PORTFOLIO PARTNERS, INC.
151 FARMINGTON AVENUE
HARTFORD, CT 06156-8962
MFS EMERGING EQUITIES PORTFOLIO
MFS RESEARCH GROWTH PORTFOLIO
MFS VALUE EQUITY PORTFOLIO
SCUDDER INTERNATIONAL GROWTH PORTFOLIO
T. ROWE PRICE GROWTH EQUITY PORTFOLIO
PROSPECTUS DATED: August 19, 1997
Portfolio Partners, Inc. (the "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 "Portfolios"). Aetna Life Insurance and Annuity Company serves
as the Investment Adviser of each Portfolio, and each has a Subadviser. The
Fund's five Portfolios (and their Subadvisers) are:
MFS Emerging Equities Portfolio (Massachusetts Financial Services Company)
MFS Research Growth Portfolio (Massachusetts Financial Services Company)
MFS Value Equity Portfolio (Massachusetts Financial Services Company)
Scudder International Growth Portfolio (Scudder, Stevens & Clark, Inc.)
T. Rowe Price Growth Equity Portfolio (T. Rowe Price Associates, Inc.)
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 August 19, 1997, contains more
information about the Portfolios. For a free copy of the Statement, call
1-800-525-4225 or write to Portfolio Partners, Inc., at the address listed
above. The Statement has been filed with the Securities and Exchange Commission
("SEC") and is incorporated by reference into this Prospectus.
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 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, NOR HAS THE SECURITIES AND EXCHANGE
COMMISSION PASSED UPON THE ACCURACY OR ADEQUACY OF THIS PROSPECTUS. ANY
REPRESENTATION TO THE CONTRARY IS A CRIMINAL OFFENSE.
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 PORTFOLIOS................................................ 3
INVESTMENT POLICIES AND PRACTICES............................................ 5
RISK FACTORS AND OTHER CONSIDERATIONS........................................ 8
INVESTMENT RESTRICTIONS...................................................... 9
MANAGEMENT OF THE PORTFOLIOS................................................. 9
PURCHASE AND REDEMPTION OF SHARES............................................ 11
NET ASSET VALUE.............................................................. 11
PERFORMANCE.................................................................. 12
TAX MATTERS.................................................................. 13
GENERAL INFORMATION.......................................................... 13
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THE FUND
The Fund is an open-end, management investment company, consisting of multiple
Portfolios. It currently has authorized five Portfolios: MFS Emerging Equities
Portfolio, MFS Research Growth Portfolio, MFS Value Equity Portfolio, Scudder
International Growth Portfolio and T. Rowe Price Growth Equity Portfolio. The
Fund may authorize additional Portfolios in the future. Aetna Life Insurance and
Annuity Company ("Aetna") serves as the Investment Adviser for each Portfolio,
and Aetna has appointed various Subadvisers that are responsible for the
day-to-day management of the Portfolios. 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 the
owners of the VA Contracts or VLI Policies or participants therein
("Participants"), are shareholders of the Fund. See "General Information."
DESCRIPTION OF THE PORTFOLIOS
Each Portfolio has an investment objective, which is a fundamental policy. A
Portfolio's fundamental policies and restrictions may not be changed without the
vote of a majority of the holders of that Portfolio's outstanding shares (see
"Voting Rights," below). Investment in a Portfolio involves risk, and, as with
all mutual funds, there can be no assurance that a Portfolio will meet its
investment objective. Each Portfolio is subject to investment policies and
restrictions described in this Prospectus and in the Statement, some of which
are fundamental.
MFS EMERGING EQUITIES PORTFOLIO
INVESTMENT OBJECTIVE. The MFS Emerging Equities Portfolio ("MFS Emerging
Equities") seeks to provide long-term growth of capital. Dividend and interest
income from portfolio securities, if any, is incidental to MFS Emerging
Equities' investment objective.
INVESTMENT POLICIES. Under normal market conditions, MFS Emerging Equities
invests primarily in common stocks issued by companies that its Subadviser
believes are early in their life cycle but which have the potential to become
major enterprises (emerging growth companies). The Subadviser generally expects
these companies, which may include domestic and foreign companies, to show
earnings growth over time that is well above the growth rate of the overall
economy and the rate of inflation. In addition, the Subadviser generally expects
these companies to have the products, technologies, management and market and
other opportunities that are usually necessary to become more widely recognized
as growth companies. Emerging growth companies can be of any size, and MFS
Emerging Equities may invest in larger or more established companies whose rates
of earnings growth are expected to accelerate because of special factors, such
as rejuvenated management, new products, changes in consumer demand, or basic
changes in the economic environment.
The nature of investing in emerging growth companies involves greater risk than
is customarily associated with investments in more established companies.
Emerging growth companies often have limited product lines, markets or other
financial resources, and they may be dependent on one-person management. In
addition, there may be less research available on many promising small- and
medium-sized emerging growth companies, making it more difficult to find and
analyze these companies. Securities issued by emerging growth companies may have
limited marketability and may be subject to more abrupt or erratic market
movements than securities of larger, more established growth companies or the
market averages in general. Shares of MFS Emerging Equities are therefore
subject to greater fluctuation in value than shares of a conservative equity
fund or of a growth fund that invests primarily in proven growth stocks.
When the Subadviser determines that other investments appear attractive, MFS
Emerging Equities may, to a limited extent, invest in other types of securities,
including investment grade fixed-income securities and
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high-yield, below investment grade fixed-income securities ("below investment
grade fixed-income securities"), or unrated fixed-income securities of
comparable quality; convertible securities and warrants. (For a description of
bond ratings, see the Statement, Appendix A.) MFS Emerging Equities may hold
cash equivalents or other forms of debt securities as a reserve for future
purchases of common stock or to meet liquidity needs.
MFS Emerging Equities may engage in strategic transactions, which may include
the use of derivatives. See "Investment Policies and Practices" and "Risk
Factors and Other Considerations."
Massachusetts Financial Services Company ("MFS") serves as the Subadviser of MFS
Emerging Equities and is responsible for its day-to-day management, subject to
the oversight of Aetna and the Fund's Board of Directors.
See "Management of the Portfolios."
MFS RESEARCH GROWTH PORTFOLIO
INVESTMENT OBJECTIVE. The MFS Research Growth Portfolio ("MFS Research Growth")
seeks long-term growth of capital and future income.
INVESTMENT POLICIES. Under normal market conditions, MFS Research Growth invests
primarily in common stocks or securities convertible into common stocks issued
by companies that the Subadviser believes to possess better-than-average
prospects for long-term growth. MFS Research Growth may invest a smaller
proportion of its assets in fixed-income securities such as bonds and short-term
debt obligations, preferred stocks or common stocks whose principal
characteristic is income production rather than growth. In the case of both
growth stocks and income issues, the Subadviser emphasizes securities issued by
progressive, well-managed companies.
MFS Research Growth may invest in investment grade fixed-income securities and
in below investment grade fixed-income securities, or unrated fixed-income
securities of comparable quality. In making investment decisions, the Subadviser
does not rely exclusively on ratings on fixed-income securities provided by
established rating agencies, but rather supplements those ratings with its own
independent and ongoing review of credit quality. Therefore, the ability of MFS
Research Growth to achieve its investment objective may be more dependent on its
Subadviser's own credit analysis than a fund that invests primarily in
higher-quality bonds. The Subadviser allocates a proportion of assets invested
in growth stocks, income-producing securities or cash (including foreign
currency) and cash equivalents, depending on its view of the relative
attractiveness of each type of investment.
MFS serves as the Subadviser of MFS Research Growth and is responsible for its
day-to-day management, subject to the oversight of Aetna and the Fund's Board of
Directors. See "Management of the Portfolios."
MFS VALUE EQUITY PORTFOLIO
INVESTMENT OBJECTIVE. The MFS Value Equity Portfolio ("MFS Value Equity") seeks
capital appreciation. Dividend income, if any, is a consideration incidental to
MFS Value Equity's objective of capital appreciation.
INVESTMENT POLICIES. Under normal market conditions, MFS Value Equity invests
primarily in common stocks (which may be issued by domestic or foreign
companies), and may seek appreciation by investing in other types of securities,
including fixed-income securities, convertible bonds, convertible preferred
stocks and warrants, when relative values make such purchases appear attractive
either as individual issues or as types of securities in certain economic
environments. MFS Value Equity may invest in investment grade fixed-income
securities and below investment grade fixed-income securities or unrated
securities of comparable quality. These may include zero coupon bonds, deferred
interest bonds and bonds
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on which the interest is payable in kind ("PIK bonds"). MFS Value Equity may
hold cash equivalents or other forms of debt securities as a reserve for future
purchases of common stock or to meet liquidity needs.
MFS Value Equity may engage in strategic transactions, which may include the use
of derivatives. See "Investment Policies and Practices" and "Risk Factors and
Other Considerations."
MFS serves as the Subadviser of MFS Value Equity and is responsible for its
day-to-day management, subject to the oversight of Aetna and the Fund's Board of
Directors. See "Management of the Portfolios."
SCUDDER INTERNATIONAL GROWTH PORTFOLIO
INVESTMENT OBJECTIVE. The Scudder International Growth Portfolio ("Scudder
International Growth") seeks long-term growth of capital primarily through a
diversified portfolio of marketable foreign equity securities.
INVESTMENT POLICIES. Under normal market conditions, Scudder International
Growth invests primarily in securities that, in the opinion of its Subadviser,
allow it to participate in non-U.S. companies and economies with prospects for
growth. Scudder International Growth invests in securities issued by companies,
wherever organized, that do business primarily outside the U.S., including
emerging market countries. Scudder International Growth intends to diversify
investments among several countries and to have represented, in substantial
proportions, business activities in not less than three countries.
Scudder International Growth generally invests in equity securities issued by
established companies listed on foreign exchanges that the Subadviser believes
have favorable characteristics. When the Subadviser believes that it is
appropriate in order to achieve long-term capital growth, Scudder International
Growth may invest in fixed-income securities of foreign governments,
supranational organizations and private issuers, including bonds denominated in
the European Currency Unit ("ECU"). The Subadviser will select fixed-income
securities on the basis of, among other things, yield, credit quality, and the
fundamental outlook for currency and interest rate trends in different parts of
the globe, taking into account the ability to hedge a degree of currency or
local bond price risk. Scudder International Growth may invest in investment
grade fixed-income securities and below investment grade fixed-income
securities, or unrated securities of comparable quality. Scudder International
Growth may hold cash equivalents or other forms of debt securities as a reserve
for future purchases of common stock or to meet liquidity needs.
When the Subadviser determines that exceptional conditions exist abroad, Scudder
International Growth may, for temporary defensive purposes, invest all or a
portion of its assets in Canadian or U.S. Government obligations or currencies,
or securities of companies incorporated in and having their principal activities
in Canada or the U.S. In addition, Scudder International Growth may engage in
strategic transactions, which may include the use of derivatives. See
"Investment Policies and Practices" and "Risk Factors and Other Considerations."
Scudder, Stevens & Clark, Inc. ("Scudder") serves as the Subadviser of Scudder
International Growth and is responsible for its day-to-day management, subject
to the oversight of Aetna and the Fund's Board of Directors. See "Management of
the Portfolios."
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T. ROWE PRICE GROWTH EQUITY PORTFOLIO
INVESTMENT OBJECTIVE. The T. Rowe Price Growth Equity Portfolio ("T. Rowe Price
Growth Equity") seeks long-term growth of capital and, secondarily, to increase
dividend income by investing primarily in common stocks of well established
growth companies.
INVESTMENT POLICIES. Under normal market conditions, T. Rowe Price Growth Equity
invests primarily in common stocks issued by a diversified group of growth
companies. The companies in which T. Rowe Price Growth Equity invests normally
(but not always) pay dividends, which are generally expected to rise in future
years as earnings increase. Most of its assets will be invested in U.S. common
stocks. However, T. Rowe Price Growth Equity may invest in foreign securities
and convertible securities and warrants, when the Subadviser considers such
investments consistent with the Portfolio's investment objective and policies.
T. Rowe Price Growth Equity generally seeks to invest in securities of companies
that satisfy one or more of several criteria established by the Subadviser. For
example, the Subadviser generally seeks companies with superior growth in
earnings and cash flow; the ability to sustain earnings momentum even during
economic slowdowns by operating in so-called "fertile fields" (areas where
earnings and dividends can outpace inflation and the overall economy); and the
capability to expand even during times of slow growth. The Subadviser generally
favors companies whose profits increase due to economic factors rather than
one-time events such as lower taxes.
T. Rowe Price Growth Equity may engage in strategic transactions, which may
include the use of derivatives. See "Investment Policies and Practices" and
"Risk Factors and Other Considerations."
T. Rowe Price Associates, Inc. ("T. Rowe Price") serves as the Subadviser of T.
Rowe Price Growth Equity and is responsible for its day-to-day management,
subject to the oversight of Aetna and the Fund's Board of Directors. See
"Management of the Portfolios."
INVESTMENT POLICIES AND PRACTICES
The Portfolios are managed in accordance with the following investment policies
and practices. See "Risk Considerations" and the Statement for a description of
the risks that these policies and practices may involve.
Investment Policies Generally: When a Portfolio invests "primarily" in
particular securities, it will invest at least 65% of its total assets in those
securities (80% in the case of MFS Emerging Equities).
Repurchase Agreements: Each Portfolio may enter into repurchase agreements in
order to earn income on available cash or as a temporary defensive measure.
Under a repurchase agreement, a Portfolio acquires securities subject to the
seller's agreement to repurchase them at a specified time and price. If the
seller becomes subject to a proceeding under the bankruptcy laws or its assets
are otherwise subject to a stay order, a Portfolio's right to liquidate the
securities may be restricted (during which time the value of the securities
could decline). As discussed in the Statement, the Fund has adopted certain
procedures that are intended to minimize this risk.
Restricted Securities: Each Portfolio may also purchase securities that are not
registered under the Securities Act of 1933 (the "1933 Act") ("restricted
securities"), including those that can be offered and sold to "qualified
institutional buyers" under Rule 144A under the 1933 Act ("Rule 144A
securities"). Under a policy established by the Board of Directors, the
Subadvisers periodically review the trading markets for the
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specific Rule 144A security and determine whether the security is liquid.
Subject to each Portfolio's respective limitation on investments in illiquid
investments, a Portfolio may also invest in restricted securities that may not
be sold under Rule 144A, which presents certain risks.
Limit: A Portfolio will not invest more than 15% of its net assets in securities
that are deemed to be illiquid.
When-Issued Securities: In order to help ensure the availability of suitable
securities, each Portfolio may purchase securities on a "when-issued" or on a
"forward delivery" basis, which means that the obligations will be delivered to
a Portfolio at a future date, usually beyond customary settlement time. It is
expected that, under normal circumstances, a Portfolio will take delivery of
such securities. In general, a Portfolio does not pay for the securities until
received and does not start earning interest on the obligations until the
contractual settlement date. For a further discussion, see the Statement.
Investments for Temporary Defensive Purposes: During periods of unusual market
conditions when a Subadviser believes that investing for temporary defensive
purposes is appropriate, or in order to meet anticipated redemption requests, a
Portfolio may invest up to 100% of its assets in cash or cash equivalents
including, but not limited to, obligations of banks with assets of $1 billion or
more (including certificates of deposit, bankers' acceptances and repurchase
agreements), commercial paper, short-term notes, obligations issued or
guaranteed by the U.S. Government or any of its agencies, authorities or
instrumentalities and related repurchase agreements. See the Statement for a
description of U.S. Government obligations and certain short-term investments.
Corporate Asset-Backed Securities: MFS Emerging Equities and Scudder
International Growth may invest in corporate asset-backed securities. These
securities, issued by trusts and special purpose corporations, are backed by a
pool of assets, such as credit card or automobile loan receivables, representing
the obligations of a number of different parties. Corporate asset-backed
securities present certain risks. For instance, in the case of credit card
receivables, these securities may not have the benefit of any security interest
in the related collateral. See the Statement for further information about these
securities.
Limit: Neither MFS Emerging Equities nor Scudder International Growth will
invest more than 20% of its total assets at the time of purchase in corporate
asset-backed securities.
Investment Grade Fixed-Income Securities: MFS Emerging Equities, MFS Value
Equity, MFS Research Growth and Scudder International Growth may invest in
"investment grade" fixed-income securities. Investment grade fixed-income
securities are rated Baa or better by Moody's Investors Service, Inc.
("Moody's") or BBB or better by Standard and Poor's Rating Services ("S&P") or
Fitch Investors Service, Inc. ("Fitch"), or, if unrated, are of comparable
quality. See "Risk Factors and Other Considerations."
High-Yield, Below Investment Grade Fixed-Income Securities: MFS Emerging
Equities, MFS Research Growth, MFS Value Equity and Scudder International Growth
may invest in below investment grade fixed-income securities. These securities,
rated lower than Baa by Moody's or BBB by S&P or Fitch, or, if unrated, of
comparable quality, are considered speculative.
Limit: The maximum percentage of its total assets that a Portfolio may invest in
below investment grade fixed-income securities, measured at the time of
purchase, is as follows: MFS Emerging Equities: 5%; MFS Value Equity: 25%; MFS
Research Growth: 10%; Scudder International Growth: 5%.
Foreign Securities: Each Portfolio may invest in securities issued by foreign
companies or governments, and in American Depository Receipts ("ADRs") and
similar securities.
Limit: The limits on Portfolio investment in foreign securities are as follows:
Scudder International Growth: 100% of assets may be invested in foreign
securities (including emerging market securities and
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Brady Bonds); MFS Value Equity: 50% of net assets may be invested in foreign
securities (including emerging market securities and Brady Bonds), although it
generally expects to invest between 10% and 25% of net assets; MFS Emerging
Equities: 25% of net assets may be invested in foreign securities (including
emerging market securities and Brady Bonds), although it generally expects to
invest up to 15% of net assets; MFS Research Growth: 20% of net assets may be
invested in foreign securities (including emerging market securities); T. Rowe
Price Growth Equity: 30% of total assets (excluding reserves) may be invested in
foreign securities (including emerging market securities). ADRs are included
within these limits with respect to T. Rowe Price Growth Equity, but not for the
other Portfolios.
Foreign Currencies: Each Portfolio may hold foreign currency received in
connection with investments in foreign securities when, in the judgment of its
Subadviser, it would be beneficial to convert such currency into U.S. dollars at
a later date, based on anticipated changes in the relevant exchange rate. Each
Portfolio may also hold foreign currency in anticipation of purchasing foreign
securities. See "Risk Factors and Other Considerations."
Brady Bonds: MFS Value Equity, MFS Emerging Equities and Scudder International
Growth may invest in Brady Bonds, which are securities created through the
exchange of existing commercial bank loans to public and private entities in
certain emerging markets for new bonds in connection with debt restructurings
under a debt restructuring plan introduced by former U.S. Secretary of the
Treasury Nicholas F. Brady (the "Brady Plan"). Brady Bonds have been issued only
recently, and for that reason do not have a long payment history. Brady Bonds
may be collateralized or uncollateralized, are issued in various currencies (but
primarily in the U.S. dollar), and are actively traded in over-the-counter
secondary markets. U.S. dollar-denominated, Brady Bonds, which may be fixed-rate
bonds or floating-rate bonds, are generally collateralized in full as to
principal by U.S. Treasury zero coupon bonds having the same maturity as the
bonds. Investments in Brady Bonds may be viewed as speculative.
Emerging Market Securities: MFS Emerging Equities, MFS Research Growth, MFS
Value Equity and Scudder International Growth may invest in securities of
issuers whose principal activities are located in emerging market countries.
Emerging market countries include any country determined by a Subadviser to have
an emerging market economy, taking into account a number of factors, including
whether the country has a low- to middle-income economy according to the
International Bank for Reconstruction and Development, the country's foreign
currency debt rating, its political and economic stability and the development
of its financial and capital markets. See "Risk Factors and Other
Considerations."
American Depository Receipts: Each Portfolio may invest in ADRs, which are
certificates issued by a U.S. depository (usually a bank) and represent a
specified quantity of shares of an underlying non-U.S. stock on deposit with a
custodian bank as collateral. ADRs are subject to many of the risks of foreign
securities such as exchange rates and more limited information about foreign
issuers. See "Risk Factors and Other Considerations."
Strategic Transactions and Derivatives: Certain Portfolios may, but are not
required to, utilize various investment strategies involving the use of
"derivative instruments" described below. A Portfolio may utilize a strategic
transaction for one or more reasons, including:
[BULLET] to hedge various market risks (such as interest rates,
currency exchange rates, and broad or specific equity or
fixed-income market movements);
[BULLET] to manage the effective maturity or duration of fixed-income
securities;
[BULLET] to establish a position in the derivatives market as a
temporary substitute for purchasing or selling a particular
security or index; or
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[BULLET] to enhance potential gain.
Derivatives are instruments whose value is derived from, or linked to, the value
of another source, typically a commodity, a security, an index, or some other
readily measurable economic variable. These strategies are generally accepted as
part of modern portfolio management and are utilized by many mutual funds and
portfolio managers.
A Portfolio may use any or all of these investment techniques at any time and in
any combination, and there is no particular strategy that dictates the use of
one technique rather than another, or none at all. The ability of a Portfolio to
utilize these transactions successfully will depend on the Subadviser's ability
to predict pertinent market movements, which cannot be assured. Strategic
transactions involve certain risks. See "Risk Factors and Other Considerations."
These strategic transactions are briefly described below and are described in
greater detail in the Statement.
Limit: Unless otherwise noted, a Portfolio may only commit up to 5% of its total
assets, measured at the time of purchase, for initial margin requirements or
premiums to engage in strategic transactions, although MFS Emerging Equities,
MFS Value Equity, Scudder International Growth and T. Rowe Price Growth Equity
are subject to this limit only when they engage in strategic transactions for
non-hedging purposes (that is, for speculation to increase its income rather
than to hedge against adverse price movements). To prevent "leverage," a
Portfolio will, consistent with applicable regulatory requirements, either
"cover" its strategic transaction or segregate liquid assets equal in value to
the exposure created by the transaction.
Options on Securities, Indices and Other Financial Instruments: MFS Emerging
Equities, MFS Value Equity, Scudder International Growth and T. Rowe Price
Growth Equity may purchase and sell exchange-listed and over-the-counter put and
call options on securities, equity and fixed-income indices and other financial
instruments, including foreign currencies. MFS Emerging Equities, MFS Value
Equity and Scudder International Growth may write (sell) calls on securities
only if such calls are covered. Scudder International Growth may sell options on
securities indices only to close out open positions. A Portfolio may also sell
combinations of put and call options on the same security, known as "straddles."
When a Portfolio buys an option, it pays a premium for the right, not the
obligation, to buy or sell a security or index within a certain time at a
certain price. The Portfolio's losses will be limited to the premium it pays for
the option. When a Portfolio sells a call option, it earns a premium and it is
obligated (if the option is exercised) to sell a security or index within a
certain time at a certain price, without regard to current market price. When a
Portfolio sells a put option, it earns a premium and it is obligated (if the
option is exercised) to buy the security or index within a certain time at a
certain price, without regard to current market price.
In certain instances, a Portfolio may enter into options on Treasury securities
which may be referred to as "reset" options or "adjustable strike" options.
These options provide for periodic adjustment of the strike price and may also
provide for the periodic adjustment of the premium during the term of the
option.
Limit: MFS Emerging Equities, MFS Value Equity and T. Rowe Price Growth Equity
will not purchase put and call options if as a result more than 5% of their
total assets would be invested in premiums for those options.
Futures Contracts and Options on Futures Contracts: MFS Emerging Equities, MFS
Value Equity, Scudder International Growth, and T. Rowe Price Growth Equity may
buy and sell futures contracts on indices and financial instruments. When a
Portfolio enters into a futures contract, it becomes obligated to buy or sell an
asset in the future at an agreed-upon price. The Portfolio will pay initial
margin deposits, which usually are small in relation to the size of the value of
the underlying assets. Each of these Portfolios may also buy and sell options on
futures contracts. Options on futures contracts are similar to options on
securities and indices, described above. These Portfolios may engage in "cross
hedges," that is, hedge a
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particular index or currency as a substitute for another index or currency. For
more information about futures contracts and related options, see "Risk Factors
and Other Considerations" and the Statement.
Limit: MFS Emerging Equities and MFS Value Equity will not enter into a futures
contract if, immediately thereafter, the value of the securities and other
obligations underlying all futures contracts exceeds 50% of their total assets.
Scudder International Growth will invest in futures contracts only for hedging
purposes.
Swaps and Related Transactions: Scudder International Growth may, without limit,
enter into various interest rate transactions, including swaps, caps, floors or
collars, and may enter into currency swaps. Generally, swaps are customized
agreements between two parties to exchange or swap cash flows or assets at
specified intervals in the future.
Hybrid Instruments: T. Rowe Price Growth Equity and MFS Value Equity may enter
into transactions involving hybrid instruments. Hybrid instruments are
derivative instruments whose value is derived from, or linked to, the value of
another source, typically a commodity, a futures contract, an index, or some
other readily measurable economic variable. Issued by banks, brokerage firms,
insurance companies, financial institutions or producers of commodities, hybrid
instruments typically are short- to intermediate-term fixed income securities
that bear interest at below-market or nominal rates. The instrument's value at
maturity, or the interest payable by the issuer, may rise or fall according to
the change in the value of the underlying instrument or index. See "Risk Factors
and Other Considerations."
Limit: Neither T. Rowe Price Growth Equity nor MFS Value Equity will invest more
than 10% of its total assets, measured at the time of purchase, in hybrid
instruments.
RISK FACTORS AND OTHER CONSIDERATIONS
General Considerations: Shares of a Portfolio represent an investment in
securities with fluctuating market prices. Thus, the value of those shares will
vary over time as the aggregate value of the securities held by a Portfolio
increases or decreases. Moreover, any dividends a Portfolio pays will increase
or decrease in relation to the income received from its investments.
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). Some of the risks
involved in the securities acquired by the 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 Portfolios do not purchase securities
with the intention of profiting from short-term trading, each Portfolio may buy
and sell securities when the 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%. Such turnover rates 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.
Hybrid Instruments: These derivative instruments, which can combine the
characteristics of securities, futures, and options, may be particularly
volatile. Under certain conditions, the redemption value of such an investment
could be zero. Some hybrid instruments in which T. Rowe Price Growth Equity or
MFS Value
<PAGE>
Equity may invest involve economic leverage, which would increase the
Portfolio's exposure to a commodity, futures contract or index. Some hybrid
instruments have principal protection, while others may have partial principal
protection or none at all. An instrument with full principal protection will pay
the stated principal amount upon maturity. Partially protected instruments may
lose a portion of their principal upon maturity if the underlying commodity,
index or contract to which it is linked declines in value, and a hybrid
instrument without principal protection may lose all its value upon maturity.
Fixed-Income Securities: The net asset value of the shares of an open-end
investment company which may invest to a limited extent in fixed income
securities changes as the general level of interest rates fluctuate. When
interest rates decline, the value of a fixed income portfolio can be expected to
rise. Conversely, when interest rates rise, the value of a fixed income
portfolio can be expected to decline.
High-Yield, Below Investment Grade Fixed-Income Securities: Investments in below
investment grade fixed-income securities, while generally providing greater
income and opportunity for gain than investments in higher-rated securities,
usually entail greater risks. These risks include lack of liquidity; an
unpredictable secondary market; a greater likelihood of default; increased
sensitivity to adverse economic or corporate developments and thus greater price
fluctuation; call provisions that may adversely affect returns; and loss of
principal and interest. Because yields may vary over time, no specified level of
income can ever be assured. Below investment grade fixed-income securities,
which are usually rated lower than Baa by Moody's or BBB by S&P or by Fitch, or,
if unrated, of comparable quality, are considered speculative. For a description
of these and other rating categories, see the Statement.
Options, Futures Contracts and Forward Contracts: Transactions in futures
contracts, options on futures contracts, forward contracts and options involve
certain risks. For example, a lack of correlation between the index or
instrument underlying an option, futures contract or forward contract and the
assets being hedged, or unexpected adverse price movements, could render a
Portfolio's hedging strategy unsuccessful and could result in losses. "Cross
hedging" transactions may involve greater correlation risks. In addition, there
can be no assurance that a liquid secondary market will exist for any contract
purchased or sold, and the Portfolio may be required to maintain a position
until exercise or expiration, which could result in losses. For more information
about these risks, see the Statement.
Foreign Securities: Investing in securities of foreign issuers generally
involves risks not ordinarily associated with investing in securities of
domestic issuers. These include changes in currency rates, exchange control
regulations, governmental administration or economic or monetary policy (in the
United States or abroad) or circumstances in dealings between nations. Costs may
be incurred in connection with conversions between various currencies. Special
considerations may also include more limited information about foreign issuers,
higher brokerage and custodial costs, different accounting standards and thinner
trading markets. Foreign securities markets may also be less liquid, more
volatile and less subject to government supervision than those in the United
States. Investments in foreign countries could be affected by other factors
including expropriation, confiscatory taxation and potential difficulties in
enforcing contractual obligations and could be subject to extended settlement
periods. For more information about the risks involved in foreign securities,
see the Statement.
<PAGE>
Emerging Market Securities: The risks of investing in foreign securities may be
intensified in the case of investments in emerging markets. Securities of many
issuers in emerging markets may be less liquid and more volatile than securities
of comparable domestic issuers. Emerging markets also have different clearance
and settlement procedures, and in certain markets there have been times when
settlements have been unable to keep pace with the volume of securities
transactions, making it difficult to conduct such transactions. Investment in
certain foreign emerging market debt obligations may be restricted or controlled
to varying degrees. These restrictions or controls may at times preclude
investment in certain foreign emerging market debt obligations or increase the
expenses of a Portfolio.
INVESTMENT RESTRICTIONS
In addition to the restrictions discussed under "Investment Policies and
Practices," each Portfolio has adopted other investment restrictions and
limitations, which are described in the Statement. Some of these restrictions
are fundamental, which means that they cannot be changed without shareholder
approval. For example, each Portfolio may not invest more than 25% of its assets
in securities of companies engaged in the same industry (other than U.S.
Government securities). Each Portfolio may borrow money, but not for leverage
purposes. As a matter of non-fundamental policy, no Portfolio may invest more
than 15% of its net assets in securities that are not readily marketable and in
repurchase agreements that mature in more than seven days.
In addition, each Portfolio is "diversified." Generally, this means that with
respect to 75% of its total assets, a Portfolio may not purchase the securities
of any single issuer (other than securities issued or guaranteed by the U.S.
government or any of its agencies or instrumentalities) if, as a result, (a)
more than 5% of the Portfolio's total assets would be invested in the securities
of that issuer, or (b) the Portfolio would hold more than 10% of the outstanding
voting securities of that issuer.
MANAGEMENT OF THE PORTFOLIOS
DIRECTORS. The operations of each Portfolio are managed under the direction of
the Board of Directors ("Directors"). The Directors set broad policies for the
Fund and each Portfolio. Information about the Directors is found in the
Statement.
INVESTMENT ADVISER. Aetna serves as the investment adviser for each of the
Portfolios. Aetna is a Connecticut insurance corporation with its principal
offices at 151 Farmington Avenue, Hartford, Connecticut 06156, and is registered
with the Securities and Exchange Commission as an investment adviser. As of June
30, 1997, Aetna managed over $34.6 billion in assets. 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 the
responsibility for day-to-day management of the investments of each Portfolio,
subject to Aetna's oversight. Aetna receives a monthly fee from each Portfolio
at an annual rate based on the average daily net assets of each Portfolio as
follows:
<PAGE>
Portfolio Fee
--------- ---
MFS Emerging Equities 0.70% on the first $500 million of
average daily net assets; 0.65% on
assets over $500 million
MFS Research Growth 0.70% on the first $500 million of
average daily net assets; 0.65% on
assets over $500 million
MFS Value Equity 0.65% of average daily net assets
Scudder International Growth 0.80% of average daily net assets
T. Rowe Price Growth Equity 0.60% of average daily net assets
Under the Investment Advisory Agreement, Aetna is responsible for all of its own
costs, including costs of Aetna's personnel, required to carry out its
investment advisory duties.
SUBADVISERS. MFS Emerging Equities, MFS Research Growth and MFS Value Equity.
Aetna has engaged Massachusetts Financial Services Company ("MFS"), 500 Boylston
Street, Boston, Massachusetts 02116, as Subadviser to MFS Emerging Equities, MFS
Research Growth and MFS Value Equity. MFS is a subsidiary of Sun Life of Canada
(U.S.), which is a subsidiary of Sun Life of Canada (U.S.) Holdings, Inc., which
in turn is a wholly owned subsidiary of Sun Life Assurance Company of Canada.
Net assets under management of the MFS Organization were approximately $60.9
billion as of June 30, 1997. John W. Ballen, a Senior Vice President of MFS, is
portfolio manager of MFS Emerging Equities. Mr. Ballen has been employed as a
portfolio manager by MFS since 1984. Portfolio securities of MFS Research Growth
are selected by a committee of investment research analysts. This committee
includes investment analysts employed not only by MFS but also by MFS
International (U.K.) Limited, a wholly owned subsidiary of MFS. MFS Research
Growth's assets are allocated among industries by the analysts acting together
as a group. Individual analysts are then responsible for selecting what they
view as the securities best suited to meet MFS Research Growth's investment
objective within their assigned industry responsibility. John F. Brennan, Jr., a
Vice President of MFS, is portfolio manager of MFS Value Equity. Mr. Brennan has
been employed by MFS as a portfolio manager since 1985.
Scudder International Growth. Aetna has engaged Scudder, Stevens & Clark, Inc.,
a Delaware corporation ("Scudder"), 345 Park Avenue, New York, New York 10154 as
Subadviser to Scudder International Growth. Scudder managed in excess of $125
billion as of June 30, 1997. Scudder International Growth is managed by a team
of Scudder professionals, each of whom plays an important role. Co-lead
Portfolio Managers Carol L. Franklin and Irene T. Cheng joined Scudder in 1981
and 1993, respectively. Ms. Franklin has eighteen years of experience and Ms.
Cheng has twelve years of experience in finance and investing. Nicholas Bratt,
portfolio manager, directs Scudder's overall global equity investment strategies
and has been with Scudder since 1976. Marc Joseph is a senior portfolio manager
for institutional international equity accounts and joined Scudder in 1997.
Sheridan Reilly joined Scudder in 1995 and is a member of Scudder's Global
Equity Group. Mr. Reilly has over ten years of industry experience focusing on
strategies for global portfolios, currency hedging, and foreign equity markets.
Joan Gregory, portfolio manager, focuses on stock selection and has been with
Scudder since 1992. Ms. Gregory has been involved with investment in global and
international stocks as an assistant portfolio manager since 1989.
T. Rowe Price Growth Equity. Aetna has engaged T. Rowe Price Associates, Inc.
("T. Rowe Price"), 100 East Pratt Street, Baltimore, Maryland 21202 as
Subadviser to T. Rowe Price Growth Equity. T. Rowe Price and its affiliates
managed over $3.9 billion as of June 30, 1997. T. Rowe Price Growth Equity is
managed by a committee. The committee chairman, Robert W. Smith, has day-to-day
responsibility for managing T. Rowe Price Growth Equity and works with the
committee in developing and executing its
<PAGE>
investment program. Mr. Smith joined T. Rowe Price in 1992 and has been managing
investments since 1988.
Under separate subadvisory agreements, each Subadviser, subject to the
supervision of Aetna and the Directors, is responsible for managing the assets
of its respective Portfolio(s) in accordance with the Portfolio's investment
objective and policies. Each Subadviser 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 each Subadviser for compliance with applicable laws and
regulations and the respective Portfolio's investment objective.
Each Subadvisory Agreement gives each Subadviser broad latitude in selecting
securities for each Portfolio subject to Aetna's oversight.
Each Subadvisory Agreement provides that Aetna will pay the Subadviser a fee at
an annual rate based on the average daily net asset value of each Portfolio as
described below. Aetna pays the subadvisory fee out of its advisory fee.
MFS Emerging Equities .425% on the first $150 million of
MFS Research Growth aggregate average daily
MFS Value Equity net assets under management
. .40% on the next $150 million
.375% on the next $450 million
.35% on the next $550 million
.30% on the next $200 million
.25% on assets over $1.5 billion
Scudder International Growth .75% on the first $20 million of
average daily net assets
.65% on the next $15 million
.50% on the next $65 million
.40% on the next $200 million
.30% on assets over $300 million
T. Rowe Price Growth Equity .40% on the first $500 million of
average daily net assets
.375% on assets over $500 million
BROKERAGE ALLOCATION. The Investment Advisory Agreement and each Subadvisory
Agreement allow Aetna or the Subadviser, as the case may be, 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
provided to the Adviser/Subadviser, in setting the amount of commissions paid
to a broker. The use of research and expense reimbursements in determining and
paying commissions are referred to as "soft dollar" practices. Aetna and the
Subadviser will engage in soft dollar practices only to the extent authorized
by applicable law.
EXPENSES AND PORTFOLIO 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. As compensation for these services, Aetna receives a
monthly fee from each Portfolio at an annual rate based on the average daily net
assets of each Portfolio as follows:
<PAGE>
Portfolio Fee
--------- ---
MFS Emerging Equities 0.13%
MFS Research Growth 0.15%
MFS Value Equity 0.25%
Scudder International Growth 0.20%
T. Rowe Price Growth Equity 0.15%
CAP ON AGGREGATE FUND FEES AND EXPENSES. Each Portfolio's aggregate expenses are
limited to the advisory and administrative fees disclosed above. Aetna has
agreed to reimburse the Portfolios for expenses and/or waive its fees, so that,
through at least April 30, 1999, the aggregate of each Portfolio's expenses will
not exceed the amounts shown above.
PRINCIPAL UNDERWRITER. Aetna, 151 Farmington Avenue, Hartford, Connecticut
06156, serves as the Fund's principal underwriter.
TRANSFER AGENT. Investors Bank & Trust Company, 200 Clarendon Street, Boston,
Massachusetts 02116, serves as the Fund's Transfer Agent.
CUSTODIAN. Investors Bank & Trust Company also serves as the Fund's custodian.
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 received by the insurance company before 4:00 p.m. will be priced at the
net asset value per share ("NAV") calculated that day, as described below. 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 or under emergency circumstances as determined by the
SEC.
NET ASSET VALUE
The NAV of each Portfolio is determined as of the later of 15 minutes following
the close of the New York Stock Exchange or 4:15 p.m. on each day that the New
York Stock Exchange 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.
<PAGE>
PERFORMANCE
PERFORMANCE OF PORTFOLIOS
From time to time advertisements and other sales materials for the Fund may
include information concerning each Portfolio's historical performance. These
advertisements will also describe the performance of the relevant insurance
company separate accounts. Advertising 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 SEC. 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.
A 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 net asset
value per share can be expected to fluctuate over time and, accordingly, upon
redemption shares may be worth more or less than their original cost.
PERFORMANCE OF SIMILARLY MANAGED MUTUAL FUNDS
Each Portfolio is newly organized and does not yet have its own performance
record. Each Portfolio, however, has substantially the same investment
objective, policies and strategies as one or more existing mutual funds ("other
Mutual Funds") that are either sold directly to the public or through variable
products, advised by MFS, Scudder or T. Rowe Price, as the case may be.
The historical performance of the Funds that are comparable to the Portfolios is
presented below. Investors should not consider the performance of the other
Mutual Funds as an indication of the future performance of a similarly managed
Portfolio. The performance figures shown below reflect the deduction of the
historical fees and expenses paid by each other Mutual Fund, and not those to be
paid by the Portfolio. The figures 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
Portfolios. The results shown below reflect the reinvestment of dividends and
distributions, and were calculated in the same manner that will be used by each
Portfolio to calculate its own performance.
The following table shows average annualized total returns of the other Mutual
Funds for the stated periods ending June 30, 1997, as well as a comparison with
the performance of the applicable benchmark.*
- --------
* The S&P 500 (Standard & Poor's 500) Index is a value-weighted, unmanaged
index of 500 widely held stocks considered to be representative of the stock
market in general. The Russell 2000 Index is a value-weighted, unmanaged
index of small capitalization stocks. Both indices assume reinvestment of
all dividends. The Morgan Stanley Capital International-Europe, Australia,
Far East (MSCI EAFE) Index is an unmanaged, market value-weighted average of
the performance of more than 900 securities listed on the stock exchanges of
countries in Europe, Australia and the Far East.
<PAGE>
<TABLE>
<CAPTION>
One Year Five Year Ten Year
<S> <C> <C> <C>
MFS Emerging Growth Fund (Class A)(1) 13.61 24.27 17.00
(Model for MFS Emerging Equities)(2)
Russell 2000 16.33 17.88 11.16
S&P 500 34.70 19.78 14.65
MFS Research Fund (Class A)(1) 23.59 22.13 14.13
(Model for MFS Research Growth)(3)
S&P 500 34.70 19.78 14.65
MFS Value Fund (Class A)(1) 17.58 21.80 13.50
(Model for MFS Value Equity)(4)
S&P 500 34.70 19.78 14.65
Scudder VLIF International 19.88 13.61 10.38
Portfolio (Model for Scudder
International Growth)
MSCI EAFE 12.84 12.83 6.58
Scudder International Fund 19.83 13.31 9.47
(Model for Scudder International
Growth)
MSCI EAFE 12.84 12.83 6.58
T. Rowe Price Growth Stock Fund 29.79 18.67 12.63
(Model for T. Rowe Price Growth
Equity)
S&P 500 34.70 19.78 14.65
</TABLE>
- --------
(1) Class A share performance includes the performance of the Fund's Class B
shares for periods prior to the commencement of offering of Class A shares
on September 13, 1993, adjusted to include Class A's 5.75% front-end sales
charge, but not adjusted to reflect differences in internal operating
expenses.
(2) MFS also manages another fund with substantially the same investment
objective, policies and strategies as those of Portfolio Partners - MFS
Emerging Equities. The performance of that fund, MFS Variable Insurance
Trust - Emerging Growth Series, was not included in the chart because it has
been in existence only since July 24, 1995, and thus has a much shorter
track record than MFS Emerging Growth Fund (Class A). The performance of MFS
Variable Insurance Trust - Emerging Growth Series for the one-year period
ending June 30, 1997, was 12.68%.
(3) MFS also manages another fund with substantially the same investment
objective, policies and strategies as those of Portfolio Partners - MFS
Research Growth. The performance of that fund, MFS Variable Insurance Trust
- Research Series, was not included in the chart because it has been in
existence only since July 26, 1995, and thus has a much shorter track record
than MFS Emerging Growth Fund (Class A). The performance of MFS Variable
Insurance Trust - Research Series for the one-year period ending June 30,
1997, was 23.98%.
(4) MFS also manages another fund with substantially the same investment
objective, policies and strategies as those of Portfolio Partners - MFS
Value Equity. The performance of that fund, MFS Variable Insurance Trust
Value Series, was not included in the chart because it has been in existence
only since August 14, 1996.
<PAGE>
TAX MATTERS
Each Portfolio intends to qualify as a regulated investment company for federal
income tax purposes by satisfying the requirements under Subchapter M of the
Internal Revenue Code of 1986, as amended (the "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 tax consequences to them of purchasing a contract or
policy.
GENERAL INFORMATION
INCORPORATION. The Fund was incorporated under the laws of Maryland on May 7,
1997.
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 50% of the Fund's outstanding shares, the Fund will hold a shareholder
meeting for the purpose of voting on the removal and replacement 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 a
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.
<PAGE>
STATEMENT OF ADDITIONAL INFORMATION DATED:
August 19, 1997
PORTFOLIO PARTNERS, INC.
151 Farmington Avenue
Hartford, Connecticut 06156-8962
This Statement of Additional Information is not a prospectus but should
be read in conjunction with the current prospectus for Portfolio Partners, Inc.
dated August 19, 1997 (the "Prospectus"). This Statement of Additional
Information is incorporated by reference in its entirety into the Prospectus. A
free Prospectus is available upon request by writing to Portfolio Partners, Inc.
at the address listed above or calling 1-800-525-4225.
READ THE PROSPECTUS BEFORE YOU INVEST.
TABLE OF CONTENTS
PAGE
----
GENERAL INFORMATION AND HISTORY 2
ADDITIONAL INVESTMENT RESTRICTIONS AND POLICIES
OF THE PORTFOLIOS 2
DESCRIPTION OF VARIOUS SECURITIES AND
INVESTMENT POLICIES AND PRACTICES 4
FUTURES CONTRACTS AND OPTIONS ON FUTURES CONTRACTS 15
RISKS ASSOCIATED WITH INVESTING IN OPTIONS,
FUTURES AND FORWARD TRANSACTIONS 19
DIRECTORS AND OFFICERS OF THE FUND 23
CONTROL PERSONS AND PRINCIPAL SHAREHOLDERS 25
THE INVESTMENT ADVISORY AGREEMENT 25
THE SUBADVISORY AGREEMENTS 26
THE ADMINISTRATIVE SERVICES AGREEMENT 26
CUSTODIAN 26
INDEPENDENT AUDITORS 27
PRINCIPAL UNDERWRITER 27
BROKERAGE ALLOCATION AND TRADING POLICIES 27
DESCRIPTION OF SHARES 28
NET ASSET VALUE 28
PERFORMANCE INFORMATION 29
TAX STATUS 29
VOTING RIGHTS 34
FINANCIAL STATEMENTS 34
APPENDIX A 39
<PAGE>
GENERAL INFORMATION AND HISTORY
Portfolio Partners, Inc. (the "Fund") was incorporated in 1997 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 "Portfolios").
The Fund currently has authorized five Portfolios: MFS Emerging Equities
Portfolio ("MFS Emerging Equities"); MFS Research Growth Portfolio ("MFS
Research Growth"); MFS Value Equity Portfolio ("MFS Value Equity"); Scudder
International Growth Portfolio ("Scudder International Growth"); and T. Rowe
Price Growth Equity Portfolio ("T. Rowe Price Growth Equity"). Much of the
information contained in this Statement of Additional Information expands on
subjects discussed in the Prospectus. Capitalized terms not defined herein are
used as defined in the Prospectus.
The investment objective and general investment policies of each
Portfolio are described in the Prospectus.
ADDITIONAL INVESTMENT RESTRICTIONS AND
POLICIES OF THE PORTFOLIOS
The investment policies and restrictions of the Portfolios, set forth
below, are matters of fundamental policy for purposes of the Investment Company
Act of 1940 (the "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, no Portfolio will:
1. Purchase or sell physical commodities unless acquired as a result of
ownership of securities or other instruments (but this shall not prevent a
Portfolio from purchasing or selling options and futures contracts or from
investing in securities or other instruments backed by physical commodities).
2. Purchase or sell real estate unless acquired as a result of ownership of
securities or other instruments (but this shall not prevent a Portfolio from
investing in securities or other instruments backed by real estate or securities
of companies engaged in the real estate business).
3. Issue any senior security (as defined in the 1940 Act), except that (a) a
Portfolio may engage in transactions that may result in the issuance of senior
securities to the extent permitted under applicable regulations and
interpretations of the 1940 Act or an exemptive order; (b) a Portfolio may
acquire other securities, the acquisition of which may result in the issuance of
a senior security, to the extent permitted under applicable regulations or
interpretations of the 1940 Act; and (c) subject to the restrictions set forth
below, a Portfolio may borrow money as authorized by the 1940 Act.
4. Borrow money, except that (a) a Portfolio may enter into commitments to
purchase securities in accordance with its investment program, including
when-issued securities and reverse repurchase agreements, provided that the
total amount of any such borrowing does not exceed 33-1/3% of the Portfolio's
total assets; and (b) a Portfolio may borrow money in an amount not to exceed
33-1/3% of the value of its total assets at the time the loan is made.
5. Lend any security or make any other loan if, as a result, more than 33-1/3%
of its total assets would be lent to other parties, but this limitation does not
apply to purchases of publicly issued debt securities or to repurchase
agreements.
6. Underwrite securities issued by others, except to the extent that a Portfolio
may be considered an underwriter within the meaning of the Securities Act of
1933 (the "1933 Act") in the disposition of restricted securities.
<PAGE>
7. Purchase the securities of an issuer if, as a result, more than 25% of its
total assets would be invested in the securities of companies whose principal
business activities are in the same industry. This limitation does not apply to
securities issued or guaranteed by the U.S. government or any of its agencies or
instrumentalities.
With respect to MFS Emerging Equities, MFS Research Growth and MFS Value Equity
only:
8. No Portfolio will 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 program of the Portfolio.
9. With respect to 100% of its total assets, purchase the securities of any
issuer (other than securities issued or guaranteed by the U.S. Government or any
of its agencies or instrumentalities) if, as a result, (a) more than 5% of the
Portfolio's total assets would be invested in the securities of that issuer, or
(b) the Portfolio would hold more than 10% of the outstanding voting securities
of that issuer.
With respect to Scudder International Growth and T. Rowe Price Growth Equity
only:
10. With respect to 75% of its total assets, purchase the securities of any
issuer (other than securities issued or guaranteed by the U.S. Government or any
of its agencies or instrumentalities) if, as a result, (a) more than 5% of the
Portfolio's total assets would be invested in the securities of that issuer, or
(b) the Portfolio would hold more than 10% of the outstanding voting securities
of that issuer.
The following restrictions are not fundamental and may be changed without
shareholder approval:
a. No Portfolio will invest more than 15% of its net 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 at approximately the price at which a Portfolio has valued them. 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, securities offered pursuant to Section 4(2) of, or securities
otherwise subject to restrictions on resale under, the 1933 Act ("Restricted
Securities"), shall not be deemed illiquid solely by reason of being
unregistered. A Subadviser determines whether a particular security is deemed to
be liquid based on the trading markets for the specific security and other
factors.
b. No Portfolio will borrow for leverage purposes.
c. No Portfolio will make short sales of securities, other than short sales
"against the box." This restriction does not apply to transactions involving
options, futures contracts and related options, and other strategic
transactions.
d. No Portfolio will lend portfolio securities.
With respect to Scudder International Growth and T. Rowe Price Growth Equity
only:
e. No Portfolio will 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 program of the Portfolio.
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General. The limitations listed above supplement those set forth in the
Prospectus. Unless otherwise noted, whenever an investment policy or limitation
states a maximum percentage of a Portfolio's assets that may be invested in any
security or other asset, or sets forth a policy regarding quality standards,
such standard or percentage limitation will be determined immediately after and
as a result of the Portfolio's acquisition of such security or other asset
except in the case of borrowing (or other activities that may be deemed to
result in the issuance of a "senior security" under the 1940 Act). Accordingly,
any subsequent change in values, net assets or other circumstances will not be
considered when determining whether the investment complies with the Portfolio's
investment policies and limitations. If the value of a Portfolio's holdings of
illiquid securities at any time exceeds the percentage limitation applicable at
the time of acquisition due to subsequent fluctuations in value or other
reasons, the Directors will consider what actions, if any, are appropriate to
maintain adequate liquidity.
DESCRIPTION OF VARIOUS SECURITIES AND INVESTMENT POLICIES AND PRACTICES
"WHEN-ISSUED" SECURITIES - Each Portfolio may purchase securities on
a "when-issued" or on a "forward delivery" basis. It is expected that, under
normal circumstances, a Portfolio will take delivery of such securities. When a
Portfolio commits to purchase a security on a "when-issued" or on a "forward
delivery" basis, it will set up procedures consistent with the applicable
interpretations of the Securities and Exchange Commission (the "SEC") concerning
such purchases. Since that policy currently recommends that an amount of a
Portfolio's assets equal to the amount of the purchase be held aside or
segregated to be used to pay for the commitment, a Portfolio will always have
cash, short-term money market instruments or other liquid securities sufficient
to fulfill any commitments or to limit any potential risk. However, although
such purchases will not be made for speculative purposes and SEC policies will
be adhered to, purchases of securities on such bases may involve more risk than
other types of purchases. For example, a Portfolio may have to sell assets which
have been set aside in order to meet redemptions. Also, if a Portfolio
determines it is necessary to sell the "when-issued" or "forward delivery"
securities before delivery, it may incur a loss because of market fluctuations
since the time the commitment to purchase such securities was made. When the
time comes to pay for "when-issued" or "forward delivery" securities, a
Portfolio will meet its obligations from the then-available cash flow on the
sale of securities, or, although it would not normally expect to do so, from the
sale of the "when-issued" or "forward delivery" securities themselves (which may
have a value greater or less than the Portfolio's payment obligation).
CORPORATE ASSET-BACKED SECURITIES - As described in the Prospectus, MFS
Emerging Equities and Scudder International Growth may invest in corporate
asset-backed securities. These securities, issued by trusts and special purpose
corporations, are backed by a pool of assets, such as credit card and automobile
loan receivables, representing the obligations of a number of different parties.
Corporate asset-backed securities present certain risks. For instance,
in the case of credit card receivables, these securities may not have the
benefit of any security interest in the related collateral. Credit card
receivables are generally unsecured and the debtors are entitled to the
protection of a number of state and federal consumer credit laws, many of which
give such debtors the right to set off certain amounts owed on the credit cards,
thereby reducing the balance due. Most issuers of automobile receivables permit
the servicers to retain possession of the underlying obligations. If the
servicer were to sell these obligations to another party, there is a risk that
the purchaser would acquire an interest superior to that of the holders of the
related automobile receivables. In addition, because of the large number of
vehicles involved in a typical issuance and technical requirements under state
laws, the trustee for the holders of the automobile receivables may not have a
proper security interest in all of the obligations backing such receivables.
Therefore, there is the possibility that recoveries on repossessed collateral
may not, in some cases, be available to support payments on these securities.
The underlying assets (e.g., loans) are also subject to prepayments which
shorten the securities' weighted average life and may lower their return.
Corporate asset-backed securities are often backed by a pool of assets
representing the obligations of a number of different parties. To lessen the
effect of failures by obligors on underlying assets to make payments, the
securities may contain elements of credit support which fall into two
categories: (i) liquidity protection and (ii) protection against losses
resulting from ultimate default by an obligor on the underlying assets.
Liquidity protection refers to the provision of advances, generally by the
entity administering the pool of assets, to ensure that the receipt of payments
on the underlying pool occurs in a timely fashion. Protection against losses
resulting from
<PAGE>
ultimate default ensures payment through insurance policies or letters of credit
obtained by the issuer or sponsor from third parties. The Portfolio will not pay
any additional or separate fees for credit support. The degree of credit support
provided for each issue is generally based on historical information respecting
the level of credit risk associated with the underlying assets. Delinquency or
loss in excess of that anticipated or failure of the credit support could
adversely affect the return on an investment in such a security.
REPURCHASE AGREEMENTS - As described in the Prospectus, each of the
Portfolios may enter into repurchase agreements with sellers that are member
firms (or subsidiaries thereof) of the New York Stock Exchange, members of the
Federal Reserve System, recognized primary U.S. Government securities dealers or
institutions which the Subadviser has determined to be of comparable
creditworthiness. The securities that a Portfolio purchases and holds through
its agent are U.S. Government securities, the values, including accrued
interest, of which are equal to or greater than the repurchase price agreed to
be paid by the seller. The repurchase price may be higher than the purchase
price, the difference being income to a Portfolio, or the purchase and
repurchase prices may be same, with interest at a standard rate due to the
Portfolio together with the repurchase price on repurchase. In either case, the
income to a Portfolio is unrelated to the interest rate on the U.S. Government
securities.
The repurchase agreement provides that in the event the seller fails to
pay the price agreed upon on the agreed upon delivery date or upon demand, as
the case may be, a Portfolio will have the right to liquidate the securities.
If, at the time a Portfolio is contractually entitled to exercise its right to
liquidate the securities, the seller is subject to a proceeding under the
bankruptcy laws or its assets are otherwise subject to a stay order, the
Portfolio's exercise of its right to liquidate the securities may be delayed and
result in certain losses and costs to the Portfolio. The Fund has adopted and
follows procedures which are intended to minimize the risks of repurchase
agreements. For example, a Portfolio only enters into repurchase agreements
after its Subadviser has determined that the seller is creditworthy, and the
Subadviser monitors the seller's creditworthiness on an ongoing basis. Moreover,
under such agreements, the value, including accrued interest, of the securities
(which are marked to market every business day) is required to be greater than
the repurchase price, and the Portfolio has the right to make margin calls at
any time if the value of the securities falls below the agreed upon margin.
LOAN PARTICIPATIONS AND OTHER DIRECT INDEBTEDNESS - MFS Emerging
Equities and MFS Value Equity may each invest up to 5% of their total assets in
loans and other direct indebtedness. The highly leveraged nature of many such
loans and other direct indebtedness may make such loans especially vulnerable to
adverse changes in economic or market conditions. Loans and other direct
indebtedness may not be in the form of securities or may be subject to
restrictions on transfer, and only limited opportunities may exist to resell
such instruments. As a result, a Portfolio may be unable to sell such
investments at an opportune time or may have to resell them at less than fair
market value.
In purchasing a loan, a Portfolio acquires some or all of the interest
of a bank or other lending institution in a loan to a corporate borrower. Many
such loans are secured, although some may be unsecured. Such loans may be in
default at the time of purchase. Loans and other direct indebtedness that are
fully secured offer a Portfolio more protection than an unsecured loan in the
event of non-payment of scheduled interest or principal. However, there is no
assurance that the liquidation of collateral from a secured loan or other direct
indebtedness would satisfy the corporate borrower's obligation, or that the
collateral can be liquidated.
These loans and other direct indebtedness are made generally to finance
internal growth, mergers, acquisitions, stock repurchases, leveraged buyouts and
other corporate activities. Such loans and other direct indebtedness loans are
typically made by a syndicate of lending institutions, represented by an agent
lending institution which has negotiated and structured the loan and is
responsible for collecting interest, principal and other amounts due on its own
behalf and on behalf of the others in the syndicate, and for enforcing its and
their other rights against the borrower. Alternatively, such loans and other
direct indebtedness may be structured as a novation, pursuant to which a
Portfolio would assume all of the rights of the lending institution in a loan,
or as an assignment, pursuant to which the Portfolio would purchase an
assignment of a portion of a lender's interest in a loan or other direct
indebtedness either directly from the lender or through an intermediary. A
Portfolio may also purchase trade or other claims against companies, which
generally represent money owed by the company to a supplier of goods or
services. These claims may also be purchased at a time when the company is in
default.
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Certain of the loans and other direct indebtedness acquired by a
Portfolio may involve revolving credit facilities or other standby financing
commitments which obligate the Portfolio to pay additional cash on a certain
date or on demand. These commitments may have the effect of requiring a
Portfolio to increase its investment in a company at a time when the Portfolio
might not otherwise decide to do so (including at a time when the company's
financial condition makes it unlikely that such amounts will be repaid). To the
extent that a Portfolio is committed to advance additional funds, it will at all
times hold and maintain in a segregated account cash or other liquid securities
in an amount sufficient to meet such commitments.
A Portfolio's ability to receive payment of principal, interest and
other amounts due in connection with these investments will depend primarily on
the financial condition of the borrower. In selecting the loans and other direct
indebtedness which a Portfolio will purchase, the Subadviser will rely upon its
own (and not the original lending institution's) credit analysis of the
borrower. As a Portfolio may be required to rely upon another lending
institution to collect and pass on to the Portfolio amounts payable with respect
to the loan and to enforce the Portfolio's rights under the loan and other
direct indebtedness, an insolvency, bankruptcy or reorganization of the lending
institution may delay or prevent the Portfolio from receiving such amounts. In
such cases, a Portfolio will evaluate as well the creditworthiness of the
lending institution and will treat both the borrower and the lending institution
as an "issuer" of the loan for purposes of certain investment restrictions
pertaining to the diversification of the Portfolio's portfolio investments. The
highly leveraged nature of many such loans and other direct indebtedness may
make such loans and other direct indebtedness especially vulnerable to adverse
changes in economic or market conditions. Investments in such loans and other
direct indebtedness may involve additional risk to the Portfolio. For example,
if a loan or other direct indebtedness is foreclosed, the Portfolio could become
part owner of any collateral, and would bear the costs and liabilities
associated with owning and disposing of the collateral. In addition, it is
conceivable that under emerging legal theories of lender liability, the
Portfolio could be held liable. It is unclear whether loans and other forms of
direct indebtedness offer securities law protections against fraud and
misrepresentation. In the absence of definitive regulatory guidance, the
Portfolio relies on the Subadviser's research in an attempt to avoid situations
where fraud and misrepresentation could adversely affect the Portfolio. In
addition, loans and other direct investments may not be in the form of
securities or may be subject to restrictions on transfer, and only limited
opportunities may exist to resell such instruments. As a result, the Portfolio
may be unable to sell such investments at an opportune time or may have to
resell them at less than fair market value. To the extent that the Subadviser
determines that any such investments are illiquid, the Portfolio will include
them in the investment limitations described below.
FOREIGN SECURITIES - The Portfolios may invest in foreign securities
(and foreign currencies) to the extent described in the Prospectus. Investing in
foreign securities generally presents a greater degree of risk than investing in
domestic securities. As a result of its investments in foreign securities, a
Portfolio may receive interest or dividend payments, or the proceeds of the sale
or redemption of such securities, in the foreign currencies in which such
securities are denominated. Under certain circumstances, such as where a
Subadviser believes that the applicable exchange rate is unfavorable at the time
the currencies are received or the Subadviser anticipates, for any other reason,
that the exchange rate will improve, a Portfolio may hold such currencies for an
indefinite period of time. A Portfolio may also hold foreign currency in
anticipation of purchasing foreign securities. While the holding of currencies
will permit the Portfolio to take advantage of favorable movements in the
applicable exchange rate, such strategy also exposes the Portfolio to risk of
loss if exchange rates move in a direction adverse to the Portfolio's position.
Such losses could reduce any profits or increase any losses sustained by a
Portfolio from the sale or redemption of securities and could reduce the dollar
value of interest or dividend payments received.
AMERICAN DEPOSITARY RECEIPTS - Each Portfolio may invest in ADRs, which
are certificates issued by a U.S. depository (usually a bank) that represent a
specified quantity of shares of an underlying non-U.S. stock on deposit with a
custodian bank as collateral. ADRs may be sponsored or unsponsored. A sponsored
ADR is issued by a depository which has an exclusive relationship with the
issuer of the underlying security. An unsponsored ADR may be issued by any
number of U.S. depositories. Under the terms of most sponsored arrangements,
depositories agree to distribute notices of shareholder meetings and voting
instructions, and to provide shareholder communications and other information to
the ADR holders at the request of the issuer of the deposited securities. The
depository of an unsponsored ADR, on the other hand, is under no obligation to
distribute shareholder
<PAGE>
communications received from the issuer of the deposited securities or to pass
through voting rights to ADR holders in respect of the deposited securities. A
Portfolio may invest in either type of ADR. Although the U.S. investor holds a
substitute receipt of ownership rather than direct stock certificates, the use
of the depository receipts in the United States can reduce costs and delays as
well as potential currency exchange and other difficulties. A Portfolio may
purchase securities in local markets and direct delivery of these ordinary
shares to the local depository of an ADR agent bank in the foreign country.
Simultaneously, the ADR agents create a certificate that settles at the
Portfolio's custodian in five days. A Portfolio may also execute trades on the
U.S. markets using existing ADRs. A foreign issuer of the security underlying an
ADR is generally not subject to the same reporting requirements in the United
States as a domestic issuer. Accordingly the information available to a U.S.
investor will be limited to the information the foreign issuer is required to
disclose in its own country and the market value of an ADR may not reflect
undisclosed material information concerning the issuer of the underlying
security. ADRs may also be subject to exchange rate risks if the underlying
foreign securities are traded in foreign currency.
ZERO COUPON, DEFERRED INTEREST AND PIK BONDS - Fixed income securities
that MFS Value Equity may invest in include zero coupon bonds, deferred interest
bonds and bonds on which the interest is payable in kind ("PIK bonds"). Zero
coupon and deferred interest bonds are debt obligations which are issued at a
significant discount from face value. The discount approximates the total amount
of interest the bonds will accrue and compound over the period until maturity or
the first interest payment date at a rate of interest reflecting the market rate
of the security at the time of issuance. While zero coupon bonds do not require
the periodic payment of interest, deferred interest bonds provide for a period
of delay before the regular payment of interest begins. PIK bonds are debt
obligations which provide that the issuer thereof may, at its option, pay
interest on such bonds in cash or in the form of additional debt obligations.
Such investments benefit the issuer by mitigating its need for cash to meet debt
service, but also require a higher rate of return to attract investors who are
willing to defer receipt of such cash. Such investments may experience greater
volatility in market value than debt obligations that make regular payments of
interest. The Portfolio will accrue income on such investments for tax and
accounting purposes, as required, which is distributable to shareholders and
which, because no cash is received at the time of accrual, may require the
liquidation of other portfolio securities to satisfy the Portfolio's
distribution obligations.
RISK OF INVESTING IN LOWER RATED FIXED-INCOME SECURITIES - Certain of
the Portfolios may invest in lower rated fixed-income securities rated Baa by
Moody's Investors Service, Inc. ("Moody's") or BBB by Standard & Poor's Ratings
Service ("S&P") or by Fitch Investors Service, Inc. ("Fitch") and comparable
unrated securities. These securities, while normally exhibiting adequate
protection parameters, have speculative characteristics and changes in economic
conditions or other circumstances are more likely to lead to a weakened capacity
to make principal and interest payments than in the case of higher grade fixed
income securities.
A Portfolio may also invest in high-yield, below investment grade
fixed-income securities, which are rated Ba or lower by Moody's or BB or lower
by S&P or by Fitch, or, if unrated, of comparable quality, to the extent
described in the Prospectus. No minimum rating standard is required by the
Portfolios. These securities are considered speculative and, while generally
providing greater income than investments in higher rated securities, will
involve greater risk of principal and income (including the possibility of
default or bankruptcy of the issuers of such securities) and may involve greater
volatility of price (especially during periods of economic uncertainty or
change) than securities in the higher rating categories and because yields vary
over time, no specific level of income can ever be assured. High-yield, below
investment grade fixed-income securities generally tend to reflect economic
changes (and the outlook for economic growth), short-term corporate and industry
developments and the market's perception of their credit quality (especially
during times of adverse publicity) to a greater extent than higher rated
securities which react primarily to fluctuations in the general level of
interest rates (although these lower rated fixed income securities are also
affected by changes in interest rates). In the past, economic downturns or an
increase in interest rates have, under certain circumstances, caused a higher
incidence of default by the issuers of these securities and may do so in the
future, especially in the case of highly leveraged issuers. The prices for these
securities may be affected by legislative and regulatory developments. The
market for these lower rated fixed income securities may be less liquid than the
market for investment grade fixed income securities. Furthermore, the liquidity
of these lower rated securities may be affected by the market's perception of
their credit quality. Therefore, the Subadviser's judgment may at times play a
greater role in valuing these securities than in the case of investment grade
fixed income securities, and it also may be more difficult during times of
certain adverse market conditions to sell these
<PAGE>
lower rated securities to meet redemption requests or to respond to changes in
the market. For a description of the rating categories described above, see
Appendix A.
While a Subadviser may refer to ratings issued by established credit
rating agencies, it is not the Portfolios' policy to rely exclusively on ratings
issued by these rating agencies, but rather to supplement such ratings with the
Subadviser's own independent and ongoing review of credit quality. To the extent
a Portfolio invests in these lower rated securities, the achievement of its
investment objective may be more dependent on the Subadviser's own credit
analysis than in the case of a fund investing in higher quality fixed income
securities. These lower rated securities may also include zero coupon bonds,
deferred interest bonds and PIK bonds which are described above.
HYBRID INSTRUMENTS - T. Rowe Price Growth Equity and MFS Value Equity
may invest in hybrid instruments. Hybrid instruments (a type of potentially
high-risk derivative) combine the elements of futures contracts or options with
those of debt, preferred equity or a depository instrument (hereinafter "Hybrid
Instruments"). Generally, a Hybrid Instrument will be a debt security, preferred
stock, depository share, trust certificate, certificate of deposit or other
evidence of indebtedness on which a portion of or all interest payments, and/or
the principal or stated amount payable at maturity, redemption or retirement, is
determined by reference to prices, changes in prices, or differences between
prices, of securities, currencies, intangibles, goods, articles or commodities
(collectively "Underlying Assets") or by another objective index, economic
factor or other measure, such as interest rates, currency exchange rates,
commodity indices, and securities indices (collectively "Benchmarks"). Thus,
Hybrid Instruments may take a variety of forms, including, but not limited to,
debt instruments with interest or principal payments or redemption terms
determined by reference to the value of a currency or commodity or securities
index at a future point in time, preferred stock with dividend rates determined
by reference to the value of a currency, or convertible securities with the
conversion terms related to a particular commodity.
Hybrid Instruments can be an efficient means of creating exposure to a
particular market, or segment of a market, with the objective of enhancing total
return. For example, the Portfolio may wish to take advantage of expected
declines in interest rates in several European countries, but avoid the
transaction costs associated with buying and currency-hedging the foreign bond
positions. One solution would be to purchase a U.S. dollar-denominated Hybrid
Instrument whose redemption price is linked to the average three year interest
rate in a designated group of countries. The redemption price formula would
provide for payoffs of greater than par if the average interest rate was lower
than a specified level, and payoffs of less than par if rates were above the
specified level. Furthermore, the Portfolio could limit the downside risk of the
security by establishing a minimum redemption price so that the principal paid
at maturity could not be below a predetermined minimum level if interest rates
were to rise significantly. The purpose of this arrangement, known as a
structured security with an embedded put option, would be to give the Portfolio
the desired European bond exposure while avoiding currency risk, limiting
downside market risk, and lowering transactions costs. Of course, there is no
guarantee that the strategy would be successful and the Portfolio could lose
money if, for example, interest rates do not move as anticipated or credit
problems develop with the issuer of the Hybrid Instrument.
The risks of investing in Hybrid Instruments reflect a combination of
the risks of investing in securities, options, futures and currencies. Thus, an
investment in a Hybrid Instrument may entail significant risks that are not
associated with a similar investment in a traditional debt instrument that has a
fixed principal amount, is denominated in U.S. dollars or bears interest either
at a fixed rate or a floating rate determined by reference to a common,
nationally published Benchmark. The risks of a particular Hybrid Instrument
will, of course, depend upon the terms of the instrument, but may include,
without limitation, the possibility of significant changes in the Benchmarks or
the prices of Underlying Assets to which the instrument is linked. Such risks
generally depend upon factors which are unrelated to the operations or credit
quality of the issuer of the Hybrid Instrument and which may not be readily
foreseen by the purchaser, such as economic and political events, the supply and
demand for the Underlying Assets and interest rate movements. In recent years,
various Benchmarks and prices for Underlying Assets have been highly volatile,
and such volatility may be expected in the future. Reference is also made to the
discussion of futures, options, and forward contracts herein for a discussion of
the risks associated with such investments.
Hybrid Instruments are potentially more volatile and carry greater
market risks than traditional debt instruments. Depending on the structure of
the particular Hybrid Instrument, changes in a Benchmark may be
<PAGE>
magnified by the terms of the Hybrid Instrument and have an even more dramatic
and substantial effect upon the value of the Hybrid Instrument. Also, the prices
of the Hybrid Instrument and the Benchmark or Underlying Asset may not move in
the same direction or at the same time.
Hybrid Instruments may bear interest or pay preferred dividends at
below market (or even relatively nominal) rates. Alternatively, Hybrid
Instruments may bear interest at above market rates but bear an increased risk
of principal loss (or gain). The latter scenario may result if "leverage" is
used to structure the Hybrid Instrument. Leverage risk occurs when the Hybrid
Instrument is structured so that a given change in a Benchmark or Underlying
Asset is multiplied to produce a greater value change in the Hybrid Instrument,
thereby magnifying the risk of loss as well as the potential for gain.
Hybrid Instruments may also carry liquidity risk since the instruments
are often "customized" to meet the portfolio needs of a particular investor, and
therefore, the number of investors that are willing and able to buy such
instruments in the secondary market may be smaller than that for more
traditional debt securities. In addition, because the purchase and sale of
Hybrid Instruments could take place in an over-the-counter market without the
guarantee of a central clearing organization or in a transaction between the
Portfolio and the issuer of the Hybrid Instrument, the creditworthiness of the
counterparty or issuer of the Hybrid Instrument would be an additional risk
factor which the Portfolio would have to consider and monitor. Hybrid
Instruments also may not be subject to regulation of the CFTC, which generally
regulates the trading of commodity futures by U.S. persons, the SEC, which
regulates the offer and sale of securities by and to U.S. persons, or any other
governmental regulatory authority.
The various risks discussed above, particularly the market risk of such
instruments, may in turn cause significant fluctuations in the net asset value
of the Portfolio. Accordingly, each Portfolio will limit its investments in
Hybrid Instruments to 10% of net assets. However, because of their volatility,
it is possible that the Portfolio's investment in Hybrid Instruments will
account for more than 10% of its return (positive or negative).
The performance of indexed securities depends to a great extent on the
performance of the security, currency, or other instrument to which they are
indexed, and may also be influenced by interest rate changes in the U.S. and
abroad. At the same time, indexed securities are subject to the credit risks
associated with the issuer of the security, and their values may decline
substantially if the issuer's creditworthiness deteriorates. Recent issuers of
indexed securities have included banks, corporations, and certain U.S.
government agencies.
SWAPS, CAPS, FLOORS AND COLLARS - Among the transactions into which
Scudder International Growth may enter are interest rate, currency and index
swaps and the purchase or sale of related caps, floors and collars. The
Portfolio expects to enter into these transactions primarily to preserve a
return or spread on a particular investment or portion of its portfolio, to
protect against currency fluctuations, as a duration management technique or to
protect against any increase in the price of securities the Portfolio
anticipates purchasing at a later date. The Portfolio intends to use these
transactions as hedges and not as speculative investments and will not sell
interest rate caps or floors where it does not own securities or other
instruments providing the income stream it may be obligated to pay. Interest
rate swaps involve the exchange by the Portfolio with another party of their
respective commitments to pay or receive interest, e.g., an exchange of floating
rate payments for fixed rate payments with respect to a notional amount of
principal. A currency swap is an agreement to exchange cash flows on a notional
amount of two or more currencies based on the relative value differential among
them and an index swap is an agreement to swap cash flows on a notional amount
based on changes in the values of the reference indices. The purchase of a cap
entitles the purchaser to receive payments on a notional principal amount from
the party selling such cap to the extent that a specified index exceeds a
predetermined interest rate or amount. The purchase of a floor entitles the
purchaser to receive payments on a notional principal amount from the party
selling such floor to the extent that a specified index falls below a
predetermined interest rate or amount. A collar is a combination of a cap and a
floor that preserves a certain return within a predetermined range of interest
rates or values.
The Portfolio will usually enter into swaps on a net basis, i.e., the
two payment streams are netted out in a cash settlement on the payment date or
dates specified in the instrument, with the Portfolio receiving or paying, as
the case may be, only the net amount of the two payments. Inasmuch as these
swaps, caps, floors and collars are entered
<PAGE>
into for good faith hedging purposes, the Subadviser and the Portfolio believe
such obligations do not constitute senior securities under the 1940 Act, and,
accordingly, will not treat them as being subject to its borrowing restrictions.
The Portfolio will not enter into any swap, cap, floor or collar transaction
unless, at the time of entering into such transaction, the unsecured long-term
debt of the counterparty, combined with any credit enhancements, is rated at
least A by S&P or Moody's or has an equivalent rating from a NRSRO or is
determined to be of equivalent credit quality by the Subadviser. If there is a
default by the counterparty, the Portfolio may have contractual remedies
pursuant to the agreements related to the transaction. The swap market has grown
substantially in recent years with a large number of banks and investment
banking firms acting both as principals and as agents utilizing standardized
swap documentation. As a result, the swap market has become relatively liquid.
Caps, floors and collars are more recent innovations for which standardized
documentation has not yet been fully developed and, accordingly, they are less
liquid than swaps.
EURODOLLAR INSTRUMENTS - Scudder International Growth and MFS Value
Equity may make investments in Eurodollar instruments. Eurodollar instruments
are U.S. dollar-denominated futures contracts or options thereon which are
linked to the London Interbank Offered Rate ("LIBOR"), although foreign
currency-denominated instruments are available from time to time. Eurodollar
futures contracts enable purchasers to obtain a fixed rate for the lending of
funds and sellers to obtain a fixed rate for borrowings. Scudder International
Growth might use Eurodollar futures contracts and options thereon to hedge
against changes in LIBOR, to which many interest rate swaps and fixed income
instruments are linked.
OPTIONS ON SECURITIES - As noted in the Prospectus, MFS Emerging
Equities, MFS Value Equity, Scudder International Growth and T. Rowe Price
Growth Equity may purchase and write (sell) call and put options on securities.
A Portfolio may sell options on securities for the purpose of increasing its
return on such securities and/or to protect the value of its Portfolio. MFS
Emerging Equities, MFS Value Equity and Scudder International Growth may only
sell calls on securities if such calls are "covered," as explained below. A
Portfolio may also write combinations of put and call options on the same
security, known as "straddles." Such transactions can generate additional
premium income but also present increased risk.
A Portfolio may also purchase put or call options in anticipation of
market fluctuations which may adversely affect the value of its portfolio or the
prices of securities that the Portfolio wants to purchase at a later date. A
Portfolio may sell call and put options only if it takes certain steps to cover
such options or segregates assets, in accordance with regulatory requirements,
as described below.
A call option sold by a Portfolio is "covered" if the Portfolio owns
the security underlying the call or has an absolute and immediate right to
acquire that security without additional cash consideration (or for additional
cash consideration held in a segregated account by its custodian) upon
conversion or exchange of other securities held in its portfolio. A call option
is considered offset, and thus held in accordance with regulatory requirements,
if a Portfolio holds a call on the same security and in the same principal
amount as the call sold when the exercise price of the call held (a) is equal to
or less than the exercise price of the call sold or (b) is greater than the
exercise price of the call sold if the difference is maintained by the Portfolio
in liquid securities in a segregated account with its custodian. If a put option
is sold by a Portfolio, the Portfolio will maintain liquid securities with a
value equal to the exercise price in a segregated account with its custodian, or
else will hold a put on the same security and in the same principal amount as
the put sold where the exercise price of the put held is equal to or greater
than the exercise price of the put sold or where the exercise price of the put
held is less than the exercise price of the put sold if the Portfolio maintains
in a segregated account with the custodian, liquid securities with an aggregate
value equal to the difference.
Effecting a closing transaction in the case of a sold call option will
permit a Portfolio to sell another call option on the underlying security with
either a different exercise price or expiration date or both, or in the case of
a sold put option will permit the Portfolio to sell another put option to the
extent that the exercise price thereof is secured by liquid securities in a
segregated account. Such transactions permit a Portfolio to generate additional
premium income, which will partially offset declines in the value of portfolio
securities or increases in the cost of securities to be acquired. Also,
effecting a closing transaction will permit the cash or proceeds from the
concurrent sale of any subject to the option to be used for other investments of
a Portfolio, provided that another option on such security is not sold. If the
Portfolio desires to sell a particular security from its portfolio on which it
has sold a call
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option, it will effect a closing transaction in connection with the option prior
to or concurrent with the sale of the security.
A Portfolio will realize a profit from a closing transaction if the
premium paid in connection with the closing of an option sold by the Portfolio
is less than the premium received from selling the option, or if the premium
received in connection with the closing of an option by the Portfolio is more
than the premium paid for the original purchase. Conversely, a Portfolio will
suffer a loss if the premium paid or received in connection with a closing
transaction is more or less, respectively, than the premium received or paid in
establishing the option position. 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
previously sold by the Portfolio is likely to be offset in whole or in part by
appreciation of the underlying security owned by the Portfolio.
A Portfolio may sell options in connection with buy-and-write
transactions; that is, the Portfolio may purchase a security and then sell a
call option against that security. The exercise price of the call a Portfolio
determines to sell will depend upon the expected price movement of the
underlying security. The exercise price of a call option may be below
("in-the-money"), equal to ("at-the-money") or above ("out-of-the-money") the
current value of the underlying security at the time the option is sold.
Buy-and-write transactions using in-the-money call options may be used when it
is expected that the price of the underlying security will decline moderately
during the option period. Buy-and-write transactions using out-of-the-money call
options may be used when it is expected that the premiums received from selling
the call option plus the appreciation in the market price of the underlying
security up to the exercise price will be greater than the appreciation in the
price of the underlying security alone. If the call options are exercised in
such transactions, a Portfolio's maximum gain will be the premium received by it
for selling the option, adjusted upwards or downwards by the difference between
the Portfolio's purchase price of the security and the exercise price, less
related transaction costs. If the options are not exercised and the price of the
underlying security declines, the amount of such decline will be offset in part,
or entirely, by the premium received.
The selling of put options is similar in terms of risk/return
characteristics to buy-and-write transactions. If the market price of the
underlying security rises or otherwise is above the exercise price, the put
option will expire worthless and the Portfolio's gain will be limited to the
premium received. If the market price of the underlying security declines or
otherwise is below the exercise price, a Portfolio may elect to close the
position or retain the option until it is exercised, at which time the Portfolio
will be required to take delivery of the security at the exercise price; the
Portfolio's return will be the premium received from the put option minus the
amount by which the market price of the security is below the exercise price,
which could result in a loss. Out-of-the-money, at-the-money and in-the-money
put options may be used by a Portfolio in the same market environments that call
options are used in equivalent buy-and-write transactions.
A Portfolio may also sell combinations of put and call options on the
same security, known as "straddles," with the same exercise price and expiration
date. By entering into a straddle, a Portfolio undertakes a simultaneous
obligation to sell and purchase the same security in the event that one of the
options is exercised. If the price of the security subsequently rises
sufficiently above the exercise price to cover the amount of the premium and
transaction costs, the call will likely be exercised and the Portfolio will be
required to sell the underlying security at a below market price. This loss may
be offset, however, in whole or in part, by the premiums received on the writing
of the call options. Conversely, if the price of the security declines by a
sufficient amount, the put will likely be exercised. Straddles will likely be
effective, therefore, only where the price of the security remains stable and
neither the call nor the put is exercised. In those instances where one of the
options is exercised, the loss on the purchase or sale of the underlying
security may exceed the amount of the premiums received.
By selling a call option, a Portfolio limits its opportunity to profit
from any increase in the market value of the underlying security above the
exercise price of the option. By selling a put option, a Portfolio assumes the
risk that it may be required to purchase the underlying security for an exercise
price above its then current market value, resulting in a capital loss unless
the security subsequently appreciates in value. The selling of options on
securities will not be undertaken by a Portfolio solely for hedging purposes,
and could involve certain risks which are not present in the case of hedging
transactions. Moreover, even where options are sold for hedging purposes, such
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transactions constitute only a partial hedge against declines in the value of
portfolio securities or against increases in the value of securities to be
acquired, up to the amount of the premium.
A Portfolio may purchase options for hedging purposes or to increase
its return. Put options may be purchased to hedge against a decline in the value
of portfolio securities. If such decline occurs, the put options will permit a
Portfolio to sell the securities at the exercise price, or to close out the
options at a profit. By using put options in this way, the Portfolio will reduce
any profit it might otherwise have realized in the underlying security by the
amount of the premium paid for the put option and by transaction costs.
A Portfolio may purchase call options to hedge against an increase in
the price of securities that the Portfolio anticipates purchasing in the future.
If such increase occurs, the call option will permit the Portfolio to purchase
the securities at the exercise price, or to close out the options at a profit.
The premium paid for the call option plus any transaction costs will reduce the
benefit, if any, realized by the Portfolio upon exercise of the option, and,
unless the price of the underlying security rises sufficiently, the option may
expire worthless to the Portfolio.
In certain instances, a Portfolio may enter into options on U.S.
Treasury securities which provide for periodic adjustment of the strike price
and may also provide for the periodic adjustment of the premium during the term
of each such option. Like other types of options, these transactions, which may
be referred to as "reset" options or "adjustable strike" options, grant the
purchaser the right to purchase (in the case of a "call"), or sell (in the case
of a "put"), a specified type and series of U.S. Treasury security at any time
up to a stated expiration date (or, in certain instances, on such date). In
contrast to other types of options, however, the price at which the underlying
security may be purchased or sold under a "reset" option is determined at
various intervals during the term of the option, and such price fluctuates from
interval to interval based on changes in the market value of the underlying
security. As a result, the strike price of a "reset" option, at the time of
exercise, may be less advantageous to the Portfolio than if the strike price had
been fixed at the initiation of the option. In addition, the premium paid for
the purchase of the option may be determined at the termination, rather than the
initiation, of the option. If the premium is paid at termination, the Portfolio
assumes the risk that (i) the premium may be less than the premium which would
otherwise have been received at the initiation of the option because of such
factors as the volatility in yield of the underlying Treasury security over the
term of the option and adjustments made to the strike price of the option, and
(ii) the option purchaser may default on its obligation to pay the premium at
the termination of the option.
OPTIONS ON STOCK INDICES - As noted in the Prospectus, MFS Emerging
Equities, MFS Value Equity, Scudder International Growth and T. Rowe Price
Growth Equity may purchase and sell call and put options on stock indices. A
portfolio generally may sell options on stock indices for the purpose of
increasing gross income and to protect the portfolio against declines in the
value of securities they own or increases in the value of securities to be
acquired, although a Portfolio may also purchase put or call options on stock
indices in order, respectively, to hedge its investments against a decline in
value or to attempt to reduce the risk of missing a market or industry segment
advance. A Portfolio's possible loss in either case will be limited to the
premium paid for the option, plus related transaction costs, although Scudder
International Growth may sell options on indices only to close out open
positions.
In contrast to an option on a security, an option on a stock index
provides the holder with the right but not the obligation to make or receive a
cash settlement upon exercise of the option, rather than the right to purchase
or sell a security. The amount of this settlement is equal to (i) the amount, if
any, by which the fixed exercise price of the option exceeds (in the case of a
call) or is below (in the case of a put) the closing value of the underlying
index on the date of exercise, multiplied by (ii) a fixed "index multiplier."
A Portfolio may sell call options on stock indices if it owns
securities whose price changes, in the opinion of the Subadviser, are expected
to be similar to those of the underlying index, or if it has an absolute and
immediate right to acquire such securities without additional cash consideration
(or for additional cash consideration held in a segregated account by its
custodian) upon conversion or exchange of other securities in its Portfolio.
When a Portfolio covers a call option on a stock index it has sold by holding
securities, such securities may not match the composition of the index and, in
that event, the Portfolio will not be fully covered and could be subject to risk
of loss in the event of adverse changes in the value of the index. A Portfolio
may also sell call options on stock indices if it
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holds a call on the same index and in the same principal amount as the call sold
when the exercise price of the call held (a) is equal to or less than the
exercise price of the call sold or (b) is greater than the exercise price of the
call sold if the difference is maintained by the Portfolio in liquid securities
in a segregated account with its custodian. A Portfolio may sell put options on
stock indices if it maintains liquid securities with a value equal to the
exercise price in a segregated account with its custodian, or by holding a put
on the same stock index and in the same principal amount as the put sold when
the exercise price of the put is equal to or greater than the exercise price of
the put sold if the difference is maintained by the Portfolio in liquid
securities in a segregated account with its custodian. Put and call options on
stock indices may also be covered in such other manner as may be in accordance
with the rules of the exchange on which, or the counterparty with which, the
option is traded and applicable laws and regulations.
A Portfolio will receive a premium from selling a put or call option,
which increases the Portfolio's gross income in the event the option expires
unexercised or is closed out at a profit. If the value of an index on which a
Portfolio has sold a call option falls or remains the same, the Portfolio will
realize a profit in the form of the premium received (less transaction costs)
that could offset all or a portion of any decline in the value of the securities
it owns. If the value of the index rises, however, the Portfolio will realize a
loss in its call option position, which will reduce the benefit of any
unrealized appreciation in the Portfolio's stock investments. By selling a put
option, the Portfolio assumes the risk of a decline in the index. To the extent
that the price changes of securities owned by the Portfolio correlate with
changes in the value of the index, selling covered put options on indices will
increase the Portfolio's losses in the event of a market decline, although such
losses will be offset in part by the premium received for selling the option.
A Portfolio may also purchase put options on stock indices to hedge its
investments against a decline in value. By purchasing a put option on a stock
index, the Portfolio will seek to offset a decline in the value of securities it
owns through appreciation of the put option. If the value of the Portfolio's
investments does not decline as anticipated, or if the value of the option does
not increase, the Portfolio's loss will be limited to the premium paid for the
option plus related transaction costs. The success of this strategy will largely
depend on the accuracy of the correlation between the changes in value of the
index and the changes in value of the Portfolio's security holdings.
The purchase of call options on stock indices may be used by a
Portfolio to attempt to reduce the risk of missing a broad market advance, or an
advance in an industry or market segment at a time when the Portfolio holds
uninvested cash or short-term debt securities awaiting investment. When
purchasing call options for this purpose, the Portfolio will also bear the risk
of losing all or a portion of the premium paid if the value of the index does
not rise. The purchase of call options on stock indices when the Portfolio is
substantially fully invested is a form of leverage, up to the amount of the
premium and related transaction costs, and involves risks of loss and of
increased volatility similar to those involved in purchasing calls on securities
the Portfolio owns.
The index underlying a stock index option may be a "broad-based" index,
such as the Standard & Poor's 500 Index or the New York Stock Exchange Composite
Index, the changes in value of which ordinarily will reflect movements in the
stock market in general. In contrast, certain options may be based on narrower
market indices, such as the Standard & Poor's 100 Index, or on indices of
securities of particular industry groups, such as those of oil and gas or
technology companies. A stock index assigns relative values to the stocks
included in the index and the index fluctuates with changes in the market values
of the stocks so included. The composition of the index is changed periodically.
YIELD CURVE OPTIONS - MFS Value Equity may also enter into options on
the "spread," or yield differential, between two fixed income securities, in
transactions referred to as "yield curve" options. In contrast to other types of
options, a yield curve option is based on the difference between the yields of
designated securities, rather than the prices of the individual securities, and
is settled through cash payments. Accordingly, a yield curve option is
profitable to the holder if this differential widens (in the case of a call) or
narrows (in the case of a put), regardless of whether the yields of the
underlying securities increase or decrease.
Yield curve options may be used for the same purposes as other options
on securities. Specifically, the Portfolio may purchase or sell such options for
hedging purposes. For example, the Portfolio may purchase a call
<PAGE>
option on the yield spread between two securities, if it owns one of the
securities and anticipates purchasing the other security and wants to hedge
against an adverse change in the yield spread between the two securities. The
Portfolio may also purchase or sell yield curve options for other than hedging
purposes (i.e., in an effort to increase its current income) if, in the judgment
of the Subadviser, the Portfolio will be able to profit from movements in the
spread between the yields of the underlying securities. The trading of yield
curve options is subject to all of the risks associated with the trading of
other types of options. In addition, however, such options present risk of loss
even if the yield of one of the underlying securities remains constant, if the
spread moves in a direction or to an extent which was not anticipated. Yield
curve options will be sold by the Portfolio only if the Portfolio holds another
call (or put) option on the spread between the same two securities and maintains
in a segregated account with its custodian liquid securities sufficient to cover
the Portfolio's net liability under the two options. Therefore, the Portfolio's
liability for such a covered option is generally limited to the difference
between the amount of the Portfolio's liability under the option sold by the
Portfolio less the value of the option held by the Portfolio. Yield curve
options may also be covered in such other manner as may be in accordance with
the requirements of the counterparty with which the option is traded and
applicable laws and regulations. Yield curve options are traded over-the-counter
and because they have been recently introduced, established trading markets for
these securities have not yet developed.
FUTURES CONTRACTS AND OPTIONS ON FUTURES CONTRACTS
MFS Emerging Equities, MFS Value Equity, Scudder International Growth
and T. Rowe Price Growth Equity may engage in the following types of
transactions:
FUTURES CONTRACTS - As noted in the Prospectus, the Portfolios may
enter into stock index futures contracts, including futures contracts related to
stock indices and interest rates among others. Such investment strategies will
be used for hedging purposes and for non-hedging purposes, subject to applicable
law. Purchases or sales of stock index futures contracts for hedging purposes
may be used to attempt to protect a Portfolio's current or intended stock
investments from broad fluctuations in stock prices, to act as a substitute for
an underlying investment, or to enhance yield ("speculation").
A futures contract is a bilateral agreement providing for the purchase
and sale of a specified type and amount of a financial instrument or for the
making and acceptance of a cash settlement, at a stated time in the future for a
fixed price. By its terms, a futures contract provides for a specified
settlement date on which, in the case of stock index futures contracts, the
difference between the price at which the contract was entered into and the
contract's closing value is settled between the purchaser and seller in cash.
Futures contracts differ from options in that they are bilateral agreements,
with both the purchaser and the seller equally obligated to complete the
transaction. Futures contracts call for settlement only on the date and cannot
be "exercised" at any other time during their term.
The purchase or sale of a futures contract differs from the purchase or
sale of a security or the purchase of an option in that no purchase price is
paid or received. Instead, an amount of cash or cash equivalents, which varies
but may be as low as 5% or less of the value of the contract, must be deposited
with the broker as "initial margin." Subsequent payments to and from the broker,
referred to as "variation margin," are made on a daily basis as the value of the
index or instrument underlying the futures contract fluctuates, making positions
in the futures contract more or less valuable - a process known as "marking to
the market."
Purchases or sales of stock index futures contracts are used to attempt
to protect the Portfolio's current or intended stock investments from broad
fluctuations in stock prices. For example, a Portfolio may sell stock index
futures contracts in anticipation of or during a market decline to attempt to
offset the decrease in market value of the Portfolio's portfolio securities that
might otherwise result if such decline occurs, because the loss in value of
portfolio securities may be offset, in whole or part, by gains on the futures
position. When a Portfolio is not fully invested in the securities market and
anticipates a significant market advance, it may purchase stock index futures
contracts in order to gain rapid market exposure that may, in part or entirely,
offset increases in the cost of securities that the Portfolio intends to
purchase. As such purchases are made, the corresponding position in stock index
futures contracts will be closed out. In a substantial majority of these
transactions, the Portfolio will purchase such securities upon termination of
the futures position, but under usual market conditions, a long futures position
may be terminated without a related purchase of securities.
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When a Portfolio buys or sells a futures contract, unless it already
owns an offsetting position, it will maintain in a segregated account held by
the custodian, liquid securities having an aggregate value at least equal to the
full "notional" value of the futures contract, thereby insuring that the
leveraging effect of such futures contract is minimized, in accordance with
regulatory requirements.
OPTIONS ON FUTURES CONTRACTS - As noted in the Prospectus, the
Portfolios may purchase and sell options to buy or sell futures contracts in
which they may invest ("options on futures contracts"). Such investment
strategies will be used for hedging purposes and for non-hedging purposes,
subject to applicable law, except that Scudder International Growth may utilize
such strategies only for hedging purposes. Put and call options on futures
contracts may be traded by a Portfolio in order to protect against declines in
the values of portfolio securities or against increases in the cost of
securities to be acquired, to act as a substitute for an underlying investment,
or to enhance yield.
An option on a futures contract provides the holder with the right to
enter into a "long" position in the underlying futures contract, in the case of
a call option, or a "short" position in the underlying futures contract, in the
case of a put option, at a fixed exercise price up to a stated expiration date
or, in the case of certain options, on such date. Upon exercise of the option by
the holder, the contract market clearinghouse establishes a corresponding short
position for the writer of the option, in the case of a call option, or a
corresponding long position in the case of a put option. In the event that an
option is exercised, the parties will be subject to all the risks associated
with the trading of futures contracts. In addition, the seller of an option on a
futures contract, unlike the holder, is subject to initial and variation margin
requirements on the option position.
A position in an option on a futures contract may be terminated by the
purchaser or seller prior to expiration by effecting a closing purchase or sale
transaction, subject to the availability of a liquid secondary market, which is
the purchase or sale of an option of the same series (i.e., the same exercise
price and expiration date) as the option previously purchased or sold. The
difference between the premiums paid and received represents the trader's profit
or loss on the transaction.
Options on futures contracts that are sold or purchased by a Portfolio
on U.S. exchanges are traded on the same contract market as the underlying
futures contract, and, like futures contracts, are subject to regulation by the
Commodities Futures Trading Commission ("CFTC") and the performance guarantee of
the exchange clearinghouse. In addition, options on futures contracts may be
traded on foreign exchanges.
A Portfolio may sell call options on futures contracts only if it also
(a) purchases the underlying futures contract, (b) owns the instrument, or
instruments included in the index, underlying the futures contract, or (c) holds
a call on the same futures contract and in the same principal amount as the call
sold when the exercise price of the call held (i) is equal to or less than the
exercise price of the call sold or (ii) is greater than the exercise price of
the call sold if the difference is maintained by the Portfolio in liquid
securities in a segregated account with its custodian. A Portfolio may sell put
options on futures contracts only if it also (A) sells the underlying futures
contract, (B) segregates liquid securities in an amount equal to the value of
the security or index underlying the futures contract, or (C) holds a put on the
same futures contract and in the same principal amount as the put sold when the
exercise price of the put held is equal to or greater than the exercise price of
the put written or when the exercise price of the put held is less than the
exercise price of the put sold if the difference is maintained by the Portfolio
in liquid securities in a segregated account with it its custodian. Upon the
exercise of a call option on a futures contract sold by a Portfolio, the
Portfolio will be required to sell the underlying futures contract which, if the
Portfolio has covered its obligation through the purchase of such contract, will
serve to liquidate its futures position. Similarly, where a put option on a
futures contract sold by the Portfolio is exercised, the Portfolio will be
required to purchase the underlying futures contract which, if the Portfolio has
covered its obligation through the sale of such contract, will close out its
futures position.
The selling of a call option on a futures contract for hedging purposes
constitutes a partial hedge against declining prices of the securities or other
instruments required to be delivered under the terms of the futures contract. If
the futures price at expiration of the option is below the exercise price, the
Portfolio will retain the full amount of
<PAGE>
the option premium, less related transaction costs, which provides a partial
hedge against any decline that may have occurred in the Portfolio's holdings.
The selling of a put option on a futures contract constitutes a partial hedge
against increasing prices of the securities or other instruments required to be
delivered under the terms of the futures contract. If the futures price at
expiration of the option is higher than the exercise price, the Portfolio will
retain the full amount of the option premium, which provides a partial hedge
against any increase in the price of securities the Portfolio intends to
purchase. If a put or call option the Portfolio has sold is exercised, the
Portfolio will incur a loss which will be reduced by the amount of the premium
it receives. Depending on the degree of correlation between changes in the value
of its portfolio securities and the changes in the value of its futures
positions, the Portfolio's losses from existing options on futures contracts may
to some extent be reduced or increased by changes in the value of portfolio
securities.
A Portfolio may purchase options on futures contracts for hedging
purposes instead of purchasing or selling the underlying futures contracts. For
example, where a decrease in the value of portfolio securities is anticipated as
a result of a projected market-wide decline or changes in interest or exchange
rates, the Portfolio could, in lieu of selling futures contracts, purchase put
options thereon. In the event that such decrease occurs, it may be offset, in
whole or in part, by a profit on the option. Conversely, where it is projected
that the value of securities to be acquired by the Portfolio will increase prior
to acquisition, due to a market advance or changes in interest or exchange
rates, the Portfolio could purchase call options on futures contracts, rather
than purchasing the underlying futures contracts.
FORWARD CONTRACTS ON FOREIGN CURRENCY - As noted in the Prospectus,
the Portfolios may enter into forward foreign currency exchange contracts for
hedging and non-hedging purposes. Forward contracts may be used for hedging to
attempt to minimize the risk to a Portfolio from adverse changes in the
relationship between the U.S. dollar and foreign currencies. Each Portfolio
intends to enter into forward contracts for hedging purposes. In particular, a
forward contract to sell a currency may be entered into where the Portfolio
seeks to protect against an anticipated increase in the rate for a specific
currency which could reduce the dollar value of portfolio securities denominated
in such currency. Conversely, a Portfolio may enter into a forward contract to
purchase a given currency to protect against a projected increase in the dollar
value of securities denominated in such currency which the Portfolio intends to
acquire. The Portfolio also may enter into a forward contract in order to assure
itself of a predetermined exchange rate in connection with a security
denominated in a foreign currency. In addition, the Portfolio may enter into
forward contracts for "cross hedging" purposes; e.g., the purchase or sale of a
forward contract on one type of currency as a hedge against adverse fluctuations
in the value of a second type of currency.
If a hedging transaction in forward contracts is successful, the
decline in the value of portfolio securities or other assets or the increase in
the cost of securities or other assets to be acquired may be offset, at least in
part, by profits on the forward contract. Nevertheless, by entering into such
forward contracts, a Portfolio may be required to forgo all or a portion of the
benefits which otherwise could have been obtained from favorable movements in
exchange rates. The Portfolio will usually seek to close out positions in such
contracts by entering into offsetting transactions, which will serve to fix the
Portfolio's profit or loss based upon the value of the contracts at the time the
offsetting transaction is executed.
A Portfolio will also enter into transactions in forward contracts for
other than hedging purposes, which present greater profit potential but also
involve increased risk. For example, a Portfolio may purchase a given foreign
currency through a forward contract if, in the judgment of the Subadviser, the
value of such currency is expected to rise relative to the U.S. dollar.
Conversely, the Portfolio may sell the currency through a forward contract if
the Subadviser believes that its value will decline relative to the dollar.
A Portfolio will profit if the anticipated movements in foreign
currency exchange rates occur which will increase its gross income. Where
exchange rates do not move in the direction or to the extent anticipated,
however, the Portfolio may sustain losses which will reduce its gross income.
Such transactions, therefore, could be considered speculative and could involve
significant risk of loss.
Each Portfolio has established procedures consistent with statements by
the SEC and its staff regarding the use of forward contracts by registered
investment companies, which require the use of segregated assets or "cover" in
<PAGE>
connection with the purchase and sale of such contracts. In those instances in
which the Portfolio satisfies this requirement through segregation of assets, it
will maintain, in a segregated account cash, cash equivalents or other liquid
securities, which will be marked to market on a daily basis, in an amount equal
to the value of its commitments under forward contracts. While these contracts
are not presently regulated by the CFTC, the CFTC may in the future assert
authority to regulate forward contracts. In such event the Portfolio's ability
to utilize forward contracts in the manner set forth above may be restricted.
A Portfolio may hold foreign currency received in connection with
investments in foreign securities when, in the judgment of the Subadviser, it
would be beneficial to convert such currency into U.S. dollars at a later date,
based on anticipated changes in the relevant exchange rate. A Portfolio may also
hold foreign currency in anticipation of purchasing foreign securities.
OPTIONS ON FOREIGN CURRENCIES - As noted in the Prospectus, the
Portfolios may purchase and sell options on foreign currencies for hedging
purposes in a manner similar to that in which forward contracts will be
utilized. For example, a decline in the dollar value of a foreign currency in
which portfolio securities are denominated will reduce the dollar value of such
securities, even if their value in the foreign currency remains constant. In
order to protect against such diminutions in the value of portfolio securities,
the Portfolio may purchase put options on the foreign currency. If the value of
the currency does decline, the Portfolio will have the right to sell such
currency for a fixed amount in dollars and will thereby offset, in whole or in
part, the adverse effect on its portfolio which otherwise would have resulted.
Conversely, where a rise in the dollar value of a currency in which
securities to be acquired are denominated is projected, thereby increasing the
cost of such securities, the Portfolio may purchase call options thereon. The
purchase of such options could offset, at least partially, the effects of the
adverse movements in exchange rates. As in the case of other types of options,
however, the benefit to the Portfolio deriving from purchases of foreign
currency options will be reduced by the amount of the premium and related
transaction costs. In addition, where currency exchange rates do not move in the
direction or to the extent anticipated, the Portfolio could sustain losses on
transactions in foreign currency options which would require it to forgo a
portion or all of the benefits of advantageous changes in such rates.
A Portfolio may sell options on foreign currencies for the same types
of hedging purposes. For example, where the Portfolio anticipates a decline in
the dollar value of foreign-denominated securities due to adverse fluctuations
in exchange rates it could, instead of purchasing a put option, sell a call
option on the relevant currency. If the expected decline occurs, the option will
most likely not be exercised, and the diminution in value of portfolio
securities will be offset by the amount of the premium received.
As in the case of other types of options, however, the selling of an
option on foreign currency will constitute only a partial hedge, up to the
amount of the premium received, and the Portfolio could be required to purchase
or sell foreign currencies at disadvantageous exchange rates, thereby incurring
losses. The purchase of an option on foreign currency may constitute an
effective hedge against fluctuations in exchange rates although, in the event of
rate movements adverse to the Portfolio's position, it may forfeit the entire
amount of the premium plus related transaction costs. As in the case of forward
contracts, certain options on foreign currencies are traded over-the-counter and
involve risks which may not be present in the case of exchange-traded
instruments.
Similarly, instead of purchasing a call option to hedge against an
anticipated increase in the dollar cost of securities to be acquired, the
Portfolio could sell a put option on the relevant currency which, if rates move
in the manner projected, will expire unexercised and allow the Portfolio to
hedge such increased cost up to the amount of the premium. Foreign currency
options sold by the Portfolio will generally be covered in a manner similar to
the covering of other types of options. As in the case of other types of
options, however, the selling of a foreign currency option will constitute only
a partial hedge up to the amount of the premium, and only if rates move in the
expected direction. If this does not occur, the option may be exercised and the
Portfolio would be required to purchase or sell the underlying currency at a
loss which may not be offset by the amount of the premium. Through the selling
of options on foreign currencies, the Portfolio also may be required to forgo
all or a portion of the benefits which might otherwise have been obtained from
favorable movements in exchange rates.
<PAGE>
RISKS ASSOCIATED WITH INVESTING IN OPTIONS, FUTURES AND FORWARD TRANSACTIONS
RISK OF IMPERFECT CORRELATION OF HEDGING INSTRUMENTS WITH A PORTFOLIO'S
SECURITIES - A Portfolio's abilities effectively to hedge all or a portion of
its portfolio through transactions in options, futures contracts, options on
futures contracts, forward contracts and options on foreign currencies depend on
the degree to which price movements in the underlying index or instrument
correlate with price movements in the relevant portion of the Portfolio's
securities. In the case of futures and options based on an index, the Portfolio
will not duplicate the components of the index, and in the case of futures and
options on fixed income securities, the portfolio securities that are being
hedged may not be the same type of obligation underlying such contract. The use
of forward contracts for cross-hedging purposes may involve greater correlation
risks. As a result, the correlation probably will not be exact. Consequently,
the Portfolio bears the risk that the price of the portfolio securities being
hedged will not move in the same amount or direction as the underlying index or
obligation.
For example, if a Portfolio purchases a put option on an index and the
index decreases less than the value of the hedged securities, the Portfolio
would experience a loss that is not completely offset by the put option. It is
also possible that there may be a negative correlation between the index or
obligation underlying an option or futures contract in which the Portfolio has a
position and the portfolio securities the Portfolio is attempting to hedge,
which could result in a loss on both the portfolio and the hedging instrument.
In addition, a Portfolio may enter into transactions in forward contracts or
options on foreign currencies in order to hedge against exposure arising from
the currencies underlying such forwards. In such instances, the Portfolio will
be subject to the additional risk of imperfect correlation between changes in
the value of the currencies underlying such forwards or options and changes in
the value of the currencies being hedged.
It should be noted that stock index futures contracts or options based
upon a narrower index of securities, such as those of a particular industry
group, may present greater risk than options or futures based on a broad market
index. This is due to the fact that a narrower index is more susceptible to
rapid and extreme fluctuations as a result of changes in the value of a small
number of securities. Nevertheless, where a Portfolio enters into transactions
in options or futures on narrow-based indices for hedging purposes, movements in
the value of the index should, if the hedge is successful, correlate closely
with the portion of the Portfolio's portfolio or the intended acquisitions being
hedged.
The trading of futures contracts, options and forward contracts for
hedging purposes entails the additional risk of imperfect correlation between
movements in the futures or option price and the price of the underlying index
or obligation. The anticipated spread between the prices may be distorted due to
the 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 options, futures and forward markets. In this regard, trading by
speculators in options, futures and forward contracts has in the past
occasionally resulted in market distortions, which may be difficult or
impossible to predict, particularly near the expiration of contracts.
The trading of options on futures contracts also entails the risk that
changes in the value of the underlying futures contract will not be fully
reflected in the value of the option. The risk of imperfect correlation,
however, generally tends to diminish as the maturity date of the futures
contract or expiration date of the option approaches.
Further, with respect to options on securities, options on stock
indices, options on currencies and options on futures contracts, the Portfolio
is subject to the risk of market movements between the time that the option is
exercised and the time of performance thereunder. This could increase the extent
of any loss suffered by the Portfolio in connection with such transactions.
In selling a covered call option on a security, index or futures
contract, a Portfolio also incurs the risk that changes in the value of the
instruments used to cover the position will not correlate closely with changes
in the value of the option or underlying index or instrument. For example, where
the Portfolio sells a call option on a stock index and segregates securities,
such securities may not match the composition of the index, and the
<PAGE>
Portfolio may not be fully covered. As a result, the Portfolio could be subject
to risk of loss in the event of adverse market movements.
The selling of options on securities, options on stock indices or
options on futures contracts constitutes only a partial hedge against
fluctuations in value of a Portfolio's portfolio. When a Portfolio sells an
option, it will receive premium income in return for the holder's purchase of
the right to acquire or dispose of the underlying obligation. In the event that
the price of such obligation does not rise sufficiently above the exercise price
of the option, in the case of a call, or fall below the exercise price, in the
case of a put, the option will not be exercised and the Portfolio will retain
the amount of the premium, less related transaction costs, which will constitute
a partial hedge against any decline that may have occurred in the Portfolio's
portfolio holdings or any increase in the cost of the instruments to be
acquired.
When the price of the underlying obligation moves sufficiently in favor
of the holder to warrant exercise of the option, however, and the option is
exercised, the Portfolio will incur a loss which may only be partially offset by
the amount of the premium it received. Moreover, by selling an option, the
Portfolio may be required to forgo the benefits which might otherwise have been
obtained from an increase in the value of portfolio securities or other assets
or a decline in the value of securities or assets to be acquired.
In the event of the occurrence of any of the foregoing adverse market
events, the Portfolio's overall return may be lower than if it had not engaged
in the hedging transactions.
It should also be noted that a Portfolio may enter into transactions in
options (except for options on foreign currencies), futures contracts, options
on futures contracts and forward contracts not only for hedging purposes, but
also for non-hedging purposes intended to increase portfolio returns.
Non-hedging transactions in such investments involve greater risks and may
result in losses which may not be offset by increases in the value of portfolio
securities or declines in the cost of securities to be acquired. A Portfolio
will only sell covered options, such that liquid securities with an aggregate
value equal to an amount necessary to satisfy an option exercise will be
segregated at all times, unless the option is covered in such other manner as
may be in accordance with the rules of the exchange on which the option is
traded and applicable laws and regulations. Nevertheless, the method of covering
an option employed by the Portfolio may not fully protect it against risk of
loss and, in any event, the Portfolio could suffer losses on the option position
which might not be offset by corresponding portfolio gains.
A Portfolio also may enter into transactions in futures contracts,
options on futures contracts and forward contracts for other than hedging
purposes, which could expose the Portfolio to significant risk of loss if
foreign currency exchange rates do not move in the direction or to the extent
anticipated. In this regard, the foreign currency may be extremely volatile from
time to time, as discussed in the Prospectus and in this Statement, and the use
of such transactions for non-hedging purposes could therefore involve
significant risk of loss.
With respect to entering into straddles on securities, a Portfolio
incurs the risk that the price of the underlying security will not remain
stable, that one of the options sold will be exercised and that the resulting
loss will not be offset by the amount of the premiums received. Such
transactions, therefore, create an opportunity for increased return by providing
the Portfolio with two simultaneous premiums on the same security, but involve
additional risk, since the Portfolio may have an option exercised against it
regardless of whether the price of the security increases or decreases.
RISK OF A POTENTIAL LACK OF A LIQUID SECONDARY MARKET - Prior to
exercise or expiration, a futures or option position can only be terminated by
entering into a closing purchase or sale transaction. This requires a secondary
market for such instruments on the exchange on which the initial transaction was
entered into. While a Portfolio will enter into options or futures positions
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 contracts at any
specific time. In that event, it may not be possible to close out a position
held by the Portfolio, and the Portfolio could be required to purchase or sell
the instrument underlying an option, make or receive a cash settlement or meet
ongoing variation margin requirements. Under such circumstances, if a Portfolio
has insufficient cash available to meet margin requirements, it will be
necessary to liquidate portfolio securities or other assets at a time when it is
<PAGE>
disadvantageous to do so. The inability to close out options and futures
positions, therefore, could have an adverse impact on the Portfolio's ability
effectively to hedge its portfolio, and could result in trading losses.
The liquidity of a secondary market in the futures contract or option
thereon may be adversely affected by "daily price fluctuation limits,"
established by exchanges, which limit the amount of fluctuation in the price of
a contract during a single trading day. Once the daily limit has been reached in
the contract, no trades may be entered into at a price beyond the limit, thus
preventing the liquidation of open futures or option positions and requiring
traders to make additional margin deposits. Prices have in the past moved the
daily limit on a number of consecutive trading days.
The trading of futures contracts and options is also subject to the
risk of trading halts, suspensions, exchange or clearinghouse equipment
failures, government intervention, insolvency of a brokerage firm or
clearinghouse 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.
MARGIN - Because of low initial margin deposits made upon the opening
of a futures or forward position and the selling of an option, such transactions
involve substantial leverage. As a result, relatively small movements in the
price of the contract can result in substantial unrealized gains or losses.
Where a Portfolio enters into such transactions for hedging purposes, any losses
incurred in connection therewith should, if the hedging strategy is successful,
be offset, in whole or in part, by increases in the value of securities or other
assets held by the Portfolio or decreases in the prices of securities or other
assets the Portfolio intends to acquire. Where a Portfolio enters into such
transactions for other than hedging purposes, the margin requirements associated
with such transactions could expose the Portfolio to greater risk.
TRADING AND POSITION LIMITS - The exchanges on which futures and
options are traded may impose limitations governing the maximum number of
positions on the same side of the market and involving the same underlying
instrument which may be held by a single investor, whether acting alone or in
concert with others (regardless of whether such contracts are held on the same
or different exchanges or held or written in one or more accounts or through one
or more brokers). Further, the CFTC and the various contract markets have
established limits referred to as "speculative position limits" on the maximum
net long or net short position which any person may hold or control in a
particular futures or option contract. An exchange may order the liquidation of
positions found to be in violation of these limits and it may impose other
sanctions or restrictions. The Subadvisers do not believe that these trading and
position limits will have any adverse impact on the strategies for hedging the
portfolio of the Portfolios.
RISKS OF OPTIONS ON FUTURES CONTRACTS - The amount of risk a
Portfolio assumes when it purchases an option on a futures contract is the
premium paid for the option, plus related transaction costs. In order to profit
from an option purchased, however, it may be necessary to exercise the option
and to liquidate the underlying futures contract subject to the risks of the
availability of a liquid offset market described herein. The seller of an option
on a futures contract is subject to the risks of commodity futures trading,
including the requirement of initial and variation margin payments, as well as
the additional risk that movements in the price of the option may not correlate
with movements in the price underlying security, index, currency or futures
contracts.
RISKS OF TRANSACTIONS RELATED TO FOREIGN CURRENCIES AND TRANSACTIONS
NOT CONDUCTED ON U.S. EXCHANGES - Transactions in forward contracts on foreign
currencies, as well as futures and options on foreign currencies and
transactions executed on foreign exchanges, are subject to all of the
correlation, liquidity and other risks outlined above. In addition, however,
such transactions are subject to the risk of governmental actions affecting
trading in or the prices of currencies underlying such contracts, which could
restrict or eliminate trading and could have a substantial adverse effect on the
value of positions held by a Portfolio. Further, the value of such positions
could be adversely affected by a number of other complex political and economic
factors applicable to the countries issuing the underlying currencies.
Further, unlike trading in most other types of instruments, there is no
systematic reporting of last sale information with respect to the foreign
currencies underlying contracts thereon. As a result, the available information
<PAGE>
on which trading systems will be based may not be as complete as the comparable
data on which the Portfolio makes investment and trading decisions in connection
with other transactions. Moreover, because the foreign currency market is a
global, 24-hour market, events could occur in that market which will not be
reflected in the forward, futures or options markets until the following day,
thereby making it more difficult for the Portfolio to respond to such events in
a timely manner.
Settlements of exercises of over-the-counter forward contracts or
foreign currency options generally must occur within the country issuing the
underlying currency, which in turn requires traders to accept or make delivery
of such currencies in conformity with any U.S. or foreign restrictions and
regulations regarding the maintenance of foreign banking relationships, fees,
taxes or other charges.
Unlike transactions entered into by a Portfolio in futures contracts
and exchange-traded options, options on foreign currencies, forward contracts
and over-the-counter options on securities are not traded on contract markets
regulated by the CFTC or (with the exception of certain foreign currency
options) the SEC. To the contrary, such instruments are traded through financial
institutions acting as market-makers, although foreign currency options are also
traded on certain national securities exchanges, such as the Philadelphia Stock
Exchange and the Chicago Board Options Exchange, subject to SEC regulation. In
an over-the-counter trading environment, many of the protections afforded to
exchange participants will not be available. For example, there are no daily
price fluctuation limits, and adverse market movements could therefore continue
to an unlimited extent over a period of time. Although the purchaser of an
option cannot lose more than the amount of the premium plus related transaction
costs, this entire amount could be lost. Moreover, the option seller and a
trader of forward contracts could lose amounts substantially in excess of their
initial investments, due to the margin and collateral requirements associated
with such positions.
In addition, over-the-counter transactions can only be entered into
with a financial institution willing to take the opposite side, as principal, of
a Portfolio's position unless the institution acts as broker and is able to find
another counterparty willing to enter into the transaction with the Portfolio.
Where no such counterparty is available, it will not be possible to enter into a
desired transaction. There also may be no liquid secondary market in the trading
of over-the-counter contracts, and the Portfolio could be required to retain
options purchased or sold, or forward contracts entered into, until exercise,
expiration or maturity. This in turn could limit the Portfolio's ability to
profit from open positions or to reduce losses experienced, and could result in
greater loses.
Further, over-the-counter transactions are not subject to the guarantee
of an exchange clearinghouse, and the Portfolio will therefore be subject to the
risk of default by, or the bankruptcy of, the financial institution serving as
its counterparty. One or more of such institutions also may decide to
discontinue their role as market-makers in a particular currency or security,
thereby restricting the Portfolio's ability to enter into desired hedging
transactions. The Portfolio will enter into an over-the-counter transaction only
with parties whose creditworthiness has been reviewed and found satisfactory by
the Subadviser.
Options on securities, options on stock indexes, futures contracts,
options on futures contracts and options on foreign currencies may be traded on
exchanges located in foreign countries. Such transactions may not be conducted
in the same manner as those entered into on U.S. exchanges, and may be subject
to different margin, exercise, settlement or expiration procedures. As a result,
many of the risks of over-the-counter trading may be present in connection with
such transactions.
Options on foreign currencies traded on national securities exchanges
are within the jurisdiction of the SEC, as are other securities traded on such
exchanges. As a result, many of the protections provided to traders on organized
exchanges will be available with respect to such transactions. In particular,
all foreign currency option positions entered into on a national securities
exchange are cleared and guaranteed by the Options Clearing Corporation (the
"OCC"), thereby reducing the risk of counterparty default. Further, a liquid
secondary market in options traded on a national securities exchange may be more
readily available than in the over-the-counter market, potentially permitting
the Portfolio to liquidate open positions at a profit prior to exercise or
expiration, or to limit losses in the event of adverse market movements.
<PAGE>
The purchase and sale of exchange-traded foreign currency options,
however, is subject to the risks of the availability of a liquid secondary
market described above, as well as the risks regarding adverse market movements,
margining of options written, the nature of the foreign currency market,
possible intervention by governmental authorities and the effects of other
political and economic events. In addition, exchange-traded options on foreign
currencies involve certain risks not presented by the over-the-counter market.
For example, exercise and settlement of such options must be made exclusively
through the OCC, which has established banking relationships in applicable
foreign countries for this purpose. As a result, the OCC may, if it determines
that foreign governmental restrictions or taxes would prevent the orderly
settlement of foreign currency option exercises, or would result in undue
burdens on the OCC or its clearing member, impose special procedures on exercise
and settlement, such as technical changes in the mechanics of delivery of
currency, the fixing of dollar settlement prices or prohibitions on exercise.
POLICIES ON THE USE OF FUTURES AND OPTIONS ON FUTURES CONTRACTS - In
order to assure that a Portfolio will not be deemed to be a "commodity pool" for
purposes of the Commodity Exchange Act, regulations of the CFTC require that a
Portfolio enter into transactions in futures contracts and options on futures
contracts only (i) for bona fide hedging purposes (as defined in CFTC
regulations), or (ii) for non-hedging purposes, provided that the aggregate
initial margin and premiums on such non-hedging positions does not exceed 5% of
the liquidation value of the Portfolio's assets.
The staff of the SEC has taken the position that over-the-counter
options and assets used to cover sold over-the-counter options are illiquid and,
therefore, together with other illiquid securities held by a Portfolio, cannot
exceed 15% of a Portfolio's assets (the "SEC illiquidity ceiling"). Although the
Subadvisers may disagree with this position, each Subadviser intends to limit
the Portfolios' selling of over-the-counter options in accordance with the
following procedure. Except as provided below, MFS Emerging Growth and MFS Value
Equity intend to sell over-the-counter options only with primary U.S. Government
securities dealers recognized as such by the Federal Reserve Bank of New York.
Also, the contracts a Portfolio has in place with such primary dealers provide
that the Portfolio has the absolute right to repurchase an option it sells at a
maximum price to be calculated by a pre-determined formula. Each Portfolio will
treat all or a portion of the formula as illiquid for purposes of the SEC
illiquidity ceiling test. Each Portfolio may also sell over-the-counter options
with non-primary dealers, including foreign dealers (where applicable), and will
treat the assets used to cover these options as illiquid for purposes of such
SEC illiquidity ceiling test.
The policies described above are not fundamental and may be changed
without shareholder approval, as may each Portfolio's investment objective.
DIRECTORS AND OFFICERS OF THE FUND
The investments and administration of the Fund are under the direction
of the Board of Directors. The Directors and executive officers of the Fund and
their principal occupations for the past five years are listed below. Some
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.,
Aetna Variable Portfolios, Inc. and Portfolio Partners, Inc.
<TABLE>
<CAPTION>
Name, Address and Age Position(s) Held with Registrant Principal Occupation During Past Five
- --------------------- -------------------------------- Years (and Positions held with
Affiliated Persons or Principal
Underwriter of the Registrant)
------------------------------
<S> <C> <C>
Daniel P. Kearney* Director and President Executive Vice President and Chief Investment Officer,
151 Farmington Avenue Aetna Inc., August 18, 1997 to present; Director,
Hartford, Connecticut President, and Chief Executive Officer, Aetna Life
Age 57 Insurance and Annuity Company, December 1993 to present;
Executive Vice President, Aetna Inc., December 1993 to
August 18, 1997; Group Executive, Aetna Inc., 1991 to
1993; Director, Aetna Investment Services, Inc.,
November 1994 to August 18, 1997; Director, Aetna
Insurance Company of America, May 1994 to August 18,
1997.
Peter C. Aldrich Director Chairman and Chief Executive Officer, AEGIS, LLC
225 Franklin Street d/b/a AEW International, January 1997 to present;
Boston, Massachusetts Co-Chairman, AEW Capital Management, March 1981
Age 53 to present.
Edward Lowenthal Director President, Wellsford Real Properties, Inc.,
610 Fifth Avenue, 7th Floor May 1997 to present; President, Wellsford
New York, New York Residential Property Trust, August 1986 to
Age 52 May 1997.
Martin T. Conroy Vice President, Chief Financial Assistant Treasurer, Aetna Life
151 Farmington Avenue Officer and Treasurer Insurance and Annuity Company, October
Hartford, Connecticut 1991 to present.
Age 57
Laurie M. LeBlanc, CFP Vice President Vice President, Aetna Retirement
151 Farmington Avenue Services, Fund Strategy and Management,
Hartford, Connecticut December 1995 to present; Vice
Age 45 President, Connecticut Mutual Financial
Services, Investment Products, July
1994 to December 1995; Vice President,
CIGNA Investments, Inc. and CIGNA
International Investment Advisers,
Ltd., October 1988 to July 1994.
Amy R. Doberman Secretary Counsel, Aetna Life Insurance and
151 Farmington Avenue Annuity Company, December 1996 to
Hartford, Connecticut present; Assistant Chief Counsel,
Age 35 Division of Investment Management, Securities
and Exchange Commission, January 1995
to November 1996; Senior Special
Counsel, Securities and Exchange
Commission, September 1994 to January
1995; Special Counsel, Securities and
Exchange Commission, September 1993 to
September 1994; Staff Attorney,
Securities and Exchange Commission,
June 1992 to September 1993.
*Interested person as defined by the 1940 Act.
</TABLE>
Members of the Board of the Fund who are also directors, officers or
employees of Aetna Inc. or its affiliates are not entitled to any compensation
from the Fund. Members of the Board who are not affiliated with Aetna or its
subsidiaries are entitled to receive an annual retainer of $20,000 for service
on the Board. In addition, each such member will receive a fee of $2,500 per
meeting for each regularly scheduled Board meeting; and $1,500 for each
in-person committee meeting on any day on which a regular Board meeting is not
scheduled. A Committee Chairperson fee of $1,500 each will be paid to the
Chairperson of the Valuation and Audit Committees. All of the above fees are to
be paid proportionately by each Portfolio based on the net assets of the
Portfolios as of the date compensation is earned.
CONTROL PERSONS AND PRINCIPAL SHAREHOLDERS
Shares of the Portfolios will 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"). It is currently expected that all shares will be 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 SEC as an investment adviser and
as of June 30, 1997, manages over $34.6 billion in assets.
<PAGE>
THE INVESTMENT ADVISORY AGREEMENT
On August 11, 1997, the Fund's Board of Directors approved an
investment advisory agreement (Investment Advisory Agreement) between the Fund
and Aetna for each of the Portfolios to continue through June 30, 1999.
Under the Investment Advisory Agreement and subject to the direction of
the Board of Directors of the Fund, Aetna has responsibility, among other
things, to (i) select the securities to be purchased, sold or exchanged by each
Portfolio, and place trades on behalf of each Portfolio, or delegate such
responsibility to one or more subadvisers; (ii) supervise all aspects of the
operations of the Portfolios; (iii) obtain the services of, contract with, and
provide instructions to custodians and/or subcustodians 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 Investment
Advisory Agreement; (iv) monitor the investment program maintained by each
Subadviser for the Portfolios and the Subadvisers' compliance programs to ensure
that the Portfolio's assets are invested in compliance with the Subadvisory
Agreement and the Portfolio's investment objectives and policies as adopted by
the Board and described in the most current effective amendment of the
registration statement for the Portfolio, as filed with the Commission under the
1933 Act and the 1940 Act ("Registration Statement"); (v) review all data and
financial reports prepared by each Subadviser to assure that they are in
compliance with applicable requirements and meet the provisions of applicable
laws and regulations; (vi) establish and maintain regular communications with
each Subadviser to share information it obtains with each Subadviser concerning
the effect of developments and data on the investment program maintained by the
Subadviser; (vii) oversee all matters relating to the offer and sale of the
Portfolios' shares, the Fund's corporate governance, reports to the Board,
contracts with all third parties on behalf of the Portfolios for services to the
Portfolios, reports to regulatory authorities and compliance with all applicable
rules and regulations affecting the Portfolios' operations; and (viii) take
other actions that appear to Aetna and the Board 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 Portfolio, 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 has an initial term of just under two
years and provides that it will remain in effect from year-to-year thereafter if
approved annually by a majority vote of the Directors, including a majority of
the Directors who are not "interested persons" as that term is defined in the
1940 Act, of the Fund or of Aetna, 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.
Aetna also serves as investment adviser to the following investment
companies: Aetna Series Fund, Inc., Aetna Variable Fund, Aetna Income Shares,
Aetna Variable Encore Fund, Aetna Investment Advisers Fund, Inc., Aetna GET
Fund, Aetna Generation Portfolios, Inc. and Aetna Variable Portfolios, Inc.
THE SUBADVISORY AGREEMENTS
On August 11, 1997, the Fund's Board of Directors approved subadvisory
agreements ("Subadvisory Agreements") between Aetna and Massachusetts Financial
Services Company ("MFS") with respect to MFS Emerging Equities, MFS Research
Growth and MFS Value Equity; with Scudder, Stevens & Clark, Inc. ("Scudder")
with respect to Scudder International Portfolio; and with T. Rowe Price
Associates, Inc. ("T. Rowe Price") with respect to T. Rowe Price Growth Equity,
to continue through June 30, 1999. Each Subadvisory 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" of the
Fund, Aetna or any Subadviser, in person, at a meeting called for that purpose.
Each 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 Portfolio, (iii) Aetna, or (iv)
the relevant
<PAGE>
Subadviser. Each 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 each Subadvisory Agreement, the Subadviser supervises the
investment and reinvestment of cash and securities comprising the assets of the
Portfolios. Each Subadvisory Agreement also directs the Subadviser 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.
Each Subadviser 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 each Subadviser a monthly fee as described
in the Prospectus. Aetna has certain obligations under the Subadvisory
Agreements and retains overall responsibility for monitoring the investment
program maintained by the Subadviser for compliance with applicable laws and
regulations and each Portfolio's respective investment objectives. 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 Subadvisers to the Fund's Board of
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. As a result, a Portfolio's costs and fees are limited to its
advisory fee, the administrative services charge and transaction costs. The
Administrative Services Agreement will remain in effect until June 30, 1999.
Thereafter, it will 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
Investors Bank & Trust Company, Boston, Massachusetts, serves as
custodian for the assets of the 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.
INDEPENDENT AUDITORS
KPMG Peat Marwick LLP, Hartford, Connecticut 06103 will serve as
independent auditors to the Portfolios. KPMG Peat Marwick LLP provides audit
services, assistance and consultation in connection with SEC filings.
PRINCIPAL UNDERWRITER
Shares of the Portfolios are offered on a continuous basis. Aetna has
agreed to use its best efforts to distribute the shares of the Portfolios as the
principal underwriter of the Fund pursuant to an Underwriting Agreement between
it and the Fund. The Agreement was approved on August 11, 1997 to continue
through June 30, 1999. Thereafter, 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 Portfolio's shares, and by a vote of a majority of the
Directors who are not "interested persons" of Aetna, or 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 Portfolio's shares without the payment of any
penalty.
<PAGE>
BROKERAGE ALLOCATION AND TRADING POLICIES
Subject to the direction of the Directors, Aetna and the Subadvisers
have responsibility for making the Portfolios' investment decisions, for
effecting the execution of trades for the Portfolios and for negotiating any
brokerage commissions thereof. It is the policy of Aetna and the Subadvisers to
obtain the best quality of execution available, giving attention to net price
(including commissions 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 the Subadvisers may place a Portfolio's transactions
with such brokers or dealers and for execution in such markets as, in the
opinion of the Adviser or Subadvisers, will lead to the best overall quality of
execution for the Portfolio.
Aetna and the Subadvisers may receive a variety of brokerage and
research services from brokerage firms that execute trades on behalf of the
Portfolios. These services may benefit the Adviser and/or advisory clients other
than 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 the
Subadvisers may 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 the Subadvisers' 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 that 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 the Subadvisers believe that more than one broker
can provide best execution, preference may be given to brokers who provide
additional services to Aetna or the Subadvisers.
Consistent with securities laws and regulations, Aetna and the
Subadvisers 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 the Subadvisers' 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 the Subadvisers' opinion as to which
services and which means of payment are in the long-term best interests of a
Portfolio. The Portfolios have no present intention to effect any brokerage
transactions in portfolio securities through Aetna, the Subadvisers or any
affiliate thereof. If a Portfolio enters into a transaction with any such person
in the future, the transaction will comply with Rule 17e-1 under the 1940 Act.
Certain officers of Aetna and the Subadvisers also manage the securities
portfolios of their own and their affiliates. Further, Aetna and the Subadvisers
also act as investment adviser to other investment companies registered under
the 1940 Act and other client accounts.
To the extent Aetna or the Subadvisers desire to buy or sell the same
publicly traded security at or about the same time for more than one client, the
purchases or sales will normally be aggregated, and 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. 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 Board of Directors has adopted a policy allowing trades to be made
between a Portfolio and a registered investment company or series thereof that
is an affiliated person of the Portfolio (and certain noninvestment company
affiliated persons) provided the transactions 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 or private
<PAGE>
advisory account advised by Aetna or by one of the Subadvisers. The Board of
Directors, Aetna and each Subadviser have also adopted Codes of Ethics governing
personal trading by persons who manage, or who have access to trading activity
by, a Portfolio. The Codes allow trades to be made in securities that may be
held by a Portfolio. However, they prohibit a person from taking advantage of
Portfolio trades or from acting on inside information.
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.
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.
NET ASSET VALUE
Securities of the 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 last sale price or at the last bid price if there has been no sale
that day. Short-term debt securities that 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. Long-term debt securities are valued at the mean
of the last bid and asked price of such securities obtained from a broker that
is a market-maker in the securities or a service providing quotations based upon
the assessment of market-makers in those securities.
Options are valued at the mean of the last bid and asked price on the
exchange where the option is primarily 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.
The performance of the Portfolios 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:
P ( 1 + T ) (n) = ERV
Investors should not consider this performance data as an indication of
the future performance of any of the Portfolios.
The performance of a Portfolio 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.
Each Portfolio is newly organized and does not yet have its own
performance record. However, each Portfolio has the same investment objective
and follows substantially the same investment strategies as a mutual fund
<PAGE>
or funds whose shares are currently sold to the public or through variable
insurance products and is/are managed by MFS, Scudder or T. Rowe Price, as
applicable. The Prospectus contains historical performance information of these
similarly managed funds. Advertisements for Portfolio Partners, Inc. may also
include historical performance of these similarly managed Funds, subject to
regulatory approval.
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. 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 included in
sales literature if comparable performance figures for the corresponding
division of the separate account accompany the sales literature. 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 Portfolio that are not described in the
Prospectus. The discussions below and in the Prospectus are not intended as
substitutes for careful tax planning.
The holders of variable life insurance policies or annuity contracts
should not be subject to tax with respect to distributions made on, or
redemptions of, Portfolio shares, assuming that the variable life insurance
policies and annuity contracts qualify under the Internal Revenue Code of 1986,
as amended (the "Code"), as life insurance or annuities, respectively, and that
the shareholders are treated as owners of the Portfolio shares. See
"Qualification of Segregated Asset Accounts." Thus, this summary does not
describe the tax consequences to a holder of a life insurance policy or annuity
contract as a result of the ownership of such policies or contracts. Policy or
contract holders must consult the prospectuses of their respective policies or
contracts for information concerning the federal income tax consequences of
owning such policies or contracts. This summary also does not describe the tax
consequences applicable to the owners of the Portfolio shares because the
Portfolio shares will be sold only to insurance companies. Thus, purchasers of
Portfolio shares must consult their own tax advisers regarding the federal,
state, and local tax consequences of owning Portfolio shares.
QUALIFICATION AS A REGULATED INVESTMENT COMPANY
Each Portfolio has elected to be taxed as a regulated investment
company under Subchapter M of the 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) for the taxable year (the "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 will 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 (the "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
<PAGE>
or forward contracts thereon) held for less than three months (the "Short-Short
Gain Test"). 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 such 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 such 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 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.
In general, 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 (as applicable,
depending on the type of Portfolio) (1) the asset is used to close a "short
sale" (which includes for certain purposes 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.
Certain 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. Under Treasury regulations, gains arising from
<PAGE>
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.
A Portfolio may enter into notional principal contracts, including
interest rate swaps, caps, floors, and collars. Under Treasury regulations, in
general, the net income or deduction from a notional principal contract for a
taxable year is included in or deducted from income for that taxable year. The
net income or deduction from a notional principal contract for a taxable year
equals the total of all the periodic payments (generally, payments that are
payable or receivable at fixed periodic intervals of one year or less during the
entire term of the contract) that are recognized from that contract for the
taxable year and all of the non-periodic payments (including premiums for caps,
floors and collars) that are recognized from that contract for the taxable year.
No portion of a payment by a party to a notional principal contract is
recognized prior to the first year to which any portion of a payment by the
counterparty relates. A periodic payment is recognized ratable over the period
to which it relates. In general, a non-periodic payment must be recognized over
the term of the notional principal contract in a manner that reflects the
economic substance of the contract. A non-periodic payment that relates to an
interest rate swap, cap, floor or collar shall be recognized over the term of
the contract by allocating it in accordance with the values of a series of
cash-settled forward or option contracts that reflect the specified index and
notional principal amount upon which the notional principal contract is based
(or, in the case of a swap, a cap or floor, under an alternative method
contained in the regulations).
A Portfolio may purchase securities of certain foreign investment funds
or trusts which constitute passive foreign investment companies ("PFIC") for
federal income tax purposes. If a Portfolio invests in a PFIC, it may elect to
treat the PFIC as a qualified electing fund (a "QEF") 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 elect to treat the PFIC as a
QEF, 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, the sum of (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 and (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 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 constitute
ordinary income and will not be subject to the Short-Short Gain Test, and the
Portfolio's holding period with respect to such PFIC stock will commence on the
first day of the next taxable year. If a Portfolio makes such election in the
first taxable year it holds PFIC stock, it will not incur the tax described in
the previous paragraph.
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.
<PAGE>
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
each of which the Portfolio has not invested more than 5% of the value of the
Portfolio's total assets in securities of such issuer and 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.
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 variable life insurance or annuity
contract will not be treated as a life insurance policy or annuity contract,
respectively, under the Code, unless the segregated asset account upon which
such contract or policy is based is "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 the segregated asset account'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 each U.S. Government agency and instrumentality is considered a separate
issuer. As a safe harbor, a segregated asset 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. In addition, a segregated asset account with
respect to a variable life insurance contract is treated as adequately
diversified to the extent of its investment in securities issued by the United
States Treasury.
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 that the shares
of such regulated investment company are held only by insurance companies and
certain fund managers (a "Closed Fund").
If the segregated asset account upon which a variable contract is based
is not "adequately diversified" under the foregoing rules for each calendar
quarter, then (a) the variable contract is not treated as a life insurance
contract or annuity contract under the Code for all subsequent periods during
which such account is not "adequately diversified" and (b) the holders of such
contract must include as ordinary income the "income on the contract" for each
taxable year. Further, the income on a life insurance contract for all prior
taxable years is treated as received or accrued during the taxable year of the
policyholder in which the contract ceases to meet the definition of a "life
insurance contract" under the Code. The "income on the contract" is, generally,
the excess of (i) the sum of the increase in the net surrender value of the
contract during the taxable year and the cost of the life insurance protection
provided under the contract during the year, over (ii) the premiums paid under
the contract during the taxable year. In addition, if a Portfolio does not
constitute a Closed Fund, the holders of the contracts and annuities which
invest in the Portfolio through a segregated asset account may be treated as
owners of Portfolio shares and may be subject to tax on distributions made by
the Portfolio.
<PAGE>
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")). 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.
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 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 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.
The Directors of the Fund shall continue to hold office until the
Annual Meeting of Shareholders next held after his/her election, or until
his/her successor is duly elected and qualified. No meeting of the shareholders
for the purpose of electing Directors will be held. However, Shareholders
holding a majority of outstanding shares may request a special meeting for the
purpose of removing and replacing a Director. Vacancies on the Board occurring
between any such meetings shall be filled by the remaining Directors. 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 Fund, in which event the holders of the remaining shares will be unable to
elect any person as a Director.
Special shareholder meetings may be called when requested in writing by
the holders of not less than 50% of the outstanding voting shares of a
Portfolio. Any request must state the purposes of the proposed meeting.
<PAGE>
The Articles may be amended if duly advised by a majority of the
Directors and approved by the affirmative vote of a majority of votes entitled
to be cast.
<PAGE>
FINANCIAL STATEMENTS
A Statement of Assets and Liabilities of each of the Portfolios as of
August 11, 1997 and related footnotes is set forth below.
Portfolio Partners, Inc.
Statements of Assets and Liabilities
August 11, 1997
(With Independent Auditors' Report Thereon)
<PAGE>
Independent Auditors' Report
The Board of Directors
Portfolio Partners, Inc.:
We have audited the accompanying statements of assets and liabilities of
Portfolio Partners MFS Emerging Equities Portfolio, Portfolio Partners MFS
Research Growth Portfolio, Portfolio Partners MFS Value Equity Portfolio,
Portfolio Partners Scudder International Growth Portfolio, and Portfolio
Partners T. Rowe Price Growth Equity Portfolio, series of Portfolio Partners,
Inc. (the "Company"), as of August 11, 1997. These financial statements are the
responsibility of the Company's management. Our responsibility is to express an
opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audits to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. Our procedures included
confirmation of cash in bank by correspondence with the custodian. An audit also
includes assessing the accounting principles used and significant estimates made
by management, as well as evaluating the overall financial statement
presentation. We believe that our audits provide a reasonable basis for our
opinion.
In our opinion, the statements of assets and liabilities referred to above
present fairly, in all material respects, the financial position of Portfolio
Partners MFS Emerging Equities Portfolio, Portfolio Partners MFS Research Growth
Portfolio, Portfolio Partners MFS Value Equity Portfolio, Portfolio Partners
Scudder International Growth Portfolio, and Portfolio Partners T. Rowe Price
Growth Equity Portfolio as of August 11, 1997, in conformity with generally
accepted accounting principles.
[Signature of KPMG Peat Marwick LLP]
Boston, Massachusetts
August 11, 1997
<PAGE>
Portfolio Partners, Inc.
Statements of Assets and Liabilities
August 11, 1997
<TABLE>
<CAPTION>
T. Rowe
MFS MFS MFS Scudder Price
Emerging Research Value International Growth
Equities Growth Equity Growth Equity
Portfolio Portfolio Portfolio Portfolio Portfolio
<S> <C> <C> <C> <C> <C>
Assets:
Cash ............. $20,000 20,000 20,000 20,000 20,000
------- ------- ------- ------- -------
Liabilities .......... -- -- -- -- --
------- ------- ------- ------- -------
Net assets .... $20,000 20,000 20,000 20,000 20,000
======= ======= ======= ======= =======
Shares outstanding ... 20,000 20,000 20,000 20,000 20,000
======= ======= ======= ======= =======
Net asset value
per share $ 1.00 1.00 1.00 1.00 1.00
======= ======= ======= ======= =======
</TABLE>
See accompanying notes to statements of assets and liabilities.
<PAGE>
Portfolio Partners, Inc.
Notes to Statements of Assets and Liabilities
August 11, 1997
(1) General
Portfolio Partners, Inc. (the "Company") was organized on May 7, 1997, as
a Maryland corporation and is registered as an open-ended management
investment company under the Investment Company Act of 1940, as
amended. The Company currently consists of five separate diversified
investment portfolios, MFS Emerging Equities Portfolio, MFS Research
Growth Portfolio, MFS Value Equity Portfolio, Scudder International
Growth Portfolio and T. Rowe Price Growth Equity Portfolio (each a
"Fund"). As of August 11, 1997, the Company and each Fund has had no
operations other than organizational matters and issuance of 20,000
shares of each Fund to Aetna Life Insurance and Annuity Company
("Aetna"). The Company's financial statements are prepared in
accordance with generally accepted accounting principles.
(2) Investment Advisory and Subadvisory Agreements
The investment adviser to the Company is Aetna. Pursuant to an Investment
Advisory Agreement, the Adviser receives an advisory fee computed
daily and paid monthly at a rate of 0.70% per annum of the average
daily net assets up to $500 million, 0.65% for average daily net
assets in excess of $500 million, of the MFS Emerging Equities
Portfolio and the MFS Research Growth Portfolio; 0.65%, 0.80% and
0.60% of the average daily net assets of MFS Value Equity Portfolio,
Scudder International Growth Portfolio and T.
Rowe Price Growth Equity Portfolio, respectively.
Aetna has entered into a subadvisory agreement with Massachusetts
Financial Services, Scudder, Stevens & Clark, Inc., and T. Rowe Price
Associates, Inc. (the "Subadvisers"). Under the subadvisory
agreements, each Subadviser, subject to the supervision of Aetna and
the Company's Board of Directors, is responsible for managing the
assets of its respective portfolio(s) in accordance with the
Portfolio's investment objective and policies. Each subadvisory
agreement provides that Aetna will pay the Subadviser a fee at an
annual rate of 0.425% of the aggregate average daily net assets of MFS
Emerging Equities Portfolio, MFS Research Growth Portfolio and MFS
Value Equity Portfolio; 0.75% of the average daily net assets of
Scudder International Growth Portfolio and 0.40% of the average daily
net assets of T. Rowe Price Growth Equity Portfolio. Lower rates apply
as net assets increase.
(3) Administration, Fund Accounting, Transfer Agency and Distribution Services
Aetna serves as the Company's administrator and is compensated for those
services at an annual rate of 0.13%, 0.15%, 0.25%, 0.20% and 0.15% of
the average daily net assets of MFS Emerging Equities Portfolio, MFS
Research Growth Portfolio, MFS Value Equity Portfolio, Scudder
International Growth Portfolio and T. Rowe Price Growth Equity
Portfolio, respectively. Aetna has entered into a sub-administrative
agreement with Investors Bank and Trust ("IBT"). IBT performs certain
administrative services for the Funds and is compensated by Aetna from
Aetna's administrative fee.
<PAGE>
2
Portfolio Partners, Inc.
Notes to Statements of Assets and Liabilities
IBT also serves as the Company's transfer agent, fund accountant and
dividend disbursing agent and is compensated for those services from
Aetna's administrative fee.
Aetna also acts as the Company's distributor pursuant to a separate
distribution agreement with the Company. Aetna receives no
compensation under this agreement.
(4) Federal Taxes
The Company intends to comply with the requirements of the Internal
Revenue Code applicable to regulated investment companies and to
distribute taxable income to the shareholders of each Fund in amounts
that will avoid or minimize federal income or excise taxes for each
Fund.
<PAGE>
APPENDIX A
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 RATING SERVICE
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.
<PAGE>
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.
FITCH INVESTORS SERVICES, INC.
AAA: Bonds considered to be investment grade and of the highest
quality. The obligor has an exceptionally strong ability to pay interest and
repay principal which is unlikely to be affected by reasonably foreseeable
events.
AA: Bonds considered to be investment grade and of very high credit
quality. The obligor's ability to pay interest and repay principal is very
strong although not quite as strong as bonds rated "AAA". Because bonds rated in
the "AAA" and "AA" categories are not significantly vulnerable to foreseeable
future developments, short-term debt of these issuers is generally rated "F-1+".
A: Bonds considered to be investment grade and of high credit quality.
The obligor's ability to pay interest and repay principal is considered to be
strong, but may be more vulnerable to adverse changes in economic conditions and
circumstances than bonds with higher ratings.
BBB: Bonds considered to be investment grade and of satisfactory credit
quality. The obligor's ability to pay interest and repay principal is considered
to be adequate. Adverse changes in economic conditions, however, are more likely
to have adverse impact on these bonds, and therefore impair timely payment. The
likelihood that the ratings of these bonds will fall below investment grade is
higher than for bonds with higher ratings.
BB: Bonds are considered speculative. The obligor's ability to pay
interest and repay principal may be affected over time by adverse economic
changes. However, business and financial alternatives can be identified which
could assist the obligor in satisfying its debt service requirements.
B: Bonds are considered highly speculative. While bonds in this class
are currently meeting debt service requirements, the probability of continued
timely payment of principal and interest reflects the obligor's limited margin
of safety and the need for reasonable business and economic activity throughout
the life of the issue.
CCC: Bonds have certain identifiable characteristics which, if not
remedied, may lead to default. The ability to meet obligations requires an
advantageous business and economic environment.
CC: Bonds are minimally protected. Default in payment of interest
and/or principal seems probable over time.
C: Bonds are in imminent default in payment of interest or principal.
Plus (+) Minus (-): Plus and minus signs are used with a rating symbol to
indicate the relative position of a credit within the rating category. Plus and
minus signs, however, are not used in the "AAA" category.
<PAGE>
NR: Indicates that Fitch does not rate the specific issue.
Conditional: A conditional rating is premised on the successful completion of a
project or the occurrence of a specific event.
Suspended: A rating is suspended when Fitch deems the amount of information
available from the issuer to be inadequate for rating purposes.
Withdrawn: A rating will be withdrawn when an issue matures or is called or
refinanced, and, at Fitch's discretion, when an issuer fails to furnish proper
and timely information.
FitchAlert: Ratings are placed on FitchAlert to notify investors of an
occurrence that is likely to result in a rating change and the likely direction
of such change. These are designated as "Positive", indicating a potential
upgrade, "Negative", for potential downgrade, or "Evolving", where ratings may
be raised or lowered. FitchAlert is relatively short-term, and should be
resolved within 12 months.
