital to the extent of
(and in reduction of) the shareholder's tax basis in his shares; any excess will
be treated as gain from the sale of his shares, as discussed below.
Distributions paid to shareholders are generally reinvested in additional
shares. Shareholders receiving a distribution in the form of additional shares
will be treated as receiving a distribution in an amount equal to the fair
market value of the shares received, determined as of the reinvestment date. In
addition, if the net asset value at the time a shareholder purchases shares of a
Portfolio reflects undistributed net investment income or recognized capital
gain net income, or unrealized appreciation in the value of the assets of the
Port-
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folio, distributions of such amounts will be taxable to the shareholder in the
manner described above, although such distributions economically constitute a
return of capital to the shareholder.
Ordinarily, shareholders are required to take distributions by a Portfolio into
account in the year in which the distributions are made. However, dividends
declared in October, November or December of any year and payable to
shareholders of record on a specified date in such a month will be deemed to
have been received by the shareholders (and made by the Portfolio) on December
31 of such calendar year if such dividends are actually paid in January of the
following year. Shareholders will be advised annually as to the U.S. federal
income tax consequences of distributions made (or deemed made) during the year.
Sale or Redemption of Shares
Shareholders generally will recognize gain or loss on the sale or redemption of
shares of a Portfolio in an amount equal to the difference between the proceeds
of the sale or redemption and the shareholder's adjusted tax basis in the
shares. All or a portion of any loss so recognized may be disallowed if the
shareholder purchases other shares of the Portfolio within 30 days before or
after the sale or redemption. In general, any gain or loss arising from (or
treated as arising from) the sale or redemption of shares of a Portfolio will be
considered capital gain or loss and will be long-term capital gain or loss if
the shares were held for longer than one year. However, any capital loss arising
from the sale or redemption of shares held, or deemed under Code rules to be
held, for six months or less will be treated as a long-term capital loss to the
extent of the amount of capital gain dividends received on such shares.
Tax Effect on Contract Owners and Policy Owners
Owners of VA Contracts and VLI Policies are taxed through prior ownership of
such contracts and policies, as described in the insurance company's prospectus
for the applicable contract or policy.
Effect of Future Legislation; Local Tax Considerations
The foregoing general discussion of U.S. federal income tax consequences is
based on the Code and the Treasury Regulations issued thereunder as in effect on
the date of this Statement of Additional Information. Future legislative or
administrative changes or court decisions may significantly change the
conclusions expressed herein, and any such changes or decisions may have a
retroactive effect with respect to the transactions contemplated herein.
Rules of state and local taxation of ordinary income dividends, exempt-interest
dividends and capital gain dividends from regulated investment companies often
differ from the rules for U.S. federal income taxation described above.
Shareholders are urged to consult their tax advisers as to the consequences of
these and other state and local tax rules affecting investment in a Portfolio.
VOTING RIGHTS
Shareholders are entitled to one vote for each full share held (and fractional
votes for fractional shares held) and will vote in the election of Directors (to
the extent hereinafter provided) and on other matters submitted to the vote of
the shareholders. The shareholders of the Portfolios are the insurance companies
for their separate accounts using the Portfolios to fund VA Contracts and VLI
Policies. The insurance company depositors of the separate accounts pass voting
rights attributable to shares held for VA Contracts and VLI Policies through to
Contract owners and Policy owners as described in the prospectus for the
applicable VA Contract or VLI Policy.
Once the initial Board of Directors is elected, no meeting of the shareholders
for the purpose of electing Directors will be held unless and until such time as
less than a majority of the Directors holding office have been elected by the
shareholders, or shareholders holding 10% or more of the outstanding shares
request such a vote. The Directors then in office will call a shareholder
meeting for election of Directors. Vacancies occurring between any such meeting
shall be filled as allowed by law, provided that immediately after filling any
such vacancy, at least two-thirds of the Directors holding office have been
elected by the shareholders.
Special shareholder meetings may be called when requested in writing by the
holders of not less than 10% of the outstanding voting shares of a Portfolio.
Any request must state the purposes of the proposed meeting.
Except as set forth above, the Directors shall continue to hold office and may
appoint successor Directors. Directors may be removed from office (1) at any
time by two-thirds vote of the Directors; (2) by a majority vote of Directors
where any Director becomes mentally or physically incapacitated; (3) at a
special meeting of shareholders by a two-thirds vote of the outstanding shares
(4) by written declaration filed with Mellon Bank, N.A., the Variable
Portfolio's custodian, signed by two-thirds of a Variable Portfolio's
shareholders. Any Director may also voluntarily resign from office. Voting
rights are not cumulative, so that the holders of more than 50% of the shares
voting in the election of Directors can, if they choose to do so, elect all the
Directors of the Variable Portfolios, in which event the holders of the
remaining shares will be unable to elect any person as a Director.
The Articles may be amended by an affirmative vote of a majority of the shares
at any meeting of shareholders or by written instrument signed by a majority of
the Directors and consented to by a majority of the shareholders.
The Directors may also amend the Articles
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without the vote or consent of shareholders if they deem it necessary to conform
the Articles to the requirements of applicable federal laws or regulations or
the requirements of the regulated investment company provisions of the Code, but
the Directors shall not be liable for failing to do so.
FINANCIAL STATEMENTS
Financial Statements for each Portfolio of Aetna Variable Portfolios, Inc. and
independent auditors' reports thereon are incorporated herein by reference to
the Annual Reports dated December 31, 1996. The Annual Reports are available
upon request and without charge by calling 1-800-525-4225 or by writing to Aetna
Variable Portfolios, Inc. at 151 Farmington Avenue, Hartford, CT 06156.
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