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MAY 1, 1998
MITCHELL HUTCHINS SERIES TRUST
1285 AVENUE OF THE AMERICAS
NEW YORK, NEW YORK 10019
STATEMENT OF ADDITIONAL INFORMATION
Mitchell Hutchins Series Trust ("Fund") is a professionally managed, open-end
investment company that offers shares in the Portfolios listed below. Shares of
each Portfolio are offered only to insurance company separate accounts that
fund benefits under certain variable annuity contracts and/or variable life
insurance contracts (collectively, "Contracts"). Mitchell Hutchins Asset
Management Inc. ("Mitchell Hutchins"), a wholly owned asset management
subsidiary of PaineWebber Incorporated ("PaineWebber"), serves as investment
adviser and administrator of each Portfolio and also serves as distributor of
each Portfolio's Class I shares. Certain Portfolios have sub-advisers ("Sub-
Advisers").
*MONEY MARKET PORTFOLIO invests in high grade money market instruments
and repurchase agreements secured by such instruments.
*HIGH GRADE FIXED INCOME PORTFOLIO invests primarily in U.S. government
bonds, including those backed by mortgages, and high quality corporate
bonds and mortgage-backed and asset-backed securities of private issuers.
*STRATEGIC FIXED INCOME PORTFOLIO invests primarily in bonds and other
fixed income securities of varying maturities with a dollar-weighted
average portfolio duration between three and eight years.
*STRATEGIC INCOME PORTFOLIO strategically allocates its investments among
three bond market categories: U.S. government and investment grade
corporate bonds; U.S. high yield, high risk corporate bonds; and foreign
and emerging market bonds.
*GLOBAL INCOME PORTFOLIO invests principally in high quality bonds of
foreign and U.S. issuers.
*HIGH INCOME PORTFOLIO invests primarily in a diversified range of high
yield, high risk U.S. and foreign corporate bonds.
*BALANCED PORTFOLIO invests primarily in a combination of equity
securities, investment grade bonds and money market instruments.
*GROWTH AND INCOME PORTFOLIO invests primarily in dividend-paying equity
securities believed to have the potential for rapid earnings growth.
*TACTICAL ALLOCATION PORTFOLIO follows a disciplined investment strategy
that allocates its assets between common stocks and U.S. Treasury notes or
U.S. Treasury bills.
*GROWTH PORTFOLIO invests primarily in equity securities of companies
believed to have substantial potential for capital growth.
*AGGRESSIVE GROWTH PORTFOLIO invests primarily in the common stocks of
U.S. companies expected to grow faster in assets and stock prices than the
average rate of companies in the Standard & Poor's 500 Composite Stock
Price Index.
*SMALL CAP PORTFOLIO invests primarily in equity securities of small
capitalization ("small cap") companies.
*GLOBAL GROWTH PORTFOLIO invests primarily in common stocks of companies
based in the United States, Europe, Japan and the Pacific Basin.
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, 1998.
A copy of the Prospectus may be obtained by contacting the Fund or your
PaineWebber investment executive or by calling toll free 1-800-986-0088.
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TABLE OF CONTENTS
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Investment Policies and Limitations........................................ 3
Hedging and Related Strategies Using Derivative Instruments................ 21
Trustees and Officers; Principal Holders of Securities..................... 30
Investment Advisory Services............................................... 38
Portfolio Transactions..................................................... 41
Additional Purchase and Redemption Information............................. 44
Valuation of Shares........................................................ 44
Taxes...................................................................... 46
Dividends.................................................................. 48
Other Information.......................................................... 48
Financial Statements....................................................... 49
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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 thirteen 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.
RISK CONSIDERATIONS RELATING TO FOREIGN SECURITIES. Investing in non-U.S.
securities involves certain risks and special considerations, including those
set forth below, which are not typically associated with investing in
securities of U.S. companies. Investments in securities of foreign issuers or
securities denominated in a foreign currency involve risks relating to
political, social and economic developments abroad as well as risks resulting
from the differences between the regulations to which U.S. and foreign issuers
and markets are subject. These risks may include expropriation, confiscatory
taxation, withholding taxes, limitations on the use or transfer of Portfolio
assets and political or social instability or diplomatic developments.
Moreover, individual foreign economies may differ favorably or unfavorably from
the U.S. economy in such respects as growth of gross national product, rate of
inflation, capital reinvestment, resource self-sufficiency and balance of
payments positions. Securities of many foreign companies may be less liquid and
their prices more volatile than those of securities of comparable U.S.
companies. From time to time, foreign securities may be difficult to liquidate
rapidly without significantly depressing the price of such securities.
Transactions in foreign securities may be subject to less efficient settlement
practices. Foreign securities trading practices, including those involving
securities settlement where a Portfolio's assets may be released prior to
receipt of payment, may expose that Portfolio to increased risk in the event of
a failed trade or the insolvency of a foreign broker-dealer. Legal remedies for
defaults and disputes may have to be pursued in foreign courts, whose
procedures differ substantially from those of U.S. courts.
Securities of foreign issuers may not be registered with the Securities and
Exchange Commission ("SEC"), and the issuers thereof may not be 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.
The Portfolios may invest in depository receipts, including American
Depository Receipts ("ADRs"), European Depository Receipts ("EDRs"), global
depository receipts ("GDRs") 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. ADRs are receipts typically issued by a U.S. bank or trust company
evidencing ownership of the underlying securities. They are generally in
registered form, are denominated in U.S. dollars and are designed for use in
the U.S. securities markets. EDRs are European receipts evidencing a similar
arrangement, may be denominated in other currencies and are designed for use in
European securities markets. GDRs are similar to EDRs and are designed for use
in several international financial markets. For purposes of each Portfolio's
investment policies, ADRs, EDRs or GDRs are deemed to have the same
classification as the underlying securities they represent. Thus, an ADR, EDR
or GDR evidencing ownership of common stock will be treated as common stock.
ADRs are publicly traded on exchanges or over-the-counter ("OTC") in the
United States and are issued through "sponsored" or "unsponsored" arrangements.
In a sponsored ADR arrangement, the foreign issuer assumes the obligation to
pay some or all of the depositary's transaction fees, whereas under an
unsponsored arrangement, the foreign issuer assumes no obligations and the
depositary's transaction fees are paid directly by the ADR holders. In
addition, less information is available in the United States about an
unsponsored ADR than about a sponsored ADR.
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The Portfolios that may invest outside the United States anticipate that
their 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. Although each Portfolio will endeavor to
achieve the best net results in effecting its portfolio transactions,
transactions on foreign exchanges are usually subject to fixed commissions that
are generally higher than negotiated commissions on U.S. transactions. There is
generally less government supervision and regulation of exchanges and brokers
in foreign countries than in the United States.
Foreign markets have different clearance and settlement procedures, and in
certain markets there have been times when settlements have failed to keep pace
with the volume of securities transactions, making it difficult to conduct such
transactions. Delays in settlement could result in temporary periods when
assets of a Portfolio are uninvested and no return is earned thereon. The
inability of a Portfolio to make intended security purchases due to settlement
problems could cause the Portfolio to miss attractive investment opportunities.
Inability to dispose of a portfolio security due to settlement problems could
result either in losses to the Portfolio due to subsequent declines in the
value of such portfolio security or, if the Portfolio has entered into a
contract to sell the security, could result in possible liability to the
purchaser.
The costs attributable to foreign investing frequently are higher than those
attributable to domestic investing; this is particularly true with respect to
emerging capital markets. For example, the cost of maintaining custody of
foreign securities exceeds custodian costs for domestic securities, and
transaction and settlement costs of foreign investing also frequently are
higher than those attributable to domestic investing. Costs associated with the
exchange of currencies also make foreign investing more expensive than domestic
investing.
Investment income earned on certain foreign securities, and gains realized
from the disposition thereof, may be subject to foreign withholding or other
taxes that could reduce the yield and/or total 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.
In addition, substantial limitations may exist in certain countries with
respect to the Portfolios' ability to repatriate investment capital or the
proceeds of sales of securities.
All or a substantial portion of High Income Portfolio's or Strategic Income
Portfolio's investments in foreign and emerging market securities may be rated
below investment grade or may be unrated securities with credit characteristics
that are comparable to securities that are rated below investment grade.
Strategic Income Portfolio may invest without limit in securities of issuers in
emerging market countries and in non-U.S. dollar-denominated fixed income
securities, including securities denominated in the local currencies of
emerging market countries.
EMERGING MARKET SECURITIES. Disclosure and regulatory standards in many
respects are less stringent in emerging market countries than in the U.S. and
other major markets. There also may be a lower level of monitoring and
regulation of emerging markets and the activities of investors in such markets,
and enforcement of existing regulations may be extremely limited. A Portfolio's
net investment income and capital gains from its foreign investment activities
may be subject to foreign withholding taxes.
Foreign investment in the securities markets of several emerging market
countries is restricted or controlled to varying degrees. These restrictions or
controls may at times limit or preclude foreign investment and increase the
costs and expenses of a Portfolio. Certain countries in which a Portfolio may
invest require governmental approval prior to investments by foreign persons,
limit the amount of investment by foreign persons in a particular issuer, limit
the investment by foreign persons only to a specific class of securities of
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an issuer that may have less advantageous rights than the classes available for
purchase by domiciliaries of the countries or impose additional taxes on
foreign investors. Certain issuers may require governmental approval for the
repatriation of investment income, capital or the proceeds of sales of
securities by foreign investors. In addition, if a deterioration occurs in a
country's balance of payments the country could impose temporary restrictions
on foreign capital remittances. A Portfolio could be adversely affected by
delays in, or a refusal to grant, any required governmental approval for
repatriation of capital, as well as by the application to the Portfolio of any
restrictions on investments. Investing in local markets may require a Portfolio
to adopt special procedures, seek local government approvals or take other
actions, each of which may involve additional costs to the Portfolio.
SOVEREIGN DEBT. Investment in debt securities issued by foreign governments
and their political subdivisions or agencies ("Sovereign Debt") involves
special risks. 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 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.
Another factor bearing on the ability of a country to repay sovereign debt is
the level of the country's international reserves. Fluctuations in the level of
these reserves can affect the amount of foreign exchange readily available for
external debt payments and, thus, could have a bearing on the capacity of the
country to make payments on its sovereign debt.
To the extent that a country has a current account deficit (generally when
exports of merchandise and services are less than the country's imports of
merchandise and services plus net transfers (e.g., gifts of currency and goods)
to foreigners), it will need to depend on loans from foreign governments,
multilateral organizations or private commercial banks, aid payments from
foreign governments and inflows of foreign investment. The access of a country
to these forms of external funding may not be certain, and a withdrawal of
external funding could adversely affect the capacity of a government to make
payments on its obligations. In addition, the cost of servicing debt
obligations can be affected by a change in international interest rates, since
the majority of these obligations carry interest rates that are adjusted
periodically based upon international rates.
With respect to sovereign debt of emerging market issuers, investors should
be aware that certain emerging market countries are among the largest debtors
to commercial banks and foreign governments. At
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times certain emerging market countries have declared moratoria on the payment
of principal and interest on external debt; such moratoria are currently in
effect in certain Latin American countries.
Certain emerging market countries have experienced difficulty in servicing
their sovereign debt on a timely basis which led to defaults on certain
obligations and the restructuring of certain indebtedness. Restructuring
arrangements have included, among other things, reducing and rescheduling
interest and principal payments by negotiating new or amended credit
agreements or converting outstanding principal and unpaid interest to Brady
Bonds (discussed below), and obtaining new credit to finance interest
payments. Holders of sovereign debt, including the Portfolios, may be
requested to participate in the rescheduling of such debt and to extend
further loans to sovereign debtors. The interests of holders of sovereign debt
could be adversely affected in the course of restructuring arrangements or by
certain other factors referred to below. Furthermore, some of the participants
in the secondary market for sovereign debt may also be directly involved in
negotiating the terms of these arrangements and may, therefore, have access to
information not available to other market participants. Obligations arising
from past restructuring agreements may affect the economic performance and
political and social stability of certain issuers of sovereign debt. There is
no bankruptcy proceeding by which sovereign debt on which a sovereign has
defaulted may be collected in whole or in part.
BRADY BONDS. Brady Bonds are sovereign debt securities issued under the
framework of the Brady Plan, an initiative announced by former U.S. Treasury
Secretary Nicholas F. Brady in 1989 as a mechanism for debtor nations to
restructure their outstanding external commercial bank indebtedness. In
restructuring its external debt under the Brady Plan framework, a debtor
nation negotiates with its existing bank lenders as well as multilateral
institutions such as the International Monetary Fund ("IMF"). The Brady Plan
framework, as it has developed, contemplates the exchange of commercial bank
debt for newly issued Brady Bonds. Brady Bonds may also be issued in respect
of new money being advanced by existing lenders in connection with the debt
restructuring. The World Bank and the IMF support the restructuring by
providing funds pursuant to loan agreements or other arrangements which enable
the debtor nation to collateralize the new Brady Bonds or to repurchase
outstanding bank debt at a discount.
Brady Bonds have been issued only in recent years, and accordingly do not
have a long payment history. Agreements implemented under the Brady Plan to
date are designed to achieve debt and debt-service reduction through specific
options negotiated by a debtor nation with its creditors. As a result, the
financial packages offered by each country differ. The types of options have
included the exchange of outstanding commercial bank debt for bonds issued at
100% of face value of such debt, which carry a below-market stated rate of
interest (generally known as par bonds), bonds issued at a discount from the
face value of such debt (generally known as discount bonds), bonds bearing an
interest rate which increases over time and bonds issued in exchange for the
advancement of new money by existing lenders. Regardless of the stated face
amount and stated interest rate of the various types of Brady Bonds, a
Portfolio will purchase Brady Bonds in secondary markets, as described below,
in which the price and yield to the investor reflect market conditions at the
time of purchase.
Certain Brady Bonds have been collateralized as to principal due at maturity
by U.S. Treasury zero coupon bonds with maturities equal to the final maturity
of such Brady Bonds. Collateral purchases are financed by the IMF, the World
Bank and the debtor nations' reserves. In the event of a default with respect
to collateralized Brady Bonds as a result of which the payment obligations of
the issuer are accelerated, the U.S. Treasury zero coupon obligations held as
collateral for the payment of principal will not be distributed to investors,
nor will such obligations be sold and the proceeds distributed. The collateral
will be held by the collateral agent to the scheduled maturity of the
defaulted Brady Bonds, which will continue to be outstanding, at which time
the face amount of the collateral will equal the principal payments which
would have then been due on the Brady Bonds in the normal course. In addition,
interest payments on certain types of Brady Bonds may be collateralized by
cash or high grade securities in amounts that typically represent between 12
and 18 months of interest accruals on these instruments, with the balance of
the interest accruals being uncollateralized.
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Brady Bonds are often viewed as having several valuation components: (1) the
collateralized repayment of principal, if any, at final maturity, (2) the
collateralized interest payments, if any, (3) the uncollateralized interest
payments and (4) any uncollateralized repayment of principal at maturity (these
uncollateralized amounts constitute the "residual risk"). In light of the
residual risk of Brady Bonds and, among other factors, the history of defaults
with respect to commercial bank loans by public and private entities of
countries issuing Brady Bonds, investments in Brady Bonds are to be viewed as
speculative. A Portfolio may purchase Brady Bonds with no or limited
collateralization, and will be relying for payment of interest and (except in
the case of principal collateralized Brady Bonds) repayment of principal
primarily on the willingness and ability of the foreign government to make
payment in accordance with the terms of the Brady Bonds. Brady Bonds issued to
date are purchased and sold in secondary markets through U.S. securities
dealers and other institutions and are generally maintained through European
transnational securities depositories.
STRUCTURED FOREIGN INVESTMENTS. This term refers to interests in U.S. and
foreign entities organized and operated solely for the purpose of securitizing
or restructuring the investment characteristics of foreign securities. This
type of securitization or restructuring involves the deposit with or purchase
by a U.S. or foreign entity, such as a corporation or trust, of specified
instruments (such as commercial bank loans or Brady Bonds) and the issuance by
that entity of one or more classes of securities backed by, or representing
interests in, the underlying instruments. The cash flow on the underlying
instruments may be apportioned among the newly issued structured foreign
investments to create securities with different investment characteristics such
as varying maturities, payment priorities and interest rate provisions, and the
extent of the payments made with respect to structured foreign investments is
dependent on the extent of the cash flow on the underlying instruments.
Structured foreign investments frequently involve no credit enhancement.
Accordingly, their credit risk generally will be equivalent to that of the
underlying instruments. In addition, classes of structured foreign investments
may be subordinated to the right of payment of another class. Subordinated
structured foreign investments typically have higher yields and present greater
risks than unsubordinated structured foreign investments. Structured foreign
investments are typically sold in private placement transactions, and there
currently is no active trading market for structured foreign investments.
FOREIGN CURRENCY TRANSACTIONS. Although each Portfolio that invests in
securities denominated in foreign currencies 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.
The value of the foreign currency-denominated assets of a Portfolio, as
measured in U.S. dollars, may be affected favorably or unfavorably by
fluctuations in currency rates and exchange control regulations. Further, a
Portfolio may incur costs in connection with conversions between various
currencies. Currency exchange dealers realize a profit based on the difference
between the prices at which they are buying and selling various currencies.
Thus, a dealer normally will offer to sell a foreign currency to a Portfolio at
one rate, while offering a lesser rate of exchange should a Portfolio desire
immediately to resell that currency to the dealer. Each Portfolio conducts its
currency exchange transactions either on a spot (i.e. cash) basis at the spot
rate prevailing in the foreign currency exchange market, or through entering
into forward, futures or options contracts to purchase or sell foreign
currencies.
INVESTMENTS IN OTHER INVESTMENT COMPANIES. From time to time, investments in
other investment companies may be the most effective available means by which a
Portfolio may invest in securities of issuers
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in certain countries. Investment in such investment companies may involve the
payment of management expenses and, in connection with some purchases, sales
loads and payment of substantial premiums above the value of such companies'
portfolio securities. At the same time, a Portfolio would continue to pay its
own management fees and other expenses. Each Portfolio that may invest outside
the United States may invest in such investment companies when, in the judgment
of Mitchell Hutchins or the applicable Sub-Adviser, the potential benefits of
such investment outweigh the payment of any applicable premium, sales load and
expenses. In addition, a Portfolio's investments in such investment companies
are subject to limitations under the Investment Company Act of 1940 ("1940
Act") and market availability and may result in special federal income tax
consequences.
SELECTION OF SECURITIES--STRATEGIC INCOME PORTFOLIO. In selecting U.S.
government and investment grade securities for Strategic Income Portfolio,
Mitchell Hutchins considers factors such as the general level of interest
rates, changes in the perceived creditworthiness of the issuers, the prepayment
outlook for the mortgage market and changes in general economic conditions and
business conditions affecting the issuers and their respective industries.
In selecting U.S. high yield securities for Strategic Income Portfolio,
Mitchell Hutchins seeks to identify issuers and industries that Mitchell
Hutchins believes are more likely to experience stable or improving financial
conditions. Many corporations are in the process of strengthening, or have
recently improved, their financial positions through cost-cutting,
restructuring or refinancing with lower cost debt. Mitchell Hutchins expects
that, at times when the U.S. economy is improving, these factors and others may
lead many issuers to experience financial improvement and possible credit
upgrades. Mitchell Hutchins seeks to identify these issuers through detailed
credit research. Mitchell Hutchins' analysis may include consideration of
general industry trends, the issuer's experience and managerial strength,
changing financial conditions, borrowing requirements or debt maturity
schedules, the issuer's responsiveness to changes in business conditions and
interest rates, and other terms and conditions. Mitchell Hutchins may also
consider relative values based on anticipated cash flow, interest or dividend
coverage, asset coverage and earnings prospects.
Mitchell Hutchins selectively invests Strategic Income Portfolio's assets
allocated to foreign and emerging market securities in securities of issuers in
countries where the combination of income market yields, the price appreciation
potential of fixed income securities and, with respect to non-U.S. dollar-
denominated securities, currency exchange rate movements present opportunities
for high current income and, secondarily, capital appreciation. Determinations
as to the foreign markets in which the Portfolio invests are based on an
evaluation of total debt levels, currency reserve levels, net exports/imports,
overall economic growth, level of inflation, currency fluctuation, political
and social climate and payment history of the country in which the issuer is
located. Particular securities are selected based upon credit risk analysis of
potential issuers, the characteristics of the security and interest rate
sensitivity of the various issues by a single issuer, analysis of volatility
and liquidity of these particular instruments and the tax implications to the
Portfolio of various instruments.
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
Balanced Portfolio will consist only of obligations of U.S. corporations that
are (1) rated at least Prime-2 by Moody's Investors
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Service, Inc. ("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.
MONEY MARKET INVESTMENTS. The money market investments of the Portfolios
other than Balanced Portfolio and Money Market Portfolio (which are described
elsewhere in the Prospectus or Statement of Additional Information) include,
among other things, (1) securities issued or guaranteed by the U.S. government
or one of its agencies or instrumentalities, (2) debt obligations of banks,
savings and loan institutions, insurance companies and mortgage bankers, (3)
commercial paper and notes, including those with variable and floating rates of
interest, (4) debt obligations of foreign branches of U.S. banks, U.S. branches
of foreign banks, and foreign branches of foreign banks, (5) debt obligations
issued or guaranteed by one or more foreign governments or any of their foreign
political subdivisions, agencies or instrumentalities, including obligations of
supranational entities, (6) debt securities issued by foreign issuers, (7)
repurchase agreements and (8) other investment companies that invest
exclusively in money market instruments. Only those Portfolios that may invest
outside the United States may invest in money market instruments that are
denominated in foreign currencies.
Global Growth Portfolio may invest, directly or indirectly, up to 25% of its
assets in the GEIM Short-Term Investment Fund ("Investment Fund"), an
investment fund created specifically to serve as a vehicle for the collective
investment of cash balances of Global Growth Portfolio and other accounts
advised by either GE Investment Management Incorporated ("GEIM") or its
affiliate, General Electric Investment Corporation. The Investment Fund invests
exclusively in the money market instruments described in (1) through (7) above.
The Investment Fund is advised by GEIM. No advisory fee is charged by GEIM to
the Investment Fund, nor will Global Growth Portfolio incur any sales charge,
redemption fee, distribution fee or service fee in connection with its
investments in the Investment Fund.
YIELD FACTORS AND RATINGS. Moody's, S&P and other nationally recognized
statistical rating organizations ("NRSROs") are private services that provide
ratings of the credit quality of debt obligations. A description of the ratings
assigned to debt obligations by S&P and Moody's is included in the Appendix to
the Prospectus. The process by which S&P and Moody's determine ratings for
mortgage- and asset-backed securities includes consideration of the likelihood
of the receipt by security holders of all distributions, the nature of the
underlying securities, the credit quality of the guarantor, if any, and the
structural, legal and tax aspects associated with such securities. Not even the
highest such ratings represent an assessment of the likelihood that principal
prepayments will be made by mortgagors or the degree to which such prepayments
may differ from that originally anticipated, nor do such ratings address the
possibility that investors may suffer a lower than anticipated yield or that
investors in such securities may fail to recoup fully their initial investment
due to prepayments.
A Portfolio may use these ratings in determining whether to purchase, sell or
hold a security. It should be emphasized, however, that ratings are general and
are not absolute standards of quality. Consequently, debt obligations with the
same maturity, interest rate and rating may have different market prices. Also,
rating agencies may fail to make timely changes in credit ratings in response
to subsequent events so that an issuer's current financial condition may be
better or worse than the rating indicates. The rating assigned to a security by
a NRSRO does not reflect an assessment of the volatility of the security's
market value or of the liquidity of an investment in the security. Subsequent
to its purchase by any Portfolio, an issue of debt obligations may cease to be
rated or its rating may be reduced below the minimum rating required for
purchase by that Portfolio.
In addition to ratings assigned to individual bond issues, Mitchell Hutchins
or a Sub-Adviser, as applicable, will analyze interest rate trends and
developments that may affect individual issuers, including
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factors such as liquidity, profitability and asset quality. The yields on debt
securities in which the Portfolios invest are dependent on a variety of
factors, including general money market conditions, general conditions in the
bond market, the financial condition of the issuer, the size of the offering,
the maturity of the obligation and its rating. There is a wide variation in the
quality of bonds, both within a particular classification and between
classifications. An issuer's obligations under its bonds are subject to the
provisions of bankruptcy, insolvency and other laws affecting the rights and
remedies of bond holders or other creditors of an issuer; litigation or other
conditions may also adversely affect the power or ability of issuers to meet
their obligations for the payment of interest and principal on their bonds.
Debt securities rated Ba or lower by Moody's, BB or lower by S&P, comparably
rated by another NRSRO or determined by Mitchell Hutchins or a Sub-Adviser, as
applicable, to be of comparable quality are below investment grade, are deemed
by those agencies to be predominantly speculative with respect to the issuer's
capacity to pay interest and repay principal and may involve major risk
exposure to adverse conditions. Lower rated debt securities generally offer a
higher current yield than that available for investment grade issues, but they
involve higher risks, in that they especially subject to adverse changes in
general economic conditions and in the industries in which the issuers are
engaged, to changes in the financial condition of the issuers and to price
fluctuations in response to changes in interest rates. During periods of
economic downturn or rising interest rates, highly leveraged issuers may
experience financial stress which could adversely affect their ability to make
payments of interest and principal and increase the possibility of default. In
addition, such issuers may not have more traditional methods of financing
available to them and may be unable to repay debt at maturity by refinancing.
The risk of loss due to default by such issuers is significantly greater
because such securities frequently are unsecured and subordinated to the prior
payment of senior indebtedness.
The market for lower rated debt securities, especially those of foreign
issuers, has expanded rapidly in recent years, which has been a period of
generally expanding growth and lower inflation. These securities will be
susceptible to greater risk when economic growth slows or reverses and when
inflation increases or deflation occurs. This has been reflected in the recent
volatility in emerging market securities, particularly in Asia. In the past,
the prices of many lower rated debt securities declined substantially,
reflecting an expectation that many issuers of such securities might experience
financial difficulties. As a result, the yields on lower rated debt securities
rose dramatically. However, such higher yields did not reflect the value of the
income stream that holders of such securities expected, but rather the risk
that holders of such securities could lose a substantial portion of their value
as a result of the issuers' financial restructuring or defaults. There can be
no assurance that such declines will not recur. The market for lower rated debt
issues generally is thinner or less active than that for higher quality
securities, which may limit a Portfolio's ability to sell such securities at
fair value in response to changes in the economy or financial markets. Adverse
publicity and investor perceptions, whether or not based on fundamental
analysis, may also decrease the values and liquidity of lower rated securities,
especially in a thinly traded market.
ASSET-BACKED SECURITIES. Asset-backed securities have structural
characteristics similar to mortgage-backed securities, as discussed in more
detail below. However, the underlying assets are not first lien mortgage loans
or interests therein, but include assets such as motor vehicle installment sale
contracts, other installment sale contracts, home equity loans, leases of
various types of real and personal property and receivables from revolving
credit (credit card) agreements. Such assets are securitized through the use of
trusts or special purpose corporations. Payments or distributions of principal
and interest may be guaranteed up to a certain amount and for a certain time
period by a letter of credit or pool insurance policy issued by a financial
institution unaffiliated with the issuer, or other credit enhancements may be
present.
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. Foreign mortgage-backed
securities may
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employ different structures. 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 Ginnie Mae
(also known as the Government National Mortgage Association), Fannie Mae (also
known as the Federal National Mortgage Association) or Freddie Mac, (also known
as the Federal Home Loan Mortgage Corporation) or other government-sponsored
enterprises. 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. 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
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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.
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 accrued on all classes of a CMO (other than any principal-
only or PO class) on a monthly, quarterly or semiannual 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 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
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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. A Portfolio 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. The yield
characteristics of mortgage- and asset-backed securities differ from those of
traditional debt securities. Among the major differences are that interest and
principal payments are made more frequently, usually monthly, and that
principal may be prepaid at any time because the underlying mortgage loans or
other obligations generally may be prepaid at any time. 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 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
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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 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 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
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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.
CONVERTIBLE SECURITIES. Before conversion, convertible securities have
characteristics similar to non-convertible debt securities in that they
ordinarily provide a stable stream of income with generally higher yields than
those of common stocks in the same or similar issuers. Convertible securities
rank senior to common stock in a corporation's capital structure but are
usually subordinated to comparable non-convertible securities.
The value of a convertible security is a function of its "investment value"
(determined by its yield comparison with the yields of other securities of
comparable maturity and quality that do not have a conversion privilege) and
its "conversion value" (the security's worth, at market value, if converted
into the underlying common stock). The investment value of a convertible
security is influenced by changes in interest rates, with investment value
declining as interest rates increase and increasing as interest rates decline.
The credit standing of the issuer and other factors also may have an effect on
the convertible security's investment value. The conversion value of a
convertible security is determined by the market price of the underlying common
stock. If the conversion value is low relative to the investment value, the
price of the convertible security is governed principally by its investment
value, and generally the conversion value decreases as the convertible security
approaches maturity. To the extent the market price of the underlying common
stock approaches or exceeds the conversion price, the price of the convertible
security will be increasingly influenced by its conversion value. In addition,
a convertible security generally will sell at a premium over its conversion
value, determined by the extent to which investors place value on the right to
acquire the underlying common stock while holding a fixed income security.
A convertible security may be subject to redemption at the option of the
issuer at a price established in the convertible security's governing
instrument. If a convertible security held by a Portfolio is called for
redemption, the Portfolio will be required to permit the issuer to redeem the
security, convert it into the underlying common stock or sell it to a third
party. The Portfolios that may invest in convertible securities may hold any
equity securities they acquire upon conversion subject only to their
limitations on holding equity securities.
DURATION. Duration is a measure of the expected life of a fixed income
security that was developed as a more precise alternative to the concept "term
to maturity." Traditionally, a debt security's "term to maturity" has been used
as a proxy for the sensitivity of the security's price to changes in interest
rates (which is the "interest rate risk" or "volatility" of the security).
However, "term to maturity" measures only the time until a debt security
provides for a final payment, taking no account of the pattern of the
security's payments prior to maturity.
For any fixed income security with interest payments occurring prior to the
payment of principal, duration is always less than maturity. For example,
depending upon its coupon and the level of market yields, a U.S. Treasury note
with a remaining maturity of five years might have a duration of 4.5 years. For
mortgage-backed and other securities that are subject to prepayments, put or
call features or adjustable coupons, the difference between the remaining
stated maturity and the duration is likely to be much greater.
Futures, options and options on futures have durations that, in general, are
closely related to the duration of the securities that underlie them. Holding
long futures or call option positions (backed by a segregated account of cash
and cash equivalents) will lengthen a Portfolio's duration by approximately the
same amount as would holding an equivalent amount of the underlying securities.
Short futures or put options have durations roughly equal to the negative
duration of the securities that underlie these positions and have the effect of
reducing portfolio duration by approximately the same amount as would selling
an equivalent amount of the underlying securities.
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There are some situations in which the standard duration calculation does not
properly reflect the interest rate exposure of a security. For example,
floating and variable rate securities often have final maturities of ten or
more years; however, their interest rate exposure corresponds to the frequency
of the coupon reset. Another example where the interest rate exposure is not
properly captured by the standard duration calculation is the case of mortgage-
backed securities. The stated final maturity of such securities is generally 30
years, but current prepayment rates are critical in determining the securities'
interest rate exposure. In these and other similar situations, Mitchell
Hutchins and the Sub-Advisers, as applicable, will use more sophisticated
analytical techniques that incorporate the economic life of a security into the
determination of its duration and, therefore, its interest rate exposure.
WARRANTS. Warrants are securities permitting but not obligating their holder
to subscribe for other securities or commodities. Warrants do not carry with
them the right to dividends or voting rights with respect to the securities
that they entitle their holder to purchase, and they do not represent any
rights in the assets of the issuer. As a result, warrants may be considered
more speculative than certain other types of investments. In addition, the
value of a warrant does not necessarily change with the value of the underlying
securities, and a warrant ceases to have value if it is not exercised prior to
its expiration date.
ILLIQUID SECURITIES. Each Portfolio may invest up to 10% or 15% 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 OTC, 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 (sometimes referred to as the "board"). 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 options 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. Under current SEC guidelines, interest-only ("IO") and
principal-only ("PO") classes of mortgage-backed securities are considered
illiquid. However, IO and PO classes of fixed-rate mortgage-backed securities
issued by the U.S. government or one of its agencies or instrumentalities will
not be considered illiquid if Mitchell Hutchins or the applicable Sub-Adviser
has determined that they are liquid pursuant to guidelines established by the
board. To the extent a Portfolio invests in illiquid securities, it may not be
able to readily liquidate such investments and may have to sell other
investments if necessary to raise cash to meet its obligations. 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.
Restricted securities are not registered under the Securities Act of 1933
("1933 Act") and may be sold only in privately negotiated or other exempted
transactions or after a 1933 Act registration statement has become effective.
However, not all restricted securities are illiquid. To the extent that foreign
securities are freely tradeable in the country in which they are principally
traded, they are not considered illiquid even if they are restricted in the
United States. A large institutional market has developed for many U.S. and
foreign securities that are not registered under the 1933 Act. 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.
Institutional markets for restricted securities have developed as a result of
Rule 144A, which establishes a "safe harbor" from the registration requirements
of the 1933 Act for resales of certain securities to qualified institutional
buyers. Such markets include automated systems for the trading, clearance and
settlement of
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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 securities and a Portfolio might be unable
to dispose of the securities promptly or at favorable prices.
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.
ZERO COUPON, OID AND PIK SECURITIES; TREASURY INFLATION PROTECTED
SECURITIES. Federal tax law requires that a holder of a security with original
issue discount ("OID") accrue a portion of the OID on the security as income
each year, even though the holder may receive no interest payment on the
security during the year. Accordingly, although a Portfolio will receive no
payments on its zero coupon securities prior to their maturity or disposition,
it will have income each year attributable to such securities. Similarly,
while payment-in-kind ("PIK") securities may pay "interest" in the form of
additional securities rather than cash, that interest must be included in a
Portfolio's annual income. Similarly, the amount of any principal increase in
a Treasury Inflation Protected Security ("TIPS") held by a Portfolio also must
be included in its annual income.
To qualify for pass-through federal income tax treatment as regulated
investment company, each Portfolio must distribute substantially all of its
net investment income each year, including non-cash income. See "Taxes."
Accordingly, each Portfolio will be required to include in its dividends an
amount equal to the income attributable to its zero coupon, other OID and PIK
securities and any amounts attributable to principal increases on TIPS. Those
dividends will be paid from the cash assets of a Portfolio or by liquidation
of portfolio securities, if necessary, at a time when the Portfolio otherwise
might not have done so.
Certain zero coupon securities are U.S. Treasury notes and bonds that have
been stripped of their unmatured interest coupon receipts or interests in such
U.S. Treasury securities or coupons. The staff of the SEC currently takes the
position that "stripped" U.S. government securities that are not issued
through the U.S. Treasury are not U.S. government securities. This technique
is frequently used with U.S. Treasury bonds to create CATS (Certificate of
Accrual Treasury Securities), TIGRs (Treasury Income Growth Receipts) and
similar securities. As long as the SEC takes this position, CATS and TIGRs,
which are not issued through the U.S. Treasury, will not be counted as U.S.
government securities for purposes of the 65% investment requirement
applicable to Strategic Fixed Income Portfolio.
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
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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 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 board. Mitchell Hutchins reviews and monitors the
creditworthiness of those institutions under the board's general supervision.
REVERSE REPURCHASE AGREEMENTS AND DOLLAR ROLLS. Strategic Fixed Income,
Strategic Income and Global Income Portfolios may enter into arbitraged reverse
repurchase agreements with banks and securities dealers. Strategic Fixed Income
and Strategic Income Portfolios also may invest in arbitraged dollar rolls.
Such transactions involve the sale of securities held by a Portfolio subject to
its agreement to repurchase the securities at an agreed-upon date or upon
demand and at a price reflecting a market rate of interest. Such transactions
are considered to be borrowings and may be entered into only for temporary
purposes. While a reverse repurchase agreement or dollar roll is outstanding, a
Portfolio's custodian segregates assets to cover the amount of its obligations
under the reverse repurchase agreement or dollar roll. See "Investment Policies
and Restrictions--Segregated Accounts."
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. Each Portfolio is authorized to lend
portfolio securities valued at up to 33 1/3% of its total assets 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. Each Portfolio may reinvest any cash collateral in money market
investments or other short-term liquid investments. 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 of its
loans at any time. A Portfolio may pay reasonable fees in connection with a
loan and may pay a negotiated portion of the interest earned on the
reinvestment of cash held as collateral to the borrower or placing broker. A
Portfolio will receive reasonable interest on a 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.
Pursuant to procedures adopted by the board governing each Portfolio's
securities lending program, PaineWebber has been retained to serve as lending
agent for each Portfolio. The board also has authorized the payment of fees
(including fees calculated as a percentage of invested cash collateral) to
PaineWebber for these services. The board periodically reviews all portfolio
securities loan transactions for which PaineWebber acted as lending agent.
LOAN PARTICIPATIONS AND ASSIGNMENTS. Strategic Fixed Income Portfolio, High
Income Portfolio [and Global Income Portfolio] each may invest up to 5% of its
net assets, and Strategic Income Portfolio may
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invest without limit, 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"). A 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.
A 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, a 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 a 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, a 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. A
Portfolio will acquire Participations only if the Lender interpositioned
between the Portfolio and the borrower is determined by Mitchell Hutchins to be
creditworthy.
When a Portfolio purchases Assignments from Lenders, it acquires direct
rights against the borrower on the Loan. However, because Assignments are
arranged through private negotiations between potential assignees and
assignors, the rights and obligations acquired by a 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 each Portfolio's limitation on investment in
illiquid securities. Because there is no liquid market for such securities, the
Portfolios anticipate 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 a Portfolio's
ability to dispose of particular Assignments or Participations when necessary
to meet its 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 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
establishes a margin account with the broker effecting the short sale, and
deposits collateral with the broker. In addition, the Portfolio maintains 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.
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. In such case, any loss in the
Portfolio's long position after the short sale should be reduced by a
corresponding gain in the short position. Conversely, any gain in the long
position after the short sale should be reduced by a corresponding 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. 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.
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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 Using Derivative Instruments," segregated accounts may also be
required in connection with certain transactions involving options or futures
contracts, interest rate swaps or forward currency contracts.
FUNDAMENTAL INVESTMENT LIMITATIONS. The following fundamental investment
limitations cannot be changed for 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.
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.
(2) issue senior securities or borrow money, except as permitted under
the 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.
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(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 and Strategic 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.
NON-FUNDAMENTAL LIMITATIONS. The following investment restrictions may be
changed by the board 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 and/or variable life insurance contracts.
(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 INSTRUMENTS
GENERAL DESCRIPTION OF DERIVATIVE INSTRUMENTS. As discussed in the
Prospectus, Mitchell Hutchins or the applicable Sub-Adviser may use a variety
of financial instruments ("Derivative Instruments"), including
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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 realize gains. For Portfolios
that are permitted to invest outside the United States, Mitchell Hutchins or
the applicable Sub-Adviser also may use forward currency contracts, foreign
currency options and futures and options thereon. Portfolios that invest
primarily in bonds also may enter into interest rate swaps. A Portfolio may
enter into transactions using one or more type s of Derivative 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. Money Market Portfolio is not
authorized to use these Derivative Instruments. The particular Derivative
Instruments used by the other Portfolios are described below.
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 INDICES--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 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 currencies, 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.
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GENERAL DESCRIPTION OF STRATEGIES USING DERIVATIVE INSTRUMENTS. Hedging
strategies can be broadly categorized as "short hedges" and "long hedges." A
short hedge is a purchase or sale of a Derivative 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
Derivative 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 Derivative 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 Derivative 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.
Derivative 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. Derivative Instruments on stock 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.
Derivative 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 Derivative
Instruments to increase or reduce a Portfolio's exposure to an asset class
without buying or selling the underlying instruments.
The use of Derivative 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 Derivative Instruments may 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 may discover
additional opportunities in connection with Derivative Instruments and with
hedging, income and gain strategies. These new opportunities may become
available as regulatory authorities broaden the range of permitted transactions
and as new Derivative Instruments and techniques are developed. Mitchell
Hutchins or the applicable Sub-Adviser may utilize these opportunities to the
extent that they are consistent with a Portfolio's investment objectives and
permitted by the Portfolio's
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investment limitations and applicable regulatory authorities. The Fund's
Prospectus or this 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 INSTRUMENTS. The use of
Derivative Instruments involves special considerations and risks, as described
below. Risks pertaining to particular Derivative Instruments are described in
the sections that follow.
(1) Successful use of most Derivative Instruments depends upon Mitchell
Hutchins' or the applicable Sub-Adviser's ability to predict movements of
the overall securities, interest rate or currency exchange 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 Derivative 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 Derivative Instrument and price movements of the
investments being hedged. For example, if the value of a Derivative
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 affecting the markets
on which Derivative Instruments are traded rather than the value of the
investments being hedged. The effectiveness of hedges using Derivative
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 Derivative Instrument. Moreover, if the price of the Derivative
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.
(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 Derivative Instruments involving obligations to third
parties (i.e., Derivative Instruments other than purchased options). If a
Portfolio were unable to close out its positions in such Derivative
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 Derivative 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 INSTRUMENTS. Transactions using
Derivative 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.
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Assets used as cover or held in a segregated account cannot be sold while the
position in the corresponding Derivative Instrument is open, unless they are
replaced with similar assets. As a result, committing a large portion of a
Portfolio's assets to cover positions or to 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. Portfolios that may invest outside the United States also may
purchase put and call options, and write covered options, 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, the Portfolios 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.
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. Closing transactions permit a Portfolio to realize
profits or limit losses on an option position prior to its exercise or
expiration.
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.
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.
25
<PAGE>
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.
A Portfolio may purchase and write put and call options on indices in much
the same manner as the more traditional options discussed above, except the
index options may serve as a hedge against overall fluctuations in a securities
market (or market sector) rather than anticipated increases or decreases in the
value of a particular security.
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 straddle
or spread, 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 its 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 its 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 call options on securities and indices. In addition, the Portfolios may
purchase or sell futures contracts or purchase options thereon to enhance
return by increasing or reducing 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.
The Portfolios that may invest outside the United States 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. A Portfolio will engage in this strategy only when it is
more advantageous to the Portfolio than purchasing the futures contract.
26
<PAGE>
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 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.
27
<PAGE>
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 its 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 its 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 its total
assets.
FOREIGN CURRENCY HEDGING STRATEGIES--SPECIAL CONSIDERATIONS. Each Portfolio
that may invest outside the United States may use options and futures on
foreign currencies, as described above, and forward currency contracts, as
described below, to hedge against movements in the values of the foreign
currencies in which the Portfolio's 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.
A Portfolio might seek to hedge against changes in the value of a particular
currency when no Derivative Instruments on that currency are available or such
Derivative Instruments are more expensive than certain other Derivative
Instruments. In such cases, a Portfolio may hedge against price movements in
that currency by entering into transactions using Derivative Instruments on
another foreign currency or a basket of currencies, the value 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. 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." The risk that movements in the
price of the Derivative 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 Derivative 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 Derivative
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.
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 Derivative Instruments
until they reopen.
28
<PAGE>
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. Portfolios that may invest outside the United
States 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. The Portfolios may use forward
currency contracts to realize gains from favorable changes in exchange rates.
The cost to a Portfolio of 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.
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. A Portfolio that may
invest outside the United States 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."
SWAP TRANSACTIONS. A Portfolio that invests primarily in bonds may enter
into interest swap transactions, including swaps, caps, floors and collars. An
interest rate swap involves 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
29
<PAGE>
period of time. An interest rate cap or floor transaction involves an agreement
between two parties in which the first party agrees to make payments to the
contra party 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. An interest rate collar transaction
involves 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 swap 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 swap
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, floors and
collars 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 a Portfolio receiving or paying, as the case may be, only the net
amount of the two payments. Inasmuch as these interest rate swap 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 applicable 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 swaps that are not entered into on a net basis and
with respect to any caps, floors and collars that are entered into by the
Portfolio.
Each Portfolio will enter into swap 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 board. 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.
TRUSTEES AND OFFICERS; PRINCIPAL HOLDERS OF SECURITIES
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**; 51 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 30
investment companies for
which Mitchell Hutchins
or PaineWebber serves as
investment adviser.
</TABLE>
30
<PAGE>
<TABLE>
<CAPTION>
BUSINESS EXPERIENCE
NAME AND ADDRESS*; AGE POSITION WITH THE FUND AND OTHER DIRECTORSHIPS
---------------------- ---------------------- -----------------------
<C> <C> <S>
Richard Q. Armstrong; 62 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 and
sparkling/still waters)
(October 1993-March
1995). He was a partner
of The New England Con-
sulting Group (manage-
ment consulting firm)
(December 1992-September
1993). He was managing
director of LVMH U.S.
Corporation (U.S. sub-
sidiary of the French
luxury goods conglomer-
ate, Louis Vuitton Moet
Hennessey Corporation)
(1987-1991) and chairman
of its wine and spirits
subsidiary, Schieffelin
& Somerset Company
(1987-1991). Mr. Arm-
strong is a director or
trustee of 29 investment
companies for which
Mitchell Hutchins or
PaineWebber serves as
investment adviser.
E. Garrett Bewkes, Jr.**; 71 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 ex-
ecutive officer of Amer-
ican
Bakeries Company. Mr.
Bewkes is also a direc-
tor of Interstate Baker-
ies Corporation and
NaPro BioTherapeutics,
Inc. Mr. Bewkes is a di-
rector or trustee of 30
investment companies for
which Mitchell Hutchins
or PaineWebber serves as
investment adviser.
Richard R. Burt; 51 Trustee Mr. Burt is chairman of
1275 Pennsylvania Avenue, IEP Advisors, Inc. (in-
N.W. ternational investments
Washington, D.C. 20004 and consulting firm)
(since March 1994) and a
partner of McKinsey &
Company (management con-
sulting firm) (since
1991). He is also a di-
rector of American Pub-
lishing 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
</TABLE>
31
<PAGE>
<TABLE>
<CAPTION>
BUSINESS EXPERIENCE
NAME AND ADDRESS*; AGE POSITION WITH THE FUND AND OTHER DIRECTORSHIPS
---------------------- ---------------------- -----------------------
<C> <C> <S>
Federal Republic of
Germany (1985-1989).
Mr. Burt is a director
or trustee of 29 in-
vestment companies for
which Mitchell Hutchins
or PaineWebber serves
as investment adviser.
Mary C. Farrell**; 48 Trustee Ms. Farrell is a manag-
ing 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
Financial Women's Asso-
ciation and Women's
Economic Roundtable and
appears as a regular
panelist on Wall $treet
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 29 in-
vestment companies for
which Mitchell Hutchins
or PaineWebber serves
as investment adviser.
Meyer Feldberg; 56 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
director of K-III Com-
munications Corpora-
tion, Federated Depart-
ment Stores Inc., and
Revlon, Inc. Dean
Feldberg is a director
or trustee of 29 in-
vestment companies for
which Mitchell Hutchins
or PaineWebber serves
as investment adviser.
George W. Gowen; 68 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 29
investment companies
for which Mitchell
Hutchins or PaineWebber
serves as investment
adviser.
Frederic V. Malek; 61 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
</TABLE>
32
<PAGE>
<TABLE>
<CAPTION>
BUSINESS EXPERIENCE
NAME AND ADDRESS*; AGE POSITION WITH THE FUND AND OTHER DIRECTORSHIPS
---------------------- ---------------------- -----------------------
<C> <C> <S>
company of Northwest
Airlines Inc.) and Wings
Holdings Inc. (holding
company of NWA Inc.).
Prior to 1989, he was
employed by the Marriott
Corporation (hotels,
restaurants, airline ca-
tering and contract
feeding), where he most
recently was an execu-
tive vice president and
president of Marriott
Hotels and Resorts.
Mr. Malek is also a di-
rector of American Man-
agement Systems, Inc.
(management consulting
and computer related
services), Automatic
Data Processing, Inc.,
CB Commercial Group,
Inc. (real estate serv-
ices), Choice Hotels In-
ternational (hotel and
hotel franchising), FPL
Group, Inc. (electric
services), Integra, Inc.
(bio-medical), Manor
Care, Inc. (health
care), National Educa-
tion Corporation and
Northwest Airlines Inc.
Mr. Malek is a director
or trustee of 29 invest-
ment companies for which
Mitchell Hutchins or
PaineWebber serves as
investment adviser.
Carl W. Schafer; 62 Trustee Mr. Schafer is president
P.O. Box 1164 of the Atlantic Founda-
Princeton, NJ 08542 tion (charitable founda-
tion supporting mainly
oceanographic explora-
tion and research). He
is a director of Roadway
Express, Inc. (truck-
ing), The Guardian Group
of Mutual Funds, Evans
Systems, Inc. (motor fu-
els, convenience store
and diversified compa-
ny), Electronic Clearing
House, Inc. (financial
transactions process-
ing), Wainoco Oil Corpo-
ration and Nutraceutix
Inc. (biotechnology com-
pany). Prior to January
1993, he was chairman of
the Investment Advisory
Committee of the Howard
Hughes Medical Insti-
tute. Mr. Schafer is a
director or trustee of
29 investment companies
for which Mitchell
Hutchins or PaineWebber
serves as investment ad-
viser.
T. Kirkham Barneby; 51 Vice President Mr. Barneby is a managing
director and chief in-
vestment officer--quan-
titative investment of
Mitchell Hutchins. Prior
to September 1994, he
was a senior vice presi-
dent at Vantage Global
Management. Prior to
June 1993, he was a se-
nior vice president at
Mitchell Hutchins.
Mr. Barneby is a vice
president of six invest-
ment companies for which
Mitchell Hutchins or
PaineWebber serves as
investment adviser.
</TABLE>
33
<PAGE>
<TABLE>
<CAPTION>
BUSINESS EXPERIENCE
NAME AND ADDRESS*; AGE POSITION WITH THE FUND AND OTHER DIRECTORSHIPS
---------------------- ---------------------- -----------------------
<C> <C> <S>
Ellen R. Harris; 51 Vice President Ms. Harris is a managing
director and a portfolio
manager of Mitchell
Hutchins. Ms. Harris is a
vice president of two in-
vestment companies for
which Mitchell Hutchins
or PaineWebber serves as
investment adviser.
Donald R. Jones; 37 Vice President Mr. Jones is a first vice
president and a portfolio
manager of Mitchell
Hutchins. Prior to Febru-
ary 1996, he was a vice
president in the asset
management group of First
Fidelity Bancorporation.
Mr. Jones is a vice pres-
ident of two investment
companies for which
Mitchell Hutchins or
PaineWebber serves as in-
vestment adviser.
James F. Keegan; 37 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.
Thomas J. Libassi; 39 Vice President Mr. Libassi is a senior
vice president and a
portfolio manager of
Mitchell Hutchins. Prior
to May 1994, he was a
vice president of Key-
stone Custodian Funds
Inc. with portfolio man-
agement responsibility.
Mr. Libassi is a vice
president of five invest-
ment companies for which
Mitchell Hutchins or
PaineWebber serves as in-
vestment adviser.
Dennis McCauley; 51 Vice President Mr. McCauley is a managing
director and chief in-
vestment officer--fixed
in-come 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 20 in-
vestment companies for
which Mitchell Hutchins
or PaineWebber serves as
investment adviser.
Ann E. Moran; 40 Vice President and Ms. Moran is a vice presi-
Assistant Treasurer dent and a manager of the
mutual fund finance divi-
sion of Mitchell
Hutchins. Ms. Moran is a
vice president and assis-
tant treasurer of 30 in-
vestment companies for
which Mitchell Hutchins
or PaineWebber serves as
investment adviser.
</TABLE>
34
<PAGE>
<TABLE>
<CAPTION>
BUSINESS EXPERIENCE
NAME AND ADDRESS*; AGE POSITION WITH THE FUND AND OTHER DIRECTORSHIPS
---------------------- ---------------------- -----------------------
<C> <C> <S>
Dianne E. O'Donnell; 45 Vice President and Ms. O'Donnell is a senior
Secretary vice president and deputy
general counsel of Mitch-
ell Hutchins. Ms.
O'Donnell is a vice pres-
ident and secretary of 29
investment companies and
vice president and assis-
tant secretary of one in-
vestment company for
which Mitchell Hutchins
or PaineWebber serves as
investment adviser.
Emil Polito; 37 Vice President Mr. Polito is a senior
vice president and direc-
tor of operations and
control for Mitchell
Hutchins. From March 1991
to September 1993 he was
director of the mutual
funds sales support and
service center for Mitch-
ell Hutchins and
PaineWebber. Mr. Polito
is a vice president of 30
investment companies
for which Mitchell
Hutchins or PaineWebber
serves as investment
adviser.
Susan Ryan; 38 Vice President Ms. Ryan is a senior vice
president and portfolio
manager of Mitchell
Hutchins and 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 adviser.
Victoria E. Schonfeld; 47 Vice President Ms. Schonfeld is a manag-
ing director and general
counsel of Mitchell
Hutchins. Prior to May
1994, she was a partner
in the law firm of Arnold
& Porter. Ms. Schonfeld
is a vice president of 29
investment companies and
a vice president and sec-
retary of one investment
company for which Mitch-
ell Hutchins or
PaineWebber serves as in-
vestment adviser.
Paul H. Schubert; 35 Vice President and Mr. Schubert is a first
Treasurer vice president and the
director of the mutual
fund finance division of
Mitchell Hutchins. From
August 1992 to August
1994, he was a vice pres-
ident at BlackRock Finan-
cial Management L.P. Mr.
Schubert is a vice presi-
dent and treasurer of 30
investment companies for
which Mitchell Hutchins
or PaineWebber serves as
investment adviser.
Nirmal Singh; 42 Vice President Mr. Singh is a senior vice
president and portfolio
manager of Mitchell
Hutchins. Prior to 1993,
he was a member of
the portfolio management
team at Merrill
</TABLE>
35
<PAGE>
<TABLE>
<CAPTION>
BUSINESS EXPERIENCE
NAME AND ADDRESS*; AGE POSITION WITH THE FUND AND OTHER DIRECTORSHIPS
---------------------- ---------------------- -----------------------
<C> <C> <S>
Lynch Asset Management,
Inc. Mr. Singh is a vice
president of four invest-
ment companies for which
Mitchell Hutchins or
PaineWebber serves as in-
vestment adviser.
Barney A. Taglialatela; 37 Vice President and Mr. Taglialatela is a vice
Assistant Treasurer president and a manager of
the mutual fund finance
division of Mitchell
Hutchins. Prior to Febru-
ary 1995, he was a manager
of the mutual fund finance
division of Kidder Peabody
Asset Management, Inc. Mr.
Taglialatela is a vice
president and assistant
treasurer of 30 investment
companies for which Mitch-
ell Hutchins or
PaineWebber serves as in-
vestment adviser.
Mark A. Tincher; 42 Vice President Mr. Tincher is a managing
director and chief invest-
ment officer--equities of
Mitchell Hutchins. Prior
to March 1995, he was a
vice president and di-
rected the U.S. funds man-
agement and equity re-
search areas of Chase Man-
hattan Private Bank. Mr.
Tincher is a vice presi-
dent of 13 investment com-
panies for which Mitchell
Hutchins or PaineWebber
serves as investment ad-
viser.
Craig M. Varrelman; 39 Vice President Mr. Varrelman is a senior
vice president and a port-
folio manager of Mitchell
Hutchins. Mr. Varrelman is
a vice president of four
investment companies for
which Mitchell Hutchins or
PaineWebber serves as in-
vestment adviser.
Stuart Waugh; 42 Vice President Mr. Waugh is a managing di-
rector and a portfolio
manager of Mitchell
Hutchins responsible for
global fixed income in-
vestments and currency
trading. Mr. Waugh is a
vice president of five in-
vestment companies for
which Mitchell Hutchins or
PaineWebber serves as in-
vestment adviser.
Keith A. Weller; 36 Vice President and Mr. Weller is a first vice
Assistant Secretary president and associate
general counsel of Mitch-
ell Hutchins. Prior to May
1995, he was an attorney
in private practice. Mr.
Weller is a vice president
and assistant secretary of
29 investment companies
for which Mitchell
Hutchins or PaineWebber
serves as investment ad-
viser.
</TABLE>
36
<PAGE>
<TABLE>
<CAPTION>
BUSINESS EXPERIENCE
NAME AND ADDRESS*; AGE POSITION WITH THE FUND AND OTHER DIRECTORSHIPS
---------------------- ---------------------- -----------------------
<C> <C> <S>
Ian W. Williams; 40 Vice President and Mr. Williams is a vice president
Assistant Treasurer and a manager of the mutual
fund finance division of Mitch-
ell Hutchins. Mr. Williams is a
vice president and assistant
treasurer of 30 investment com-
panies for which Mitchell
Hutchins or PaineWebber serves
as investment 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 with respect to that Portfolio. The Fund
presently has 13 Portfolios and thus pays each such trustee $6,500 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 and the applicable
Sub-Advisers perform 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, 1997.
COMPENSATION TABLE+
<TABLE>
<CAPTION>
AGGREGATE TOTAL COMPENSATION
COMPENSATION FROM THE FUND AND
NAME OF PERSON, POSITION FROM THE FUND* THE FUND COMPLEX**
------------------------ -------------- ------------------
<S> <C> <C>
Richard Q. Armstrong,
Trustee.................................... $12,600 $ 94,885
Richard R. Burt,
Trustee.................................... 11,250 87,085
Meyer Feldberg,
Trustee.................................... 12,600 117,853
George W. Gowen,
Trustee.................................... 14,209 101,567
Frederic V. Malek,
Trustee.................................... 12,600 95,845
Carl W. Schafer,
Trustee.................................... 12,600 94,885
</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, 1997.
** Represents total compensation paid to each trustee by the fund complex
during the twelve months ended December 31, 1997; no fund within the complex
has a bonus, pension, profit sharing or retirement plan.
37
<PAGE>
PRINCIPAL HOLDERS OF SECURITIES
The following shareholders are shown in the Fund's records as owning more
than 5% of the Class H shares of the Portfolios as of April 17, 1998, as
indicated below:
<TABLE>
<CAPTION>
AMERICAN
PAINEWEBBER REPUBLIC
LIFE VARIABLE VARIABLE
ANNUITY ANNUITY
ACCOUNT ACCOUNT
------------- --------
<S> <C> <C>
Money Market Portfolio................................... 71% 27%
High Grade Fixed Income Portfolio........................ 100% 0%
Strategic Fixed Income Portfolio......................... 59% 36%
Global Income Portfolio.................................. 55% 44%
Balanced Portfolio....................................... 70% 28%
Growth and Income Portfolio.............................. 67% 31%
Growth Portfolio......................................... 60% 39%
Aggressive Growth Portfolio.............................. 100% 0%
Global Growth Portfolio.................................. 72% 27%
</TABLE>
PaineWebber Life Variable Annuity Account is a segregated investment account
of PaineWebber Life Insurance Company, 1200 Harbor Blvd., Weehawken, New Jersey
07087. American Republic Variable Annuity Account is a segregated investment
account of American Republic Insurance Company, 601 6th Avenue, Des Moines,
Iowa 50309.
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, September
1, 1993 and May 1, 1998 ("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, 1997,
Mitchell Hutchins earned (or accrued) advisory fees (net of any waivers) in the
amounts set forth below for the Portfolios that had operations during that
period:
<TABLE>
<CAPTION>
FOR THE YEARS ENDED
DECEMBER 31,
--------------------------
PORTFOLIO 1997 1996 1995
- --------- -------- -------- --------
<S> <C> <C> <C>
Money Market Portfolio............................... $ 56,346 $ 79,283 $128,777
High Grade Fixed Income Portfolio.................... 39,763 44,461 48,852
Strategic Fixed Income Portfolio..................... 53,270 62,785 90,046
Global Income Portfolio.............................. 165,480 230,262 351,681
Balanced Portfolio................................... 252,729 249,995 110,377
Growth and Income Portfolio.......................... 138,089 111,599 94,315
Growth Portfolio..................................... 299,373 325,065 334,603
Aggressive Growth Portfolio.......................... 170,723 155,896 133,956
Global Growth Portfolio.............................. 182,141 198,128 257,692
</TABLE>
38
<PAGE>
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
$26,635, $31,393 and $11,324 for the fiscal years ended December 31, 1997,
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 $106,702, $97,434
and $83,723 for the fiscal years ended December 31, 1997, December 31, 1996 and
December 31, 1995, respectively. Under a Sub-Advisory Contract dated March 23,
1995, GEIM serves as Sub-Adviser to Global Growth Portfolio and was paid (or
accrued) by Mitchell Hutchins (not the Portfolio) sub-advisory fees of $70,428,
$76,609 and $74,893 for the fiscal years ended December 31, 1997, 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 for the fiscal year ended December 31, 1995. 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 for the fiscal year ended December 31, 1995.
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 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
39
<PAGE>
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 board 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 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.
DISTRIBUTION ARRANGEMENTS
Mitchell Hutchins acts as the distributor of the Class I shares of each
Portfolio under a distribution contract with the Fund ("Distribution Contract")
that requires Mitchell Hutchins to use its best efforts, consistent with its
other businesses, to sell Class I shares of each Portfolio. Class H shares have
no distributor or distribution contract. Shares of both Class H and Class I
shares are offered continuously to separate accounts of insurance companies.
Under a plan of distribution pertaining to the Class I shares adopted by the
Fund in the manner prescribed under Rule 12b-1 under the 1940 Act ("Class I
Plan"), each Portfolio pays Mitchell Hutchins a distribution fee, accrued daily
and payable monthly, at the annual rate of 0.25% of the average daily net
assets attributable to its Class I shares. Among other things, the Class I Plan
provides (1) that Mitchell Hutchins will submit to the board at least
quarterly, and the board will review, reports regarding all amounts expended
under the Class I Plan and the purposes for which such expenditures were made,
(2) the Class I Plan will continue in effect only so long as it is approved at
least annually, and any material amendment thereto is approved, by the board,
including those trustees who are not "interested persons" of the Fund and who
have no direct or indirect financial interest in the operation of the Class I
Plan or any agreement related to the Class I Plan, acting in person at a
meeting called for that purpose, (3) payments by a Portfolio under the Plan
shall not be materially increased without the affirmative vote of the holders
of a majority of the
40
<PAGE>
outstanding Class I shares of that Portfolio and (4) while the Class I Plan
remains in effect, the election and nomination of trustees who are not
"interested persons" of the Fund shall be committed to the discretion of the
trustees who are not "interested persons" of the Fund.
In approving the Class I Plan for each Portfolio, the board considered all
the features of the distribution system for the Class I shares, including (1)
the expectation that Class I shares would be sold primarily to the separate
accounts of insurance companies unaffiliated with Mitchell Hutchins or
PaineWebber, (2) the expenses those unaffiliated insurance companies were
likely to incur in marketing Class I shares to the owners of Contracts issued
by their separate accounts, (3) the need to encourage those unaffiliated
insurance companies to educate their agents concerning the Portfolio and to
compensate their agents for selling its Class I shares and (4) the need to
encourage those unaffiliated insurance companies to educate their Contract
owners concerning the Portfolio, to respond to Contract owner inquiries
concerning the Portfolio and to provide personal and account maintenance
services to Contract owners with respect to Class I shares of the Portfolio
attributable to their accounts.
The board also considered all compensation that Mitchell Hutchins would
receive under the Class I Plan and the Distribution Contract and the benefits
that would accrue to Mitchell Hutchins under the Class I Plan in that Mitchell
Hutchins would receive distribution and advisory fees that are calculated based
on a percentage of the average net assets of each Portfolio and would increase
if the Class I Plan were successful and the Portfolio attained and maintained
significant asset levels.
PORTFOLIO TRANSACTIONS
Subject to policies established by the board, 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. 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. 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.
During each of the three years in the period ended December 31, 1997, the
Portfolios that had operations paid the brokerage commissions set forth below:
<TABLE>
<CAPTION>
FOR THE YEARS ENDED DECEMBER 31,
----------------------------------
PORTFOLIO 1997 1996 1995
- --------- ----------- ---------- -----------
<S> <C> <C> <C>
Money Market Portfolio...................... $ 0 $ 0 $ 0
High Grade Fixed Income Portfolio........... 0 0 0
Strategic Fixed Income Portfolio............ 1,149 2,729 0
Global Income Portfolio..................... 0 0 0
Balanced Portfolio.......................... 51,556 65,857 39,766
Growth and Income Portfolio................. 39,178 31,792 34,846
Growth Portfolio............................ 71,334 33,885 52,967
Aggressive Growth Portfolio................. 47,838 53,904 57,802
Global Growth Portfolio..................... 113,093 78,261 341,107
</TABLE>
41
<PAGE>
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 board 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, 1997, the Portfolios that had
operations paid to PaineWebber the brokerage commissions set forth below:
<TABLE>
<CAPTION>
FOR THE YEARS ENDED DECEMBER 31,
----------------------------------
PORTFOLIO 1997 1996 1995
- --------- ---------- ----------- -----------
<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.......................... 1,992 1,320 504
Growth and Income Portfolio................. 558 852 1,400
Growth Portfolio............................ 4,020 300 900
Aggressive Growth Portfolio................. 1,621 186 0
Global Growth Portfolio..................... 0 0 0
</TABLE>
The $4,020 in brokerage commissions paid by Growth Portfolio to PaineWebber
during the fiscal year ended December 31, 1997 represented 5.64% of the
aggregate brokerage commissions paid by that Portfolio and 6.70% of the
aggregate dollar amount of transactions involving the payment of commissions.
The $1,992 in brokerage commissions paid by Balanced Portfolio to PaineWebber
during the fiscal year ended December 31, 1997 represented 3.86% of the
aggregate brokerage commissions paid by that Portfolio and 3.32% of the
aggregate dollar amount of transactions involving the payment of commissions.
The $558 in brokerage commissions paid by Growth and Income Portfolio to
PaineWebber during the fiscal year ended December 31, 1997 represented 1.42%
of the aggregate brokerage commissions paid by that Portfolio and 1.12% of the
aggregate dollar amount of transactions involving the payment of commissions.
The $1,621 in brokerage commissions paid by Aggressive Growth Portfolio to
PaineWebber during the fiscal year ended December 31, 1997 represented 3.60%
of the aggregate brokerage commissions paid by that Portfolio and 3.79% 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 board, 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, 1997, the
Portfolios that had operations 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:
42
<PAGE>
<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......................... $10,806,216 $12,374
Growth and Income Portfolio................ $ 3,272,033 $ 3,843
Growth Portfolio........................... $ 8,727,539 $10,179
Aggressive Growth Portfolio................ $28,830,873 $42,851
Global Growth Portfolio.................... $ 0 $ 0
</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 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 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.
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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, 1997 and December 31, 1996, respectively, the portfolio turnover
rates were as set forth below:
<TABLE>
<CAPTION>
PORTFOLIO TURNOVER RATES
FOR THE YEARS ENDED
DECEMBER 31,
---------------------------
PORTFOLIO 1997 1996
- --------- ---- ----
<S> <C> <C>
Money Market Portfolio............................ n/a n/a
High Grade Fixed Income Portfolio................. 95% 282%
Strategic Fixed Income Portfolio.................. 175% 317%
Global Income Portfolio........................... 142% 134%
Balanced Portfolio................................ 169% 235%
Growth and Income Portfolio....................... 92% 99%
Growth Portfolio.................................. 89% 53%
Aggressive Growth Portfolio....................... 89% 115%
Global Growth Portfolio........................... 81% 44%
</TABLE>
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, Martin Luther King, Jr. 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 separately for each class of
shares 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
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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 board 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 board.
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. In valuing thinly traded securities
and lower rated corporate bonds, it should be recognized that judgment often
plays a greater role than is the case with respect to securities for which a
broader range of dealer quotations and last-sale information is available.
All investments 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 conducted on a spot (that is, cash) basis for the Portfolios that
invest outside the United States 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 board 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
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<PAGE>
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.
TAXES
Shares of the Portfolios are offered only to insurance company separate
accounts that fund benefits under 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.
Each Portfolio is treated as a separate corporation for federal income tax
purposes. To qualify or 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 some 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) 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 (3) 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 intends to comply or continue to
comply with the diversification requirements imposed on it 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 amount, 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.
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Dividends and interest received by a Portfolio, and gains realized thereby,
may be subject to income, withholding or other taxes imposed by foreign
countries and U.S. possessions that would reduce the yield and/or total return
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--other than a "controlled foreign corporation" (i.e., a foreign
corporation in which, on any day during its taxable year, more than 50% of the
total voting power of all voting stock therein or the total value of all stock
therein is owned, directly, indirectly, or constructively, by "U.S.
shareholders," defined as U.S. persons that individually own, directly,
indirectly, or constructively, at least 10% of that voting power) as to which a
Portfolio is a U.S. shareholder --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 will be subject to
federal income tax on a portion of any "excess distribution" received on the
stock of a PFIC or of any gain from disposition of such 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 each 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 gain were not
distributed to the Portfolio by the QEF. In most instances it will be very
difficult, if not impossible, to make this election because of certain
requirements thereof.
Each Portfolio may elect to "mark-to-market" its stock in any PFIC. "Marking-
to-market," in this context, means including in ordinary income each taxable
year the excess, if any, of the fair market value of a PFIC's stock over a
Portfolio's adjusted basis therein as of the end of that year. Pursuant to the
election, a Portfolio also would be allowed to deduct (as an ordinary, not
capital, loss) the excess, if any, of its adjusted basis in PFIC stock over the
fair market value thereof as of the taxable year-end, but only to the extent of
any net mark-to-market gains with respect to that stock included by the
Portfolio for prior taxable years. A Portfolio's adjusted basis in each PFIC's
stock with respect to which it makes this election will be adjusted to reflect
the amounts of income included and deductions taken under the election.
Regulations proposed in 1992 provided a similar election with respect to the
stock of certain PFICs.
If a Portfolio has an "appreciated financial position"--generally, an
interest (including an interest through an option, future or forward contract,
or short sale) with respect to any stock, debt instrument (other than "straight
debt"), or partnership interest the fair market value of which exceeds its
adjusted basis--and enters into a "constructive sale" of the same or
substantially similar property, the Portfolio will be treated as having made an
actual sale thereof, with the result that gain will be recognized at that time.
A constructive sale generally consists of a short sale, an offsetting notional
principal contract, or futures or forward contract entered into by a Portfolio
or a related person with respect to the same or substantially similar property.
In addition, if the appreciated financial position is itself a short sale or
such a contract, acquisition of the underlying property or substantially
similar property will be deemed a constructive sale.
A Portfolio may acquire zero coupon or other securities issued with OID
and/or TIPS A Portfolio must include in its gross income the OID that accrues
on those securities, and the amount of any principal increases on TIPS, during
the taxable year, even if the Portfolio receives no corresponding payment on
them during the year. A Portfolio may acquire zero coupon or other securities
issued with OID and/or TIPS. A Portfolio
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<PAGE>
must include in its gross income the OID that accures on those securities, and
the amount of any principal increases on TIPS, during the taxable year, even if
the Portfolio receives no corresponding payment on them during the year.
Because a Portfolio annually must distribute substantially all of its
investment company taxable income, including any accrued OID and other non-cash
income, to satisfy the Distribution Requirement, it may be required in a
particular year to distribute as a dividend an amount that is greater than the
total amount of cash it actually receives. Those distributions will be made
from a Portfolio's cash assets or from the proceeds of sales of portfolio
securities, if necessary.
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 board may revise the above dividend policy, or postpone the payment of
dividends, if the Portfolio has or anticipates 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 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 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." Prior to
November 19, 1997, the Fund was known as "PaineWebber Series Trust."
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 board intends 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.
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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, 1997 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.
49
