PORTFOLIO PARTNERS, INC.
151 Farmington Avenue
Hartford, Connecticut 06156-8962
MFS Emerging Equities Portfolio
MFS Research Growth Portfolio
MFS Value Equity Portfolio
Scudder International Growth Portfolio
T. Rowe Price Growth Equity Portfolio
Statement of Additional Information dated: May 3, 1999
This Statement of Additional Information ("Statement") is not a prospectus but
should be read in conjunction with the current prospectus for Portfolio
Partners, Inc. dated May 3, 1999 (the "Prospectus"). This Statement 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 by calling 1-800-525-4225.
TABLE OF CONTENTS
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Fund History.................................................................... 2
Description of the Fund and Its Investments and Risks........................... 2
Description of Various Securities and Investment Policies and Practices ........ 4
Futures Contracts and Options on Futures Contracts.............................. 14
Risks Associated With Investing in Options, Futures and Forward Transactions.... 18
Management of the Fund.......................................................... 23
Control Persons and Principal Shareholders...................................... 24
Investment Advisory and Other Services.......................................... 25
Principal Underwriter........................................................... 27
Brokerage Allocation and Trading Policies....................................... 27
Description of Shares........................................................... 29
Voting Rights................................................................... 29
Net Asset Value................................................................. 29
Tax Status...................................................................... 30
Performance Information......................................................... 33
Financial Statements............................................................ 34
Appendix ....................................................................... 35
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FUND HISTORY
Portfolio Partners, Inc. (the "Fund") was incorporated in 1997 in Maryland and
commenced operations on November 28, 1997.
DESCRIPTION OF THE FUND
AND ITS INVESTMENTS AND RISKS
The Fund is an open-end management investment company 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 expands on subjects discussed in the Prospectus. Capitalized
terms not defined herein are used as defined in the Prospectus.
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.
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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.
General. 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
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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. With respect to fundamental policy
number 7, industry classifications of domestic issuers for Scudder International
Growth and T. Rowe Price Growth Equity are determined in accordance with the
current Directory of Companies Filing Annual Reports with the Securities and
Exchange Commission. Industry classifications of foreign issuers for these
Portfolios are based on data provided by Bloomberg L.P. and other industry data
sources. All industry classifications for MFS Emerging Equities, MFS Research
Growth and MFS Value Equity have been selected by Massachusetts Financial
Services Company ("MFS"), the subadviser for those Portfolios. MFS believes the
industry characteristics it has selected are reasonable and not so broad that
the primary economic characteristics of the companies in a single class are
materially different. The industry classifications selected by MFS may be
changed from time to time to reflect changes in the marketplace.
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--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
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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 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--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.
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Foreign Securities--The Portfolios may invest in foreign securities (and foreign
currencies) as 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 holding 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
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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 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.
Warrants--The Portfolios (except the Scudder International Growth) may acquire
warrants. Warrants are pure speculation in that they have no voting rights, pay
no dividends, and have no rights with respect to the assets of the corporation
issuing them. Warrants basically are options to purchase equity securities at a
specific price valid for a specific period of time. They do not represent
ownership of the securities, but only the right to buy them. Warrants differ
from call options in that warrants are issued by the issuer of the security
which may be purchased on their exercise, whereas call options may be written or
issued by anyone. The prices of warrants do not necessarily move parallel to the
prices of the underlying securities.
Zero Coupon, Deferred Interest and PIK Bonds--Fixed income securities that MFS
Emerging Equities, MFS Research Growth and MFS Value Equity may each 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 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 each 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
Group ("S&P") or by Fitch IBCA, 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. 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
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(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 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 the Appendix.
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 Research Growth 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
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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 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 Commodities Futures
Trading Commission ("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 total 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
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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 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, MFS Emerging Equities, MFS
Research 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--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
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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 security 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 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.
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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 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--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
securities 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
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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 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.
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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--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
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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.
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--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 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 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
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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 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--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.
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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 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--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
17
<PAGE>
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.
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
18
<PAGE>
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 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
19
<PAGE>
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 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
20
<PAGE>
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
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 losses.
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
21
<PAGE>
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.
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.
Temporary Defensive Positions--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. 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.
22
<PAGE>
MANAGEMENT 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.
<TABLE>
<CAPTION>
Principal Occupation(s) During Past
Five Years (and Positions held with
Affiliated Persons or Principal
Name, Address and Birthdate Position(s) Held with Fund Underwriter of the Fund)
- --------------------------- -------------------------- -----------------------------------
<S> <C> <C>
Laurie M. LeBlanc, CFP* Director and President Vice President, Aetna Life Insurance
151 Farmington Avenue and Annuity Company, January 1998 to
Hartford, Connecticut present; Vice President, Aetna
05/12/52 Retirement Services, Fund Strategy
and Management, December 1995 to
January 1998; Vice 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.
John V. Boyer Director Executive Director, The Mark Twain
63 Penn Drive House Museum, 1989 to present.
West Hartford, Connecticut
07/19/53
Richard A. Johnson Director Retired for more than five years.
24 Sulgrave Road
West Hartford, Connecticut
03/22/36
Philip M. Markert Director Retired since March 1996; Division
164 Calhoun Street Executive, Citibank,
Washington, Connecticut Caribbean/Central America Region,
06/22/38 February 1964 to March 1996.
Martin T. Conroy* Director, Vice President, Chief Assistant Treasurer, Aetna
151 Farmington Avenue Financial Officer and Treasurer Retirement Holdings, Inc., September
Hartford, Connecticut 1997 to present; Assistant
01/11/40 Treasurer, Aetna Life Insurance and
Annuity Company, October 1991 to present.
Susan C. Mosher Secretary Director, Mutual Fund Administration
200 Clarendon Street - Legal Administration, Investors
Boston, Massachusetts Bank & Trust Company, 1995 -
1/29/55 present; Associate Counsel, 440
Financial Group of Worcester, Inc.,
1993 - 1995.
</TABLE>
23
<PAGE>
*Interested person as defined by the 1940 Act.
Members of the Board of the Directors 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 of Directors 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; $2,500 for each
in-person Contract Committee meeting on any day on which a regular board meeting
is not scheduled; and $1,500 for each in-person committee meeting, other than a
Contract 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, Audit and Contract 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 previous December 31.
The following table describes the compensation received by the Directors of the
Fund for the fiscal year ended December 31, 1998.
Compensation Table
<TABLE>
<CAPTION>
Total Compensation From Fund and
Name of Person, Position Aggregate Compensation From Fund Fund Complex Paid to Directors
- ------------------------ -------------------------------- ------------------------------
<S> <C> <C>
John V. Boyer, Director $39,833.34 $39,833.34
Richard A. Johnson, Director 39,833.34 39,833.34
Philip M. Markert, Director 39,833.34 39,833.34
</TABLE>
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 contracts ("VLI Contracts"). Aetna and
its subsidiary, Aetna Insurance Company of America, Inc. may be deemed a control
person of the Fund in that certain of their separate accounts hold 100% of the
shares of each Portfolio of the Fund.
As of February 4, 1999, the following owned of record or, to the knowledge of
management, beneficially owned more than 5% of the outstanding shares of:
T. Rowe Price Growth Equity Portfolio--Aetna Life Insurance & Annuity Company
(ALIAC), c/o Aetna Retirement Plan Services, Treasury Services, 151 Farmington
Avenue, Hartford, Connecticut 06156 (95.26%)
MFS Emerging Equities Portfolio--Aetna Life Insurance & Annuity Company (ALIAC),
c/o Aetna Retirement Plan Services, Treasury Services, 151 Farmington Avenue,
Hartford, Connecticut 06156 (93.42%).
MFS Research Growth Portfolio--Aetna Life Insurance & Annuity Company (ALIAC),
c/o Aetna Retirement Plan Services, Treasury Services, 151 Farmington Avenue,
Hartford, Connecticut 06156 (93.45%).
MFS Value Equity Portfolio--Aetna Life Insurance & Annuity Company (ALIAC), c/o
Aetna Retirement Plan Services, Treasury Services, 151 Farmington Avenue,
Hartford, Connecticut 06156 (96.58%).
Scudder International Growth Portfolio--Aetna Life Insurance & Annuity Company
(ALIAC), c/o Aetna Retirement Plan Services, Treasury Services, 151 Farmington
Avenue, Hartford, Connecticut 06156 (95.42%).
24
<PAGE>
The Fund has no knowledge of any other owners of record of 5% or more of the
outstanding shares of a Portfolio. Shareholders owning more than 25% of the
outstanding shares of a Portfolio may take actions without the approval of other
investors in the Fund. 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.
The Directors and Officers of the Fund as a group owned less than 1% of the
outstanding shares of any Portfolio of the Fund as of February 4, 1999.
INVESTMENT ADVISORY AND OTHER SERVICES
Investment Advisory Agreement. 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.
The Prospectus contains a description of fees payable to Aetna.
For the fiscal year ended December 31, 1998, and for the period November 28,
1997 (commencement of operations) to December 31, 1997, the advisory fees for
the MFS Emerging Equities, MFS Research Growth, MFS Value Equity, Scudder
International Growth and T. Rowe Price Growth Equity amounted to $6,073,693 and
$482,568, $3,075,409 and $257,457, $1,073,994 and $79,213, $3,330,261 and
$282,965, and $2,643,704 and $202,630, respectively.
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<PAGE>
Subadvisory Agreements. 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 Kemper Investments, Inc. ("Scudder
Kemper") with respect to Scudder International Growth; and with T. Rowe Price
Associates, Inc. ("T. Rowe Price") with respect to T. Rowe Price Growth Equity.
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 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 below.
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.
<TABLE>
<S> <C>
MFS Emerging Equities....................... .40% on the first $300 million of aggregate
MFS Research Growth average daily net assets under management
MFS Value Equity .375% on the next $300 million
.35% on the next $300 million
.325% on the next $600 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
</TABLE>
For the fiscal year ended December 31, 1998 and the period November 28, 1997
(commencement of operations) to December 31, 1997, Aetna paid MFS $5,423,591 and
$446,631 on behalf of MFS Emerging Equities, MFS Research Growth and MFS Value
Equity, respectively. For the fiscal year ended December 31, 1998, and the
period November 28, 1997 (commencement of operations) to December 31, 1997,
Aetna paid Scudder Kemper $1,721,358 and $150,126 on behalf of Scudder
International Growth and T. Rowe Price $1,762,470 and $135,087 on behalf of T.
Rowe Price Growth Equity.
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<PAGE>
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 and is responsible for the
supervision of the Fund's other service providers. Each Portfolio's costs and
fees are limited to its advisory fee and the administrative services charge. The
Administrative Services Agreement 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. As compensation for its 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:
<TABLE>
<CAPTION>
Portfolio Fee
- --------- ---
<S> <C>
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%
</TABLE>
For the fiscal year ended December 31, 1998, the MFS Emerging Equities, MFS
Research Growth, MFS Value Equity, Scudder International Growth and T. Rowe
Price Growth Equity Portfolios paid Aetna $1,164,739, $659,016, $413,075,
$832,612 and $660, 926, respectively, for such administrative services.
Each Portfolio's aggregate expenses are limited to the advisory and
administrative service fees disclosed above. Aetna has agreed to reimburse the
Portfolios for expenses and/or waive its fees, so that, through at least April
30, 2000, the aggregate of each Portfolio's expenses will not exceed the
combined investment advisory and administrative service fee rates shown above.
Custodian and Transfer Agent. Investors Bank & Trust Company ("Investors Bank"),
200 Clarendon Street, Boston, Massachusetts, serves as custodian and transfer
agent for the Fund. Investors Bank 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, 99 High Street, Boston,
Massachusetts 02110 serves as independent auditors to the Portfolios. KPMG Peat
Marwick LLP provides audit services, assistance and consultation in connection
with SEC filings.
PRINCIPAL UNDERWRITER
The Fund has entered into an Underwriting Agreement (the "Agreement") pursuant
to which Aetna, as agent, serves as principal underwriter for the continuous
offering of shares of the Portfolios. The 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. The
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. The Underwriter has agreed to use its best efforts to solicit orders
for the purchase of shares of all the Portfolios, although it is not obligated
to sell any particular amount of shares. Aetna shall be responsible for any
costs of printing and distributing prospectuses and Statements necessary to
offer and sell the shares, and such other sales literature, reports, forms and
advertisements as it elects to prepare. The Fund shall be responsible for the
costs of registering the shares with the SEC and for the costs of preparing
prospectuses and Statements and such other documents as are required to maintain
the registration of the shares with the SEC. Aetna does not receive compensation
for providing services under the Agreement.
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
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<PAGE>
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 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.
During the fiscal year ended December 31, 1998, and the period November 28, 1997
(commencement of operations) to December 31, 1997 the aggregate amount of
brokerage commissions paid by the Portfolios was as
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<PAGE>
follows: MFS Emerging Equities: $332,149 and $453,702; MFS Research Growth:
$984,339 and $433,626; MFS Value Equity: $642,245 and $214,636; Scudder
International Growth: $1,314,765 and $66,716; and T. Rowe Price Growth Equity:
$567,634 and $380,629.
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.
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
Contracts. The insurance company depositors of the separate accounts pass voting
rights attributable to shares held for VA Contracts and VLI Contracts through to
Contract owners as described in the prospectus for the applicable VA or VLI
Contract.
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.
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.
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.
29
<PAGE>
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.
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 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").
30
<PAGE>
31
<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.
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"). It is intended that each Portfolio will be 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
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<PAGE>
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.
Excise Tax on Regulated Investment Companies--A 4% nondeductible excise tax is
generally 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.
No excise tax applies, however, to a regulated investment company whose sole
shareholders are segregated asset accounts (aside from up to $250,000 of shares
attributable to seed capital). The Portfolios should qualify for this exemption.
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. 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.
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 total 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
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<PAGE>
Investors should not consider this performance data as an indication of the
future performance of any of the Portfolios.
The average annual total returns for the Portfolios for the one year period
ended December 31, 1998 were as follows: MFS Emerging Equities, 29.67%; MFS
Research Growth, 23.00%; MFS Value Equity, 26.74%; Scudder International Growth,
19.09%; and T. Rowe Price Growth Equity, 27.60%.
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 has the same investment objective and follows substantially the
same investment strategies as a mutual fund or funds whose shares are currently
sold to the public or through variable insurance products and is/are managed by
MFS, Scudder Kemper 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 and VLI Contract 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.
FINANCIAL STATEMENTS
The financial statements and independent auditors' report thereon for MFS
Emerging Equities, MFS Research Growth, MFS Value Equity, Scudder International
Growth and T. Rowe Price Growth Equity are incorporated by reference to the
Fund's Annual Report as of and for the period ended December 31, 1998, and have
been incorporated by reference into this Statement.
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<PAGE>
APPENDIX
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 GROUP
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.
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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 IBCA, 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.
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.
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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.
