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MAY 1, 1997
PAINEWEBBER SERIES TRUST
1285 AVENUE OF THE AMERICAS
NEW YORK, NEW YORK 10019
STATEMENT OF ADDITIONAL INFORMATION
PaineWebber Series Trust ("Fund") is a professionally managed mutual fund
that offers the nine series of shares ("Portfolios") listed below. All the
Portfolios except Global Income Portfolio are diversified, and each has its own
investment objective and policies. Shares of each Portfolio are offered only to
insurance company separate accounts that fund certain variable contracts
("Contracts"). Advisory and administrative services are provided to the Fund by
Mitchell Hutchins Asset Management Inc. ("Mitchell Hutchins"), a wholly owned
subsidiary of PaineWebber Incorporated ("PaineWebber"), and certain Portfolios,
as indicated below, have sub-advisers ("Sub-Advisers").
*MONEY MARKET PORTFOLIO seeks maximum current income consistent with
liquidity and conservation of capital. This Portfolio invests in high grade
money market instruments and repurchase agreements secured by such
instruments.
*HIGH GRADE FIXED INCOME PORTFOLIO primarily seeks current income
consistent with the preservation of capital and secondarily seeks capital
appreciation. This Portfolio invests primarily in debt securities issued or
guaranteed by the U.S. government, its agencies or instrumentalities and
high quality corporate debt securities and mortgage- and asset-backed
securities of private issuers.
*STRATEGIC FIXED INCOME PORTFOLIO seeks total return consisting of
capital appreciation and income. This Portfolio invests primarily in fixed
income securities of varying maturities with a dollar-weighted average
portfolio duration between three and eight years. Pacific Investment
Management Company serves as Sub-Adviser to this Portfolio.
*GLOBAL INCOME PORTFOLIO primarily seeks high current income and
secondarily seeks capital appreciation. This Portfolio invests principally
in high quality debt securities of foreign and U.S. issuers.
*BALANCED PORTFOLIO seeks high total return with low volatility. This
Portfolio invests primarily in a combination of equity securities,
investment grade debt obligations and money market instruments, based on
Mitchell Hutchins' assessment of the optimal allocation of the Portfolio's
assets.
*GROWTH AND INCOME PORTFOLIO seeks current income and capital growth.
This Portfolio invests primarily in dividend-paying equity securities
believed by Mitchell Hutchins to have the potential for rapid earnings
growth.
*GROWTH PORTFOLIO seeks long-term capital appreciation. This Portfolio
invests primarily in equity securities of companies that, in the judgment
of Mitchell Hutchins, have substantial potential for capital growth.
*AGGRESSIVE GROWTH PORTFOLIO seeks to maximize long-term capital
appreciation. This Portfolio invests primarily in the common stocks of U.S.
companies. Nicholas-Applegate Capital Management serves as Sub-Adviser to
this Portfolio.
*GLOBAL GROWTH PORTFOLIO seeks long-term capital appreciation. This
Portfolio invests primarily in common stocks of companies based in the
United States, Europe, Japan and the Pacific Basin. GE Investment
Management Incorporated serves as Sub-Adviser to this Portfolio.
This Statement of Additional Information is not a prospectus and should be
read only in conjunction with the Fund's current Prospectus, dated May 1, 1997.
A copy of the Prospectus may be obtained by contacting the Fund or your
PaineWebber investment executive.
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TABLE OF CONTENTS
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Investment Policies and Limitations........................................ 3
Hedging and Related Strategies............................................. 14
Trustees and Officers...................................................... 23
Investment Advisory Services............................................... 30
Portfolio Transactions..................................................... 32
Additional Purchase and Redemption Information............................. 35
Valuation of Shares........................................................ 35
Taxes...................................................................... 36
Dividends.................................................................. 38
Other Information.......................................................... 38
Financial Statements....................................................... 39
Description of Commercial Paper and Bond Ratings........................... 39
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INVESTMENT POLICIES AND LIMITATIONS
The following supplements the information contained in the Fund's Prospectus
concerning the investment policies and limitations of its nine Portfolios.
Except as otherwise indicated in the Prospectus or the Statement of Additional
Information, there are no policy limitations on a Portfolio's ability to use
the investments or techniques discussed in these documents.
SPECIAL CONSIDERATIONS RELATING TO FOREIGN SECURITIES. As noted in the
Prospectus, Global Income Portfolio, Global Growth Portfolio and Strategic
Fixed Income Portfolio each invests in securities of foreign issuers. In
addition, all Portfolios may invest in U.S. dollar-denominated securities of
foreign issuers. Many of these foreign securities are not registered with the
Securities and Exchange Commission ("SEC"), nor are the issuers thereof subject
to its reporting requirements. Accordingly, there may be less publicly
available information concerning foreign issuers of securities held by the
Portfolios than is available concerning U.S. companies. Foreign companies are
not generally subject to uniform accounting, auditing and financial reporting
standards or to other regulatory requirements comparable to those applicable to
U.S. companies.
In addition to purchasing securities of foreign issuers in foreign markets,
Global Income, Global Growth and Strategic Fixed Income Portfolios may invest
in American Depository Receipts ("ADRs"), European Depository Receipts ("EDRs")
or other securities convertible into securities of companies based in foreign
countries. These securities may not necessarily be denominated in the same
currency as the securities into which they may be converted. Generally, ADRs,
in registered form, are denominated in U.S. dollars and are designed for use in
the U.S. securities markets and EDRs, in bearer form, may be denominated in
other currencies and are designed for use in European securities markets. ADRs
are receipts typically issued by a U.S. bank or trust company evidencing
ownership of the underlying securities. EDRs are European receipts evidencing a
similar arrangement. The other Portfolios generally invest in securities of
foreign companies only if such securities are traded in the U.S. securities
markets directly or through ADRs. For purposes of the Fund's investment
policies, ADRs and EDRs are deemed to have the same classification as the
underlying securities they represent. Thus, an ADR or EDR evidencing ownership
of common stock will be treated as common stock.
Global Growth Portfolio anticipates that its brokerage transactions involving
securities of companies headquartered in countries other than the United States
will be conducted primarily on the principal exchanges of such countries.
Foreign security trading practices, including those involving securities
settlement where Portfolio assets may be released prior to receipt of payment,
may expose the Portfolio to increased risk in the event of a failed trade or
the insolvency of a foreign broker-dealer. Transactions on foreign exchanges
are usually subject to fixed commissions that are generally higher than
negotiated commissions on U.S. transactions, although the Portfolio will
endeavor to achieve the best net results in effecting portfolio transactions.
There is generally less government supervision and regulation of exchanges and
brokers in foreign countries than in the United States.
Investment income on certain foreign securities may be subject to foreign
withholding or other taxes that could reduce the return on these securities.
Tax treaties between the United States and foreign countries, however, may
reduce or eliminate the amount of foreign taxes to which a Portfolio would be
subject.
SOVEREIGN DEBT. Investment in debt securities issued by foreign governments
and their political subdivisions or agencies ("Sovereign Debt") involves
special risks. The issuer of the debt or the governmental authorities that
control the repayment of the debt may be unable or unwilling to repay principal
and/or interest when due in accordance with the terms of such debt, and a
Portfolio may have limited legal recourse in the event of a default.
Sovereign Debt differs from debt obligations issued by private entities in
that, generally, remedies for defaults must be pursued in the courts of the
defaulting party. Legal recourse is therefore somewhat diminished. Political
conditions, especially a sovereign entity's willingness to meet the terms of
its debt
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obligations, are of considerable significance. Also, there can be no assurance
that the holders of commercial bank debt issued by the same sovereign entity
may not contest payments to the holders of Sovereign Debt in the event of
default under commercial bank loan agreements.
A sovereign debtor's willingness or ability to repay principal and interest
due in a timely manner may be affected by, among other factors, its cash flow
situation, the extent of its foreign reserves, the availability of sufficient
foreign exchange on the date a payment is due, the relative size of the debt
service burden to the economy as a whole, the sovereign debtor's policy toward
principal international lenders and the political constraints to which a
sovereign debtor may be subject. Increased protectionism on the part of a
country's trading partners, or political changes in those countries, could also
adversely affect its exports. Such events could diminish a country's trade
account surplus, if any, or the credit standing of a particular local
government or agency.
The occurrence of political, social or diplomatic changes in one or more of
the countries issuing Sovereign Debt could adversely affect a Portfolio's
investments. Political changes or a deterioration of a country's domestic
economy or balance of trade may affect the willingness of countries to service
their Sovereign Debt. While Mitchell Hutchins or the applicable Sub-Adviser
manages the Portfolios' investments in a manner that is intended to minimize
the exposure to such risks, there can be no assurance that adverse political
changes will not cause a Portfolio to suffer a loss of interest or principal on
any of its holdings.
FOREIGN CURRENCY TRANSACTIONS. Although each of Strategic Fixed Income,
Global Income and Global Growth Portfolios values its assets daily in U.S.
dollars, none of these Portfolios intends to convert its holdings of foreign
currencies to U.S. dollars on a daily basis. The Portfolios' foreign currencies
may be held as "foreign currency call accounts" at foreign branches of foreign
or domestic banks. These accounts bear interest at negotiated rates and are
payable upon relatively short demand periods. If a bank became insolvent, a
Portfolio could suffer a loss of some or all of the amounts deposited. The
Portfolios may convert foreign currency to U.S. dollars from time to time.
Although foreign exchange dealers generally do not charge a stated commission
or fee for conversion, the prices posted generally include a "spread," which is
the difference between the prices at which the dealers are buying and selling
foreign currencies.
SELECTION OF INVESTMENTS BY BALANCED PORTFOLIO. The money market instruments
in which Balanced Portfolio may invest include U.S. Treasury bills and other
obligations issued or guaranteed as to interest and principal by the U.S.
government, its agencies and instrumentalities; obligations of U.S. banks
(including certificates of deposit and bankers' acceptances) having total
assets at the time of purchase in excess of $1.5 billion and interest-bearing
savings deposits in U.S. commercial and savings banks in principal amounts at
each such bank not greater than are fully insured by the Federal Deposit
Insurance Corporation, provided that the aggregate amount of such deposits does
not exceed 5% of the value of the Portfolio's assets; commercial paper and
other short-term corporate obligations; and variable and floating rate
securities and repurchase agreements. The Portfolio may also hold cash.
The commercial paper and other short-term corporate obligations purchased by
the Portfolio will consist only of obligations of U.S. corporations that are
(1) rated at least Prime-2 by Moody's Investors Service ("Moody's") or A-2 by
Standard & Poor's, a division of the McGraw-Hill Companies, Inc. ("S&P"), (2)
comparably rated by another nationally recognized statistical rating
organization ("NRSRO") or (3) unrated and determined by Mitchell Hutchins to be
of comparable quality. These obligations may include variable amount master
demand notes, which are unsecured obligations redeemable upon notice that
permit investment of fluctuating amounts at varying rates of interest pursuant
to direct arrangements with the issuer of the instrument. Such obligations are
usually unrated by a rating agency.
The Portfolio may purchase variable rate securities with remaining maturities
of one year or more issued by U.S. government agencies or instrumentalities or
guaranteed by the U.S. government. The Portfolio may also acquire certain
variable and floating rate instruments issued by U.S. companies. The yield of
these securities varies in relation to changes in specific money market rates
such as the prime rate. These changes
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are reflected in adjustments to the yields of the variable rate securities at
least semi-annually, and different securities may have different adjustment
rates.
MORTGAGE-BACKED SECURITIES. Mortgage-backed securities represent direct or
indirect participations in, or are secured by and payable from, mortgage loans
secured by real property and include single- and multi-class pass-through
securities and collateralized mortgage obligations. Multi-class pass-through
securities and collateralized mortgage obligations are collectively referred to
herein as CMOs. The U.S. government mortgage-backed securities in which the
Portfolios may invest include mortgage-backed securities issued or guaranteed
as to the payment of principal and interest (but not as to market value) by the
Government National Mortgage Association ("Ginnie Mae"), Fannie Mae (also known
as, the Federal National Mortgage Association), or the Federal Home Loan
Mortgage Corporation ("Freddie Mac"). Other mortgage-backed securities are
issued by private issuers, generally originators of and investors in mortgage
loans, including savings associations, mortgage bankers, commercial banks,
investment bankers and special purpose entities (collectively "Private Mortgage
Lenders"). Payments of principal and interest (but not the market value) of
such private mortgage-backed securities may be supported by pools of mortgage
loans or other mortgage-backed securities that are guaranteed, directly or
indirectly, by the U.S. government or one of its agencies or instrumentalities,
or they may be issued without any government guarantee of the underlying
mortgage assets but with some form of non-government credit enhancement. New
types of mortgage-backed securities are developed and marketed from time to
time and, consistent with its investment limitations, each Portfolio expects to
invest in those new types of mortgage-backed securities that Mitchell Hutchins
or a Sub-Adviser believes may assist a Portfolio in achieving its investment
objective. Similarly, a Portfolio may invest in mortgage-backed securities
issued by new or existing governmental or private issuers other than those
identified herein.
Ginnie Mae Certificates. Ginnie Mae guarantees certain mortgage pass-through
certificates ("Ginnie Mae certificates") that are issued by Private Mortgage
Lenders and that represent ownership interests in individual pools of
residential mortgage loans. These securities are designed to provide monthly
payments of interest and principal to the investor. Timely payment of interest
and principal is backed by the full faith and credit of the U.S. government.
Each mortgagor's monthly payments to his lending institution on his residential
mortgage are "passed through" to certificateholders such as a Portfolio.
Mortgage pools consist of whole mortgage loans or participations in loans. The
terms and characteristics of the mortgage instruments are generally uniform
within a pool but may vary among pools. Lending institutions that originate
mortgages for the pools are subject to certain standards, including credit and
other underwriting criteria for individual mortgages included in the pools.
Fannie Mae Certificates. Fannie Mae facilitates a national secondary market
in residential mortgage loans insured or guaranteed by U.S. government agencies
and in privately insured or uninsured residential mortgage loans (sometimes
referred to as "conventional mortgage loans" or "conventional loans") through
its mortgage purchase and mortgage-backed securities sales activities. Fannie
Mae issues guaranteed mortgage pass-through certificates ("Fannie Mae
certificates"), which represent pro rata shares of all interest and principal
payments made and owed on the underlying pools. Fannie Mae guarantees timely
payment of interest and principal on Fannie Mae certificates. The Fannie Mae
guarantee is not backed by the full faith and credit of the U.S. government.
Freddie Mac Certificates. Freddie Mac also facilitates a national secondary
market for conventional residential and U.S. government-issued mortgage loans
through its mortgage purchase and mortgage-backed securities sales activities.
Freddie Mac issues two types of mortgage pass-through securities: mortgage
participation certificates ("PCs") and guaranteed mortgage certificates
("GMCs"). Each PC represents a pro rata share of all interest and principal
payments made and owed on the underlying pool. Freddie Mac generally guarantees
timely monthly payment of interest on PCs and the ultimate payment of
principal, but it also has a PC program under which it guarantees timely
payment of both principal and interest. GMCs also represent a pro rata interest
in a pool of mortgages. These instruments, however, pay interest semi-annually
and return principal once a year in guaranteed minimum payments. Freddie Mac
does not guarantee
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the market value of the security itself. The Freddie Mac guarantee is not
backed by full faith and credit of the U.S. government.
Private, RTC and Similar Mortgage-Backed Securities. Mortgage-backed
securities issued by Private Mortgage Lenders are structured similarly to the
CMOs or single class mortgage-backed securities issued or guaranteed by Ginnie
Mae, Fannie Mae and Freddie Mac. Such mortgage-backed securities may be
supported by pools of U.S. government or agency insured or guaranteed mortgage
loans or by other mortgage-backed securities issued by a government agency or
instrumentality, but they generally are supported by pools of conventional
(i.e., non-government guaranteed or insured) mortgage loans. Since such
mortgage-backed securities normally are not guaranteed by an entity having the
credit standing of Ginnie Mae, Fannie Mae or Freddie Mac, they normally are
structured with one or more types of credit enhancement. See "--Types of Credit
Enhancement." Such credit enhancements do not protect investors from changes in
market value.
The Resolution Trust Corporation ("RTC"), which was organized by the U.S.
government in connection with the savings and loan crisis, held assets of
failed savings associations as either a conservator or receiver for such
associations, or it acquired such assets in its corporate capacity. These
assets include, among other things, single family and multi-family mortgage
loans, as well as commercial mortgage loans. In order to dispose of such assets
in an orderly manner, RTC established a vehicle registered with the SEC through
which it sold mortgage-backed securities. RTC mortgage-backed securities
represent pro rata interests in pools of mortgage loans that RTC held or had
acquired, as described above, and are supported by one or more of the types of
private credit enhancements used by Private Mortgage Lenders.
Collateralized Mortgage Obligations and Multi-Class Mortgage Pass-
Throughs. CMOs are debt obligations that are collateralized either by mortgage
loans, mortgage pass-through securities or other CMOs (such collateral
collectively being called "Mortgage Assets"). CMOs may be issued by Private
Mortgage Lenders or by government entities such as Fannie Mae or Freddie Mac.
Multi-class mortgage pass-through securities are interests in trusts that are
comprised of Mortgage Assets and that have multiple classes similar to those of
CMOs. Unless the context indicates otherwise, references herein to CMOs include
multi-class mortgage pass-through securities. Payments of principal of and
interest on the Mortgage Assets (and, in the case of CMOs, any reinvestment
income thereon) provide the funds to pay debt service on the CMOs or to make
scheduled distributions on the multi-class mortgage pass-through securities.
In a CMO, a series of bonds or certificates is issued in multiple classes.
Each class of a CMO, also referred to as a "tranche," is issued at a specific
fixed or floating coupon rate and has a stated maturity or final distribution
date. Principal prepayments on the Mortgage Assets may cause CMOs to be retired
substantially earlier than their stated maturities or final distribution dates.
Interest is paid or accrues on all classes of a CMO (other than any principal-
only or PO class) on a monthly, quarterly or semi-annual basis. The principal
and interest on the Mortgage Assets may be allocated among the several classes
of a CMO in many ways. In one structure, payments of principal, including any
principal prepayments, on the Mortgage Assets are applied to the classes of a
CMO in the order of their respective stated maturities or final distribution
dates so that no payment of principal will be made on any class of the CMO
until all other classes having an earlier stated maturity or final distribution
date have been paid in full. In some CMO structures, all or a portion of the
interest attributable to one or more of the CMO classes may be added to the
principal amounts attributable to such classes, rather than passed through to
certificateholders on a current basis, until other classes of the CMO are paid
in full.
Parallel pay CMOs are structured to provide payments of principal on each
payment date to more than one class. These simultaneous payments are taken into
account in calculating the stated maturity date or final distribution date of
each class, which, as with other CMO structures, must be retired by its stated
maturity date or final distribution date but may be retired earlier.
Some CMO classes are structured to pay interest at rates that are adjusted in
accordance with a formula, such as a multiple or fraction of the change in a
specified interest rate index, so as to pay at a rate that will be
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attractive in certain interest rate environments but not in others. For
example, an inverse floating rate CMO class pays interest at a rate that
increases as a specified interest rate index decreases but decreases as that
index increases. For other CMO classes, the yield may move in the same
direction as market interest rates--i.e. the yield may increase as rates
increase and decrease as rates decrease--but may do so more rapidly or to a
greater degree. The market value of such securities generally is more volatile
than that of a fixed rate obligation. Such interest rate formulas may be
combined with other CMO characteristics. For example, a CMO class may be an
"inverse IO," on which the holders are entitled to receive no payments of
principal and are entitled to receive interest at a rate that will vary
inversely with a specified index or a multiple thereof.
Types of Credit Enhancement. To lessen the effect of failures by obligors on
Mortgage Assets to make payments, mortgage-backed securities may contain
elements of credit enhancement. Such credit enhancement falls into two
categories: (1) liquidity protection and (2) protection against losses
resulting after default by an obligor on the underlying assets and collection
of all amounts recoverable directly from the obligor and through liquidation of
the collateral. Liquidity protection refers to the provision of advances,
generally by the entity administering the pool of assets (usually the bank,
savings association or mortgage banker that transferred the underlying loans to
the issuer of the security), to ensure that the receipt of payments on the
underlying pool occurs in a timely fashion. Protection against losses resulting
after default and liquidation ensures ultimate payment of the obligations on at
least a portion of the assets in the pool. Such protection may be provided
through guarantees, insurance policies or letters of credit obtained by the
issuer or sponsor from third parties, through various means of structuring the
transaction or through a combination of such approaches. The Portfolios will
not pay any additional fees for such credit enhancement, although the existence
of credit enhancement may increase the price of a security. Credit enhancements
do not provide protection against changes in the market value of a security.
Examples of credit enhancement arising out of the structure of the
transaction include "senior-subordinated securities" (multiple class securities
with one or more classes subordinate to other classes as to the payment of
principal thereof and interest thereon, with the result that defaults on the
underlying assets are borne first by the holders of the subordinated class),
creation of "spread accounts" or "reserve funds" (where cash or investments,
sometimes funded from a portion of the payments on the underlying assets, are
held in reserve against future losses) and "over-collateralization" (where the
scheduled payments on, or the principal amount of, the underlying assets exceed
that required to make payment of the securities and pay any servicing or other
fees). The degree of credit enhancement provided for each issue generally is
based on historical information regarding the level of credit risk associated
with the underlying assets. Delinquency or loss in excess of that anticipated
could adversely affect the return on an investment in such a security.
Special Characteristics of Mortgage- and Asset-Backed Securities. Prepayments
on a pool of mortgage loans are influenced by a variety of economic,
geographic, social and other factors, including changes in mortgagors' housing
needs, job transfers, unemployment, mortgagors' net equity in the mortgaged
properties and servicing decisions. Generally, however, prepayments on fixed-
rate mortgage loans will increase during a period of falling interest rates and
decrease during a period of rising interest rates. Similar factors apply to
prepayments on asset-backed securities, but the receivables underlying asset-
backed securities generally are of a shorter maturity and thus are less likely
to experience substantial prepayments. Such securities, however, often provide
that for a specified time period the issuers will replace receivables in the
pool that are repaid with comparable obligations. If the issuer is unable to do
so, repayment of principal on the asset-backed securities may commence at an
earlier date. Mortgage- and asset-backed securities may decrease in value as a
result of increases in interest rates and may benefit less than other fixed-
income securities from declining interest rates because of the risk of
prepayment.
The rate of interest on mortgage-backed securities is lower than the interest
rates paid on the mortgages included in the underlying pool due to the annual
fees paid to the servicer of the mortgage pool for passing through monthly
payments to certificateholders and to any guarantor, and due to any yield
retained by the issuer. Actual yield to the holder may vary from the coupon
rate, even if adjustable, if the mortgage-backed
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securities are purchased or traded in the secondary market at a premium or
discount. In addition, there is normally some delay between the time the issuer
receives mortgage payments from the servicer and the time the issuer makes the
payments on the mortgage-backed securities, and this delay reduces the
effective yield to the holder of such securities.
Yields on pass-through securities are typically quoted by investment dealers
and vendors based on the maturity of the underlying instruments and the
associated average life assumption. The average life of pass-through pools
varies with the maturities of the underlying mortgage loans. A pool's term may
be shortened by unscheduled or early payments of principal on the underlying
mortgages. Because prepayment rates of individual pools vary widely, it is not
possible to predict accurately the average life of a particular pool. In the
past, a common industry practice has been to assume that prepayments on pools
of fixed rate 30-year mortgages would result in a 12-year average life for the
pool. At present, mortgage pools, particularly those with loans with other
maturities or different characteristics, are priced on an assumption of average
life determined for each pool. In periods of declining interest rates, the rate
prepayment tends to increase, thereby shortening the actual average life of a
pool of mortgage-related securities. Conversely, in periods of rising interest
rates, the rate of prepayment tends to decrease, thereby lengthening the actual
average life of the pool. However, these effects may not be present, or may
differ in degree, if the mortgage loans in the pools have adjustable interest
rates or other special payment terms, such as a prepayment charge. Actual
prepayment experience may cause the yield of mortgage-backed securities to
differ from the assumed average life yield. Reinvestment of prepayments may
occur at lower interest rates than the original investment, thus adversely
affecting the yield of a Portfolio.
Additional Information on ARM and Floating Rate Mortgage-Backed
Securities. Adjustable rate mortgage ("ARM") securities are mortgage-backed
securities that represent a right to receive interest payments at a rate that
is adjusted to reflect the interest earned on a pool of mortgage loans bearing
variable or adjustable rates of interest (such mortgage loans are referred to
as "ARMs"). Floating rate mortgage-backed securities are classes of mortgage-
backed securities that have been structured to represent the right to receive
interest payments at rates that fluctuate in accordance with an index but that
generally are supported by pools comprised of fixed-rate mortgage loans.
Because the interest rates on ARM and floating rate mortgage-backed
securities are reset in response to changes in a specified market index, the
values of such securities tend to be less sensitive to interest rate
fluctuations than the values of fixed-rate securities. As a result, during
periods of rising interest rates, ARMs generally do not decrease in value as
much as fixed rate securities. Conversely, during periods of declining rates,
ARMs generally do not increase in value as much as fixed rate securities. ARM
mortgage-backed securities represent a right to receive interest payments at a
rate that is adjusted to reflect the interest earned on a pool of ARMs. ARMs
generally specify that the borrower's mortgage interest rate may not be
adjusted above a specified lifetime maximum rate or, in some cases, below a
minimum lifetime rate. In addition, certain ARMs specify for limitations on the
maximum amount by which the mortgage interest rate may adjust for any single
adjustment period. ARMs also may limit changes in the maximum amount by which
the borrower's monthly payment may adjust for any single adjustment period. In
the event that a monthly payment is not sufficient to pay the interest accruing
on the ARM, any such excess interest is added to the mortgage loan ("negative
amortization"), which is repaid through future payments. If the monthly payment
exceeds the sum of the interest accrued at the applicable mortgage interest
rate and the principal payment that would have been necessary to amortize the
outstanding principal balance over the remaining term of the loan, the excess
reduces the principal balance of the ARM. Borrowers under ARMs experiencing
negative amortization may take longer to build up their equity in the
underlying property and may be more likely to default.
ARMs also may be subject to a greater rate of prepayments in a declining
interest rate environment. For example, during a period of declining interest
rates, prepayments on ARMs could increase because the availability of fixed
mortgage loans at competitive interest rates may encourage mortgagors to "lock-
in" at a
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lower interest rate. Conversely, during a period of rising interest rates,
prepayments on ARMs might decrease. The rate of prepayments with respect to
ARMs has fluctuated in recent years.
The rates of interest payable on certain ARMs, and therefore on certain ARM
mortgage-backed securities, are based on indices, such as the one-year constant
maturity Treasury rate, that reflect changes in market interest rates. Others
are based on indices, such as the 11th District Federal Home Loan Bank Cost of
Funds Index ("COFI"), that tend to lag behind changes in market interest rates.
The values of ARM mortgage-backed securities supported by ARMs that adjust
based on lagging indices tend to be somewhat more sensitive to interest rate
fluctuations than those reflecting current interest rate levels, although the
values of such ARM mortgage-backed securities still tend to be less sensitive
than fixed-rate securities.
Floating rate mortgage-backed securities are classes of mortgage-backed
securities that have been structured to represent the right to receive interest
payments at rates that fluctuate in accordance with an index but that generally
are supported by pools comprised of fixed-rate mortgage loans. As with ARM
mortgage-backed securities, interest rate adjustments on floating rate
mortgage-backed securities may be based on indices that lag behind market
interest rates. Interest rates on floating rate mortgage-backed securities
generally are adjusted monthly. Floating rate mortgage-backed securities are
subject to lifetime interest rate caps, but they generally are not subject to
limitations on monthly or other periodic changes in interest rates or monthly
payments.
ILLIQUID SECURITIES. Each Portfolio may invest up to 10% (15% for Strategic
Fixed Income and Aggressive Growth Portfolios) of its net assets in illiquid
securities. The term "illiquid securities" for this purpose means securities
that cannot be disposed of within seven days in the ordinary course of business
at approximately the amount at which a Portfolio has valued the securities and
includes, among other things, purchased over-the-counter ("OTC") options,
repurchase agreements maturing in more than seven days and restricted
securities other than those securities Mitchell Hutchins or the applicable Sub-
Adviser has determined are liquid pursuant to guidelines established by the
Fund's board of trustees. The assets used as cover for OTC options written by a
Portfolio will be considered illiquid unless the OTC options are sold to
qualified dealers who agree that the Portfolio may repurchase any OTC option it
writes at a maximum price to be calculated by a formula set forth in the option
agreement. The cover for an OTC option written subject to this procedure will
be considered illiquid only to the extent that the maximum repurchase price
under the option formula exceeds the intrinsic value of the option. Illiquid
restricted securities may be sold only in privately negotiated transactions or
in public offerings with respect to which a registration statement is in effect
under the Securities Act of 1933 ("1933 Act"). Restricted securities acquired
by Strategic Fixed Income, Global Income and Global Growth Portfolios include
those that are subject to restrictions contained in the securities laws of
other countries. For these Portfolios, securities that are freely marketable in
the country where they are principally traded, but would not be freely
marketable in the United States, will not be considered illiquid. Where
registration is required, a Portfolio may be obligated to pay all or part of
the registration expenses and a considerable period may elapse between the time
of the decision to sell and the time it may be permitted to sell a security
under an effective registration statement. If, during such a period, adverse
market conditions were to develop, the Portfolio might obtain a less favorable
price than prevailed when it decided to sell.
Not all restricted securities are illiquid. In recent years a large
institutional market has developed for certain securities that are not
registered under the 1933 Act, including private placements, repurchase
agreements, commercial paper, foreign securities and corporate bonds and notes.
These instruments are often restricted securities because the securities are
sold in transactions not requiring registration. Institutional investors
generally will not seek to sell these instruments to the general public, but
instead will often depend either on an efficient institutional market in which
such unregistered securities can be readily resold or on an issuer's ability to
honor a demand for repayment. Therefore, the fact that there are contractual or
legal restrictions on resale to the general public or certain institutions is
not dispositive of the liquidity of such investments.
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Rule 144A under the 1933 Act establishes a "safe harbor" from the
registration requirements of the 1933 Act for resales of certain securities to
qualified institutional buyers. Institutional markets for restricted securities
have developed as a result of Rule 144A, providing both readily ascertainable
values for restricted securities and the ability to liquidate an investment to
satisfy share redemption orders. Such markets might include automated systems
for the trading, clearance and settlement of unregistered securities of
domestic and foreign issuers, such as the PORTAL System sponsored by the
National Association of Securities Dealers, Inc. An insufficient number of
qualified buyers interested in purchasing Rule 144A-eligible restricted
securities held by a Portfolio, however, could affect adversely the
marketability of such portfolio securities and a Portfolio might be unable to
dispose of such securities promptly or at favorable prices.
The Fund's board of trustees (sometimes referred to as the "board") has
delegated the function of making day-to-day determinations of liquidity to
Mitchell Hutchins or the applicable Sub-Adviser, pursuant to guidelines
approved by the board. Mitchell Hutchins or the applicable Sub-Adviser takes
into account a number of factors in reaching liquidity decisions, including but
not limited to (1) the frequency of trades for the security, (2) the number of
dealers that make quotes for the security, (3) the number of dealers that have
undertaken to make a market in the security, (4) the number of other potential
purchasers and (5) the nature of the security and how trading is effected
(e.g., the time needed to sell the security, how bids are solicited and the
mechanics of transfer). Mitchell Hutchins or the applicable Sub-Adviser
monitors the liquidity of restricted securities in each Portfolio and reports
periodically on such decisions to the board of trustees.
SECTION 4(2) PAPER. Commercial paper issues in which the Portfolios may
invest include securities issued by major corporations without registration
under the 1933 Act in reliance on the exemption from such registration afforded
by Section 3(a)(3) thereof, and commercial paper issued in reliance on the so-
called "private placement" exemption from registration which is afforded by
Section 4(2) of the 1933 Act ("Section 4(2) paper"). Section 4(2) paper is
restricted as to disposition under the federal securities laws in that any
resale must similarly be made in an exempt transaction. Section 4(2) paper is
normally resold to other institutional investors through or with the assistance
of investment dealers who make a market in Section 4(2) paper, thus providing
liquidity. Section 4(2) paper that is issued by a company that files reports
under the Securities Exchange Act of 1934 is generally eligible to be sold in
reliance on the safe harbor of Rule 144A described under "Illiquid Securities"
above. The Portfolios' 10% (15% for Strategic Fixed Income and Aggressive
Growth Portfolios) limitation on investments in illiquid securities includes
Section 4(2) paper other than Section 4(2) paper that Mitchell Hutchins or the
applicable Sub-Adviser has determined to be liquid pursuant to guidelines
established by the Fund's board of trustees. The board has delegated to
Mitchell Hutchins or the applicable Sub-Adviser the function of making day-to-
day determinations of liquidity with respect to Section 4(2) paper, pursuant to
guidelines approved by the board that require Mitchell Hutchins or the
applicable Sub-Adviser to take into account the same factors described under
"Illiquid Securities" above for other restricted securities and require
Mitchell Hutchins or the applicable Sub-Adviser to perform the same monitoring
and reporting functions.
REPURCHASE AGREEMENTS. Repurchase agreements are transactions in which a
Portfolio purchases securities from a bank or recognized securities dealer and
simultaneously commits to resell the securities to the bank or dealer at an
agreed-upon date or upon demand and at a price reflecting a market rate of
interest unrelated to the coupon rate or maturity of the purchased securities.
The Portfolio maintains custody of the underlying securities prior to their
repurchase; thus, the obligation of the bank or dealer to pay the repurchase
price on the date agreed to is, in effect, secured by such securities. If the
value of these securities is less than the repurchase price, plus any agreed-
upon additional amount, the other party to the agreement must provide
additional collateral so that at all times the collateral is at least equal to
the repurchase price plus any agreed-upon additional amount. The difference
between the total amount to be received upon repurchase of the securities and
the price that was paid by the Portfolio upon their acquisition is accrued as
interest and included in the Portfolio's net investment income.
Repurchase agreements carry certain risks not associated with direct
investments in securities, including possible declines in the market value of
the underlying securities and delays and costs to a Portfolio if the
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other party to a repurchase agreement becomes insolvent. Each Portfolio intends
to enter into repurchase agreements only with banks and dealers in transactions
believed by Mitchell Hutchins or the applicable Sub-Adviser to present minimum
credit risks in accordance with guidelines established by the Fund's board of
trustees. Mitchell Hutchins or the applicable Sub-Adviser will review and
monitor the creditworthiness of those institutions under the board's general
supervision.
WHEN-ISSUED AND DELAYED DELIVERY SECURITIES. A security purchased on a when-
issued or delayed delivery basis is recorded as an asset on the commitment date
and is subject to changes in market value, generally based upon changes in the
level of interest rates. Thus, fluctuation in the value of the security from
the time of the commitment date will affect a Portfolio's net asset value. When
a Portfolio commits to purchase securities on a when-issued or delayed delivery
basis, its custodian segregates assets to cover the amount of the commitment.
See "Investment Policies and Limitations--Segregated Accounts." The Portfolios
purchase when-issued securities only with the intention of taking delivery, but
may sell the right to acquire the security prior to delivery if Mitchell
Hutchins or the applicable Sub-Adviser deems it advantageous to do so, which
may result in a capital gain or loss to a Portfolio.
LENDING OF PORTFOLIO SECURITIES. As indicated in the Prospectus, each
Portfolio is authorized to lend up to 33 1/3% of its total assets. A Portfolio
may lend its portfolio securities to broker-dealers or institutional investors
that Mitchell Hutchins deems qualified, but only when the borrower maintains
acceptable collateral with the Portfolio's custodian, marked to market daily,
in an amount at least equal to the market value of the securities loaned, plus
accrued interest and dividends. Acceptable collateral is limited to cash, U.S.
government securities and irrevocable letters of credit that meet certain
guidelines established by Mitchell Hutchins. In determining whether to lend
securities to a particular broker-dealer or institutional investor, Mitchell
Hutchins will consider, and during the period of the loan will monitor, all
relevant facts and circumstances, including the creditworthiness of the
borrower. The Portfolios will retain authority to terminate any loans at any
time. A Portfolio may pay reasonable administrative and custodial fees in
connection with a loan and may pay a negotiated portion of the interest earned
on the cash or money market instruments held as collateral to the borrower or
placing broker. A Portfolio will receive reasonable interest on the loan or a
flat fee from the borrower and amounts equivalent to any dividends, interest or
other distributions on the securities loaned. A Portfolio will regain record
ownership of loaned securities to exercise beneficial rights, such as voting
and subscription rights and rights to dividends, interest or other
distributions, when regaining such rights is considered to be in the
Portfolio's interest.
LOAN PARTICIPATIONS AND ASSIGNMENTS. Strategic Fixed Income Portfolio may
invest up to 5% of its net assets in secured or unsecured fixed or floating
rate loans ("Loans") arranged through private negotiations between a borrowing
corporation and one or more financial institutions ("Lenders"). The Portfolio's
investments in Loans are expected in most instances to be in the form of
participations ("Participations") in Loans and assignments ("Assignments") of
all or a portion of Loans from third parties. Participations typically result
in the Portfolio's having a contractual relationship only with the Lender, not
with the borrower. The Portfolio has the right to receive payments of
principal, interest and any fees to which it is entitled only from the Lender
selling the Participation and only upon receipt by the Lender of the payments
from the borrower. In connection with purchasing Participations, the Portfolio
generally has no direct right to enforce compliance by the borrower with the
terms of the loan agreement relating to the Loan, nor any rights of set-off
against the borrower, and the Portfolio may not directly benefit from any
collateral supporting the Loan in which it has purchased the Participation. As
a result, the Portfolio assumes the credit risk of both the borrower and the
Lender that is selling the Participation. In the event of the insolvency of the
Lender selling a Participation, the Portfolio may be treated as a general
creditor of the Lender and may not benefit from any set-off between the Lender
and the borrower. The Portfolio will acquire Participations only if the Lender
interpositioned between the Portfolio and the borrower is determined by
Mitchell Hutchins to be creditworthy.
When Strategic Fixed Income Portfolio purchases Assignments from Lenders, it
acquires direct rights against the borrower on the Loan. However, because
Assignments are arranged through private negotiations
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between potential assignees and assignors, the rights and obligations acquired
by the Portfolio as the purchaser of an Assignment may differ from, and be more
limited than, those held by the assigning Lender.
Assignments and Participations are generally not registered under the 1933
Act and thus are subject to the Portfolio's limitation on investment in
illiquid securities. Because there is no liquid market for such securities, the
Portfolio anticipates that such securities could be sold only to a limited
number of institutional investors. The lack of a liquid secondary market will
have an adverse impact on the value of such securities and on the Portfolio's
ability to dispose of particular Assignments or Participations when necessary
to meet the Portfolio's liquidity needs or in response to a specific economic
event, such as a deterioration in the creditworthiness of the borrower.
SHORT SALES "AGAINST THE BOX". Each Portfolio (other than Money Market
Portfolio) may engage in short sales of securities it owns or has the right to
acquire at no added cost through conversion or exchange of other securities it
owns (short sales "against the box") to defer realization of gains or losses
for tax or other purposes. To make delivery to the purchaser in a short sale,
the executing broker borrows the securities being sold short on behalf of the
Portfolio, and the Portfolio is obligated to replace the securities borrowed at
a date in the future. When a Portfolio sells short, it will establish a margin
account with the broker effecting the short sale, and will deposit collateral
with the broker. In addition, the Portfolio will maintain with its custodian,
in a segregated account, the securities that could be used to cover the short
sale. A Portfolio will incur transaction costs, including interest expense, in
connection with opening, maintaining and closing short sales against the box.
None of the Portfolios currently intends to have obligations under short sales
that at any time during the coming year exceed 5% of the Portfolio's net
assets.
A Portfolio might make a short sale "against the box" in order to hedge
against market risks when Mitchell Hutchins or a Sub-Adviser believes that the
price of a security may decline, thereby causing a decline in the value of a
security owned by the Portfolio or a security convertible into or exchangeable
for a security owned by the Portfolio, or when Mitchell Hutchins or a Sub-
Adviser wants to sell a security that the Portfolio owns at a current price,
but also wishes to defer recognition of gain or loss for federal income tax
purposes. In such case, any loss in the Portfolio's long position after the
short sale should be reduced by a gain in the short position. Conversely, any
gain in the long position should be reduced by a loss in the short position.
The extent to which gains or losses in the long position are reduced will
depend upon the amount of the securities sold short relative to the amount of
the securities the Portfolio owns, either directly or indirectly, and in the
case where the Portfolio owns convertible securities, changes in the investment
values or conversion premiums of such securities
SEGREGATED ACCOUNTS. When a Portfolio enters into certain transactions that
involve obligations to make future payments to third parties, including dollar
rolls, reverse repurchase agreements or the purchase of securities on a when-
issued or delayed delivery basis, the Portfolio will maintain with an approved
custodian in a segregated account cash or liquid securities, marked to market
daily, in an amount at least equal to the Portfolio's obligation or commitment
under such transactions. As described below under "Hedging and Related
Strategies," segregated accounts may also be required in connection with
certain transactions involving options or futures contracts, interest rate
protection transactions or forward currency contracts.
INVESTMENT LIMITATIONS. Each Portfolio will not:
(1) purchase any security if, as a result of that purchase, 25% or more
of the Portfolio's total assets would be invested in securities of issuers
having their principal business activities in the same industry, except
that this limitation does not apply to securities issued or guaranteed by
the U.S. government, its agencies or instrumentalities or to municipal
securities (or, in the case of Money Market Portfolio, to certificates of
deposit and bankers' acceptances of domestic branches of U.S. banks).
For Money Market Portfolio only--the following interpretation applies to,
but is not a part of, this fundamental restriction: With respect to this
limitation, domestic and foreign banking will be considered to be different
industries.
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(2) issue senior securities or borrow money, except as permitted under
the Investment Company Act of 1940 ("1940 Act") and then not in excess of
33 1/3% of the Portfolio's total assets (including the amount of the senior
securities issued but reduced by any liabilities not constituting senior
securities) at the time of the issuance or borrowing, except that the
Portfolio may borrow up to an additional 5% of its total assets (not
including the amount borrowed) for temporary or emergency purposes.
(3) make loans, except through loans of portfolio securities or through
repurchase agreements, provided that for purposes of this restriction, the
acquisition of bonds, debentures, other debt securities or instruments, or
participations or other interests therein and investments in government
obligations, commercial paper, certificates of deposit, bankers'
acceptances or similar instruments will not be considered the making of a
loan.
(4) engage in the business of underwriting securities of other issuers,
except to the extent that the Portfolio might be considered an underwriter
under the federal securities laws in connection with its disposition of
portfolio securities.
(5) purchase or sell real estate, except that investments in securities
of issuers that invest in real estate and investments in mortgage-backed
securities, mortgage participations or other instruments supported by
interests in real estate are not subject to this limitation, and except
that the Portfolio may exercise rights under agreements relating to such
securities, including the right to enforce security interests and to hold
real estate acquired by reason of such enforcement until that real estate
can be liquidated in an orderly manner.
(6) purchase or sell physical commodities unless acquired as a result of
owning securities or other instruments, but the Portfolio may purchase,
sell or enter into financial options and futures, forward and spot currency
contracts, swap transactions and other financial contracts or derivative
instruments.
The following investment restriction applies to all Portfolios except Global
Income Portfolio:
(7) purchase securities of any one issuer if, as a result, more than 5%
of the Portfolio's total assets would be invested in securities of that
issuer or the Portfolio would own or hold more than 10% of the outstanding
voting securities of that issuer, except that up to 25% of the Portfolio's
total assets may be invested without regard to this limitation, and except
that this limitation does not apply to securities issued or guaranteed by
the U.S. government, its agencies and instrumentalities or to securities
issued by other investment companies.
The following interpretation applies to, but is not a part of, this
fundamental limitation: Mortgage- and asset-backed securities will not be
considered to have been issued by the same issuer by reason of the
securities having the same sponsor, and mortgage- and asset-backed
securities issued by a finance or other special purpose subsidiary that are
not guaranteed by the parent company will be considered to be issued by a
separate issuer from the parent company.
The foregoing fundamental investment limitations cannot be changed with
respect to a Portfolio without the affirmative vote of the lesser of (a) more
than 50% of the outstanding shares of the Portfolio or (b) 67% or more of the
Portfolio's shares present at a meeting of its shareholders if more than 50% of
the outstanding shares of the Portfolio are represented at the meeting in
person or by proxy. If a percentage restriction is adhered to at the time of an
investment or transaction, a later change in percentage resulting from a change
in values of portfolio securities or amount of total assets will not be
considered a violation of any of the foregoing limitations.
The following investment restrictions, which apply to each Portfolio, are not
fundamental and may be changed by the vote of the Fund's board of trustees
without shareholder approval. Each Portfolio will not:
(1) hold assets of any issuers, at the end of any calendar quarter (or
within 30 days thereafter), to the extent such holdings would cause the
Portfolio to fail to comply with the diversification requirements imposed
by section 817(h) of the Internal Revenue Code and the Treasury regulations
issued thereunder on segregated asset accounts used to fund variable
annuity contracts.
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(2) purchase securities on margin, except for short-term credit necessary
for clearance of portfolio transactions and except that the Portfolio may
make margin deposits in connection with its use of financial options and
futures, forward and spot currency contracts, swap transactions and other
financial contracts or derivative instruments.
(3) engage in short sales of securities or maintain a short position,
except that the Portfolio may (a) sell short "against the box" and (b)
maintain short positions in connection with its use of financial options
and futures, forward and spot currency contracts, swap transactions and
other financial contracts or derivative instruments.
(4) purchase securities of other investment companies, except to the
extent permitted by the 1940 Act and except that this limitation does not
apply to securities received or acquired as dividends, through offers of
exchange, or as a result of reorganization, consolidation, or merger.
(5) purchase portfolio securities while borrowings in excess of 5% of its
total assets are outstanding.
HEDGING AND RELATED STRATEGIES USING DERIVATIVE CONTRACTS
As discussed in the Prospectus, Mitchell Hutchins or the applicable Sub-
Adviser may use a variety of financial instruments ("Strategic Instruments"),
including certain options, futures contracts (sometimes referred to as
"futures") and options on futures contracts, to attempt to hedge the
Portfolios' investments or attempt to enhance the Portfolios' income or return.
For Strategic Fixed Income, Global Income and Global Growth Portfolios,
Mitchell Hutchins or the applicable Sub-Adviser also may use forward currency
contracts, foreign currency options and futures and options thereon. High Grade
Fixed Income, Strategic Fixed Income and Global Income Portfolios also may
enter into interest rate protection transactions. A Portfolio may enter into
transactions using one or more types of Strategic Instruments under which the
full value of its portfolio is at risk. Under normal circumstances, however, a
Portfolio's use of these instruments will place at risk a much smaller portion
of its assets. The particular Strategic Instruments used by the Portfolios are
described below. Money Market Portfolio is not authorized to use these
Strategic Instruments.
OPTIONS ON EQUITY AND DEBT SECURITIES AND FOREIGN CURRENCIES--A call option
is a short-term contract pursuant to which the purchaser of the option, in
return for a premium, has the right to buy the security or currency underlying
the option at a specified price at any time during the term of the option. The
writer of the call option, who receives the premium, has the obligation, upon
exercise of the option during the option term, to deliver the underlying
security or currency against payment of the exercise price. A put option is a
similar contract that gives its purchaser, in return for a premium, the right
to sell the underlying security or currency at a specified price during the
option term. The writer of the put option, who receives the premium, has the
obligation, upon exercise of the option during the option term, to buy the
underlying security or currency at the exercise price.
OPTIONS ON STOCK INDEXES--A stock index assigns relative values to the stocks
included in the index and fluctuates with changes in the market values of those
stocks. A stock index option operates in the same way as a more traditional
stock option, except that exercise of a stock index option is effected with
cash payment and does not involve delivery of securities. Thus, upon exercise
of a stock index option, the purchaser will realize, and the writer will pay,
an amount based on the difference between the exercise price and the closing
price of the stock index.
STOCK INDEX FUTURES CONTRACTS--A stock index futures contract is a bilateral
agreement pursuant to which one party agrees to accept, and the other party
agrees to make, delivery of an amount of cash equal to a specified dollar
amount times the difference between the stock index value at the close of
trading of the contract and the price at which the futures contract is
originally struck. No physical delivery of the stocks comprising the index is
made. Generally, contracts are closed out prior to the expiration date of the
contract.
INTEREST RATE AND FOREIGN CURRENCY FUTURES CONTRACTS--Interest rate and
foreign currency futures contracts are bilateral agreements pursuant to which
one party agrees to make, and the other party agrees to
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accept, delivery of a specified type of debt security or currency at a
specified future time and at a specified price. Although such futures contracts
by their terms call for actual delivery or acceptance of debt securities or
currency, in most cases the contracts are closed out before the settlement date
without the making or taking of delivery.
OPTIONS ON FUTURES CONTRACTS--Options on futures contracts are similar to
options on securities or currency, except that an option on a futures contract
gives the purchaser the right, in return for the premium, to assume a position
in a futures contract (a long position if the option is a call and a short
position if the option is a put), rather than to purchase or sell a security or
currency, at a specified price at any time during the option term. Upon
exercise of the option, the delivery of the futures position to the holder of
the option will be accompanied by delivery of the accumulated balance that
represents the amount by which the market price of the futures contract
exceeds, in the case of a call, or is less than, in the case of a put, the
exercise price of the option on the future. The writer of an option, upon
exercise, will assume a short position in the case of a call and a long
position in the case of a put.
FORWARD CURRENCY CONTRACTS--A forward currency contract involves an
obligation to purchase or sell a specific currency at a specified future date,
which may be any fixed number of days from the contract date agreed upon by the
parties, at a price set at the time the contract is entered into.
GENERAL DESCRIPTION OF HEDGING STRATEGIES. Hedging strategies can be broadly
categorized as "short hedges" and "long hedges." A short hedge is a purchase or
sale of a Strategic Instrument intended partially or fully to offset potential
declines in the value of one or more investments held by a Portfolio. Thus, in
a short hedge a Portfolio takes a position in a Strategic Instrument whose
price is expected to move in the opposite direction of the price of the
investment being hedged. For example, a Portfolio might purchase a put option
on a security to hedge against a potential decline in the value of that
security. If the price of the security declined below the exercise price of the
put, the Portfolio could exercise the put and thus limit its loss below the
exercise price to the premium paid plus transaction costs. In the alternative,
because the value of the put option can be expected to increase as the value of
the underlying security declines, the Portfolio might be able to close out the
put option and realize a gain to offset the decline in the value of the
security.
Conversely, a long hedge is a purchase or sale of a Strategic Instrument
intended partially or fully to offset potential increases in the acquisition
cost of one or more investments that a Portfolio intends to acquire. Thus, in a
long hedge a Portfolio takes a position in a Strategic Instrument whose price
is expected to move in the same direction as the price of the prospective
investment being hedged. For example, a Portfolio might purchase a call option
on a security it intends to purchase in order to hedge against an increase in
the cost of the security. If the price of the security increased above the
exercise price of the call, the Portfolio could exercise the call and thus
limit its acquisition cost to the exercise price plus the premium paid and
transaction costs. Alternatively, the Portfolio might be able to offset the
price increase by closing out an appreciated call option and realizing a gain.
A Portfolio may purchase and write (sell) covered straddles on securities and
stock indices. A long straddle is a combination of a call and a put option
purchased on the same security or on the same futures contract, where the
exercise price of the put is equal to the exercise price of the call. A
Portfolio might enter into a long straddle when Mitchell Hutchins or the
applicable Sub-Adviser believes it likely that interest rates will be more
volatile during the term of the option than the option pricing implies. A short
straddle is a combination of a call and a put written on the same security
where the exercise price of the put is equal to the exercise price of the call.
A Portfolio might enter into a short straddle when Mitchell Hutchins or the
applicable Sub-Adviser believes it unlikely that interest rates will be as
volatile during the term of the option as the option pricing implies.
Strategic Instruments on securities generally are used to hedge against price
movements in one or more particular securities positions that a Portfolio owns
or intends to acquire. Strategic Instruments on stock
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indices, in contrast, generally are used to hedge against price movements in
broad equity market sectors in which the Portfolio has invested or expects to
invest. Strategic Instruments on debt securities may be used to hedge either
individual securities or broad fixed income market sectors.
Income strategies include the writing of covered options to obtain the
related option premiums. Return strategies include the use of Strategic
Instruments to increase or reduce a Portfolio's exposure to an asset class
without buying or selling the underlying instruments.
The use of Strategic Instruments is subject to applicable regulations of the
SEC, the several options and futures exchanges upon which they are traded and
the Commodity Futures Trading Commission ("CFTC"). In addition, a Portfolio's
ability to use Strategic Instruments will be limited by tax considerations. See
"Taxes."
In addition to the products, strategies and risks described below and in the
Prospectus, Mitchell Hutchins or the applicable Sub-Adviser expects to discover
additional opportunities in connection with options, future contracts, forward
currency contracts and other hedging, income and return strategies. These new
opportunities may become available as Mitchell Hutchins or the applicable Sub-
Adviser develops new techniques, as regulatory authorities broaden the range of
permitted transactions and as new options, futures contracts, forward currency
contracts or other techniques are developed. Mitchell Hutchins or the
applicable Sub-Adviser may utilize these opportunities to the extent that they
are consistent with the Portfolios' investment objectives and permitted by the
Portfolios' investment limitations and applicable regulatory authorities. The
Fund's Prospectus or Statement of Additional Information will be supplemented
to the extent that new products or techniques involve materially different
risks than those described below or in the Prospectus.
SPECIAL RISKS OF STRATEGIES USING DERIVATIVES CONTRACTS. The use of Strategic
Instruments involves special considerations and risks, as described below.
Risks pertaining to particular Strategic Instruments are described in the
sections that follow.
(1) Successful use of most Strategic Instruments depends upon Mitchell
Hutchins' or the applicable Sub-Adviser's ability to predict movements of
the overall securities, currency and interest rate markets, which requires
different skills than predicting changes in the prices of individual
securities. While Mitchell Hutchins or the applicable Sub-Adviser is
experienced in the use of Strategic Instruments, there can be no assurance
that any particular strategy adopted will succeed.
(2) There might be imperfect correlation, or even no correlation, between
price movements of a Strategic Instrument and price movements of the
investments being hedged. For example, if the value of a Strategic
Instrument used in a short hedge increased by less than the decline in
value of the hedged investment, the hedge would not be fully successful.
Such a lack of correlation might occur due to factors unrelated to the
value of the investments being hedged, such as speculative or other
pressures on the markets in which Strategic Instruments are traded. The
effectiveness of hedges using Strategic Instruments on indices will depend
on the degree of correlation between price movements in the index and price
movements in the securities being hedged.
(3) Hedging strategies, if successful, can reduce risk of loss by wholly
or partially offsetting the negative effect of unfavorable price movements
in the investments being hedged. However, hedging strategies can also
reduce opportunity for gain by offsetting the positive effect of favorable
price movements in the hedged investments. For example, if a Portfolio
entered into a short hedge because Mitchell Hutchins or the applicable Sub-
Adviser projected a decline in the price of a security held by a Portfolio,
and the price of that security increased instead, the gain from that
increase might be wholly or partially offset by a decline in the price of
the Strategic Instrument. Moreover, if the price of the Strategic
Instrument declined by more than the increase in the price of the security,
the Portfolio could suffer a loss. In either such case, the Portfolio would
have been in a better position had it not hedged at all.
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(4) As described below, a Portfolio might be required to maintain assets
as "cover," maintain segregated accounts or make margin payments when it
takes positions in Strategic Instruments involving obligations to third
parties (i.e., Strategic Instruments other than purchased options). If a
Portfolio were unable to close out its positions in such Strategic
Instruments, it might be required to continue to maintain such assets or
accounts or make such payments until the position expired or matured. These
requirements might impair a Portfolio's ability to sell a portfolio
security or make an investment at a time when it would otherwise be
favorable to do so, or require that a Portfolio sell a portfolio security
at a disadvantageous time. A Portfolio's ability to close out a position in
a Strategic Instrument prior to expiration or maturity depends on the
existence of a liquid secondary market or, in the absence of such a market,
the ability and willingness of a contra party to enter into a transaction
closing out the position. Therefore, there is no assurance that any
position can be closed out at a time and price that is favorable to the
Portfolio.
COVER FOR STRATEGIES USING DERIVATIVES CONTRACTS. Transactions using
Strategic Instruments, other than purchased options, expose a Portfolio to an
obligation to another party. A Portfolio will not enter into any such
transactions unless it owns either (1) an offsetting ("covered") position in
securities, currencies or other options, futures contracts or forward currency
contracts or (2) cash and liquid, securities, with a value sufficient at all
times to cover its potential obligations to the extent not covered as provided
in (1) above. Each Portfolio will comply with SEC guidelines regarding cover
for such transactions and will, if the guidelines so require, set aside cash or
liquid, securities in a segregated account with its custodian in the prescribed
amount.
Assets used as cover or held in a segregated account cannot be sold while the
position in the corresponding Strategic Instrument is open, unless they are
replaced with similar assets. As a result, the commitment of a large portion of
a Portfolio's assets to cover or segregated accounts could impede portfolio
management or the Portfolio's ability to meet redemption requests or other
current obligations.
OPTIONS. Each Portfolio that may use options may purchase put and call
options, and write (sell) covered put and call options, on equity and debt
securities and, in the case of Strategic Fixed Income, Global Income and Global
Growth Portfolios, on foreign currencies. Each Portfolio that may use options
may purchase put and call options and write (sell) covered call options on
stock indices. The purchase of call options may serve as a long hedge, and the
purchase of put options may serve as a short hedge. In addition, Balanced
Portfolio may purchase options to enhance return by increasing or reducing its
exposure to an asset class without purchasing or selling the underlying
securities. Writing covered put or call options can enable a Portfolio to
enhance income by reason of the premiums paid by the purchasers of such
options. Writing covered put options serves as a limited long hedge because
increases in the value of the hedged instrument would be offset to the extent
of the premium received for writing the option. However, if the market price of
the security underlying a covered put option declines to less than the exercise
price of the option, minus the premium received, the Portfolio would expect to
suffer a loss. Writing covered call options serves as a limited short hedge,
because declines in the value of the hedged investment would be offset to the
extent of the premium received for writing the option. However, if the security
appreciates to a price higher than the exercise price of the call option, it
can be expected that the option will be exercised and the Portfolio will be
obligated to sell the security at less than its market value. The securities or
other assets used as cover for OTC options written by a Portfolio would be
considered illiquid to the extent described under "Investment Policies and
Restrictions--Illiquid Securities."
The value of an option position will reflect, among other things, the current
market value of the underlying investment, the time remaining until expiration,
the relationship of the exercise price to the market price of the underlying
investment, the historical price volatility of the underlying investment and
general market conditions. Options normally have expiration dates of up to nine
months. Options that expire unexercised have no value.
17
<PAGE>
A Portfolio may effectively terminate its right or obligation under an option
by entering into a closing transaction. For example, a Portfolio may terminate
its obligation under a call option that it had written by purchasing an
identical call option; this is known as a closing purchase transaction.
Conversely, a Portfolio may terminate a position in a put or call option it had
purchased by writing an identical put or call option; this is known as a
closing sale transaction.
The Portfolios may purchase or write both exchange-traded and OTC options.
Currently, many options on equity securities are exchange-traded. Exchange
markets for options on debt securities and foreign currencies exist but are
relatively new, and these instruments are primarily traded on the OTC market.
Exchange-traded options in the United States are issued by a clearing
organization affiliated with the exchange on which the option is listed which,
in effect, guarantees completion of every exchange-traded option transaction.
In contrast, OTC options are contracts between the Portfolio and its contra
party (usually a securities dealer or a bank) with no clearing organization
guarantee. Thus, when the Portfolio purchases or writes an OTC option, it
relies on the contra party to make or take delivery of the underlying
investment upon exercise of the option. Failure by the contra party to do so
would result in the loss of any premium paid by the Portfolio as well as the
loss of any expected benefits of the transaction. A Portfolio will enter into
OTC option transactions only with contra parties that have a net worth of at
least $20 million.
Generally, the OTC debt and foreign currency options used by the Portfolios
are European-style options. This means that the option is only exercisable
immediately prior to its expiration. This is in contrast to American-style
options, which are exercisable at any time prior to the expiration date of the
option.
A Portfolio's ability to establish and close out positions in exchange-listed
options depends on the existence of a liquid market. Each Portfolio intends to
purchase or write only those exchange-traded options for which there appears to
be a liquid secondary market. However, there can be no assurance that such a
market will exist at any particular time. Closing transactions can be made for
OTC options only by negotiating directly with the contra party, or by a
transaction in the secondary market if any such market exists. Although a
Portfolio will enter into OTC options only with contra parties that are
expected to be capable of entering into closing transactions with the
Portfolio, there is no assurance that the Portfolio will in fact be able to
close out an OTC option position at a favorable price prior to expiration. In
the event of insolvency of the contra party, the Portfolio might be unable to
close out an OTC option position at any time prior to its expiration.
If a Portfolio were unable to effect a closing transaction for an option it
had purchased, it would have to exercise the option to realize any profit. The
inability to enter into a closing purchase transaction for a covered call
option written by a Portfolio could cause material losses because the Portfolio
would be unable to sell the investment used as cover for the written option
until the option expires or is exercised.
LIMITATIONS ON THE USE OF OPTIONS. The Portfolios' use of options is governed
by the following guidelines, which can be changed by the board without
shareholder vote:
(1) A Portfolio may purchase a put or call option, including any
straddles or spreads, only if the value of its premium, when aggregated
with the premiums on all other options held by the Portfolio, does not
exceed 5% of the Portfolio's total assets.
(2) The aggregate value of securities underlying put options written by a
Portfolio, determined as of the date the put options are written, will not
exceed 50% of the Portfolio's net assets.
(3) The aggregate premiums paid on all options (including options on
securities, foreign currencies and stock or bond indices and options on
futures contracts) purchased by a Portfolio that are held at any time will
not exceed 20% of the Portfolio's net assets.
FUTURES. The purchase of futures or call options thereon can serve as a long
hedge, and the sale of futures or the purchase of put options thereon can serve
as a short hedge. Writing covered call options on futures contracts can serve
as a limited short hedge, using a strategy similar to that used for writing
covered
18
<PAGE>
call options on securities and indices. In addition, Balanced Portfolio may
purchase or sell futures contracts or purchase options thereon to enhance
return by increasing or reducing its exposure to an asset class without
purchasing or selling the underlying securities.
Futures strategies also can be used to manage the average duration of a
Portfolio. If Mitchell Hutchins or the applicable Sub-Adviser wishes to shorten
the average duration of a Portfolio, the Portfolio may sell a futures contract
or a call option thereon, or purchase a put option on that futures contract. If
Mitchell Hutchins or the applicable Sub-Adviser wishes to lengthen the average
duration of a Portfolio, the Portfolio may buy a futures contract or a call
option thereon.
Strategic Fixed Income, Global Income and Global Growth Portfolios may also
write put options on foreign currency futures contracts while at the same time
purchasing call options on the same futures contracts in order synthetically to
create a long futures contract position. Such options would have the same
strike prices and expiration dates. Each Portfolio will engage in this strategy
only when it is more advantageous to the Portfolio than is purchasing the
futures contract.
No price is paid upon entering into a futures contract. Instead, at the
inception of a futures contract a Portfolio is required to deposit in a
segregated account with its custodian, in the name of the futures broker
through whom the transaction was effected, "initial margin" consisting of cash,
obligations of the United States or obligations fully guaranteed as to
principal and interest by the United States, in an amount generally equal to
10% or less of the contract value. Margin must also be deposited when writing
an option on a futures contract, in accordance with applicable exchange rules.
Unlike margin in securities transactions, initial margin on futures contracts
does not represent a borrowing, but rather is in the nature of a performance
bond or good-faith deposit that is returned to the Portfolio at the termination
of the transaction if all contractual obligations have been satisfied. Under
certain circumstances, such as periods of high volatility, the Portfolio may be
required by an exchange to increase the level of its initial margin payment,
and initial margin requirements might be increased generally in the future by
regulatory action.
Subsequent "variation margin" payments are made to and from the futures
broker daily as the value of the futures position varies, a process known as
"marking to market." Variation margin does not involve borrowing, but rather
represents a daily settlement of the Portfolio's obligations to or from a
futures broker. When a Portfolio purchases an option on a future, the premium
paid plus transaction costs is all that is at risk. In contrast, when a
Portfolio purchases or sells a futures contract or writes a call option
thereon, it is subject to daily variation margin calls that could be
substantial in the event of adverse price movements. If the Portfolio has
insufficient cash to meet daily variation margin requirements, it might need to
sell securities at a time when such sales are disadvantageous.
Holders and writers of futures positions and options on futures can enter
into offsetting closing transactions, similar to closing transactions on
options, by selling or purchasing, respectively, an instrument identical to the
instrument held or written. Positions in futures and options on futures may be
closed only on an exchange or board of trade that provides a secondary market.
Each Portfolio intends to enter into futures transactions only on exchanges or
boards of trade where there appears to be a liquid secondary market. However,
there can be no assurance that such a market will exist for a particular
contract at a particular time.
Under certain circumstances, futures exchanges may establish daily limits on
the amount that the price of a future or related option can vary from the
previous day's settlement price; once that limit is reached, no trades may be
made that day at a price beyond the limit. Daily price limits do not limit
potential losses because prices could move to the daily limit for several
consecutive days with little or no trading, thereby preventing liquidation of
unfavorable positions.
If a Portfolio were unable to liquidate a futures or related options position
due to the absence of a liquid secondary market or the imposition of price
limits, it could incur substantial losses. The Portfolio would
19
<PAGE>
continue to be subject to market risk with respect to the position. In
addition, except in the case of purchased options, the Portfolio would
continue to be required to make daily variation margin payments and might be
required to maintain the position being hedged by the future or option or to
maintain cash or securities in a segregated account.
Certain characteristics of the futures market might increase the risk that
movements in the prices of futures contracts or related options might not
correlate perfectly with movements in the prices of the investments being
hedged. For example, all participants in the futures and related options
markets are subject to daily variation margin calls and might be compelled to
liquidate futures or related options positions whose prices are moving
unfavorably to avoid being subject to further calls. These liquidations could
increase price volatility of the instruments and distort the normal price
relationship between the futures or options and the investments being hedged.
Also, because initial margin deposit requirements in the futures market are
less onerous than margin requirements in the securities markets, there might
be increased participation by speculators in the futures markets. This
participation also might cause temporary price distortions. In addition,
activities of large traders in both the futures and securities markets
involving arbitrage, "program trading" and other investment strategies might
result in temporary price distortions.
LIMITATIONS ON THE USE OF FUTURES AND RELATED OPTIONS. The Portfolios' use
of futures is governed by the following guidelines, which can be changed by
the board without shareholder vote.
(1) To the extent a Portfolio enters into futures contracts, options on
futures contracts or options on foreign currencies traded on a commodities
exchange that are not for bona fide hedging purposes (as defined by the
CFTC), the aggregate initial margin and premiums on those positions
(excluding the amount by which options are "in-the-money") may not exceed
5% of the Portfolio's net assets.
(2) The aggregate premiums on all options (including options on
securities, foreign currencies and stock indices and options on futures
contracts) purchased by a Portfolio that are held at any time will not
exceed 20% of the Portfolio's net assets.
(3) The aggregate margin deposits on all futures contracts and options
thereon held at any time by a Portfolio will not exceed 5% of the
Portfolio's total assets.
FOREIGN CURRENCY HEDGING STRATEGIES--SPECIAL CONSIDERATIONS. Strategic Fixed
Income, Global Income and Global Growth Portfolios may use options and futures
on foreign currencies, as described above, and forward currency forward
contracts, as described below, to hedge against movements in the values of the
foreign currencies in which the Portfolios' securities are denominated. Such
currency hedges can protect against price movements in a security that a
Portfolio owns or intends to acquire that are attributable to changes in the
value of the currency in which it is denominated. Such hedges do not, however,
protect against price movements in the securities that are attributable to
other causes.
The Portfolios might seek to hedge against changes in the value of a
particular currency when no Strategic Instruments on that currency are
available or such Strategic Instruments are more expensive than certain other
Strategic Instruments. In such cases, a Portfolio may hedge against price
movements in that currency by entering into transactions using Strategic
Instruments on another foreign currency or a basket of currencies, the values
of which Mitchell Hutchins or the applicable Sub-Adviser believes will have a
high degree of positive correlation to the value of the currency being hedged.
The risk that movements in the price of the Strategic Instrument will not
correlate perfectly with movements in the price of the currency being hedged
is magnified when this strategy is used.
The value of Strategic Instruments on foreign currencies depends on the
value of the underlying currency relative to the U.S. dollar. Because foreign
currency transactions occurring in the interbank market might involve
substantially larger amounts than those involved in the use of such Strategic
Instruments, the Portfolios could be disadvantaged by having to deal in the
odd lot market (generally consisting of transactions of less than $1 million)
for the underlying foreign currencies at prices that are less favorable than
for round lots.
20
<PAGE>
There is no systematic reporting of last sale information for foreign
currencies or any regulatory requirement that quotations available through
dealers or other market sources be firm or revised on a timely basis. Quotation
information generally is representative of very large transactions in the
interbank market and thus might not reflect odd-lot transactions where rates
might be less favorable. The interbank market in foreign currencies is a
global, round-the-clock market. To the extent the U.S. options or futures
markets are closed while the markets for the underlying currencies remain open,
significant price and rate movements might take place in the underlying markets
that cannot be reflected in the markets for the Strategic Instruments until
they reopen.
Settlement of hedging transactions involving foreign currencies might be
required to take place within the country issuing the underlying currency.
Thus, a Portfolio might be required to accept or make delivery of the
underlying foreign currency in accordance with any U.S. or foreign regulations
regarding the maintenance of foreign banking arrangements by U.S. residents and
might be required to pay any fees, taxes and charges associated with such
delivery assessed in the issuing country.
FORWARD CURRENCY CONTRACTS. Strategic Fixed Income, Global Income and Global
Growth Portfolios may enter into forward currency contracts to purchase or sell
foreign currencies for a fixed amount of U.S. dollars or another foreign
currency. Such transactions may serve as long hedges--for example, a Portfolio
may purchase a forward currency contract to lock in the U.S. dollar price of a
security denominated in a foreign currency that the Portfolio intends to
acquire. Forward currency contract transactions may also serve as short
hedges--for example, a Portfolio may sell a forward currency contract to lock
in the U.S. dollar equivalent of the proceeds from the anticipated sale of a
security denominated in a foreign currency.
As noted above, these Portfolios may seek to hedge against changes in the
value of a particular currency by using forward contracts on another foreign
currency or a basket of currencies, the value of which Mitchell Hutchins or the
applicable Sub-Adviser believes will have a positive correlation to the values
of the currency being hedged. In addition, the Portfolios may use forward
currency contracts to shift exposure to foreign currency fluctuations from one
country to another. For example, if a Portfolio owns securities denominated in
a foreign currency and Mitchell Hutchins or the applicable Sub-Adviser believes
that currency will decline relative to another currency, it might enter into a
forward contract to sell an appropriate amount of the first foreign currency,
with payment to be made in the second foreign currency. Transactions that use
two foreign currencies are sometimes referred to as "cross hedging." Use of a
different foreign currency magnifies the risk that movements in the price of
the Strategic Instrument will not correlate or will correlate unfavorably with
the foreign currency being hedged.
The cost to the Portfolios engaging in forward currency contracts varies with
factors such as the currency involved, the length of the contract period and
the market conditions then prevailing. Because forward currency contracts are
usually entered into on a principal basis, no fees or commissions are involved.
When a Portfolio enters into a forward currency contract, it relies on the
contra party to make or take delivery of the underlying currency at the
maturity of the contract. Failure by the contra party to do so would result in
the loss of any expected benefit of the transaction.
As is the case with future contracts, parties to forward currency contracts
can enter into offsetting closing transactions, similar to closing transactions
on futures, by entering into an instrument identical to the instrument held or
written, but in the opposite direction. Secondary markets generally do not
exist for forward currency contracts, with the result that closing transactions
generally can be made for forward currency contracts only by negotiating
directly with the contra party. Thus, there can be no assurance that a
Portfolio will in fact be able to close out a forward currency contract at a
favorable price prior to maturity. In addition, in the event of insolvency of
the contra party, the Portfolio might be unable to close out a forward currency
contract at any time prior to maturity. In either event, the Portfolio would
continue to be subject to market risk with respect to the position, and would
continue to be required to maintain a position in securities denominated in the
securities or currencies that are the subject of the hedge or to maintain cash
or securities in a segregated account.
21
<PAGE>
The precise matching of forward currency contract amounts and the value of
the securities involved generally will not be possible because the value of
such securities, measured in the foreign currency, will change after the
foreign currency contract has been established. Thus, a Portfolio might need to
purchase or sell foreign currencies in the spot (cash) market to the extent
such foreign currencies are not covered by forward contracts. The projection of
short-term currency market movements is extremely difficult, and the successful
execution of a short-term hedging strategy is highly uncertain.
LIMITATIONS ON THE USE OF FORWARD CURRENCY CONTRACTS. Strategic Fixed Income,
Global Income and Global Growth Portfolios may enter into forward currency
contracts or maintain a net exposure to such contracts only if (1) the
consummation of the contracts would not obligate the Portfolio to deliver an
amount of foreign currency in excess of the value of the position being hedged
by such contracts or (2) the Portfolio maintains appropriate assets in a
segregated account in an amount not less than the value of its total assets
committed to the consummation of the contract and not covered as provided in
(1) above, as described above in "Investment Policies and Limitations--
Segregated Accounts."
INTEREST RATE PROTECTION TRANSACTIONS. High Grade Fixed Income, Strategic
Fixed Income and Global Income Portfolios may enter into interest rate
protection transactions, including interest rate swaps and interest rate caps,
collars and floors. Interest rate swap transactions involve an agreement
between two parties to exchange payments that are based, for example, on
variable and fixed rates of interest and that are calculated on the basis of a
specified amount of principal (the "notional principal amount") for a specified
period of time. Interest rate cap and floor transactions involve an agreement
between two parties in which the first party agrees to make payments to the
counterparty when a designated market interest rate goes above (in the case of
a cap) or below (in the case of a floor) a designated level on predetermined
dates or during a specified time period. Interest rate collar transactions
involve an agreement between two parties in which payments are made when a
designated market interest rate either goes above a designated ceiling level or
goes below a designated floor level on predetermined dates or during a
specified time period.
Each Portfolio expects to enter into interest rate protection transactions to
preserve a return or spread on a particular investment or portion of its
portfolio or to protect against any increase in the price of securities it
anticipates purchasing at a later date. The Portfolios intend to use these
transactions as a hedge and not as a speculative investment. Interest rate
protection transactions are subject to risks comparable to those described
above with respect to other hedging strategies.
The Portfolios each may enter into interest rate swaps, caps, collars and
floors on either an asset-based or liability-based basis, depending on whether
it is hedging its assets or its liabilities, and will usually enter into
interest rate swaps on a net basis, i.e., the two payment streams are netted
out, with the Portfolio receiving or paying, as the case may be, only the net
amount of the two payments. Inasmuch as these interest rate protection
transactions are entered into for good faith hedging purposes, and inasmuch as
segregated accounts will be established with respect to such transactions,
Mitchell Hutchins and the Sub-Adviser believe such obligations do not
constitute senior securities and, accordingly, will not treat them as being
subject to any Portfolio's borrowing restrictions. The net amount of the
excess, if any, of a Portfolio's obligations over its entitlements with respect
to each interest rate swap will be accrued on a daily basis and appropriate
Portfolio assets having an aggregate net asset value at least equal to the
accrued excess will be maintained in a segregated account as described above in
"Investment Policies and Restrictions--Segregated Accounts." Each Portfolio
also will establish and maintain such segregated accounts with respect to its
total obligations under any interest rate swaps that are not entered into on a
net basis and with respect to any interest rate caps, collars and floors that
are entered into by the Portfolio.
Each Portfolio will enter into interest rate protection transactions only
with banks and recognized securities dealers believed by Mitchell Hutchins or
the Sub-Adviser to present minimal credit risks in accordance with guidelines
established by the Fund's board of trustees. If there is a default by the other
party to such a transaction, the Portfolio will have to rely on its contractual
remedies (which may be limited by bankruptcy, insolvency or similar laws)
pursuant to the agreements related to the transaction.
22
<PAGE>
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. Caps, collars and floors are more
recent innovations for which documentation is less standardized, and,
accordingly, they are less liquid than swaps.
TRUSTEES AND OFFICERS
The trustees and executive officers of the Fund, their ages, business
addresses and principal occupations during the past five years are:
<TABLE>
<CAPTION>
BUSINESS EXPERIENCE
NAME AND ADDRESS*; AGE POSITION WITH THE FUND AND OTHER DIRECTORSHIPS
---------------------- ---------------------- -----------------------
<C> <C> <S>
Margo N. Alexander**; 50 Trustee and President Mrs. Alexander is presi-
dent, chief executive of-
ficer and a director of
Mitchell Hutchins (since
January 1995) and an ex-
ecutive vice president
and director of
PaineWebber. Mrs. Alexan-
der is president and a
director or trustee of 29
investment companies for
which Mitchell Hutchins
or PaineWebber serves as
investment adviser.
Richard Q. Armstrong; 61 Trustee Mr. Armstrong is chairman
78 West Brother Drive and principal of RQA En-
Greenwich, CT 06830 terprises (management
consulting firm) (since
April 1991 and principal
occupation since March
1995). Mr. Armstrong is
also a director of Hi Lo
Automotive, Inc. He was
chairman of the board,
chief executive officer
and co-owner of Adiron-
dack Beverages (producer
and distributor of soft
drinks andsparkling/still
waters) (October 1993-
March 1995). Mr. Arm-
strong was a partner of
The New England Consult-
ing Group (management
consulting firm) (Decem-
ber 1992-September 1993).
He was managing director
of LVMH U.S. Corporation
(U.S. subsidiary of the
French luxury goods con-
glomerate, Luis Vuitton
Moet Hennessey Corpora-
tion) (1987-1991) and
chairman of its wine and
spirits subsidiary,
Schieffelin & Somerset
Company (1987-1991). Mr.
Armstrong is a director
or trustee of 28 invest-
ment companies for which
Mitchell Hutchins or
PaineWebber serves as in-
vestment adviser.
E. Garrett Bewkes, Jr.**; 70 Trustee and Chairman Mr. Bewkes is a director
of the Board of of Paine Webber Group
Trustees Inc. ("PW Group") (hold-
ing company of
PaineWebber and Mitchell
Hutchins). Prior to De-
cember 1995, he was a
consultant to PW Group.
Prior to 1988 he was
chairman of the board,
president and chief exec-
utive officer of American
Bakeries
</TABLE>
23
<PAGE>
<TABLE>
<CAPTION>
BUSINESS EXPERIENCE
NAME AND ADDRESS*; AGE POSITION WITH THE FUND AND OTHER DIRECTORSHIPS
---------------------- ---------------------- -----------------------
<C> <C> <S>
Company. Mr. Bewkes is
also a director of In-
terstate Bakeries Corpo-
ration and NaPro
BioTherapeutics, Inc.
Mr. Bewkes is a director
or trustee of 29 invest-
ment companies for which
Mitchell Hutchins or
PaineWebber serves as
investment adviser.
Richard R. Burt; 50 Trustee Mr. Burt is chairman of
1101 Connecticut Avenue, International Equity
N.W. Partners (international
Washington, D.C. 20036 investments and consult-
ing firm) (since March
1994) and a partner of
McKinsey & Company (man-
agement consulting firm)
(since 1991). He is also
a director of American
Publishing Company and
Archer-Daniels-Midland
Co. (agricultural com-
modities). He was the
chief negotiator in the
Strategic Arms Reduction
Talks with the former
Soviet Union (1989-1991)
and the U.S. Ambassador
to the Federal Republic
of Germany (1985-1989).
Mr. Burt is a director
or trustee of 28 invest-
ment companies for which
Mitchell Hutchins or
PaineWebber serves as
investment adviser.
Mary C. Farrell**; 47 Trustee Ms. Farrell is a managing
director, senior
investment strategist
and member of the In-
vestment Policy Commit-
tee of PaineWebber. Ms.
Farrell joined
PaineWebber in 1982. She
is a member of the Fi-
nancial Women's Associa-
tion and Women's Eco-
nomic Roundtable and is
employed as a regular
panelist on Wall Street
Week with Louis
Rukeyser. She also
serves on the Board of
Overseers of New York
University's Stern
School of Business. Ms.
Farrell is a director or
trustee of 28 investment
companies for which
Mitchell Hutchins or
PaineWebber serves as
investment adviser.
Meyer Feldberg; 55 Trustee Mr. Feldberg is Dean and
Columbia University Professor of Management
101 Uris Hall of the Graduate School
New York, New York 10027 of Business, Columbia
University. Prior to
1989, he was president
of the Illinois Insti-
tute of Technology. Dean
Feldberg is also a di-
rector of K-III Communi-
cations Corporation,
Federated Department
Stores, Inc., and Rev-
lon, Inc. Dean Feldberg
is a director or trustee
of 28 investment compa-
nies for which Mitchell
Hutchins or PaineWebber
serves as investment ad-
viser.
</TABLE>
24
<PAGE>
<TABLE>
<CAPTION>
BUSINESS EXPERIENCE
NAME AND ADDRESS*; AGE POSITION WITH THE FUND AND OTHER DIRECTORSHIPS
---------------------- ---------------------- -----------------------
<C> <C> <S>
George W. Gowen; 67 Trustee Mr. Gowen is a partner
666 Third Avenue in the law firm of Dun-
New York, New York 10017 nington, Bartholow &
Miller. Prior to May
1994 he was a partner
in the law firm of Fry-
er, Ross & Gowen.
Mr. Gowen is also a di-
rector of Columbia Real
Estate Investments,
Inc. Mr. Gowen is a di-
rector or trustee of 28
investment companies
for which Mitchell
Hutchins or PaineWebber
serves as investment
adviser.
Frederic V. Malek; 60 Trustee Mr. Malek is Chairman of
1455 Pennsylvania Avenue, N.W. Thayer Capital Partners
Suite 350 (merchant bank). From
Washington, D.C. 20004 January 1992 to Novem-
ber 1992 he was cam-
paign manager of Bush-
Quayle '92. From 1990
to 1992, he was vice
chairman and, from 1989
to 1990, he was presi-
dent of Northwest Air-
lines Inc., NWA Inc.
(holding company of
Northwest Airlines
Inc.) and Wings Hold-
ings Inc. (holding com-
pany of NWA Inc.).
Prior to 1989, he was
employed by the
Marriott Corporation
(hotels, restaurants,
airline catering and
contract feeding),
where he most recently
was an executive vice
president and president
of Marriott Hotels and
Resorts. Mr. Malek is
also a director of
American Management
Systems, Inc. (manage-
ment consulting and
computer related ser-
vices), Automatic Data
Processing, Inc., CB
Commercial Group, Inc.
(real estate services),
Choice Hotels Interna-
tional (hotel and hotel
franchising), FPL
Group, Inc. (electric
services), Integra,
Inc. (bio-medical),
Manor Care, Inc.
(health care), National
Education Corporation
and Northwest Airlines
Inc. Mr. Malek is a di-
rector or trustee of 28
investment companies
for which Mitchell
Hutchins or PaineWebber
serves as investment
adviser.
Carl W. Schafer; 61 Trustee Mr. Schafer is president
P.O. Box 1164 of the Atlantic Founda-
Princeton, NJ 08542 tion (charitable foun-
dation supporting
mainly oceanographic
exploration and re-
search). He is a direc-
tor of Roadway Express,
Inc. (trucking), The
Guardian Group of Mu-
tual Funds, Evans Sys-
tems, Inc. (motor fu-
els, convenience store
and diversified compa-
ny), Electronic Clear-
ing House, Inc. (finan-
cial transactions
processing), Wainoco
Oil Corporation and
Nutraceutix Inc. (bio-
technology company).
Prior to
</TABLE>
25
<PAGE>
<TABLE>
<CAPTION>
BUSINESS EXPERIENCE
NAME AND ADDRESS*; AGE POSITION WITH THE FUND AND OTHER DIRECTORSHIPS
---------------------- ---------------------- -----------------------
<C> <C> <S>
January 1993, he was
chairman of the Invest-
ment Advisory Committee
of the Howard Hughes Med-
ical Institute. Mr. Scha-
fer is a director or
trustee of 28 investment
companies for which
Mitchell Hutchins or
PaineWebber serves as in-
vestment adviser.
T. Kirkham Barneby; 50 Vice President Mr. Barneby is a managing
director and chief in-
vestment officer--quanti-
tative investment of
Mitchell Hutchins. Prior
to September 1994, he was
a senior vice president
at Vantage Global Manage-
ment. Prior to June 1993,
he was a senior vice
president at Mitchell
Hutchins. Mr. Barneby is
a vice president of five
investment companies for
which Mitchell Hutchins
or PaineWebber serves as
investment adviser.
Ellen R. Harris; 50 Vice President Ms. Harris is a managing
director and a portfolio
manager of Mitchell
Hutchins. Ms. Harris is a
vice president of three
investment companies for
which Mitchell Hutchins
or PaineWebber serves as
investment adviser.
James F. Keegan; 36 Vice President Mr. Keegan is a senior
vice president and a
portfolio manager of
Mitchell Hutchins. Prior
to March 1996, he was di-
rector of fixed income
strategy and research of
Merrion Group, L.P. From
1987 to 1994, he was a
vice president of global
investment management of
Bankers Trust. Mr. Keegan
is a vice president of
three investment compa-
nies for which Mitchell
Hutchins or PaineWebber
serves as investment ad-
viser.
C. William Maher; 35 Vice President and Mr. Maher is a first vice
Assistant Treasurer president and a senior
manager of the mutual
fund finance division of
Mitchell Hutchins. Mr.
Maher is a vice president
and assistant treasurer
of 29 investment com-
panies for which Mitchell
Hutchins or PaineWebber
serves as investment
adviser.
Dennis McCauley; 50 Vice President Mr. McCauley is a managing
director and chief in-
vestment officer--fixed
income of Mitchell
Hutchins. Prior to Decem-
ber 1994, he was director
of fixed income
investments of IBM Corpo-
ration. Mr. McCauley is a
vice president of 19 in-
vestment companies for
which Mitchell Hutchins
or PaineWebber serves as
investment adviser.
</TABLE>
26
<PAGE>
<TABLE>
<CAPTION>
BUSINESS EXPERIENCE
NAME AND ADDRESS*; AGE POSITION WITH THE FUND AND OTHER DIRECTORSHIPS
---------------------- ---------------------- -----------------------
<C> <C> <S>
Ann E. Moran; 39 Vice President and Ms. Moran is a vice president
Assistant Treasurer of Mitchell Hutchins. Ms.
Moran is a vice president
and assistant treasurer of
29 investment companies for
which Mitchell Hutchins or
PaineWebber serves as in-
vestment adviser.
Dianne E. O'Donnell; 44 Vice President and Ms. O'Donnell is a senior
Secretary vice president and deputy
general counsel of Mitchell
Hutchins. Ms. O'Donnell is a
vice pres- ident of 29 in-
vestment companies and sec-
retary of 28 investment com-
panies for which Mitchell
Hutchins or PaineWebber
serves as investment advis-
er.
Emil Polito; 36 Vice President Mr. Polito is a senior vice
president and director of
operations and control for
Mitchell Hutchins. From
March 1991 to September 1993
he was director of the Mu-
tual Funds Sales Support and
Service Center for Mitchell
Hutchins and PaineWebber.
Mr. Polito is a vice presi-
dent of 29 investment compa-
nies for which Mitchell
Hutchins or PaineWebber
serves as investment
adviser.
Susan Ryan; 37 Vice President Ms. Ryan is a senior vice
president of Mitchell
Hutchins. Ms. Ryan has been
with Mitchell Hutchins since
1982. Ms. Ryan is a vice
president of five investment
companies for which Mitchell
Hutchins or PaineWebber
serves as investment advis-
er.
Victoria E. Schonfeld; 46 Vice President Ms. Schonfeld is a managing
director and general counsel
of Mitchell Hutchins. Prior
to May 1994, she was a part-
ner in the law firm of Ar-
nold & Porter. Ms. Schonfeld
is a vice president of 29
investment companies for
which Mitchell Hutchins or
PaineWebber serves as in-
vestment adviser.
Paul H. Schubert; 34 Vice President and Mr. Schubert is a first vice
Assistant Treasurer president and a senior man-
ager of the mutual fund fi-
nance division of Mitchell
Hutchins. From August 1992
to August 1994, he was a
vice president at BlackRock
Financial Management Inc.
Prior to August 1992, he was
an audit manager with Ernst
& Young LLP. Mr. Schubert is
a vice president and assis-
tant treasurer of 29 invest-
ment companies for which
Mitchell Hutchins or
PaineWebber serves as in-
vestment adviser.
</TABLE>
27
<PAGE>
<TABLE>
<CAPTION>
BUSINESS EXPERIENCE
NAME AND ADDRESS*; AGE POSITION WITH THE FUND AND OTHER DIRECTORSHIPS
---------------------- ---------------------- -----------------------
<C> <C> <S>
Nirmal Singh; 41 Vice President Mr. Singh is a first vice presi-
dent and portfolio manager of
Mitchell Hutchins. Prior to
1993, he was a member of
the portfolio management team
at Merrill Lynch Asset Manage-
ment, Inc. Mr. Singh is a vice
president of five investment
companies for which Mitchell
Hutchins or PaineWebber serves
as investment adviser.
Julian F. Sluyters; 36 Vice President and Mr. Sluyters is a senior vice
Treasurer president and the director of
the mutual fund finance divi-
sion of Mitchell Hutchins. Mr.
Sluyters is a vice president
and treasurer of 29 investment
companies for which Mitchell
Hutchins or PaineWebber serves
as investment adviser.
Mark A. Tincher; 41 Vice President Mr. Tincher is a managing direc-
tor and chief investment offi-
cer--equities of Mitchell
Hutchins. Prior to March 1995,
he was a vice president and di-
rected the U.S. funds manage-
ment and equity research areas
of Chase Manhattan Private
Bank. Mr. Tincher is a vice
president of 13 investment com-
panies for which Mitchell
Hutchins or PaineWebber serves
as investment adviser.
Craig M. Varrelman; 38 Vice President Mr. Varrelman is a first vice
president and a portfolio man-
ager of Mitchell Hutchins. Mr.
Varrelman is a vice president
of five investment companies
for which Mitchell Hutchins or
PaineWebber serves as invest-
ment adviser.
Stuart Waugh; 41 Vice President Mr. Waugh is a managing director
and a portfolio manager of
Mitchell Hutchins responsible
for global fixed income invest-
ments and currency trading.
Mr. Waugh is a vice president
of five investment companies
for which Mitchell Hutchins or
PaineWebber serves as invest-
ment adviser.
Keith A. Weller; 35 Vice President and Mr. Weller is a first vice pres-
Assistant Secretary ident and associate general
counsel of Mitchell Hutchins.
Prior to May 1995, he was an
attorney in private practice.
Mr. Weller is a vice president
and assistant secretary of 28
investment companies for which
Mitchell Hutchins or
PaineWebber serves as invest-
ment adviser.
</TABLE>
28
<PAGE>
<TABLE>
<CAPTION>
BUSINESS EXPERIENCE
NAME AND ADDRESS*; AGE POSITION WITH THE FUND AND OTHER DIRECTORSHIPS
---------------------- ---------------------- -----------------------
<C> <C> <S>
Teresa M. West; 38 Vice President Ms. West is a first vice presi-
dent of Mitchell Hutchins.
Prior to November 1993, she
was compliance manager of Hy-
perion Capital Management,
Inc., an investment advisory
firm. Prior to April 1993,
Ms. West was a vice president
and manager--legal administra-
tion of Mitchell Hutchins. Ms.
West is a vice president of 29
investment companies for which
Mitchell Hutchins or
PaineWebber serves as invest-
ment adviser.
</TABLE>
- --------
*Unless otherwise indicated, the business address of each listed person is
1285 Avenue of the Americas, New York, New York 10019.
**Mrs. Alexander, Mr. Bewkes and Ms. Farrell are "interested persons" of the
Fund as defined in the 1940 Act by virtue of their positions with Mitchell
Hutchins, PaineWebber and/or PW Group.
The Fund pays trustees who are not "interested persons" of the Fund $500
annually for each Portfolio and $150 for each board meeting and for each
separate meeting of a board committee. The Fund presently has nine Portfolios
and thus pays each such trustee $4,500 annually, plus any additional amounts
due for board or committee meetings. Each chairman of the audit and contract
review committees of individual funds within the PaineWebber fund complex
receives additional compensation aggregating $15,000 annually from the relevant
funds. All trustees are reimbursed for any expenses incurred in attending
meetings. Because Mitchell Hutchins performs substantially all of the services
necessary for the operation of the Fund, the Fund requires no employees. No
officer, director or employee of Mitchell Hutchins or PaineWebber receives any
compensation from the Fund for acting as a trustee or officer.
The table below includes certain information relating to the compensation of
the Fund's current trustees who held office with the Fund or other PaineWebber
funds during the fiscal year ended December 31, 1996.
COMPENSATION TABLE+
<TABLE>
<CAPTION>
AGGREGATE TOTAL COMPENSATION
COMPENSATION FROM THE TRUST AND
NAME OF PERSON, POSITION FROM THE TRUST* THE FUND COMPLEX**
------------------------ --------------- ------------------
<S> <C> <C>
Richard Q. Armstrong,
Trustee................................... $6,176 $59,873
Richard R. Burt,
Trustee................................... 4,826 51,173
Meyer Feldberg,
Trustee................................... 9,286 96,181
George W. Gowen,
Trustee................................... 9,286 92,431
Frederic V. Malek,
Trustee................................... 9,286 92,431
Carl W. Schafer,
Trustee................................... 6,176 62,307
</TABLE>
- --------
+ Only independent members of the board of trustees are compensated by the
Fund and identified above; trustees who are "interested persons," as defined
by the 1940 Act, do not receive compensation.
* Represents fees paid to each trustee during the fiscal year ended December
31, 1996.
** Represents total compensation paid to each trustee by the fund complex
during the twelve months ended December 31, 1996; no fund within the complex
has a bonus, pension, profit sharing or retirement plan.
29
<PAGE>
INVESTMENT ADVISORY SERVICES
Mitchell Hutchins acts as the investment adviser and administrator of each
Portfolio pursuant to a contract with the Fund dated April 21, 1988 as
supplemented by Fee Agreements dated May 1, 1989, December 30, 1991 and
September 1, 1993 ("Advisory Contract"). Under the Advisory Contract, the Fund
pays Mitchell Hutchins a fee for each Portfolio, computed daily and payable
monthly, according to the schedule set forth in the Prospectus.
During each of the three years in the period ended December 31, 1996,
Mitchell Hutchins earned (or accrued) advisory fees (net of any waivers) in the
amounts set forth below:
<TABLE>
<CAPTION>
FOR THE YEARS ENDED
DECEMBER 31,
--------------------------
PORTFOLIO 1996 1995 1994
- --------- -------- -------- --------
<S> <C> <C> <C>
Money Market Portfolio............................... $ 79,283 $128,777 $103,238
High Grade Fixed Income Portfolio.................... 44,461 48,852 23,797
Strategic Fixed Income Portfolio..................... 62,785 90,046 105,843
Global Income Portfolio.............................. 230,262 351,681 473,755
Balanced Portfolio................................... 249,995 110,377 236,113
Growth and Income Portfolio.......................... 111,599 94,315 93,915
Growth Portfolio..................................... 325,065 334,603 355,689
Aggressive Growth Portfolio.......................... 155,896 133,956 79,623
Global Growth Portfolio.............................. 198,128 257,692 332,624
</TABLE>
The Advisory Contract authorizes Mitchell Hutchins to retain one or more Sub-
Advisers but does not require Mitchell Hutchins to do so. Under a Sub-Advisory
Contract dated September 21, 1995, Pacific Investment Management Company
("PIMCO") serves as Sub-Adviser to Strategic Fixed Income Portfolio and was
paid (or accrued) by Mitchell Hutchins (not the Portfolio) sub-advisory fees of
$31,393 and $11,324 for the fiscal years ended December 31, 1996 and December
31, 1995, respectively. Under a Sub-Advisory Contract dated September 1, 1993,
Nicholas-Applegate Capital Management serves as Sub-Adviser to Aggressive
Growth Portfolio and was paid (or accrued) by Mitchell Hutchins (not the
Portfolio) sub-advisory fees of $97,434, $83,723 and $49,765 for the fiscal
years ended December 31, 1996, December 31, 1995 and December 31, 1994,
respectively. Under a Sub-Advisory Contract dated March 23, 1995, GE Investment
Management Incorporated serves as Sub-Adviser to Global Growth Portfolio and
was paid (or accrued) by Mitchell Hutchins (not the Portfolio) sub-advisory
fees of $76,609 and $74,893 for the fiscal years ended December 31, 1996 and
December 31, 1995, respectively.
Under a Sub-Advisory Contract dated September 1, 1993, Wolf, Webb, Burk &
Campbell served as Sub-Adviser to High Grade Fixed Income Portfolio until July
21, 1995 and was paid (or accrued) by Mitchell Hutchins (not the Portfolio)
sub-advisory fees of $15,832 and $14,277 for the fiscal years ended
December 31, 1995 and December 31, 1994, respectively. Under a Sub-Advisory
Contract dated May 26, 1994, Mitchell Hutchins Institutional Investors Inc.
served as Sub-Adviser to Growth and Income Portfolio until April 3, 1995 and
was paid (or accrued) by Mitchell Hutchins (not the Portfolio) sub-advisory
fees of $7,400 and $27,400 for the fiscal years ended December 31, 1995 and
December 31, 1994, respectively.
Under the terms of the Advisory Contract, each Portfolio bears all expenses
incurred in its operation that are not specifically assumed by Mitchell
Hutchins. General expenses of the Fund not readily identifiable as belonging to
one of the Portfolios are allocated among the Portfolios by or under the
direction of the Fund's board of trustees in such manner as the board
determines to be fair and equitable. Expenses borne by each Portfolio include,
but are not limited to, the following (or the Portfolio's allocated share of
the following): (1) the cost (including brokerage commissions, if any) of
securities purchased or sold by the Portfolio and any losses incurred in
connection therewith; (2) fees payable to and expenses incurred on behalf of
the Portfolio by Mitchell Hutchins; (3) organizational expenses; (4) filing
fees and expenses relating to the registration and qualification of the Fund or
the shares of a Portfolio under federal and state securities laws
30
<PAGE>
and maintenance of such registrations and qualifications; (5) fees and salaries
payable to the trustees who are not "interested persons" of the Fund or
Mitchell Hutchins; (6) all expenses incurred in connection with the trustees'
services, including travel expenses; (7) taxes (including any income or
franchise taxes) and governmental fees; (8) costs of any liability,
uncollectible items of deposit and other insurance and fidelity bonds; (9) any
costs, expenses or losses arising out of a liability of or claim for damages or
other relief asserted against the Fund or Portfolio for violation of any law;
(10) legal, accounting and auditing expenses, including legal fees of special
counsel for the trustees who are not interested persons of the Fund; (11)
charges of custodians, transfer agents and other agents; (12) costs of
preparing share certificates, if any; (13) expenses of setting in type and
printing prospectuses and supplements thereto, statements of additional
information and supplements thereto, reports and proxy materials for existing
shareholders and costs of mailing such materials to shareholders; (14) any
extraordinary expenses (including fees and disbursements of counsel) incurred
by the Fund or Portfolio; (15) fees, voluntary assessments and other expenses
incurred in connection with membership in investment company organizations;
(16) costs of mailing and tabulating proxies and costs of meetings of
shareholders, the board and any committees thereof; (17) the cost of investment
company literature and other publications provided to the trustees and
officers; and (18) costs of mailing, stationery and communications equipment.
Under the Advisory Contract, Mitchell Hutchins will not be liable for any
error of judgment or mistake of law or for any loss suffered by the Fund in
connection with the performance of the Advisory Contract, except a loss
resulting from willful misfeasance, bad faith or gross negligence on the part
of Mitchell Hutchins in the performance of its duties or from reckless
disregard of its duties and obligations thereunder. Under each Sub-Advisory
Contract, the Sub-Adviser will not be liable for any error of judgment or
mistake of law or for any loss suffered by the Fund, the Portfolio, its
shareholders or Mitchell Hutchins in connection with the Sub-Advisory Contract,
except any liability to the Fund, the Portfolio, its shareholders or Mitchell
Hutchins to which the Sub-Adviser would otherwise be subject by reason of
willful misfeasance, bad faith, gross negligence on its part in the performance
of its duties or from reckless disregard by it of its obligations and duties
under the Sub-Advisory Contract.
The Advisory Contract terminates automatically upon assignment and is
terminable at any time without penalty by the Fund's board of trustees or by
vote of the holders of a majority of the Portfolio's outstanding voting
securities on 60 days' written notice to Mitchell Hutchins or by Mitchell
Hutchins on 60 days' written notice to the Fund. Each Sub-Advisory Contract
terminates automatically upon its assignment or the termination of the Advisory
Contract and is terminable at any time without penalty by the board of trustees
or by vote of the holders of a majority of the Portfolio's outstanding voting
securities on 60 days' notice to the Sub-Adviser, or by the Sub-Adviser on 120
days' written notice to Mitchell Hutchins. The Sub-Advisory Contract may also
be terminated by Mitchell Hutchins (1) upon material breach by the Sub-Adviser
of its representations and warranties; (2) if the Sub-Adviser becomes unable to
discharge its duties and obligations under the Sub-Advisory Contract or (3) on
120 days' notice to the Sub-Adviser.
Mitchell Hutchins personnel may invest in securities for their own accounts
pursuant to a code of ethics that describes the fiduciary duty owed to
shareholders of the PaineWebber funds and other Mitchell Hutchins' advisory
accounts by all Mitchell Hutchins' directors, officers and employees,
establishes procedures for personal investing and restricts certain
transactions. For example, employee accounts generally must be maintained at
PaineWebber, personal trades in most securities require pre-clearance and
short-term trading and participation in initial public offerings generally are
prohibited. In addition, the code of ethics puts restrictions on the timing of
personal investing in relation to trades by PaineWebber funds and other
Mitchell Hutchins advisory clients.
Personnel of each Sub-Adviser also may invest in securities for their own
accounts pursuant to the applicable Sub-Adviser's code of ethics, which
establishes procedures for personal investing and restricts certain
transactions.
31
<PAGE>
PORTFOLIO TRANSACTIONS
Subject to policies established by the Fund's board of trustees, Mitchell
Hutchins or the applicable Sub-Adviser is responsible for the execution of
portfolio transactions and the allocation of brokerage transactions for each
Portfolio. In executing portfolio transactions, Mitchell Hutchins or the
applicable Sub-Adviser seeks to obtain the best net results for each Portfolio
taking into account such factors as the price (including the applicable
brokerage commission or dealer spread), size of the order, difficulty of
execution and operational facilities of the firm involved. Prices paid to
dealers in principal transactions through which most debt securities and some
equity securities are traded generally include a "spread," which is the
difference between the prices at which the dealer is willing to purchase and
sell a specific security at that time. Each Portfolio may invest in securities
traded in the OTC markets and will engage primarily in transactions with the
dealers who make markets in such securities, unless a better price or execution
could be obtained by using a broker. While Mitchell Hutchins or the applicable
Sub-Adviser generally seeks reasonably competitive commission rates, payment of
the lowest commission is not necessarily consistent with obtaining the best net
results.
During each of the three years in the period ended December 31, 1996, the
Portfolios paid the brokerage commissions set forth below:
<TABLE>
<CAPTION>
FOR THE YEARS ENDED DECEMBER 31,
----------------------------------
PORTFOLIO 1996 1995 1994
- --------- ---------- ----------- -----------
<S> <C> <C> <C>
Money Market Portfolio...................... $ 0 $ 0 $ 0
High Grade Fixed Income Portfolio........... 0 0 0
Strategic Fixed Income Portfolio............ 2,729 0 0
Global Income Portfolio..................... 0 0 0
Balanced Portfolio.......................... 65,857 39,766 63,641
Growth and Income Portfolio................. 31,792 34,846 45,863
Growth Portfolio............................ 33,885 52,967 37,100
Aggressive Growth Portfolio................. 53,904 57,802 49,178
Global Growth Portfolio..................... 78,261 341,107 397,060
</TABLE>
The Fund has no obligation to deal with any broker or group of brokers in the
execution of portfolio transactions. The Fund contemplates that, consistent
with the policy of obtaining the best net results, a substantial amount of the
Portfolios' brokerage transactions may be conducted through Mitchell Hutchins
or its affiliates, including PaineWebber. The Fund's board of trustees has
adopted procedures in conformity with Rule 17e-1 under the 1940 Act to ensure
that all brokerage commissions paid to Mitchell Hutchins or its affiliates are
fair and reasonable. Specific provisions included in the Advisory Contract
authorize Mitchell Hutchins and any of its affiliates that is a member of a
national securities exchange to effect securities transactions for the
Portfolios on such exchange and to retain compensation in connection with such
transactions. Any such transactions will be effected and related compensation
paid in accordance with applicable SEC regulations. During each of the three
years in the period ended December 31, 1996, the Portfolios paid to PaineWebber
the brokerage commissions set forth below:
<TABLE>
<CAPTION>
FOR THE YEARS ENDED DECEMBER 31,
--------------------------------
PORTFOLIO 1996 1995 1994
- --------- ---------- ---------- ----------
<S> <C> <C> <C>
Money Market Portfolio........................ $ 0 $ 0 $ 0
High Grade Fixed Income Portfolio............. 0 0 0
Strategic Fixed Income Portfolio.............. 0 0 0
Global Income Portfolio....................... 0 0 0
Balanced Portfolio............................ 1,320 504 720
Growth and Income Portfolio................... 852 1,400 1,817
Growth Portfolio.............................. 300 900 600
Aggressive Growth Portfolio................... 186 0 0
Global Growth Portfolio....................... 0 0 1,137
</TABLE>
32
<PAGE>
The $300 in brokerage commissions paid by Growth Portfolio to PaineWebber
during the fiscal year ended December 31, 1996 represented 0.89% of the
aggregate brokerage commissions paid by that Portfolio and 0.11% of the
aggregate dollar amount of transactions involving the payment of commissions.
The $1,320 in brokerage commissions paid by Balanced Portfolio to PaineWebber
during the fiscal year ended December 31, 1996 represented 2.01% of the
aggregate brokerage commissions paid by that Portfolio and 0.15% of the
aggregate dollar amount of transactions involving the payment of commissions.
The $852 in brokerage commissions paid by Growth and Income Portfolio to
PaineWebber during the fiscal year ended December 31, 1996 represented 2.68%
of the aggregate brokerage commissions paid by that Portfolio and 0.14% of the
aggregate dollar amount of transactions involving the payment of commissions.
The $186 in brokerage commissions paid by Aggressive Growth Portfolio to
PaineWebber during the fiscal year ended December 31, 1996 represented 0.35%
of the aggregate brokerage commissions paid by that Portfolio and 0.15% of the
aggregate dollar amount of transactions involving the payment of commissions.
Transactions in futures contracts are executed through futures commission
merchants ("FCMs") who receive brokerage commissions for their services. The
Fund's procedures in selecting FCMs to execute the Portfolios' transactions in
futures contracts, including procedures permitting the use of Mitchell
Hutchins and its affiliates, are similar to those in effect with respect to
brokerage transactions in securities.
Consistent with the interest of each Portfolio and subject to the review of
the Fund's board of trustees, Mitchell Hutchins or the applicable Sub-Adviser
may cause a Portfolio to purchase and sell portfolio securities from and to
brokers who provide the Portfolio with research, analysis, advice and similar
services. In return for such services, the Portfolio may pay to those brokers
a higher commission than may be charged by other brokers, provided that
Mitchell Hutchins or the applicable Sub-Adviser determines in good faith that
such commission is reasonable in terms either of that particular transaction
or of the overall responsibility of Mitchell Hutchins or the applicable Sub-
Adviser to the Portfolio and its other clients and that the total commissions
paid by the Portfolio will be reasonable in relation to the benefits to the
Portfolio over the long term. During the fiscal year ended December 31, 1996,
the Portfolios directed the portfolio transactions indicated below to brokers
chosen because they provide research and analysis, for which the Portfolios
paid the brokerage commissions indicated below:
<TABLE>
<CAPTION>
AMOUNT OF PORTFOLIO BROKERAGE
PORTFOLIO TRANSACTIONS COMMISSIONS PAID
- --------- ------------------- ----------------
<S> <C> <C>
Money Market Portfolio..................... $ 0 $ 0
High Grade Fixed Income Portfolio.......... $ 0 $ 0
Strategic Fixed Income Portfolio........... $ 0 $ 0
Global Income Portfolio.................... $ 0 $ 0
Balanced Portfolio......................... $18,272,505 $23,693
Growth and Income Portfolio................ $ 3,968,857 $ 5,400
Growth Portfolio........................... $ 3,617,056 $ 5,892
Aggressive Growth Portfolio................ $30,861,782 $50,022
Global Growth Portfolio.................... $ 2,192,000 $ 4,991
</TABLE>
For purchases or sales with broker-dealer firms that act as principal,
Mitchell Hutchins seeks best execution. Although Mitchell Hutchins may receive
certain research or execution services in connection with these transactions,
Mitchell Hutchins or the applicable Sub-Adviser will not purchase securities
at a higher price or sell securities at a lower price than would otherwise be
paid if no weight was attributed to the services provided by the executing
dealer. Moreover, Mitchell Hutchins or the applicable Sub-Adviser will not
enter into any explicit soft dollar arrangements relating to principal
transactions and will not receive in principal transactions the types of
services which could be purchased for hard dollars. Mitchell Hutchins or the
applicable Sub-Adviser may engage in agency transactions in OTC equity and
debt securities in return for research and execution services. These
transactions are entered into only in compliance with procedures ensuring that
the transaction (including commissions) is at least as favorable as it would
have been if effected directly with a market-maker that did not provide
research or execution services. These procedures include
33
<PAGE>
Mitchell Hutchins or the applicable Sub-Adviser receiving multiple quotes from
dealers before executing the transaction on an agency basis.
Information and research received from such brokers and dealers will be in
addition to, and not in lieu of, the services required to be performed by
Mitchell Hutchins or the applicable Sub-Adviser under the Advisory Contract or
Sub-Advisory Contract. Research services furnished by brokers or dealers
through which or with which the Portfolios effect securities transactions may
be used by Mitchell Hutchins or the applicable Sub-Adviser in advising other
funds or accounts and, conversely, research services furnished to Mitchell
Hutchins or the applicable Sub-Adviser in connection with these other funds or
accounts may be used in advising the Portfolios.
Investment decisions for each Portfolio and for other investment accounts
managed by Mitchell Hutchins or the applicable Sub-Adviser are made
independently of each other in light of differing considerations for the
various accounts. However, the same investment decision may occasionally be
made for a Portfolio and one or more of such accounts. In such cases,
simultaneous transactions are inevitable. Purchases or sales are then averaged
as to price and allocated between the Portfolio and such other account(s) as
to amount according to a formula deemed equitable to the Portfolio and such
account(s). While in some cases this practice could have a detrimental effect
upon the price or value of the security as far as a Portfolio is concerned, or
upon its ability to complete its entire order, in other cases it is believed
that coordination and the ability to participate in volume transactions will
be beneficial to the Portfolio.
The Portfolios will not purchase securities that are offered in
underwritings in which Mitchell Hutchins, the applicable Sub-Adviser or any of
their affiliates is a member of the underwriting or selling group, except
pursuant to procedures adopted by the Fund's board of trustees pursuant to
Rule 10f-3 under the 1940 Act. Among other things, these procedures require
that the commission or spread paid in connection with such a purchase be
reasonable and fair, that the purchase be at not more than the public offering
price prior to the end of the first business day after the date of the public
offering and that Mitchell Hutchins, the applicable Sub-Adviser or any
affiliate thereof not participate in or benefit from the sale to the Fund.
PORTFOLIO TURNOVER. The turnover rate may vary greatly from year to year for
any Portfolio and will not be a limiting factor when Mitchell Hutchins or the
applicable Sub-Adviser deems portfolio changes appropriate. The annual
portfolio turnover rate is calculated by dividing the lesser of a Portfolio's
annual sales or purchases of portfolio securities (exclusive of purchases or
sales of securities whose maturities at the time of acquisition were one year
or less) by the monthly average value of the securities except short-term
securities in the Portfolio during the year. For the fiscal years ended
December 31, 1996 and December 31, 1995, respectively, the portfolio turnover
rates were as set forth below:
<TABLE>
<CAPTION>
PORTFOLIO TURNOVER RATES
FOR THE YEARS ENDED
DECEMBER 31,
---------------------------
PORTFOLIO 1996 1995
- --------- ---- ----
<S> <C> <C>
Money Market Portfolio............................ n/a n/a
High Grade Fixed Income Portfolio................. 282% 136%
Strategic Fixed Income Portfolio.................. 317% 234%
Global Income Portfolio........................... 134% 160%
Balanced Portfolio................................ 235% 171%
Growth and Income Portfolio....................... 99% 134%
Growth Portfolio.................................. 53% 41%
Aggressive Growth Portfolio....................... 115% 119%
Global Growth Portfolio........................... 44% 157%
</TABLE>
The substantial increase in the portfolio turnover rate for High Grade Fixed
Income Portfolio in 1996, as compared to 1995, was primarily attributable to a
portfolio realignment following a 1996 increase in the
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<PAGE>
percentage of this Portfolio's assets that may be invested in investment grade
debt securities. The substantial increase in the portfolio turnover rate for
Strategic Fixed Income Portfolio in 1996, as compared to 1995, was primarily
attributed to rolling buy forwards of foreign securities, as well as pair-off
transactions of mortgage-backed securities, and turn-around transactions with
respect to U.S. government and agency securities. The substantial decrease in
the portfolio turnover rate for Global Growth Portfolio in 1996, as compared
to 1995, was primarily attributed to GE Investment Management rebalancing the
portfolio's investments to coincide with the investments of other funds they
subadvise.
ADDITIONAL PURCHASE AND REDEMPTION INFORMATION
The insurance company separate accounts purchase and redeem shares of each
Portfolio on each day on which the New York Stock Exchange ("NYSE") is open
for trading ("Business Day") based on, among other things, the amount of
premium payments to be invested and surrendered and transfer requests to be
effected on that day pursuant to the variable contracts. Currently, the NYSE
is closed on the observance of New Year's Day, Presidents' Day, Good Friday,
Memorial Day, Independence Day, Labor Day, Thanksgiving Day and Christmas Day.
Such purchases and redemptions of the shares of each Portfolio are effected at
their respective net asset values per share determined as of the close of
regular trading (currently 4:00 p.m., Eastern time) on the NYSE on that
Business Day. Payment for redemptions are made by the Fund within seven days
thereafter. No fee is charged the separate accounts when they purchase or
redeem Portfolio shares.
The Fund may suspend redemption privileges of shares of any Portfolio or
postpone the date of payment during any period (1) when the NYSE is closed or
trading on the NYSE is restricted as determined by the SEC, (2) when an
emergency exists, as defined by the SEC, that makes it not reasonably
practicable for the Fund to dispose of securities owned by it or fairly to
determine the value of its assets or (3) as the SEC may otherwise permit. The
redemption price may be more or less than the shareholder's cost, depending on
the market value of the Portfolio's securities at the time.
VALUATION OF SHARES
Each Portfolio determines its net asset value as of the close of regular
trading (currently 4:00 p.m., Eastern time) on the NYSE on each Monday through
Friday when the NYSE is open.
Securities that are listed on U.S. and foreign stock exchanges are valued at
the last sale price on the day the securities are being valued or, lacking any
sales on such day, at the last available bid price. In cases where securities
are traded on more than one exchange, the securities are generally valued on
the exchange considered by Mitchell Hutchins or the applicable Sub-Adviser as
the primary market. Securities traded in the OTC market and listed on the
Nasdaq Stock Market ("Nasdaq") are valued at the last available sale price
listed on Nasdaq at 4:00 p.m., Eastern time; other OTC securities are valued
at the last available bid price prior to the time of valuation.
When market quotations are readily available, the debt securities of the
Portfolios (with the exception of Money Market Portfolio) are valued based
upon market quotations, provided such quotations adequately reflect, in the
judgment of Mitchell Hutchins or the applicable Sub-Adviser, the fair value of
the securities. The amortized cost method of valuation generally is used with
respect to debt obligations with 60 days or less remaining to maturity unless
the Fund's board of trustees determines that this does not represent fair
value. When market quotations for options and futures positions held by the
Portfolios are readily available, those positions are valued based upon such
quotations. Market quotations are not generally available for options traded
in the OTC market. When market quotations for options and futures positions,
or any other securities or assets of the Portfolios, are not available, they
are valued at fair value as determined in good faith by or under the direction
of the Fund's board of trustees. When practicable, such determinations are
based upon appraisals received from a pricing service using a computerized
matrix system or appraisals derived from information concerning the security
or similar securities received from recognized dealers in those securities.
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<PAGE>
All securities quoted in foreign currencies are valued daily in U.S. dollars
on the basis of the foreign currency exchange rates prevailing at the time
such valuation is determined. Foreign currency exchange rates generally are
determined prior to the close of regular trading on the NYSE. Occasionally,
events affecting the value of foreign securities and such exchange rates occur
between the time at which they are determined and the close of the NYSE, which
events would not be reflected in the computation of a Portfolio's net asset
value. If events materially affecting the value of such securities or currency
exchange rates occurred during such time period, the securities will be valued
at their fair value as determined in good faith by or under the direction of
the board of trustees. The foreign currency exchange transactions of Strategic
Fixed Income, Global Income and Global Growth Portfolios conducted on a spot
(that is, cash) basis are valued at the spot rate for purchasing or selling
currency prevailing on the foreign exchange market. This rate under normal
market conditions differs from the prevailing exchange rate in an amount
generally less than one-tenth of one percent due to the costs of converting
from one currency to another.
Money Market Portfolio values its portfolio securities in accordance with
the amortized cost method of valuation under Rule 2a-7 under the 1940 Act. To
use amortized cost to value its portfolio securities, the Portfolio must
adhere to certain conditions under that Rule relating to its investments, some
of which are discussed in the Prospectus. Amortized cost is an approximation
of market value, whereby the difference between acquisition cost and value at
maturity is amortized on a straight-line basis over the remaining life of the
instrument. The effect of changes in the market value of a security as a
result of fluctuating interest rates is not taken into account and thus the
amortized cost method of valuation may result in the value of a security being
higher or lower than its actual market value. In the event that a large number
of redemptions takes place at a time when interest rates have increased, the
Portfolio might have to sell portfolio securities prior to maturity and at a
price that might not be as desirable as the value at maturity.
The Fund's board of trustees has established procedures for the purpose of
maintaining a constant net asset value of $1.00 per share for Money Market
Portfolio, which include a review of the extent of any deviation of net asset
value per share, based on available market quotations, from the $1.00
amortized cost per share. Should that deviation exceed 1/2 of 1%, the trustees
will promptly consider whether any action should be initiated to eliminate or
reduce material dilution or other unfair results to shareholders. Such action
may include redeeming shares in kind, selling portfolio securities prior to
maturity, reducing or withholding dividends and utilizing a net asset value
per share as determined by using available market quotations. Money Market
Portfolio will maintain a dollar-weighted average portfolio maturity of 90
days or less and will not purchase any instrument with a remaining maturity
greater than 13 months (as calculated under Rule 2a-7) and except that
securities subject to repurchase agreements may have maturities in excess of
13 months, will limit portfolio investments, including repurchase agreements,
to those U.S. dollar-denominated instruments that are of high quality and that
the trustees determine present minimal credit risks as advised by Mitchell
Hutchins and will comply with certain reporting and recordkeeping procedures.
There is no assurance that constant net asset per share value will be
maintained. In the event amortized cost ceases to represent fair value, the
board will take appropriate action.
In determining the approximate market value of portfolio investments, the
Fund may employ outside organizations, which may use a matrix or formula
method that takes into consideration market indices, matrices, yield curves
and other specific adjustments. This may result in the securities being valued
at a price different from the price that would have been determined had the
matrix or formula method not been used. All cash, receivables and current
payables are carried at their face value. Other assets, if any, are valued at
fair value as determined in good faith by or under the direction of the board
of trustees.
TAXES
Shares of the Portfolios are offered only to insurance company separate
accounts that fund the Contracts. See the applicable Contract prospectus for a
discussion of the special taxation of insurance companies with respect to such
accounts and of the Contract holders.
36
<PAGE>
Each Portfolio is treated as a separate corporation for federal income tax
purposes. In order to continue to qualify for treatment as a regulated
investment company ("RIC") under the Internal Revenue Code, each Portfolio must
distribute to its shareholders for each taxable year at least 90% of its
investment company taxable income (consisting generally of net investment
income, net short-term capital gain and, for certain Portfolios, net gains from
certain foreign currency transactions) ("Distribution Requirement") and must
meet several additional requirements. With respect to each Portfolio, these
requirements include the following: (1) the Portfolio must derive at least 90%
of its gross income each taxable year from dividends, interest, payments with
respect to securities loans and gains from the sale or other disposition of
securities or foreign currencies, or other income (including gains from
options, futures or forward currency contracts) derived with respect to its
business of investing in securities or those currencies ("Income Requirement");
(2) the Portfolio must derive less than 30% of its gross income each taxable
year from the sale or other disposition of securities, or any of the following,
that were held for less than three months--options or futures (other than those
on foreign currencies), or foreign currencies (or options, futures or forward
contracts thereon) that are not directly related to the Portfolio's principal
business of investing in securities (or options and futures with respect to
securities) ("Short-Short Limitation"); (3) at the close of each quarter of the
Portfolio's taxable year, at least 50% of the value of its total assets must be
represented by cash and cash items, U.S. government securities, securities of
other RICs and other securities, with these other securities limited, in
respect of any one issuer, to an amount that does not exceed 5% of the value of
the Portfolio's total assets and that does not represent more than 10% of the
issuer's outstanding voting securities; and (4) at the close of each quarter of
the Portfolio's taxable year, not more than 25% of the value of its total
assets may be invested in securities (other than U.S. government securities or
the securities of other RICs) of any one issuer.
As noted in the Prospectus, each Portfolio must, and intends to continue to,
comply with the diversification requirements imposed by section 817(h) of the
Internal Revenue Code and the regulations thereunder. These requirements, which
are in addition to the diversification requirements mentioned above, place
certain limitations on the proportion of each Portfolio's assets that may be
represented by any single investment (which includes all securities of the same
issuer). For these purposes, each U.S. government agency or instrumentality is
treated as a separate issuer.
The use of hedging and related strategies, such as selling (writing) and
purchasing options and futures contracts and entering into forward currency
contracts, involves complex rules that will determine for income tax purposes
the character and timing of recognition of the gains and losses a Portfolio
realizes in connection therewith. Gains from the disposition of foreign
currencies (except certain gains therefrom that may be excluded by future
regulations), and gains from options, futures and forward currency contracts
derived by a Portfolio with respect to its business of investing in securities
or foreign currencies, will qualify as permissible income under the Income
Requirement. However, income from the disposition of options and futures
contracts (other than those on foreign currencies) will be subject to the
Short-Short Limitation if they are held for less than three months. Income from
the disposition of foreign currencies, and options, futures and forward
contracts on foreign currencies, also will be subject to the Short-Short
Limitation if they are held for less than three months and are not directly
related to a Portfolio's principal business of investing in securities (or
options and futures with respect to securities).
If a Portfolio satisfies certain requirements, any increase in value of a
position that is part of a "designated hedge" will be offset by any decrease in
value (whether realized or not) of the offsetting hedging position during the
period of the hedge for purposes of determining whether the Portfolio satisfies
the Short-Short Limitation. Thus, only the net gain (if any) from the
designated hedge will be included in gross income for purposes of that
limitation. Each Portfolio will consider whether it should seek to qualify for
this treatment for its hedging transactions. To the extent a Portfolio does not
qualify for this treatment, it may be forced to defer the closing out of
certain options, futures, forward currency contracts and foreign currency
positions beyond the time when it otherwise would be advantageous to do so, in
order for the Portfolio to continue to qualify as a RIC.
37
<PAGE>
Dividends and interest received by a Portfolio may be subject to income,
withholding or other taxes imposed by foreign countries and U.S. possessions
that would reduce the yield on its securities. Tax conventions between certain
countries and the United States may reduce or eliminate these foreign taxes,
however, and many foreign countries do not impose taxes on capital gains in
respect of investments by foreign investors.
Any Portfolio that may purchase or hold equity securities may invest in the
stock of "passive foreign investment companies" ("PFICs"). A PFIC is a foreign
corporation that, in general, meets either of the following tests: (1) at least
75% of its gross income is passive or (2) an average of at least 50% of its
assets produce, or are held for the production of, passive income. Under
certain circumstances, a Portfolio that holds stock of a PFIC will be subject
to federal income tax on a portion of any "excess distribution" received on the
stock or of any gain on disposition of the stock (collectively "PFIC income"),
plus interest thereon, even if the Portfolio distributes the PFIC income as a
taxable dividend to its shareholders. The balance of the PFIC income will be
included in the Portfolio's investment company taxable income and, accordingly,
will not be taxable to it to the extent that income is distributed to its
shareholders.
If a Portfolio invests in a PFIC and elects to treat the PFIC as a "qualified
electing fund" ("QEF") then in lieu of the foregoing tax and interest
obligation, the Portfolio would be required to include in income each year its
pro rata share of the QEF's annual ordinary earnings and net capital gain (the
excess of net long-term capital gain over net short-term capital loss) which
most likely would have to be distributed to the Portfolio's shareholders to
satisfy the Distribution Requirement--even if those earnings and gains were not
distributed to the Portfolios by the QEF. In most instances it will be very
difficult, if not impossible, to make this election because of certain
requirements thereof.
Pursuant to proposed regulations, open-end RICs, such as the Portfolios,
would be entitled to elect to "mark-to-market" their stock in certain PFICs.
"Marking-to-market," in this context, means recognizing as gain for each
taxable year the excess, as of the end of that year, of the fair market value
of each such PFIC's stock over the adjusted basis in that stock (including
mark-to-market gain for each prior year for which an election was in effect).
The foregoing is only a general summary of some of the important federal
income tax considerations generally affecting the Portfolios and their
shareholders. No attempt is made to present a complete explanation of the
federal tax treatment of the Portfolios' activities, and this discussion is not
intended as a substitute for careful tax planning. Accordingly, potential
investors are urged to consult their own tax advisers for more detailed
information and for information regarding any state, local or foreign taxes
applicable to the Portfolios and to dividends and other distributions
therefrom.
DIVIDENDS
MONEY MARKET PORTFOLIO. Shares begin earning dividends on the day of
purchase; dividends are accrued to shareholder accounts daily and are
automatically reinvested in Portfolio shares monthly. The Portfolio does not
expect to realize net capital gain. In the event of a redemption of all of the
Portfolio's shares held by a shareholder, all accrued dividends declared on the
shares up to the date of redemption are credited to the shareholder's account.
The Fund's board of trustees may revise the above dividend policy, or
postpone the payment of dividends, if the Portfolio should have or anticipate
any large unexpected expense, loss or fluctuation in net assets that, in the
opinion of the board, might have a significant adverse effect on shareholders.
To date, no situation has arisen to cause the board of trustees to take any
such action.
OTHER INFORMATION
Prior to August 14, 1995, the name of Growth and Income Portfolio was
"Dividend Growth Portfolio." Prior to September 21, 1995, the name of Strategic
Fixed Income Portfolio was "Government Portfolio" and
38
<PAGE>
the name of High Grade Fixed Income Portfolio was "Fixed Income Portfolio."
Prior to January 26, 1996, the name of Balanced Portfolio was "Asset Allocation
Portfolio."
The Fund is an entity of the type commonly known as a "Massachusetts business
trust." Under Massachusetts law, shareholders could, under certain
circumstances, be held personally liable for the obligations of the Fund or a
Portfolio. However, the Fund's Declaration of Trust disclaims shareholder
liability for acts or obligations of the Fund or any Portfolio and requires
that notice of such disclaimer be given in each note, bond, contract,
instrument, certificate or undertaking made or issued by the trustees or by any
officers or officer by or on behalf of the Fund, the trustees or any of them in
connection with the Fund. The Declaration of Trust provides for indemnification
from Fund or Portfolio property, as appropriate, for all losses and expenses of
any shareholder held personally liable for the obligations of the Fund or
Portfolio. Thus, the risk of a shareholder's incurring financial loss on
account of shareholder liability is limited to circumstances in which the Fund
or Portfolio itself would be unable to meet its obligations, a possibility that
Mitchell Hutchins believes is remote and not material. Upon payment of any
liability incurred by a shareholder of a Portfolio, the shareholder paying such
liability will be entitled to reimbursement from the general assets of the
Portfolio. The trustees intend to conduct the operations of the Fund so as to
avoid, as far as possible, ultimate liability of the shareholders for
liabilities of the Fund and the Portfolios.
More than 99% of the outstanding shares of Money Market, Strategic Fixed
Income, Global Income, Balanced, Growth and Income, Growth and Global Growth
Portfolios is, at the date of this Statement of Additional Information, owned
by American Republic Variable Annuity Account, a segregated investment account
of American Republic Insurance Company, American Benefit Variable Annuity
Account, a segregated investment account of American Benefit Life Insurance
Company, and PaineWebber Life Variable Annuity Account, a segregated investment
account of PaineWebber Life Insurance Company. More than 99% of the outstanding
shares of High Grade Fixed Income and Aggressive Growth Portfolios is, at the
date of this Statement of Additional Information, owned by PaineWebber Life
Variable Annuity Account. American Benefit Life Insurance Company is a wholly
owned subsidiary of American Republic Insurance Company.
COUNSEL. The law firm of Kirkpatrick & Lockhart LLP, 1800 Massachusetts
Avenue, N.W., Washington, D.C. 20036-1800, serves as counsel to the Fund.
Kirkpatrick & Lockhart LLP also acts as counsel to Mitchell Hutchins and
PaineWebber in connection with other matters.
AUDITORS. Ernst & Young LLP, 787 Seventh Avenue, New York, New York 10019,
serves as independent auditors for the Fund.
FINANCIAL STATEMENTS
The Fund's Annual Report to shareholders for the fiscal year ended December
31, 1996 is a separate document supplied with this Statement of Additional
Information, and the financial statements, accompanying notes and report of
independent auditors appearing therein are incorporated by reference in this
Statement of Additional Information.
DESCRIPTION OF COMMERCIAL PAPER AND BOND RATINGS
COMMERCIAL PAPER RATINGS. Moody's employs the designation "Prime-1," "Prime-
2" and "Prime-3" to indicate the repayment capacity of issuers of commercial
paper. Issuers rated Prime-1 have a superior capacity for repayment of short-
term promissory obligations. Prime-1 repayment capacity will normally be
evidenced by the following characteristics: leading market positions in well-
established industries; high rates of return on funds employed; conservative
capitalization structures with moderate reliance on debt and ample asset
protection; broad margins in earnings coverage of fixed financial charges and
high internal cash
39
<PAGE>
generation; well-established access to a range of financial markets and assured
sources of alternate liquidity. Issuers rated Prime-2 have a strong capacity
for repayment of short-term promissory obligations. This will normally be
evidenced by many of the characteristics cited above but to a lesser degree.
Earnings trends and coverage ratios, while sound, will be more subject to
variation. Capitalization characteristics, while still appropriate, may be more
affected by external conditions. Ample alternate liquidity is maintained.
Issuers rated Prime-3 have an acceptable capacity for repayment of short-term
promissory obligations. The effect of industry characteristics and market
composition may be more pronounced. Variability in earnings and profitability
may result in changes in the level of debt protection measurements and the
requirement for relatively high financial leverage. Adequate alternate
liquidity is maintained. Not Prime. Issuers assigned this rating do not fall
within any of the Prime rating categories.
S&P's ratings of commercial paper are graded into four categories ranging
from "A" for the highest quality obligations to "D" for the lowest. A--Issues
assigned this highest rating are regarded as having the greatest capacity for
timely payment. Issues in this category are delineated with numbers 1, 2, and 3
to indicate the relative degree of safety. A-1--This designation indicates that
the degree of safety regarding timely payment is either overwhelming or very
strong. Those issues determined to possess overwhelming safety characteristics
are denoted with a plus (+) sign designation. A-2--Capacity for timely payments
on issues with this designation is strong. However, the relative degree of
safety is not as high as for issues designated "A-1." A-3--Issues carrying this
designation have a satisfactory capacity for timely payment. They are, however,
somewhat more vulnerable to the adverse effects of changes in circumstances
than obligations carrying the higher designations. B--Issues rated B are
regarded as having only an adequate capacity for timely payment. However, such
capacity may be damaged by changing conditions or short-term adversities. C--
This rating is assigned to short-term debt obligations with a doubtful capacity
for payment. D--This rating indicates that the issue is either in default or is
expected to be in default upon maturity.
CORPORATE DEBT SECURITIES. Moody's rates the long-term debt securities issued
by various entities from "Aaa" to "D". Aaa--Best quality. These securities
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--High quality by
all standards. They are rated lower than the best bonds because margins of
protection may not be as large as in Aaa securities, 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-- Upper medium grade obligations. These bonds possess many favorable
investment attributes. 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--Medium grade obligations. 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--
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--
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. Caa--Poor standing. Such
issues may be in default or there may be present elements of danger with
respect to principal or interest. Ca--Obligations which are speculative in a
high degree. Such issues are often in default or have other marked
shortcomings. C--Lowest rated class of bonds; issues so rated can be regarded
as having extremely poor prospects of ever attaining any real investment
standing.
Note: Moody's may apply numerical modifiers, 1, 2 and 3 in each generic
rating classification from Aa through B in its corporate bond rating system.
The modifier 1 indicates that the security ranks in the higher end of its
generic rating category; the modifier 2 indicates a mid-range ranking; and the
modifier 3 indicates that the issue ranks in the lower end of its generic
rating category.
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<PAGE>
S&P also rates the long-term debt securities of various entities in
categories ranging from "AAA" to "D" according to quality. AAA--Highest grade.
Capacity to pay interest and repay principal extremely strong. AA--High grade.
Debt rated AA has a very strong capacity to pay interest and repay principal
and differs from AAA issues only in a small degree. 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. BBB--Regarded as having adequate capacity to pay interest and repay
principal. Whereas these bonds 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 than for debt in
higher rated categories. BB, B, CCC, CC, C--Regarded, on balance, as
predominantly speculative with respect to capacity to pay interest and repay
principal in accordance with the terms of the obligation. BB indicates the
lowest degree of speculation and C the highest degree of speculation. While
such debt will likely have some quality and protective characteristics, these
are outweighed by large uncertainties or major risk exposures to adverse
conditions. CI--Reserved for income bonds on which no interest is being paid.
D--In default, and payment of interest and/or repayment of principal is in
arrears.
Plus (+) or Minus (-): The ratings from "AA" to "CCC" may be modified by the
addition of a plus or minus sign to show relative standing within the major
rating categories.
41
