Mitchell Hutchins Series Trust
51 West 52nd Street
New York, New York 10019-6114
STATEMENT OF ADDITIONAL INFORMATION
The following funds are series of Mitchell Hutchins Series Trust
("Trust"), a professionally managed open-end investment company.
Money Market Portfolio High Grade Fixed Income Portfolio
Strategic Fixed Income Portfolio Strategic Income Portfolio
Global Income Portfolio High Income Portfolio
Balanced Portfolio Growth and Income Portfolio
Tactical Allocation Portfolio Growth Portfolio
Aggressive Growth Portfolio Small Cap Portfolio
Global Equity Portfolio
Global Income Portfolio and Strategic Income Portfolio are
non-diversified series of the Trust. The other funds are diversified series.
Each fund offers its Class H and Class I shares only to insurance company
separate accounts that fund benefits under certain variable annuity contracts
and variable life insurance contracts.
Mitchell Hutchins Asset Management Inc. ("Mitchell Hutchins"), a wholly
owned asset management subsidiary of PaineWebber Incorporated ("PaineWebber"),
serves as investment adviser and administrator for each fund. Certain funds have
sub-advisers. Mitchell Hutchins also serves as distributor for the funds' Class
I shares.
Portions of the funds' Annual Reports to Shareholders are incorporated
by reference into this Statement of Additional Information ("SAI"). The Annual
Reports accompany this SAI. You may obtain additional copies of a fund's Annual
Report by calling toll-free 1-800-986-0088.
This SAI is not a prospectus and should be read only in conjunction
with funds' current Prospectus, dated May 1, 2000. A copy of the Prospectus may
be obtained by calling any PaineWebber Financial Advisor or correspondent firm
or by calling toll-free 1-800-986-0088. The Prospectus contains more complete
information about the funds. You should read it carefully before investing.
This SAI is dated May 1, 2000, as revised July 24, 2000.
TABLE OF CONTENTS
Page
The Funds and Their Investment Policies............................ 2
The Funds' Investments, Related Risks and Limitations.............. 10
Strategies Using Derivative Instruments............................ 31
Organization; Trustees and Officers; Principal Holders and
Management Ownership of Securities..................................40
Investment Advisory, Administration and Distribution Arrangements...48
Portfolio Transactions..............................................53
Additional Purchase and Redemption Information......................57
Valuation of Shares.................................................58
Taxes...............................................................59
Dividends...........................................................62
Other Information...................................................62
Financial Statements................................................63
Appendix............................................................64
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THE FUNDS AND THEIR INVESTMENT POLICIES
No fund's investment objective may be changed without shareholder
approval. Except where noted, the other investment policies of each fund may be
changed by the board without shareholder approval. As with other mutual funds,
there is no assurance that a fund will achieve its investment objective.
MONEY MARKET PORTFOLIO'S investment objective is maximum current income
consistent with liquidity and conservation of capital. The fund invests in high
quality money market instruments that have, or are deemed to have, remaining
maturities of 13 months or less. Money market instruments are short-term debt
obligations and similar securities. These instruments include (1) U.S. and
foreign government securities, (2) obligations of U.S. and foreign banks, (3)
commercial paper and other short-term corporate obligations of U.S. and foreign
corporations, partnerships, trusts and similar entities, (4) repurchase
agreements and (5) investment company securities. Money market instruments also
include longer term bonds that have variable interest rates or other special
features that give them the financial characteristics of short-term debt. The
fund may purchase participation interests in any of the securities in which it
is permitted to invest. Participation interests are pro rata interests in
securities held by others. The fund maintains a dollar-weighted average
portfolio maturity of 90 days or less.
Money Market Portfolio may invest in obligations (including
certificates of deposit, bankers' acceptances, time deposits and similar
obligations) of U.S. and foreign banks only if the institution has total assets
at the time of purchase in excess of $1.5 billion. The fund's investments in
non-negotiable time deposits of these institutions will be considered illiquid
if they have maturities greater than seven days.
Money Market Portfolio may purchase only those obligations that
Mitchell Hutchins determines, pursuant to procedures adopted by the board,
present minimal credit risks and are "First Tier Securities" as defined in Rule
2a-7 under the Investment Company Act of 1940, as amended ("Investment Company
Act"). A First Tier Security is either (1) rated in the highest short-term
rating category by at least two nationally recognized statistical rating
organizations ("rating agencies"), (2) rated in the highest short-term rating
category by a single rating agency if only that rating agency has assigned the
obligation a short-term rating, (3) issued by an issuer that has received such a
short-term rating with respect to a security that is comparable in priority and
security, (4) subject to a guarantee rated in the highest short-term rating
category or issued by a guarantor that has received the highest short-term
rating for a comparable debt obligation or (5) unrated, but determined by
Mitchell Hutchins to be of comparable quality.
Subsequent to its purchase by Money Market Portfolio, an issue may
cease to be rated or its rating may be reduced. If a security in the fund's
portfolio ceases to be a First Tier Security (as defined above) or Mitchell
Hutchins becomes aware that a security has received a rating below the second
highest rating by any rating agency, Mitchell Hutchins and, in certain cases,
the board, will consider whether the fund should continue to hold the
obligation. A First Tier Security rated in the highest short-term category by a
single rating agency at the time of purchase that subsequently receives a rating
below the highest rating category from a different rating agency may continue to
be considered a First Tier Security.
Money Market Portfolio may purchase variable and floating rate
securities with remaining maturities in excess of 13 months issued by U.S.
government agencies or instrumentalities or guaranteed by the U.S. government.
In addition, the fund may purchase variable and floating rate securities of
other issuers. The yields on these securities are adjusted in relation to
changes in specific rates, such as the prime rate, and different securities may
have different adjustment rates. Certain of these obligations carry a demand
feature that gives the fund the right to tender them back to a specified party,
usually the issuer or a remarketing agent, prior to maturity. The fund's
investment in these securities must comply with conditions established by the
Securities and Exchange Commission ("SEC") under which they may be considered to
have remaining maturities of 13 months or less. The fund will purchase variable
and floating rate securities of non-U.S. government issuers that have remaining
maturities of more than 13 months only if the securities are subject to a demand
feature exercisable within 13 months or less.
Generally, Money Market Portfolio may exercise demand features (1) upon
a default under the terms of the underlying security, (2) to maintain its
portfolio in accordance with its investment objective and policies or applicable
legal or regulatory requirements or (3) as needed to provide liquidity to the
fund in order to meet redemption requests. The ability of a bank or other
financial institution to fulfill its obligations under a letter of credit,
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guarantee or other liquidity arrangement might be affected by possible financial
difficulties of its borrowers, adverse interest rate or economic conditions,
regulatory limitations or other factors. The interest rate on floating rate or
variable rate securities ordinarily is readjusted on the basis of the prime rate
of the bank that originated the financing or some other index or published rate,
such as the 90-day U.S. Treasury bill rate, or is otherwise reset to reflect
market rates of interest. Generally, these interest rate adjustments cause the
market value of floating rate and variable rate securities to fluctuate less
than the market value of fixed-rate securities.
Variable rate securities include variable amount master demand notes,
which are unsecured redeemable obligations that permit investment of varying
amounts at fluctuating interest rates under a direct agreement between Money
Market Portfolio and an issuer. The principal amount of these notes may be
increased from time to time by the parties (subject to specified maximums) or
decreased by the fund or the issuer. These notes are payable on demand and may
or may not be rated.
Money Market Portfolio generally may invest no more than 5% of its
total assets in the securities of a single issuer (other than securities issued
by the U.S. government, its agencies or instrumentalities), except that the fund
may invest up to 25% of its total assets in First Tier Securities of a single
issuer for a period of up to three business days. The fund may purchase only
U.S. dollar denominated obligations of foreign issuers.
Money Market Portfolio may invest up to 10% of its net assets in
illiquid securities. The fund may purchase securities on a when-issued or
delayed delivery basis. The fund may lend its portfolio securities to qualified
broker-dealers or institutional investors in an amount up to 33 1/3% of its
total assets. The fund may borrow from banks or through reverse repurchase
agreements for temporary or emergency purposes, but not in excess of 10% of its
total assets. The fund may invest in the securities of other investment
companies.
HIGH GRADE FIXED INCOME PORTFOLIO'S primary investment objective is
current income; capital appreciation is a secondary investment objective. The
fund invests in U.S. government bonds, including those backed by mortgages. The
fund may also invest in corporate bonds and may invest up to 25% of its total
assets in mortgage- and asset-backed securities of private issuers. The
corporate bonds in which the fund may invest consist primarily of bonds that
are, at the time of purchase, rated within one of the two highest grades
assigned by Standard & Poor's, a division of The McGraw-Hill Companies, Inc.
("S&P"), or Moody's Investors Service Inc. ("Moody's"), except that the fund may
invest up to 35% of its total assets in investment grade bonds that are rated at
the time of purchase lower than the two highest grades assigned by S&P or
Moody's. The fund may invest in bonds that are assigned comparable ratings by
another rating agency and unrated bonds that Mitchell Hutchins determines are of
comparable quality to rated securities in which the fund may invest. The fund
may invest up to 15% of its total assets in U.S. dollar denominated bonds sold
in the United States by foreign issuers (Yankee bonds) if the securities are
traded on recognized U.S. exchanges or in the U.S. over-the-counter market.
No more than 55% of High Grade Fixed Income Portfolio's total assets
may be represented by U.S. Treasury obligations to assure the fund's
satisfaction of the diversification requirements imposed by the Internal Revenue
Code on segregated asset accounts used to fund variable annuity and/or life
insurance contracts. These diversification requirements must be satisfied by the
fund as an investment vehicle underlying the segregated asset accounts.
High Grade Fixed Income Portfolio may invest up to 10% of its net
assets in illiquid securities. The fund may purchase securities on a when-issued
or delayed delivery basis. The fund may lend its portfolio securities to
qualified broker-dealers or institutional investors in an amount up to 33 1/3%
of its total assets. The fund may borrow from banks or through reverse
repurchase agreements up to 33 1/3% of its total assets for temporary or
emergency purposes. The fund may invest in the securities of other investment
companies and may sell short "against the box."
STRATEGIC FIXED INCOME PORTFOLIO'S investment objective is total return
with low volatility. The fund's investments are managed by a sub-adviser,
Pacific Investment Management Company ("PIMCO"). The fund invests in bonds of
varying maturities but normally maintains a dollar-weighted average portfolio
duration between three and eight years. Under normal circumstances, the fund
invests at least 65% of its total assets in fixed income securities, which
include U.S. government and foreign government bonds (including bonds issued by
supranational and quasi-governmental entities and mortgage-backed securities),
corporate bonds of U.S. and foreign issuers (including mortgage- and
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asset-backed securities of private issuers), convertible securities, foreign
currency exchange-related securities, loan participations and assignments and
money market instruments. The fund's investments in mortgage-backed securities
of private issuers are limited to 35% of its total assets and its investments in
loan participations and assignments are limited to 5% of its net assets.
Strategic Fixed Income Portfolio invests primarily in investment grade
bonds but may invest up to 20% of its total assets in securities, including
convertible securities, that are not investment grade but are rated at least B
by S&P or Moody's, assigned a comparable rating by another rating agency or, if
unrated, determined by the sub-adviser to be of comparable quality. The fund may
invest up to 20% of its total assets in a combination of Yankee bonds,
Eurodollar bonds and bonds denominated in foreign currencies, except that not
more than 10% of its total assets may be invested in bonds denominated in
foreign currencies. Yankee bonds are U.S. dollar denominated obligations of
foreign issuers that are held in the United States, and Eurodollar bonds are
U.S. dollar denominated obligations of issuers that are held outside the United
States, primarily in Europe.
Strategic Fixed Income Portfolio may invest up to 15% of its net assets
in illiquid securities. The fund may purchase securities on a when-issued or
delayed delivery basis. The fund may lend its portfolio securities to qualified
broker-dealers or institutional investors in an amount up to 33 1/3% of its
total assets. The fund may borrow money from banks or through reverse repurchase
agreements for temporary or emergency purposes, but not in excess of 33 1/3% of
its total assets. The fund may invest in the securities of other investment
companies and may sell short "against the box."
STRATEGIC INCOME PORTFOLIO'S primary investment objective is to achieve
a high level of current income. As a secondary investment objective, the fund
seeks capital appreciation. The fund strategically allocates its investments
among three distinct bond market categories: (1) U.S. government and investment
grade corporate bonds, including mortgage- and asset-backed securities; (2) U.S.
high yield corporate bonds, including convertible bonds, and preferred stock;
and (3) foreign and emerging market bonds. A portion of the fund's assets
normally is invested in each of these investment sectors. However, the fund has
the flexibility at any time to invest all or substantially all of its
investments in any one sector.
Strategic Income Portfolio may invest in high yield bonds that are
rated as low as D by S&P or C by Moody's.
The foreign and emerging market bonds in which Strategic Income
Portfolio may invest include (1) government bonds, including Brady bonds and
other sovereign debt, and bonds issued by multi-national institutions such as
the International Bank for Reconstruction and Development and the International
Monetary Fund; (2) corporate bonds and preferred stock issued by entities
located in foreign countries, or denominated in or indexed to foreign
currencies; (3) interests in foreign loan participations and assignments; and
(4) foreign mortgage-backed securities and other structured foreign investments.
The fund may invest without limit in securities of issuers located in any
country in the world, including both industrialized and emerging market
countries. The fund generally is not restricted in the portion of its assets
that may be invested in a single country or region, but the fund's assets
normally are invested in issuers located in at least three countries. No more
than 25% of the fund's total assets are invested in securities issued or
guaranteed by any single foreign government. The fund may invest in foreign and
emerging market bonds that do not meet any minimum credit rating standard or
that are unrated.
Mitchell Hutchins believes that Strategic Income Portfolio's strategy
of sector allocation should be less risky than investing in only one sector of
the bond market. Data from the Lehman Brothers Aggregate Bond Index, the Salomon
Smith Barney High Yield Master Index, the Merrill Lynch High Yield Index and the
Salomon Smith Barney World Government Bond Index indicate that these sectors are
not closely correlated. If successful, the fund's strategy should enable the
fund to achieve a higher level of investment return than if the fund invested
exclusively in any one investment sector or allocated a fixed proportion of its
assets to each investment sector.
Strategic Income Portfolio may invest up to 10% of its total assets in
preferred stock of U.S. and foreign issuers. It also may acquire equity
securities when attached to bonds or as part of a unit including bonds or in
connection with a conversion or exchange of bonds. The fund also may invest
without limit in certificates of deposit issued by banks and savings
associations and in bankers' acceptances.
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Strategic Income Portfolio may invest in zero coupon bonds, other
original issue discount securities, payment-in-kind securities and principal
only mortgage-backed securities. The fund also may invest in fixed and floating
rate loans through either participations in or assignments of all or a portion
of loans made by banks.
Strategic Income Portfolio may invest up to 15% of its net assets in
illiquid securities. The fund may purchase securities on a when-issued or
delayed delivery basis. The fund may lend its portfolio securities to qualified
broker-dealers or institutional investors in an amount up to 33 1/3% of its
total assets. The fund may engage in dollar rolls and reverse repurchase
agreements for investment purposes to enhance the fund's return. Dollar rolls
and reverse repurchase agreements are considered borrowings. The fund may also
borrow from banks or through reverse repurchase agreements for temporary or
emergency purposes, but the fund's aggregate borrowings for all purposes may not
exceed 33 1/3% of its total assets, plus an additional 5% of its total assets
for temporary or emergency purposes. The fund may invest in the securities of
other investment companies and may sell short "against the box."
GLOBAL INCOME PORTFOLIO'S primary investment objective is high current
income consistent with prudent investment risk; capital appreciation is a
secondary objective. The fund invests principally in high-quality bonds issued
or guaranteed by foreign governments, the U.S. government, their respective
agencies or instrumentalities or supranational organizations or issued by U.S.
or foreign companies.
Global Income Portfolio's portfolio consists primarily of bonds rated
within one of the two highest grades assigned by S&P, Moody's or another rating
agency or, if unrated, determined by Mitchell Hutchins to be of comparable
quality. Normally, at least 65% of the fund's total assets consist of these
high-quality bonds (and receivables from the sale of such bonds) denominated in
foreign currencies or U.S. dollars of issuers located in at least three of the
following countries: Australia, Austria, Belgium, Canada, Denmark, Finland,
France, Germany, Hong Kong, Ireland, Italy, Japan, the Netherlands, New Zealand,
Norway, Portugal, Singapore, Spain, Sweden, Switzerland, the United Kingdom and
the United States. No more than 40% of the fund's total assets are normally
invested in securities of issuers located in any one country other than the
United States. The fund's investments may include zero coupon securities and
other bonds sold with a discount. Up to 5% of the fund's total assets may be
invested in bonds convertible into equity securities.
Global Income Portfolio may invest up to 35% of its total assets in
bonds rated below the two highest grades assigned by a rating agency. Except as
noted below, these securities must be investment grade (that is, rated at least
BBB by S&P, Baa by Moody's or comparably rated by another rating agency or, if
unrated, determined by Mitchell Hutchins to be of comparable quality). Within
this 35% limitation, the fund may invest up to 20% of its total assets in bonds
that are rated below investment grade. These bonds may be rated as low as D by
S&P, C by Moody's or comparably rated by another rating agency or, in the case
of bonds assigned a short-term debt rating, as low as D by S&P or comparably
rated by another rating agency or, if not so rated, determined by Mitchell
Hutchins to be of comparable quality. Bonds rated D by S&P are in payment
default or the rating is assigned upon the filing of a bankruptcy petition or
the taking of a similar action if payments on an obligation are jeopardized.
Bonds rated C by Moody's are in the lowest rated class and can be regarded as
having extremely poor prospects of attaining any real investment standing.
Mitchell Hutchins will purchase these securities for the fund only when it
concludes that the anticipated return to the fund on the investment warrants
exposure to the additional level of risk. Lower-rated bonds are often issued by
businesses and governments in emerging markets. Because the fund may also invest
in emerging market bonds that are investment grade, the fund's total investment
in emerging market bonds may exceed 20% of its total assets.
Global Income Portfolio may invest up to 35% of its total assets in
mortgage-backed securities of U.S. or foreign issuers that are rated in one of
the two highest rating categories by S&P, Moody's or another rating agency or,
if unrated, determined by Mitchell Hutchins to be of comparable quality. Up to
20% of the fund's total assets may be invested in bonds that are not paying
current income (a category that does not include zero coupon bonds and other
bonds sold with a discount). The fund may purchase these bonds if Mitchell
Hutchins believes that they have a potential for capital appreciation. The fund
also may invest in secured and unsecured fixed or floating rate loans in the
form of participations and assignments.
Global Income Fund may invest up to 35% of its total assets in cash or
investment grade money market instruments as part of its ordinary investment
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activities. The fund's investment of cash collateral from securities lending in
these money market instruments is not subject to this 35% limitation, and there
is no limitation on its investments in short-term bonds denominated in foreign
currencies.
Global Income Portfolio may invest up to 10% of its net assets in
illiquid securities. The fund may purchase securities on a when-issued or
delayed delivery basis. The fund may lend its portfolio securities to qualified
broker-dealers or institutional investors in an amount up to 33 1/3% of its
total assets. The fund may borrow money from banks or through reverse repurchase
agreements for temporary or emergency purposes, but not in excess of 10% of its
total assets. The fund may invest in the securities of other investment
companies and may sell short "against the box."
HIGH INCOME PORTFOLIO'S investment objective is to provide high income.
The fund normally invests at least 65% of its total assets in high yield
corporate bonds that, at the time of purchase, are rated B or better by S&P or
Moody's, are comparably rated by another rating agency or, if unrated, are
considered to be of comparable quality by Mitchell Hutchins. The fund may
include in this 65% of its total assets any equity securities (including common
stocks and rights and warrants for equity securities) that are attached to
corporate bonds or are part of a unit including corporate bonds, so long as the
corporate bonds meet these quality requirements. The fund also may invest up to
35% of its total assets in (1) bonds that are rated below B (and rated as low as
D by S&P or C by Moody's) or comparable unrated bonds, (2) U.S. government
bonds, (3) equity securities and (4) money market instruments, including
repurchase agreements.
Up to 35% of High Income Portfolio's net assets may be invested in
securities of foreign issuers, including securities that are U.S. dollar
denominated but whose value is linked to the value of foreign currencies.
However, no more than 10% of the fund's net assets may be invested in securities
of foreign issuers that are denominated and traded in currencies other than the
U.S. dollar.
Up to 25% of High Income Portfolio's total assets may be invested in
bonds and equity securities that are not paying current income. The fund may
purchase these securities if Mitchell Hutchins believes they have a potential
for capital appreciation. High Income Portfolio may invest in zero coupon bonds,
other original discount securities, payment-in-kind securities and principal
only mortgage-backed securities, all of which are considered income producing
securities. The fund also may invest up to 5% of its net assets in fixed and
floating rate loans through either participations in or assignments of all or a
portion of loans made by banks.
High Income Portfolio may invest up to 15% of its net assets in
illiquid securities. The fund may purchase securities on a when-issued or
delayed delivery basis. The fund may lend its portfolio securities to qualified
broker-dealers or institutional investors in an amount up to 33 1/3% of its
total assets. The fund may borrow money from banks or through reverse repurchase
agreements for temporary or emergency purposes, but not in excess of 33 1/3% of
its total assets. The fund may invest in the securities of other investment
companies and may sell short "against the box."
BALANCED PORTFOLIO'S investment objective is high total return with low
volatility. The fund invests primarily in a combination of three asset classes:
stocks (equity securities), bonds (investment grade bonds) and cash (money
market instruments) and maintains a fixed income allocation (including bonds and
cash) of at least 25%.
Balanced Portfolio may invest in a broad range of equity securities
issued by companies believed by Mitchell Hutchins to have the potential for
rapid earnings growth, investment grade bonds, U.S. government securities,
convertible securities and money market instruments. The fund may invest in U.S.
dollar denominated securities of foreign issuers that are traded on recognized
U.S. exchanges or in the U.S. over-the-counter market. The fund may also invest
up to 10% of its assets in bonds and other securities (including convertible
securities) rated below investment grade but rated at least B by S&P or Moody's,
comparably rated by another rating agency or, if unrated, determined by Mitchell
Hutchins to be of comparable quality. The fund's bond investments may include
zero coupon bonds and other original issue discount securities.
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
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and bankers' acceptances) having total assets at the time of purchase in excess
of $1.5 billion; commercial paper and other short-term corporate obligations;
variable and floating rate securities and repurchase agreements; participation
interests in these money market instruments; and the securities of other
investment companies that invest exclusively in money market instruments. The
fund 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 or A-2 by S&P, (2)
comparably rated by another rating agency 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.
Balanced Portfolio may invest up to 10% of its net assets in illiquid
securities. The fund may purchase securities on a when-issued or delayed
delivery basis. The fund may lend its portfolio securities to qualified
broker-dealers or institutional investors in an amount up to 33 1/3% of its
total assets. The fund may borrow from banks or through reverse repurchase
agreements for temporary or emergency purposes, but not in excess of 10% of its
total assets. The fund may invest in the securities of other investment
companies and may sell short "against the box."
GROWTH AND INCOME PORTFOLIO'S investment objective is current income
and capital growth. The fund seeks to achieve the capital growth portion of its
objective by investing, under normal circumstances, at least 65% of its total
assets in equity securities believed by Mitchell Hutchins to have the potential
for rapid earnings growth. The fund seeks to achieve the income portion of its
investment objective by investing, under normal circumstances, at least 65% of
its total assets in income producing securities, which may include dividend
paying equity securities, bonds and money market instruments. The fund may
invest up to 10% of its total assets in convertible securities rated below
investment grade but no lower than B by S&P or Moody's, comparably rated by
another rating agency or, if unrated, determined by Mitchell Hutchins to be of
comparable quality. The fund may invest up to 25% of its total assets in U.S.
dollar denominated equity securities and bonds of foreign issuers that are
traded on recognized U.S. exchanges or in the U.S. over-the-counter market.
Growth and Income Portfolio may invest up to 10% of its net assets in
illiquid securities. The fund may purchase securities on a when-issued or
delayed delivery basis. The fund may lend its portfolio securities to qualified
broker-dealers or institutional investors in an amount up to 33 1/3% of its
total assets. The fund may borrow from banks or through reverse repurchase
agreements for temporary or emergency purposes, but not in excess of 10% of its
total assets. The fund may invest in the securities of other investment
companies and may sell short "against the box."
TACTICAL ALLOCATION PORTFOLIO'S investment objective is total return,
consisting of long-term capital appreciation and current income. The fund seeks
to achieve its objective by using the Tactical Allocation Model, a systematic
investment strategy that allocates its investments between an equity portion
designed to track the performance of the Standard & Poor's 500 Composite Stock
Index ("S&P 500 Index") and a fixed income portion that generally will be
comprised of either five-year U.S. Treasury notes or 30-day U.S. Treasury bills.
Tactical Allocation Portfolio seeks to achieve total return during all
economic and financial market cycles, with lower volatility than that of the S&P
500 Index. Mitchell Hutchins allocates the fund's assets based on the Tactical
Allocation Model's quantitative assessment of the projected rates of return for
each asset class. The fund seeks to achieve total return during all economic and
financial market cycles, with lower volatility than that of the S&P 500 Index.
Mitchell Hutchins allocates the fund's assets based on the Model's quantitative
assessment of the projected rates of return for each asset class. The Model
attempts to track the S&P 500 Index in periods of strongly positive market
performance but attempts to take a more defensive posture by reallocating assets
to bonds or cash when the Model signals a potential bear market, prolonged
downtown in stock prices or significant loss in value.
The basic premise of the Tactical Allocation Model is that investors
accept the risk of owning stocks, measured as volatility of return, because they
expect a return advantage. This expected return advantage of owning stocks is
called the equity risk premium ("ERP"). The Model projects the stock market's
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expected ERP based on several factors, including the current price of stocks and
their expected future dividends and the yield-to-maturity of the one-year U.S.
Treasury bill. When the stock market's ERP is high, the Model signals the fund
to invest 100% in stocks. Conversely, when the ERP decreases below certain
threshold levels, the Model signals the fund to reduce its exposure to stocks.
The Model can recommend stock allocations of 100%, 75%, 50%, 25% or 0%.
If the Tactical Allocation Model recommends a stock allocation of less
than 100%, the Model also recommends a fixed income allocation for the remainder
of the fund's assets. The Model will recommend either bonds (five-year U.S.
Treasury notes) or cash (30-day U.S. Treasury bills), but not both. To make this
determination, the Model calculates the risk premium available for the notes.
This bond risk premium ("BRP") is calculated based on the yield-to-maturity of
the five-year U.S. Treasury note and the one-year U.S. Treasury bill.
Tactical Allocation Portfolio deviates from the recommendations of the
Tactical Allocation Model only to the extent necessary to
o Maintain an amount in cash, not expected to exceed 2% of its total
assets under normal market conditions, to pay fund operating expenses,
dividends and other distributions on its shares and to meet
anticipated redemptions of shares and
o Satisfy the diversification requirements imposed by the Internal
Revenue Code on segregated asset accounts used to fund variable
annuity and variable life insurance contracts. These diversification
requirements must be satisfied by the fund as an investment vehicle
underlying the segregated asset accounts. To satisfy these
requirements, the fund may not invest more than 55% of its total
assets in U.S. Treasury obligations. If the Tactical Allocation Model
recommends more than a 50% allocation to bonds or cash, Tactical
Allocation Portfolio must invest a portion of its assets in bonds or
money market instruments that are not U.S. Treasury obligations.
In its stock portion, Tactical Allocation Portfolio attempts to
duplicate, before the deduction of operating expenses, the investment results of
the S&P 500 Index. Securities in the S&P 500 Index are selected, and may change
from time to time, based on a statistical analysis of such factors as the
issuer's market capitalization (the S&P 500 Index emphasizes large
capitalization stocks), the security's trading activity and its adequacy as a
representative of stocks in a particular industry sector. The fund's investment
results for its stock portion will not be identical to those of the S&P 500
Index. Deviations from the performance of the S&P 500 Index may result from
purchases and redemptions of fund shares that may occur daily, as well as from
expenses borne by the fund. Instead, the fund attempts to achieve a correlation
of at least 0.95 between the performance of the fund's stock portion, before the
deduction of operating expenses, and that of the S&P 500 Index (a correlation of
1.00 would mean that the net asset value of the stock portion increased or
decreased in exactly the same proportion as changes in the S&P 500 Index). The
S&P 500 Index can include U.S. dollar denominated equity securities of foreign
issuers, and the fund invests in those securities to the extent needed to track
the performance of the S&P 500 Index.
Asset reallocations are made, if required, on the first business day of
each month. In addition to any reallocation of assets directed by the Tactical
Allocation Model, any material amounts resulting from appreciation or receipt of
dividends, other distributions, interest payments and proceeds from securities
maturing in each of the asset classes are reallocated (or "rebalanced") to the
extent practicable to establish the Model's recommended asset mix. Any cash
maintained to pay fund operating expenses, pay dividends and other distributions
and to meet share redemptions is invested on a daily basis.
Tactical Allocation Portfolio may invest up to 15% of its net assets in
illiquid securities. The fund may purchase securities on a when-issued or
delayed delivery basis. The fund may lend its portfolio securities to qualified
broker-dealers or institutional investors in an amount up to 33 1/3% of its
total assets. The fund may borrow from banks or through reverse repurchase
agreements for temporary or emergency purposes, but not in excess of 33 1/3% of
its total assets. The fund may invest in the securities of other investment
companies and may sell short "against the box."
GROWTH PORTFOLIO'S investment objective is long-term capital
appreciation. The fund invests primarily in equity securities issued by
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companies believed by Mitchell Hutchins to have substantial potential for
capital growth. Under normal circumstances, the fund invests at least 65% of its
total assets in equity securities.
Growth Portfolio may invest up to 35% of its total assets in U.S.
government bonds and in corporate bonds, including up to 10% in convertible
bonds that are rated below investment grade. These convertible bonds may be
rated no lower than B by S&P or Moody's, comparably rated by another rating
agency or, if unrated, determined by Mitchell Hutchins to be of comparable
quality. The fund may invest up to 25% of its total assets in U.S. dollar
denominated equity securities and bonds of foreign issuers that are traded on
recognized U.S. exchanges or in the U.S. over-the-counter market.
Growth Portfolio may invest up to 10% of its net assets in illiquid
securities. The fund may purchase securities on a when-issued or delayed
delivery basis. The fund may lend its portfolio securities to qualified
broker-dealers or institutional investors in an amount up to 33 1/3% of its
total assets. The fund may borrow from banks or through reverse repurchase
agreements for temporary or emergency purposes, but not in excess of 10% of its
total assets. The fund may invest in the securities of other investment
companies and may sell short "against the box."
AGGRESSIVE GROWTH PORTFOLIO'S investment objective is maximizing
long-term capital appreciation. The fund's investments are managed by a
sub-adviser, Nicholas-Applegate Capital Management. Under normal market
conditions, the fund invests at least 75% of its total assets in common stocks.
The fund invests primarily in common stocks of U.S. companies the assets and
stock prices of which the sub-adviser expects to grow faster than the average
rate of companies in the S&P 500 Index. The fund is not restricted to
investments in companies of any particular size. The fund may invest up to 25%
of its total assets in preferred and convertible securities issued by similar
growth companies, U.S. government bonds and investment grade corporate bonds.
The fund may invest up to 25% of its total assets in U.S. dollar denominated
equity securities and bonds of foreign issuers that are traded on recognized
U.S. exchanges or in the U.S. over-the-counter market.
Aggressive Growth Portfolio may invest up to 15% of its net assets in
illiquid securities. The fund may purchase securities on a when-issued or
delayed delivery basis. The fund may lend its portfolio securities to qualified
broker-dealers or institutional investors in an amount up to 33 1/3% of its
total assets. The fund may borrow from banks or through reverse repurchase
agreements for temporary or emergency purposes, but not in excess of 20% of its
total assets. The fund may invest in the securities of other investment
companies and may sell short "against the box."
SMALL CAP PORTFOLIO'S investment objective is long-term capital
appreciation. The fund invests at least 65% of its total assets in equity
securities of small capitalization ("small cap") companies, which are defined as
companies having market capitalizations of up to $1.5 billion at the time of
purchase. The fund may invest up to 35% of its total assets in equity securities
of companies that are larger than small cap companies, as well as in bonds and
money market instruments. This includes up to 10% in convertible bonds that are
rated below investment grade but no lower than B by S&P or Moody's, comparably
rated by another rating agency or, if unrated, determined by Mitchell Hutchins
to be of comparable quality. The fund may invest up to 25% of its total assets
in U.S. dollar denominated equity securities of foreign issuers that are traded
on recognized U.S. exchanges or in the U.S. over-the-counter market.
Small Cap Portfolio may invest up to 15% of its net assets in illiquid
securities. The fund may purchase securities on a when-issued or delayed
delivery basis. The fund may lend its portfolio securities to qualified
broker-dealers or institutional investors in an amount up to 33 1/3% of its
total assets. The fund may borrow from banks or through reverse repurchase
agreements for temporary or emergency purposes, but not in excess of 33 1/3% of
its total assets. The fund may invest in the securities of other investment
companies and may sell short "against the box."
GLOBAL EQUITY PORTFOLIO'S investment objective is long-term capital
appreciation. The fund invests primarily in common stocks issued by companies in
United States, Europe, Japan and the Pacific Basin. Under normal circumstances,
the fund invests at least 65% of its total assets in common stocks and
securities convertible into common stocks. The fund may also hold other types of
securities, including non-convertible investment grade bonds, government bonds
and money market securities of U.S. and foreign issuers and cash (foreign
currencies or U.S. dollars).
Mitchell Hutchins allocates Global Equity Portfolio's assets between
U.S. investments and foreign investments and manages the assets allocated to
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U.S. investments. Mitchell Hutchins has selected Invista Capital Management, LLC
("Invista") to serve as the fund's sub-adviser to manage the assets allocated to
the fund's foreign investments. Mitchell Hutchins reevaluates the allocation of
the fund's assets between U.S. and foreign securities monthly and does not
expect to reallocate the fund's assets to reflect relatively minor changes (that
is, less than 5%) in the asset allocation model employed. When Mitchell Hutchins
determines that a reallocation of the fund's assets is appropriate, the fund may
effect the reallocation by using cash available from the purchase of fund shares
or by selectively selling securities in a region to meet share redemption
requests in addition to buying or selling portfolio securities specifically to
implement a reallocation. The fund also may use derivative instruments to adjust
its exposure to U.S. and foreign stock markets. Mitchell Hutchins determines the
extent to which the fund uses derivative instruments for this purpose and is
responsible for implementing these transactions.
Under normal circumstances, Global Equity Portfolio invests at least
80% of its total assets in securities of issuers in the United States and
countries represented in the Morgan Stanley Capital International ("MSCI")
Europe, Australasia and Far East Index ("EAFE Index"). The EAFE Index is a well
known index that reflects most major equity markets outside the United States.
The fund may invest up to 20% of its assets in securities of issuers located in
other countries (for example, Canada and emerging markets.) Mitchell Hutchins
may also invest, as part of the fund's U.S. investments, up to 10% of the fund's
total assets in U.S. dollar denominated equity securities and bonds of foreign
issuers that are traded on recognized U.S. exchanges or in the U.S.
over-the-counter market.
Global Equity Portfolio may invest up to 10% of its net assets in
illiquid securities. The fund may purchase securities on a when-issued or
delayed delivery basis, but these securities may not exceed 10% of its net
assets. The fund may lend its portfolio securities to qualified broker-dealers
or institutional investors in an amount up to 33 1/3% of its total assets. The
fund may borrow money from banks or through reverse repurchase agreements for
temporary or emergency purposes, but not in excess of 10% of its total assets.
The fund may invest in the securities of other investment companies and may sell
short "against the box."
THE FUNDS' INVESTMENTS, RELATED RISKS AND LIMITATIONS
The following supplements the information contained in the Prospectus
and above concerning the funds' investments, related risks and limitations.
Except as otherwise indicated in the Prospectus or the SAI, the funds have
established no policy limitations on their ability to use the investments or
techniques discussed in these documents.
EQUITY SECURITIES. Equity securities include common stocks, most
preferred stocks and securities that are convertible into them, including common
stock purchase warrants and rights, equity interests in trusts, partnerships,
joint ventures or similar enterprises and depositary receipts. Common stocks,
the most familiar type, represent an equity (ownership) interest in a
corporation.
Preferred stock has certain fixed income features, like a bond, but
actually it is equity that is senior to a company's common stock. Convertible
bonds may be converted into or exchanged for a prescribed amount of common stock
of the same or a different issuer within a particular period of time at a
specified price or formula. Some preferred stock also may be converted into or
exchanged for common stock. Depositary receipts typically are issued by banks or
trust companies and evidence ownership of underlying equity securities.
While past performance does not guarantee future results, equity
securities historically have provided the greatest long-term growth potential in
a company. However, their prices generally fluctuate more than other securities
and reflect changes in a company's financial condition and in overall market and
economic conditions. Common stocks generally represent the riskiest investment
in a company. It is possible that a fund may experience a substantial or
complete loss on an individual equity investment. While this is possible with
bonds, it is less likely.
BONDS are fixed or variable rate debt obligations, including bills,
notes, debentures, money market instruments and similar instruments and
securities. Mortgage- and asset-backed securities are types of bonds, and
certain types of income producing, non-convertible preferred stocks may be
treated as bonds for investment purposes. Bonds generally are used by
corporations, governments and other issuers to borrow money from investors. The
issuer pays the investor a fixed or variable rate of interest and normally must
repay the amount borrowed on or before maturity. Many preferred stocks and some
bonds are "perpetual" in that they have no maturity date.
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Bonds are subject to interest rate risk and credit risk. Interest rate
risk is the risk that interest rates will rise and that, as a result, bond
prices will fall, lowering the value of a fund's investments in bonds. In
general, bonds having longer durations are more sensitive to interest rate
changes than are bonds with shorter durations. Credit risk is the risk that an
issuer may be unable or unwilling to pay interest and/or principal on the bond.
Credit risk can be affected by many factors, including adverse changes in the
issuer's own financial condition or in economic conditions.
CREDIT RATINGS; NON-INVESTMENT GRADE BONDS. Moody's, S&P and other
rating agencies are private services that provide ratings of the credit quality
of bonds and certain other securities. A description of the ratings assigned to
corporate bonds by Moody's and S&P is included in the Appendix to this SAI. The
process by which Moody's and S&P determine ratings for mortgage-backed
securities includes consideration of the likelihood of the receipt by security
holders of all distributions, the nature of the underlying assets, the credit
quality of the guarantor, if any, and the structural, legal and tax aspects
associated with these securities. Not even the highest such rating represents an
assessment of the likelihood that principal prepayments will be made by obligors
on the underlying assets 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.
Credit ratings attempt to evaluate the safety of principal and interest
payments, but they do not evaluate the volatility of a bond's value or its
liquidity and do not guarantee the performance of the issuer. 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. There is a risk that rating agencies may downgrade
the rating of a bond. Subsequent to a bond's purchase by a fund, it may cease to
be rated or its rating may be reduced below the minimum rating required for
purchase by the fund. The funds 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,
bonds with the same maturity, interest rate and rating may have different market
prices.
In addition to ratings assigned to individual bond issues, Mitchell
Hutchins or the applicable sub-adviser will analyze interest rate trends and
developments that may affect individual issuers, including factors such as
liquidity, profitability and asset quality. The yields on bonds 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.
Investment grade bonds are rated in one of the four highest rating
categories by Moody's or S&P, comparably rated by another rating agency or, if
unrated, determined by Mitchell Hutchins or the applicable sub-adviser to be of
comparable quality. Moody's considers bonds rated Baa (its lowest investment
grade rating) to have speculative characteristics. This means that changes in
economic conditions or other circumstances are more likely to lead to a weakened
capacity to make principal and interest payments than is the case for higher
rated bonds. Bonds rated D by S&P are in payment default or such rating is
assigned upon the filing of a bankruptcy petition or the taking of a similar
action if payments on an obligation are jeopardized. Bonds rated C by Moody's
are in the lowest rated class and can be regarded as having extremely poor
prospects of attaining any real investment standing.
Non-investment grade bonds (commonly known as "junk bonds" and
sometimes referred to as "high-yield" bonds) are rated Ba or lower by Moody's,
BB or lower by S&P, comparably rated by another rating agency or, if unrated,
determined by Mitchell Hutchins or the sub-adviser to be of comparable quality.
A fund's investments in non-investment grade bonds entail greater risk than its
investments in higher rated bonds. Non-investment grade bonds are considered
predominantly speculative with respect to the issuer's ability to pay interest
and repay principal and may involve significant risk exposure to adverse
conditions. Non-investment grade bonds generally offer a higher current yield
than that available for investment grade issues; however, they involve greater
risks, in that they are especially sensitive 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
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response to changes in interest rates. During periods of economic downturn or
rising interest rates, highly leveraged issuers may experience financial stress
that 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 by collateral and will not receive payment until more senior claims
are paid in full.
The market for non-investment grade bonds, 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 recent years
by volatility in emerging market securities. In the past, many lower rated bonds
experienced substantial price declines reflecting an expectation that many
issuers of such securities might experience financial difficulties. As a result,
the yields on lower rated bonds rose dramatically. However, those higher yields
did not reflect the value of the income stream that holders of such securities
expected. Rather, they reflected the risk that holders of such securities could
lose a substantial portion of their value due to the issuers' financial
restructurings or defaults by the issuers. There can be no assurance that those
declines will not recur.
The market for non-investment grade bonds generally is thinner and less
active than that for higher quality securities, which may limit a fund'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
non-investment grade bonds, especially in a thinly traded market.
U.S. GOVERNMENT SECURITIES include direct obligations of the U.S.
Treasury (such as Treasury bills, notes or bonds) and obligations issued or
guaranteed as to principal and interest (but not as to market value) by the U.S.
government, its agencies or its instrumentalities. U.S. government securities
include mortgage-backed securities issued or guaranteed by government agencies
or government-sponsored enterprises. Other U.S. government securities may be
backed by the full faith and credit of the U.S. government or supported
primarily or solely by the creditworthiness of the government-related issuer or,
in the case of mortgage-backed securities, by pools of assets.
U.S. government securities also include separately traded principal and
interest components of securities issued or guaranteed by the U.S. Treasury,
which are traded independently under the Separate Trading of Registered Interest
and Principal of Securities ("STRIPS") program. Under the STRIPS programs, the
principal and interest components are individually numbered and separately
issued by the U.S. Treasury.
Treasury inflation protected securities ("TIPS") (also known as
"inflation-indexed securities") are Treasury bonds on which the principal value
is adjusted daily in accordance with changes in the Consumer Price Index.
Interest on TIPS is payable semi-annually on the adjusted principal value. The
principal value of TIPS would decline during periods of deflation, but the
principal amount payable at maturity would not be less than the original par
amount. If inflation is lower than expected while a fund holds TIPS, the fund
may earn less on the TIPS than it would on conventional Treasury bonds. Any
increase in the principal value of TIPS is taxable in the year the increase
occurs, even though holders do not receive cash representing the increase at
that time. See "Taxes -- Other Information," below.
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 sales
contracts, other installment sales 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 interests in pools of underlying mortgage loans that are secured by
real property. U.S. government mortgage-backed securities are issued or
guaranteed as to the payment of principal and interest (but not as to market
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value) by Ginnie Mae (also known as the Government National Mortgage
Association), Fannie Mae (also known as the Federal National Mortgage
Association), Freddie Mac (also known as the Federal Home Loan Mortgage
Corporation) or other government sponsored enterprises. Other domestic
mortgage-backed securities are sponsored or issued by private entities,
generally originators of and investors in mortgage loans, including savings
associations, mortgage bankers, commercial banks, investment bankers and special
purposes 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. Foreign mortgage-backed
securities may be issued by mortgage banks and other private or governmental
entities outside the United States and are supported by interests in foreign
real estate.
Mortgage-backed securities may be composed of one or more classes and
may be structured either as pass-through securities or collateralized debt
obligations. Multiple-class mortgage-backed securities are referred to herein as
"CMOs." Some CMOs are directly supported by other CMOs, which in turn are
supported by mortgage pools. Investors typically receive payments out of the
interest and principal on the underlying mortgages. The portions of these
payments that investors receive, as well as the priority of their rights to
receive payments, are determined by the specific terms of the CMO class. CMOs
involve special risk and evaluating them requires special knowledge.
A major difference between mortgage-backed securities and traditional
bonds is that interest and principal payments are made more frequently (usually
monthly) and that principal may be repaid at any time because the underlying
mortgage loans may be prepaid at any time. When interest rates go down and
homeowners refinance their mortgages, mortgage-backed securities may be paid off
more quickly than investors expect. When interest rates rise, mortgage-backed
securities may be paid off more slowly than originally expected. Changes in the
rate or "speed" of these prepayments can cause the value of mortgage-backed
securities to fluctuate rapidly.
Mortgage-backed securities also may decrease in value as a result of
increases in interest rates and, because of prepayments, may benefit less than
other bonds from declining interest rates. Reinvestments of prepayments may
occur at lower interest rates than the original investment, thus adversely
affecting a fund's yield. Actual prepayment experience may cause the yield of a
mortgage-backed security to differ from what was assumed when the fund purchased
the security. Prepayments at a slower rate than expected may lengthen the
effective life of a mortgage-backed security. The value of securities with
longer effective lives generally fluctuates more widely in response to changes
in interest rates than the value of securities with shorter effective lives.
CMO classes may be specially structured in a manner that provides any
of a wide variety of investment characteristics, such as yield, effective
maturity and interest rate sensitivity. As market conditions change, however,
and particularly during periods of rapid or unanticipated changes in market
interest rates, the attractiveness of the CMO classes and the ability of the
structure to provide the anticipated investment characteristics may be
significantly reduced. These changes can result in volatility in the market
value, and in some instances reduced liquidity, of the CMO class.
Certain classes of CMOs and other mortgage-backed securities are
structured in a manner that makes them extremely sensitive to changes in
prepayment rates. Interest only ("IO") and principal only ("PO") classes are
examples of this. IOs are entitled to receive all or a portion of the interest,
but none (or only a nominal amount) of the principal payments, from the
underlying mortgage assets. If the mortgage assets underlying an IO experience
greater than anticipated principal prepayments, then the total amount of
interest payments allocable to the IO class, and therefore the yield to
investors, generally will be reduced. In some instances, an investor in an IO
may fail to recoup all of his or her initial investment, even if the security is
government issued or guaranteed or is rated AAA or the equivalent. Conversely,
PO classes are entitled to receive all or a portion of the principal payments,
but none of the interest, from the underlying mortgage assets. PO classes are
purchased at substantial discounts from par, and the yield to investors will be
reduced if principal payments are slower than expected. Some IOs and POs, as
well as other CMO classes, are structured to have special protections against
the effects of prepayments. These structural protections, however, normally are
effective only within certain ranges of prepayment rates and thus will not
protect investors in all circumstances. Inverse floating rate CMO classes also
may be extremely volatile. These classes pay interest at a rate that decreases
when a specified index of market rates increases.
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The market for privately issued mortgage-backed securities is smaller
and less liquid than the market for U.S. government mortgage-backed securities.
Foreign mortgage-backed securities markets are substantially smaller than U.S.
markets, but have been established in several countries, including Germany,
Denmark, Sweden, Canada and Australia, and may be developed elsewhere. Foreign
mortgage-backed securities generally are structured differently than domestic
mortgage-backed securities, but they normally present substantially similar
investment risks as well as the other risks normally associated with foreign
securities.
During 1994, the value and liquidity of many mortgage-backed securities
declined sharply due primarily to increases in interest rates. There can be no
assurance that such declines will not recur. The market value of certain
mortgage-backed securities, including IO and PO classes of mortgage-backed
securities, can be extremely volatile, and these securities may become illiquid.
Mitchell Hutchins or the applicable sub-adviser seeks to manage a fund's
investments in mortgage-backed securities so that the volatility of its
portfolio, taken as a whole, is consistent with its investment objective.
Management of portfolio duration is an important part of this. However,
computing the duration of mortgage-backed securities is complex. See, "The
Funds' Investments, Related Risks and Limitations -- Duration." If Mitchell
Hutchins or the applicable sub-adviser does not compute the duration of
mortgage-backed securities correctly, the value of the fund's portfolio may be
either more or less sensitive to changes in market interest rates than intended.
In addition, if market interest rates or other factors that affect the
volatility of securities held by a fund change in ways that Mitchell Hutchins or
the applicable sub-adviser does not anticipate, the fund's ability to meet its
investment objective may be reduced.
More information concerning these mortgage-backed securities and the
related risks of investments therein is set forth below. New types of
mortgage-backed securities are developed and marketed from time to time and,
consistent with their investment limitations, the funds expect to invest in
those new types of mortgage-backed securities that Mitchell Hutchins or the
applicable sub-adviser believe may assist the funds in achieving their
investment objectives. Similarly, the funds may invest in mortgage-backed
securities issued by new or existing governmental or private issuers other than
those identified herein. The funds that may invest in foreign securities may
invest in foreign mortgage-backed securities, which may be structured
differently than domestic mortgage-backed securities.
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 the funds. 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-insured
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 the full faith and credit of the U.S. government.
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PRIVATE MORTGAGE-BACKED SECURITIES -- Mortgage-backed securities issued
by Private Mortgage Lenders are structured similarly to CMOs issued or
guaranteed by Ginnie Mae, Fannie Mae and Freddie Mac. Such mortgage-backed
securities may be supported by pools of U.S. government or agency insured or
guaranteed mortgage loans or by other mortgage-backed securities issued by a
government agency or instrumentality, but they generally are supported by pools
of conventional (i.e., non-government guaranteed or insured) mortgage loans.
Since such mortgage-backed securities normally are not guaranteed by an entity
having the credit standing of Ginnie Mae, Fannie Mae and Freddie Mac, they
normally are structured with one or more types of credit enhancement. See "The
Funds' Investments, Related Risks and Limitations -- Types of Credit
Enhancement." These 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 by mortgage
loans or mortgage pass-through securities (collectively "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 in 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 the 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 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 PO class) on a monthly, quarterly or semi-annual basis. The principal
and interest on the Mortgage Assets may be allocated among the several classes
of a CMO in many ways. In one structure, payments of principal, including any
principal prepayments, on the Mortgage Assets are applied to the classes of a
CMO in the order of their respective stated maturities or final distribution
dates so that no payment of principal will be made on any class of the CMO until
all other classes having an earlier stated maturity or final distribution date
have been paid in full. In some CMO structures, all or a portion of the interest
attributable to one or more of the CMO classes may be added to the principal
amounts attributable to such classes, rather than passed through to
certificateholders on a current basis, until other classes of the CMO are paid
in full.
Parallel pay CMOs are structured to provide payments of principal on
each payment date to more than one class. These simultaneous payments are taken
into account in calculating the stated maturity date or final distribution date
of each class, which, as with other CMO structures, must be retired by its
stated maturity date or final distribution date but may be retired earlier.
Some CMO classes are structured to pay interest at rates that are
adjusted in accordance with a formula, such as a multiple or fraction of the
change in a specified interest rate index, so as to pay at a rate that will be
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 class, 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) loss protection. Loss protection
relates to losses resulting after default by an obligor on the underlying assets
and collection of all amounts recoverable directly from the obligor and through
liquidation of the collateral. Liquidity protection refers to the provision of
advances, generally by the entity administering the pool of assets (usually the
bank, savings association or mortgage banker that transferred the underlying
loans to the issuer of the security), to ensure that the receipt of payments on
the underlying pool occurs in a timely fashion. Loss protection ensures ultimate
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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 fund 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 the 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 traditiona1 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 was to assume that prepayments on pools of
fixed-rate 30-year mortgages would result in a 12-year average life for the
pool. At present, mortgage pools, particularly those with loans with other
maturities or different characteristics, are priced on an assumption of average
life determined for each pool. In periods of declining interest rates, the rate
of 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 a fund's yield.
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ADJUSTABLE RATE MORTGAGE AND FLOATING RATE MORTGAGE-BACKED SECURITIES
-- Adjustable rate mortgage ("ARM") securities (sometimes referred to as "ARMs")
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. 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. ARMs represent a right to receive interest payments at a
rate that is adjusted to reflect the interest earned on a pool of ARM loans.
These mortgage loans 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 ARM loans specify
limitations on the maximum amount by which the mortgage interest rate may adjust
for any single adjustment period. These mortgage loans 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 loan, any such excess interest is added
to the mortgage loan ("negative amortization"), which is repaid through future
payments. If a 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 loan. Borrowers
under these mortgage loans experiencing negative amortization may take longer to
build up their equity in the underlying property and may be more likely to
default.
ARM loans 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-rate 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 ARM loans might decrease. The rate of prepayments
with respect to ARM loans has fluctuated in recent years.
The rates of interest payable on certain ARM loans, and therefore on
certain ARM 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 securities supported by ARM loans 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
securities still tend to be less sensitive to interest rate fluctuations 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
securities, interest rate adjustments on floating rate mortgage-backed
securities may be based on indices that lag behind market interest rates.
Interest rates on floating rate mortgage-backed securities generally are
adjusted monthly. Floating rate mortgage-backed securities are subject to
lifetime interest rate caps, but they generally are not subject to limitations
on monthly or other periodic changes in interest rates or monthly payments.
INVESTING IN FOREIGN SECURITIES. Investing in foreign securities may
involve more risks than investing in U.S. securities. The value of foreign
securities is subject to economic and political developments in the countries
where the issuers operate and to changes in foreign currency values. Investments
in foreign securities 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 on
interest and/or dividends, limitations on the use of or transfer of fund 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
position. In those European countries that are using the Euro as a common
currency unit, individual national economies may be adversely affected by the
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inability of national governments to use monetary policy to address their own
economic or political concerns.
Securities of many foreign companies may be less liquid and their
prices more volatile than 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. 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 some of a fund's
assets are uninvested and no return is earned thereon. The inability of a fund
to make intended security purchases due to settlement problems could cause the
fund to miss attractive investment opportunities. Inability to dispose of a
portfolio security due to settlement problems could result either in losses to
the fund due to subsequent declines in the value of such portfolio security or,
if the fund has entered into a contract to sell the security, could result in
possible liability to the purchaser. Foreign securities trading practices,
including those involving securities settlement where fund assets may be
released prior to receipt of payment, may expose a fund 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.
The costs of investing outside the United States frequently are higher
than those attributable to investing in the United States. 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 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.
Securities of foreign issuers may not be registered with the 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 a fund 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.
A fund may invest in foreign securities by purchasing depositary
receipts, including American Depositary Receipts ("ADRs"), European Depositary
Receipts ("EDRs") and Global Depositary Receipts ("GDRs"), or other securities
convertible into securities of issuers 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 generally are 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 fund's investment policies, depositary receipts
generally are deemed to have the same classification as the underlying
securities they represent. Thus, a depositary receipt representing ownership of
common stock will be treated as common stock.
ADRs are publicly traded on exchanges or over-the-counter 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.
The funds that invest outside the United States anticipate that their
brokerage transactions involving foreign securities of companies headquartered
in countries other than the United States will be conducted primarily on the
principal exchanges of such countries. Although a fund 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.
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Substantial limitations may exist in certain countries with respect to
the funds' ability to repatriate investment capital or the proceeds of sales of
securities.
FOREIGN CURRENCY RISKS. Currency risk is the risk that changes in
foreign exchange rates may reduce the U.S. dollar value of a fund's foreign
investments. If the value of a foreign currency rises against the value of the
U.S. dollar, the value of a fund's investments that are denominated in, or
linked to, that currency will increase. Conversely, if the value of a foreign
currency declines against the value of the U.S. dollar, the value of such fund
investments will decrease. These changes may have a significant impact on the
value of fund shares. In some instances, a fund may use derivative strategies to
hedge against changes in foreign currency value. (See "Strategies Using
Derivative Instruments," below.) However, opportunities to hedge against
currency risk may not exist in certain markets, particularly with respect to
emerging market currencies, and even when appropriate hedging opportunities are
available, a fund may choose not to hedge against currency risk.
Generally, currency exchange rates are determined by supply and demand
in the foreign exchange markets and the relative merits of investments in
different countries. In the case of those European countries that use the Euro
as a common currency unit, the relative merits of investments in the common
market in which they participate, rather than the merits of investments in the
individual country, will be a determinant of currency exchange rates. Currency
exchange rates also can be affected by the intervention of the U.S. and foreign
governments or central banks, the imposition of currency controls, speculation,
devaluation or other political or economic developments inside and outside the
United States.
Each fund values its assets daily in U.S. dollars, and funds that hold
foreign currencies do not intend to convert them to U.S. dollars on a daily
basis. From time to time a fund's 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 fund could suffer a loss of some
or all of the amounts deposited. Each fund may convert foreign currency to U.S.
dollars from time to time.
The U.S. dollar value of fund assets that are denominated in foreign
currencies may be affected favorably or unfavorably by fluctuations in currency
rates and exchange control regulations. Further, a fund 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 fund at one rate, while offering a lesser
rate of exchange should a fund desire immediately to resell that currency to the
dealer. Funds that conduct currency exchange transactions do so 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.
EMERGING MARKET INVESTMENTS. The special risks of investing in foreign
securities are heightened in emerging markets. For example, many emerging market
currencies recently have experienced significant devaluations relative to the
U.S. dollar in recent years. Emerging market countries typically have economic
and political systems that are less fully developed and can be expected to be
less stable than those of developed countries. Emerging market countries may
have policies that restrict investment by foreigners, and there is a higher risk
of government expropriation or nationalization of private property. The
possibility of low or nonexistent trading volume in the securities of companies
in emerging markets also may result in a lack of liquidity and in price
volatility. Issuers in emerging markets typically are subject to a greater
degree of change in earnings and business prospects than are companies in more
developed markets.
INVESTMENT AND REPATRIATION RESTRICTIONS -- Foreign investment in the
securities markets of several emerging market countries is restricted or
controlled to varying degrees. These restrictions may limit a fund's investment
in these countries and may increase its expenses. For example, certain countries
may require governmental approval prior to investments by foreign persons in a
particular company or industry sector or limit investment by foreign persons to
only a specific class of securities of a company, which may have less
advantageous terms (including price) than securities of the company available
for purchase by nationals. Certain countries may restrict or prohibit investment
opportunities in issuers or industries deemed important to national interests.
In addition, the repatriation of both investment income and capital from some
emerging market countries is subject to restrictions, such as the need for
certain government consents. Even where there is no outright restriction on
repatriation of capital, the mechanics of repatriation may affect certain
aspects of a fund's operations. These restrictions may in the future make it
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undesirable to invest in the countries to which they apply. In addition, if
there is a deterioration in a country's balance of payments or for other
reasons, a country may impose restrictions on foreign capital remittances
abroad. A fund could be adversely affected by delays in, or a refusal to grant,
any required governmental approval for repatriation, as well as by the
application to it of other restrictions on investments.
If, because of restrictions on repatriation or conversion, a fund were
unable to distribute substantially all of its net investment income and capital
gains within applicable time periods, the fund would be subject to federal
income and/or excise taxes that would not otherwise be incurred and could cease
to qualify for the favorable tax treatment afforded to regulated investment
companies under the Internal Revenue Code. If it did cease to qualify for that
treatment, it would become subject to federal income tax on all of its income
and net gains. See "Taxes -- Qualification as a Regulated Investment Company,"
below.
DIFFERENCES BETWEEN THE U.S. AND EMERGING MARKET SECURITIES MARKETS.
Most of the securities markets of emerging market countries have substantially
less volume than the New York Stock Exchange, and equity securities of most
companies in emerging market countries are less liquid and more volatile than
equity securities of U.S. companies of comparable size. Some of the stock
exchanges in emerging market countries are in the earliest stages of their
development. As a result, securities settlements may in some instances be
subject to delays and related administrative uncertainties. Many companies whose
securities are traded on securities markets in emerging market countries are
smaller, newer and less seasoned than companies whose securities are traded on
securities markets in the United States. Investments in smaller companies
involve greater risk than is customarily associated with investing in larger
companies. Smaller companies may have limited product lines, markets or
financial or managerial resources and may be more susceptible to losses and
risks of bankruptcy. Additionally, market-making and arbitrage activities are
generally less extensive in such markets, which may contribute to increased
volatility and reduced liquidity of such markets. Accordingly, each of these
markets may be subject to greater influence by adverse events generally
affecting the market, and by large investors trading significant blocks of
securities, than is usual in the United States. To the extent that an emerging
market country experiences rapid increases in its money supply and investment in
equity securities for speculative purposes, the equity securities traded in that
country may trade at price-earnings multiples higher than those of comparable
companies trading on securities markets in the United States, which may not be
sustainable.
GOVERNMENT SUPERVISION OF EMERGING MARKET SECURITIES MARKETS; LEGAL
SYSTEMS. There is also less government supervision and regulation of securities
exchanges, listed companies and brokers in emerging market countries than exists
in the United States. Therefore, less information may be available to a fund
than with respect to investments in the United States. Further, in certain
countries, less information may be available to a fund than to local market
participants. Brokers in other countries may not be as well capitalized as those
in the United States, so that they are more susceptible to financial failure in
times of market, political or economic stress. In addition, existing laws and
regulations are often inconsistently applied. As legal systems in some of the
emerging market countries develop, foreign investors may be adversely affected
by new laws and regulations, changes to existing laws and regulations and
preemption of local laws and regulations by national laws. In circumstances
where adequate laws exist, it may not be possible to obtain swift and equitable
enforcement of the law.
SOCIAL, POLITICAL AND ECONOMIC FACTORS -- Many emerging market
countries may be subject to a greater degree of social, political and economic
instability than is the case in the United States. Any change in the leadership
or policies of these countries may halt the expansion of or reverse any
liberalization of foreign investment policies now occurring. Such instability
may result from, among other things, the following: (1) authoritarian
governments or military involvement in political and economic decision making,
and changes in government through extra-constitutional means; (2) popular unrest
associated with demands for improved political, economic and social conditions;
(3) internal insurgencies; (4) hostile relations with neighboring countries; and
(5) ethnic, religious and racial disaffection. Such social, political and
economic instability could significantly disrupt the financial markets in those
countries and elsewhere and could adversely affect the value of a fund's assets.
In addition, there may be the possibility of asset expropriations or future
confiscatory levels of taxation affecting a fund.
The economies of many emerging markets are heavily dependent upon
international trade and are accordingly affected by protective trade barriers
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and the economic conditions of their trading partners, principally the United
States, Japan, China and the European Union. The enactment by the United States
or other principal trading partners of protectionist trade legislation,
reduction of foreign investment in the local economies and general declines in
the international securities markets could have a significant adverse effect
upon the securities markets of these countries. In addition, the economies of
some countries are vulnerable to weakness in world prices for their commodity
exports, including crude oil. A country whose exports are concentrated in a few
commodities could be vulnerable to a decline in the international price of such
commodities.
Emerging markets include formerly communist countries of Eastern
Europe, Russia and the other countries that once formed the Soviet Union, and
China. Upon the accession to power of communist regimes approximately 50 to 80
years ago, the governments of a number of these countries seized a large amount
of property. The claims of many property owners against those governments were
never finally settled. There can be no guarantee that a fund's investments in
these countries, if any, would not also be seized or otherwise taken away, in
which case the fund could lose its entire investment in the country involved.
FINANCIAL INFORMATION AND LEGAL STANDARDS -- Issuers in emerging market
countries generally are subject to accounting, auditing and financial standards
and requirements that differ, in some cases significantly, from those applicable
to U.S. issuers. In particular, the assets and profits appearing on the
financial statements of an emerging market issuer may not reflect its financial
position or results of operations in the way they would be reflected had the
financial statements been prepared in accordance with U.S. generally accepted
accounting principles. In addition, for an issuer that keeps accounting records
in local currency, inflation accounting rules may require, for both tax and
accounting purposes, that certain assets and liabilities be restated on the
issuer's balance sheet in order to express items in terms of currency of
constant purchasing power. Inflation accounting may indirectly generate losses
or profits. Consequently, financial data may be materially affected by
restatements for inflation and may not accurately reflect the real condition of
those issuers and securities markets.
In addition, existing laws and regulations are often inconsistently
applied. As legal systems in some of the emerging market countries develop,
foreign investors may be adversely affected by new laws and regulations, changes
to existing laws and regulations and preemption of local laws and regulations by
national laws. In circumstances where adequate laws exist, it may not be
possible to obtain swift and equitable enforcement of the law.
FOREIGN SOVEREIGN DEBT. Sovereign debt includes bonds that are issued
by foreign governments or their agencies, instrumentalities or political
subdivisions or by foreign central banks. Sovereign debt also may be issued by
quasi-governmental entities that are owned by foreign governments but are not
backed by their full faith and credit or general taxing powers. Investment in
sovereign debt involves special risks. The issuer of the debt or the
governmental authorities that control the repayment of the debt may be unable or
unwilling to repay principal and/or interest when due in accordance with the
terms of such debt, and the funds may have limited legal recourse in the event
of a default.
Sovereign debt differs from debt obligations issued by private entities
in that, generally, remedies for defaults must be pursued in the courts of the
defaulting party. Legal recourse is therefore somewhat diminished. Political
conditions, especially a sovereign entity's willingness to meet the terms of its
debt 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. A country whose exports are concentrated in a
few commodities could be vulnerable to a decline in the international price of
such commodities. 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. 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
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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.
The occurrence of political, social or diplomatic changes in one or
more of the countries issuing sovereign debt could adversely affect a fund'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 sub-adviser manages a
fund's portfolio 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
fund to suffer a loss of interest or principal on any of its sovereign debt
holdings.
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. Some emerging market
countries have from time to time declared moratoria on the payment of principal
and interest on external debt.
Some 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 funds, 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.
Foreign investment in certain sovereign debt is restricted or
controlled to varying degrees. These restrictions or controls may at times limit
or preclude foreign investment in such sovereign debt and increase the costs and
expenses of a fund. Certain countries in which a fund 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 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 fund 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 fund of any restrictions on investments. Investing
in local markets may require a fund to adopt special procedures, seek local
government approvals or take other actions, each of which may involve additional
costs to the fund.
BRADY BONDS -- Brady Bonds are sovereign bonds 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 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
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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 fund will purchase Brady Bonds 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 until 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 that would have then been due on the Brady Bonds in the
normal course. Interest payments on Brady Bonds may be wholly uncollateralized
or 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.
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 fund 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.
STRUCTURED FOREIGN INVESTMENTS. This term generally 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 usually 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 often 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.
CURRENCY-LINKED INVESTMENTS. The principal amount of securities that
are indexed to specific foreign currency exchange rates may be adjusted up or
down (but not below zero) at maturity to reflect changes in the exchange rate
between two currencies. A fund may experience loss of principal due to these
adjustments.
INVESTMENTS IN OTHER INVESTMENT COMPANIES. Each fund may invest in
securities of other investment companies, subject to limitations under the
Investment Company Act. Among other things, these limitations currently restrict
a fund's aggregate investments in other investment companies to no more than 10%
of its total assets. A fund's investments in certain private investment vehicles
are not subject to this restriction. The shares of other investment companies
are subject to the management fees and other expenses of those companies, and
the purchase of shares of some investment companies requires the payment of
sales loads and (in the case of closed-end investment companies) sometimes
substantial premiums above the value of those companies' portfolio securities.
At the same time, a fund would continue to pay its own management fees and
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expenses with respect to all its investments, including shares of other
investment companies. Each fund may invest in the shares of other investment
companies when, in the judgment of Mitchell Hutchins or the applicable
sub-adviser, the potential benefits of the investment outweigh the payment of
any management fees and expenses and, where applicable, premium or sales load.
From time to time, investments in other investment companies may be the
most effective available means for a fund to invest a portion of its assets. In
some cases, investment in another investment company may be the most practical
way for a fund to invest in securities of issuers in certain countries. These
investments may include World Equity Benchmark SharesSM (commonly known as
"WEBS"), which are exchange-traded shares of series of an investment company
that are designed to replicate the composition and performance of publicly
traded issuers in particular foreign countries. A fund's investment in another
investment company is subject to the risks of that investment company's
underlying portfolio securities. Shares of exchange-traded investment companies
also can trade at substantial discounts below the value of the companies'
portfolio securities.
Money Market Portfolio may invest in the securities of other money
market funds when Mitchell Hutchins believes that (1) the amounts to be invested
are too small or are available too late in the day to be effectively invested in
money market instruments, (2) shares of other money market funds otherwise would
provide a better return than direct investment in money market instruments or
(3) such investments would enhance the fund's liquidity. The other funds may
invest in the securities of money market funds for similar reasons.
ZERO COUPON AND OTHER OID SECURITIES; PIK SECURITIES. Zero coupon
securities are securities on which no periodic interest payments are made but
instead are issued at a deep discount from their maturity value. The buyer of
these securities receives a rate of return by the gradual appreciation of the
security, which results from the fact that it will be paid at face value on a
specified maturity date. There are many types of zero coupon securities. Some
are issued in zero coupon form, including Treasury bills, notes and bonds that
have been stripped of (separated from) their unmatured interest coupons
(unmatured interest payments) and receipts or certificates representing
interests in such stripped debt obligations and coupons. Others are created by
brokerage firms that strip the coupons from interest-paying bonds and sell the
principal and the coupons separately.
Other securities that are sold with original issue discount ("OID")
(i.e., the difference between the issue price and the value at maturity) may
provide for some interest to be paid prior to maturity. In addition,
payment-in-kind ("PIK") securities pay interest in additional securities, not in
cash. OID and PIK securities usually trade at a discount from their face value.
Zero coupon securities are generally more sensitive to changes in
interest rates than debt obligations of comparable maturities that make current
interest payments. This means that when interest rates fall, the value of zero
coupon securities rises more rapidly than securities paying interest on a
current basis. However, when interest rates rise, their value falls more
dramatically. Other OID securities and PIK securities also are subject to
greater fluctuations in market value in response to changing interest rates than
bonds of comparable maturities that make current distributions of interest in
cash.
Because federal tax law requires that accrued OID and "interest" on PIK
securities must be included in a fund's current income (see "Taxes," below), a
fund might be required to distribute as a dividend an amount that is greater
than the total amount of cash it actually receives. These distributions would
have to be made from the fund's cash assets or, if necessary, from the proceeds
of sales of portfolio securities. A fund would not be able to purchase
additional securities with cash used to make these distributions and its current
income and the value of its shares would ultimately be reduced as a result.
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.
CONVERTIBLE SECURITIES. A convertible security is a bond, preferred
stock or other security that may be converted into or exchanged for a prescribed
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amount of common stock of the same or a different issuer within a particular
period of time at a specified price or formula. A convertible security entitles
the holder to receive interest or dividends until the convertible security
matures or is redeemed, converted or exchanged. Convertible securities have
unique investment characteristics in that they generally (1) have higher yields
than common stocks, but lower yields than comparable non-convertible securities,
(2) are less subject to fluctuation in value than the underlying stock because
they have fixed income characteristics and (3) provide the potential for capital
appreciation if the market price of the underlying common stock increases. While
no securities investment is without some risk, investments in convertible
securities generally entail less risk than the issuer's common stock. However,
the extent to which such risk is reduced depends in large measure upon the
degree to which the convertible security sells above its value as 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 fund is called for redemption,
the fund 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.
LOAN PARTICIPATIONS AND ASSIGNMENTS. Investments in secured or
unsecured fixed or floating rate loans ("Loans") arranged through private
negotiations between a borrowing corporation, government or other entity and one
or more financial institutions ("Lenders") may be in the form of participations
("Participations") in Loans or assignments ("Assignments") of all or a portion
of Loans from third parties. Participations typically result in the fund's
having a contractual relationship only with the Lender, not with the borrower. A
fund 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 fund 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 fund may not
directly benefit from any collateral supporting the Loan in which it has
purchased the Participation. As a result, a fund assumes the credit risk of both
the borrower and the Lender that is selling the Participation. In the event of
the insolvency of the selling Lender, the fund may be treated as a general
creditor of that Lender and may not benefit from any set-off between the Lender
and the borrower. A fund will acquire Participations only if Mitchell Hutchins
or the applicable sub-adviser determines that the selling Lender is
creditworthy.
When a fund purchases Assignments from Lenders, it acquires direct
rights against the borrower on the Loan. In an Assignment, the fund is entitled
to receive payments directly from the borrower and, therefore, does not depend
on the selling bank to pass these payments onto the fund. However, because
Assignments are arranged through private negotiations between potential
assignees and assignors, the rights and obligations acquired by the fund 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
Securities Act of 1933, as amended ("Securities Act"), and thus may be subject
to a fund's limitation on investment in illiquid securities. Because there may
be no liquid market for such securities, such securities may be sold only to a
limited number of institutional investors. The lack of a liquid secondary market
could have an adverse impact on the value of such securities and on a fund's
ability to dispose of particular Assignments or Participations when necessary to
meet the fund's liquidity needs or in response to a specific economic event,
such as a deterioration in the creditworthiness of the borrower.
TEMPORARY AND DEFENSIVE INVESTMENTS; MONEY MARKET INVESTMENTS. Each
fund may invest in money market investments for temporary or defensive purposes,
to reinvest cash collateral from its securities lending activities or as part of
its normal investment program. Except for Money Market Portfolio and Balanced
Fund (whose money market investments are described elsewhere), such investments
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) bonds issued by foreign issuers, (7)
repurchase agreements and (8) other investment companies that invest exclusively
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in money market instruments and similar private investment vehicles. Only those
funds that may invest outside the United States may invest in money market
instruments that are denominated in foreign currencies.
WARRANTS. Warrants are securities permitting, but not obligating,
holders to subscribe for other securities. 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. The term "illiquid securities" for purposes of the
Prospectus and SAI means securities that cannot be disposed of within seven days
in the ordinary course of business at approximately the amount at which a fund
has valued the securities and includes, among other things, purchased
over-the-counter options, repurchase agreements maturing in more than seven days
and restricted securities other than those Mitchell Hutchins or the applicable
sub-adviser has determined are liquid pursuant to guidelines established by the
board. The assets used as cover for over-the-counter options written by a fund
will be considered illiquid unless the over-the-counter options are sold to
qualified dealers that agree that the fund may repurchase any over-the-counter
options it writes at a maximum price to be calculated by a formula set forth in
the option agreements. The cover for an over-the-counter option written subject
to this procedure would be considered illiquid only to the extent that the
maximum repurchase price under the formula exceeds the intrinsic value of the
option. Under current SEC guidelines, interest only and principal only classes
of mortgage-backed securities generally are considered illiquid. However,
interest only and principal only 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. A fund may not be able to readily liquidate
its investments in illiquid securities and may have to sell other investments if
necessary to raise cash to meet its obligations. The lack of a liquid secondary
market for illiquid securities may make it more difficult for a fund to assign a
value to those securities for purposes of valuing its portfolio and calculating
its net asset value.
Restricted securities are not registered under the Securities Act and
may be sold only in privately negotiated or other exempted transactions or after
a Securities Act registration statement has become effective. Where registration
is required, a fund 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 a fund may be permitted to sell a security under an
effective registration statement. If, during such a period, adverse market
conditions were to develop, a fund might obtain a less favorable price than
prevailed when it decided to sell.
Not all restricted securities are illiquid. If a fund that may invest
outside the United States holds foreign securities that are freely tradeable in
the country in which they are principally traded, they generally 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 Securities 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 also have developed as
a result of Rule 144A, which establishes a "safe harbor" from the registration
requirements of the Securities Act for resales of certain securities to
qualified institutional buyers. Such markets include automated systems for the
trading, clearance and settlement of unregistered securities of domestic and
foreign issuers, such as the PORTAL System sponsored by the National Association
of Securities Dealers, Inc. An insufficient number of qualified institutional
buyers interested in purchasing Rule 144A-eligible restricted securities held by
a fund, however, could affect adversely the marketability of the securities, and
the fund might be unable to dispose of them 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
sub-adviser takes into account a number of factors in reaching liquidity
decisions, including (1) the frequency of trades for the security, (2) the
number of dealers that make quotes for the security, (3) the number of dealers
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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 sub-adviser monitors the
liquidity of restricted securities in each fund's portfolio and reports
periodically on such decisions to the board.
Mitchell Hutchins and (where applicable) the sub-adviser monitor each
fund's overall holdings of illiquid securities. If a fund's holdings of illiquid
securities exceeds its limitation on investments in illiquid securities for any
reason (such as a particular security becoming illiquid, changes in relative
market values of liquid and illiquid portfolio securities or shareholder
redemptions), Mitchell Hutchins and the sub-adviser will consider what action
would be in the best interest of the fund and its shareholders. Such action may
include engaging in an orderly disposition of securities to reduce the fund's
holdings of illiquid securities. However, a fund is not required immediately to
dispose of illiquid securities under these circumstances, and Mitchell Hutchins
or the applicable sub-adviser, with the concurrence of the board, may determine
that it is in the best interests of the fund and its shareholders to continue to
hold the illiquid securities.
REPURCHASE AGREEMENTS. Repurchase agreements are transactions in which
a fund purchases securities or other obligations from a bank or securities
dealer (or its affiliate) and simultaneously commits to resell them to the
counterparty 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 obligations. A fund maintains custody of the underlying obligations
prior to their repurchase, either through its regular custodian or through a
special "tri-party" custodian or sub-custodian that maintains separate accounts
for both the fund and its counterparty. Thus, the obligation of the counterparty
to pay the repurchase price on the date agreed to or upon demand is, in effect,
secured by such obligations.
Repurchase agreements carry certain risks not associated with direct
investments in securities, including a possible decline in the market value of
the underlying obligations. If their value becomes less than the repurchase
price, plus any agreed-upon additional amount, the counterparty 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 obligations and
the price that was paid by a fund upon acquisition is accrued as interest and
included in its net investment income. Repurchase agreements involving
obligations other than U.S. government securities (such as commercial paper and
corporate bonds) may be subject to special risks and may not have the benefit of
certain protections in the event of the counterparty's insolvency. If the seller
or guarantor becomes insolvent, the fund may suffer delays, costs and possible
losses in connection with the disposition of collateral. Each fund intends to
enter into repurchase agreements only with counterparties in transactions
believed by Mitchell Hutchins or the applicable sub-adviser to present minimum
credit risks.
REVERSE REPURCHASE AGREEMENTS. Reverse repurchase agreements involve
the sale of securities held by a fund 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. Reverse repurchase agreements are subject to each
fund's limitation on borrowings and may be entered into only with banks or
securities dealers or their affiliates. While a reverse repurchase agreement is
outstanding, a fund will maintain, in a segregated account with its custodian,
cash or liquid securities, marked to market daily, in an amount at least equal
to its obligations under the reverse repurchase agreement. See "The Funds'
Investments, Related Risks and Limitations -- Segregated Accounts."
Reverse repurchase agreements involve the risk that the buyer of the
securities sold by a fund might be unable to deliver them when that fund seeks
to repurchase. If the buyer of securities under a reverse repurchase agreement
files for bankruptcy or becomes insolvent, the buyer or trustee or receiver may
receive an extension of time to determine whether to enforce that fund's
obligation to repurchase the securities, and the fund's use of the proceeds of
the reverse repurchase agreement may effectively be restricted pending such
decision.
WHEN-ISSUED AND DELAYED DELIVERY SECURITIES. Each fund may purchase
securities on a "when-issued" basis or may purchase or sell securities for
delayed delivery, i.e., for issuance or delivery to the fund later than the
normal settlement date at a stated price and yield. When issued securities
include TBA ("to be announced") securities. TBA securities are usually
mortgage-backed securities that are purchased on a forward commitment basis with
an approximate principal amount and no defined maturity date. The actual
principal amount and maturity date are determined upon settlement when the
specific mortgage pools are assigned. A fund generally would not pay for such
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securities or start earning interest on them until they are received. However,
when a fund undertakes a when-issued or delayed delivery obligation, it
immediately assumes the risks of ownership, including the risks of price
fluctuation. Failure of the issuer to deliver a security purchased by a fund on
a when-issued or delayed delivery basis may result in the fund's incurring or
missing an opportunity to make an alternative investment.
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 fund's net asset value. When a fund commits to purchase securities
on a when-issued or delayed delivery basis, its custodian segregates assets to
cover the amount of the commitment. See "The Funds' Investments, Related Risks
and Limitations -- Segregated Accounts." A fund's when-issued and
delayed-delivery purchase commitments could cause its net asset value per share
to be more volatile. A fund 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 gain or loss to the fund.
DOLLAR ROLLS. In a dollar roll, a fund sells TBA mortgage-backed or
other securities for delivery on the next regular settlement date for those
securities and, simultaneously, contracts to purchase substantially similar
securities for delivery on a later settlement date. Dollar rolls also are
subject to a fund's limitation on borrowings.
DURATION. Duration is a measure of the expected life of a bond on a
present value basis. Duration incorporates the bond's yield, coupon interest
payments, final maturity and call features into one measure and is one of the
fundamental tools used by Mitchell Hutchins or the applicable sub-adviser in
portfolio selection and yield curve positioning of a fund's bond investments.
Duration was developed as a more precise alternative to the concept "term to
maturity." Traditionally, a bond's "term to maturity" has been used as a proxy
for the sensitivity of the bond's price to changes in interest rates (which is
the "interest rate risk" or "volatility" of the bond). However, "term to
maturity" measures only the time until the scheduled final payment on the bond,
taking no account of the pattern of payments prior to maturity.
Duration takes the length of the time intervals between the present
time and the time that the interest and principal payments are scheduled or, in
the case of a callable bond, expected to be made, and weights them by the
present values of the cash to be received at each future point in time. For any
bond with interest payments occurring prior to the payment of principal,
duration is always less than maturity. For example, depending on its coupon and
the level of market yields, a 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.
Duration allows Mitchell Hutchins or the applicable sub-adviser to make
certain predictions as to the effect that changes in the level of interest rates
will have on the value of a fund's portfolio of bonds. For example, when the
level of interest rates increases by 1%, a bond having a positive duration of
three years generally will decrease by approximately 3%. Thus, if Mitchell
Hutchins or a sub-adviser calculates the duration of a fund's portfolio of bonds
as three years, it normally would expect the portfolio to change in value by
approximately 3% for every 1% change in the level of interest rates. However,
various factors, such as changes in anticipated prepayment rates, qualitative
considerations and market supply and demand, can cause particular securities to
respond somewhat differently to changes in interest rates than indicated in the
above example. Moreover, in the case of mortgage-backed and other complex
securities, duration calculations are estimates and are not precise. This is
particularly true during periods of market volatility. Accordingly, the net
asset value of a fund's portfolio of bonds may vary in relation to interest
rates by a greater or lesser percentage than indicated by the above example.
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 will lengthen portfolio
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 bond. For example,
floating and variable rate bonds 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
or the applicable sub-adviser 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.
LENDING OF PORTFOLIO SECURITIES. Each fund is authorized to lend its
portfolio to broker-dealers or institutional investors that Mitchell Hutchins
deems qualified. Lending securities enables a fund to earn additional income,
but could result in a loss or delay in recovering these securities. The borrower
of a fund's portfolio securities must maintain acceptable collateral with the
fund's custodian in an amount, marked to market daily, 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 fund may reinvest any cash collateral in money market
investments or other short-term liquid investments including other investment
companies. A fund also may reinvest cash collateral in private investment
vehicles similar to money market funds, including one managed by Mitchell
Hutchins. In determining whether to lend securities to a particular
broker-dealer or institutional investor, Mitchell Hutchins will consider, and
during the period of the loan will monitor, all relevant facts and
circumstances, including the creditworthiness of the borrower. Each fund will
retain authority to terminate any of its loans at any time. Each fund may pay
reasonable fees in connection with a loan and may pay the borrower or placing
broker a negotiated portion of the interest earned on the reinvestment of cash
held as collateral. A fund will receive amounts equivalent to any dividends,
interest or other distributions on the securities loaned. Each fund will regain
record ownership of loaned securities to exercise beneficial rights, such as
voting and subscription rights, when regaining such rights is considered to be
in the fund's interest.
Pursuant to procedures adopted by the board governing each fund's
securities lending program, PaineWebber has been retained to serve as lending
agent for each fund. The boards also have authorized the payment of fees
(including fees calculated as a percentage of invested cash collateral) to
PaineWebber for these services. Each board periodically reviews all portfolio
securities loan transactions for which PaineWebber acted as lending agent.
PaineWebber also has been approved as a borrower under each fund's securities
lending program.
SHORT SALES "AGAINST THE BOX." Each fund (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 a fund, and that fund is obligated to replace the securities borrowed
at a date in the future. When a fund sells short, it establishes a margin
account with the broker effecting the short sale and deposits collateral with
the broker. In addition, the fund maintains, in a segregated account with its
custodian, the securities that could be used to cover the short sale. Each fund
incurs transaction costs, including interest expense, in connection with
opening, maintaining and closing short sales "against the box."
A fund might make a short sale "against the box" 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 fund or a security convertible into or exchangeable for a security
owned by the fund. In such case, any loss in the fund'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 a fund owns,
either directly or indirectly, and in the case where the fund owns convertible
securities, changes in the investment values or conversion premiums of such
securities.
SEGREGATED ACCOUNTS. When a fund enters into certain transactions that
involve obligations to make future payments to third parties, including the
purchase of securities on a when-issued or delayed delivery basis, and reverse
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repurchase agreements, it 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 fund's obligation or commitment under such
transactions. As described below under "Strategies Using Derivative
Instruments," segregated accounts may also be required in connection with
certain transactions involving options, futures or forward currency contracts
and swaps.
INVESTMENT LIMITATIONS OF THE FUNDS
FUNDAMENTAL LIMITATIONS. The following fundamental investment
limitations cannot be changed for a fund without the affirmative vote of the
lesser of (a) more than 50% of the outstanding shares of the fund or (b) 67% or
more of the shares of the fund present at a shareholders' meeting if more than
50% of the outstanding shares 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, later changes 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 following limitations. With regard to the borrowings
limitation in fundamental limitation (2), each fund will comply with the
applicable restrictions of Section 18 of the Investment Company Act.
Each fund will not:
(1) purchase any security if, as a result of that purchase, 25% or more of the
fund'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 interpretations apply to, but are
not a part of, this fundamental restriction: (a) with respect to this
limitation, domestic and foreign banking will be considered to be different
industries and (b) asset-backed securities will be grouped in industries based
upon their underlying assets and not treated as constituting a single, separate
industry.
(2) issue senior securities or borrow money, except as permitted under the
Investment Company Act and then not in excess of 33 1/3% of the fund'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 fund 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 bonds 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.
The following interpretation applies to, but is not part of, this fundamental
restriction: A fund's investments in master notes and similar instruments will
not be considered to be the making of a loan.
(4) engage in the business of underwriting securities of other issuers, except
to the extent that the fund 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 fund may
exercise rights under agreements relating to such securities, including the
right to enforce security interests and to hold real estate acquired by reason
of such enforcement until that real estate can be liquidated in an orderly
manner.
(6) purchase or sell physical commodities unless acquired as a result of owning
securities or other instruments, but the fund may purchase, sell or enter into
financial options and futures, forward and spot currency contracts, swap
transactions and other financial contracts or derivative instruments.
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The following investment restriction applies to all funds except Global Income
Portfolio and Strategic Income Portfolio:
(7) purchase securities of any one issuer if, as a result, more than 5% of the
fund's total assets would be invested in securities of that issuer or the fund
would own or hold more than 10% of the outstanding voting securities of that
issuer, except that up to 25% of the fund'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 restriction: 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 are
non-fundamental and may be changed by the vote of the board without shareholder
approval. If a percentage restriction is adhered to at the time of an investment
or transaction, later changes 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 following limitations.
Each fund will not:
(1) hold assets of any issuers, at the end of any calendar quarter (or within 30
days thereafter), to the extent those holdings would cause the fund to fail to
satisfy 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 (which requirements must be satisfied by the fund as the
investment vehicle underlying those accounts);
(2) purchase portfolio securities while borrowings in excess of 5% of its total
assets are outstanding;
(3) purchase securities on margin, except for short-term credit necessary for
clearance of portfolio transactions and except that the fund 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;
(4) engage in short sales of securities or maintain a short position, except
that the fund 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; or
(5) purchase securities of other investment companies, except to the extent
permitted by the Investment Company 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.
STRATEGIES USING DERIVATIVE INSTRUMENTS
GENERAL DESCRIPTION OF DERIVATIVE INSTRUMENTS. Each fund other than
Money Market Portfolio is authorized to use a variety of financial instruments
("Derivative Instruments"), including certain options, futures contracts
(sometimes referred to as "futures"), options on futures contracts and swaps.
For funds that are permitted to invest outside the United States, Mitchell
Hutchins or the sub-adviser also may use forward currency contracts, foreign
currency options and futures and options on foreign currency futures. A fund may
enter into transactions involving one or more types of Derivative Instruments
under which the full value of its portfolio is at risk. Under normal
circumstances, however, each fund's use of these instruments will place at risk
a much smaller portion of its assets. In particular, each fund except Money
Market Portfolio may use the Derivative Instruments described below.
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A fund might not use any derivative instruments or strategies, and
there can be no assurance that using any strategy will succeed. If Mitchell
Hutchins or a sub-adviser, as applicable, is incorrect in its judgment on market
values, interest rates or other economic factors in using a derivative
instrument or strategy, a fund may have lower net income and a net loss on the
investment.
OPTIONS ON 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 or at specified
times or at the expiration of the option, depending on the type of option
involved. 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 or at specified times or at the expiration of the option,
depending on the type of option involved. 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 SECURITIES INDICES -- A securities index assigns relative
values to the securities included in the index and fluctuates with changes in
the market values of those securities. A securities index option operates in the
same way as a more traditional securities option, except that exercise of a
securities index option is effected with cash payment and does not involve
delivery of securities. Thus, upon exercise of a securities 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 securities
index.
SECURITIES INDEX FUTURES CONTRACTS -- A securities 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 securities 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 securities 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 bonds or currency, in most cases the contracts
are closed out before the settlement date without the making or taking of
delivery.
OPTIONS ON FUTURES CONTRACTS -- Options on futures contracts are
similar to options on securities or currency, except that an option on a futures
contract gives the purchaser the right, in return for the premium, to assume a
position in a futures contract (a long position if the option is a call and a
short position if the option is a put), rather than to purchase or sell a
security or currency, at a specified price at any time during the option term or
at specified times or at the expiration of the option, depending on the type of
option involved. Upon exercise of the option, the delivery of the futures
position to the holder of the option will be accompanied by delivery of the
accumulated balance that represents the amount by which the market price of the
futures contract exceeds, in the case of a call, or is less than, in the case of
a put, the exercise price of the option on the future. The writer of an option,
upon exercise, will assume a short position in the case of a call and a long
position in the case of a put.
FORWARD CURRENCY CONTRACTS -- A forward currency contract involves an
obligation to purchase or sell a specific currency at a specified future date,
which may be any fixed number of days from the contract date agreed upon by the
parties, at a price set at the time the contract is entered into.
GENERAL DESCRIPTION OF STRATEGIES USING DERIVATIVE INSTRUMENTS. A fund
may use Derivative Instruments to attempt to hedge its portfolio and also to
attempt to enhance income or return or realize gains and to manage the duration
of its bond portfolio. A fund may use Derivative Instruments to maintain
exposure to stocks or bonds while maintaining a cash balance for fund management
purposes (such as to provide liquidity to meet anticipated shareholder sales of
fund shares and for fund operating expenses), to facilitate trading or to adjust
its exposure to different asset classes. For example, Global Equity Portfolio
may use Derivative Instruments to adjust its exposure to U.S. and foreign equity
markets in connection with a reallocation or rebalancing of the fund's assets. A
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fund that may invest outside the United States also may use Derivative
Instruments on currencies, including forward currency contracts, to hedge
against price changes of securities that the fund owns or intends to acquire
that are attributable to changes in the value of the currencies in which the
securities are denominated. A fund may also use Derivative Instruments on
currencies to shift exposure from one currency to another or to attempt to
realize gains from favorable changes in exchange rates.
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 in a fund's portfolio. Thus, in a short hedge a fund 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
fund 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, a fund 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, a fund 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 fund intends to acquire.
Thus, in a long hedge, a fund 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 fund 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, a fund could exercise the call and thus limit its acquisition
cost to the exercise price plus the premium paid and transactions costs.
Alternatively, a fund might be able to offset the price increase by closing out
an appreciated call option and realizing a gain.
A fund may purchase and write (sell) straddles on securities or indices
of securities. 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 fund
might enter into a long straddle when Mitchell Hutchins or a sub-adviser
believes it likely that the prices of the securities 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 fund
might enter into a short straddle when Mitchell Hutchins or a sub-adviser
believes it unlikely that the prices of the securities will be as volatile
during the term of the option as the option pricing implies.
Derivative Instruments on securities or currencies generally are used
to hedge against price movements in one or more particular securities positions
that a fund 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 a fund has invested or expects to invest. Derivative
Instruments on bonds may be used to hedge either individual securities or broad
fixed income market sectors.
Income strategies using Derivative Instruments may include the writing
of covered options to obtain the related option premiums. Return or gain
strategies may include using Derivative Instruments to increase or decrease a
fund's exposure to different asset classes without buying or selling the
underlying instruments. A fund also may use derivatives to simulate full
investment by the fund while maintaining a cash balance for fund management
purposes (such as to provide liquidity to meet anticipated shareholder sales of
fund shares and for fund operating expenses).
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 fund'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 and the sub-advisers may discover
additional opportunities in connection with Derivative Instruments and with
hedging, income, return and gain strategies. These new opportunities may become
available as regulatory authorities broaden the range of permitted transactions
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and as new Derivative Instruments and techniques are developed. Mitchell
Hutchins or the applicable sub-adviser may use these opportunities for a fund to
the extent that they are consistent with the fund's investment objective and
permitted by its investment limitations and applicable regulatory authorities.
The Prospectus or SAI 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 DERIVATIVE 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 the ability of
Mitchell Hutchins or the applicable sub-adviser 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 and the sub-advisers are 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 that
are 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 in 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 fund entered into a short
hedge because Mitchell Hutchins or a sub-adviser projected a decline in the
price of a security in that fund's 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 fund could suffer a loss. In either such case, the
fund would have been in a better position had it not hedged at all.
(4) As described below, a fund 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 the fund was unable to close out
its positions in those Derivative Instruments, it might be required to continue
to maintain such assets or accounts or make such payments until the positions
expired or matured. These requirements might impair a fund'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 the fund sell a portfolio security at a
disadvantageous time. A fund'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 counterparty to enter into a transaction closing out the
position. Therefore, there is no assurance that any hedging position can be
closed out at a time and price that is favorable to a fund.
COVER FOR STRATEGIES USING DERIVATIVE INSTRUMENTS. Transactions using
Derivative Instruments, other than purchased options, expose the funds to an
obligation to another party. A fund will not enter into any such transactions
unless it owns either (1) an offsetting ("covered") position in securities,
currencies or other options or futures contracts or (2) cash or 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 fund will
comply with SEC guidelines regarding cover for such transactions and will, if
the guidelines so require, set aside cash or liquid securities in a segregated
account with its custodian in the prescribed amount.
Assets used as cover or held in a segregated account cannot be sold
while the position in the corresponding Derivative Instrument is open, unless
they are replaced with similar assets. As a result, committing a large portion
of a fund's assets to cover positions or to segregated accounts could impede
portfolio management or the fund's ability to meet redemption requests or other
current obligations.
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OPTIONS. The funds may purchase put and call options, and write (sell)
covered put or call options on securities in which they invest and related
indices. Funds that may invest outside the United States also may purchase put
and call options and write covered options on foreign currencies. 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, a fund may also use options to attempt to
enhance return or realize gains 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 fund to enhance income by reason of the
premiums paid by the purchasers of such options. 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 affected fund will be obligated to sell the security at less than its
market value. Writing covered put options serves as a limited long hedge because
increases 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
depreciates to a price lower than the exercise price of the put option, it can
be expected that the put option will be exercised and the fund will be obligated
to purchase the security at more than its market value. The securities or other
assets used as cover for over-the-counter options written by a fund would be
considered illiquid to the extent described under "The Funds' Investment
Policies, Related Risks and Limitations--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. Generally, over-the-counter debt options or foreign
currency options used by the funds 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. There are also other types of options that
may be exercised on certain specified dates before expiration. Options that
expire unexercised have no value.
A fund may effectively terminate its right or obligation under an
option by entering into a closing transaction. For example, a fund may terminate
its obligation under a call or put option that it had written by purchasing an
identical call or put option; this is known as a closing purchase transaction.
Conversely, a fund 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 fund to realize profits or limit
losses on an option position prior to its exercise or expiration.
The funds may purchase and write both exchange-traded and
over-the-counter options. Currently, many options on equity securities are
exchange-traded. Exchange markets for options on bonds and foreign currencies
exist but are relatively new, and these instruments are primarily traded on the
over-the-counter market. Exchange-traded options in the United States are issued
by a clearing organization affiliated with the exchange on which the option is
listed that, in effect, guarantees completion of every exchange-traded option
transaction. In contrast, over-the-counter options are contracts between a fund
and its counterparty (usually a securities dealer or a bank) with no clearing
organization guarantee. Thus, when a fund purchases or writes an
over-the-counter option, it relies on the counterparty to make or take delivery
of the underlying investment upon exercise of the option. Failure by the
counterparty to do so would result in the loss of any premium paid by the fund
as well as the loss of any expected benefit of the transaction.
The funds' ability to establish and close out positions in
exchange-listed options depends on the existence of a liquid market. The funds
intend 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 over-the-counter options only by negotiating directly with the
counterparty, or by a transaction in the secondary market if any such market
exists. Although the funds will enter into over-the-counter options only with
counterparties that are expected to be capable of entering into closing
transactions with the funds, there is no assurance that a fund will in fact be
able to close out an over-the-counter option position at a favorable price prior
to expiration. In the event of insolvency of the counterparty, a fund might be
unable to close out an over-the-counter option position at any time prior to its
expiration.
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If a fund 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 put or call
option written by the fund could cause material losses because the fund would be
unable to sell the investment used as cover for the written option until the
option expires or is exercised.
A fund 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 funds' use of options is
governed by the following guidelines, which can be changed by the board without
shareholder vote:
(1) A fund 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 fund, does not exceed 5% of its total assets.
(2) The aggregate value of securities underlying put options written by a fund,
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 securities indices and options on futures contracts)
purchased by a fund that are held at any time will not exceed 20% of its net
assets.
FUTURES. The funds may purchase and sell securities index futures
contracts, interest rate futures contracts, debt security index futures
contracts and (for those funds that invest outside the United States) foreign
currency futures contracts. A fund may also purchase put and call options, and
write covered put and call options, on futures in which it is allowed to invest.
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, and writing covered put options on futures contracts can serve as a
limited long hedge, using a strategy similar to that used for writing covered
options on securities or indices. In addition, a fund may purchase or sell
futures contracts or purchase options thereon to increase or reduce its exposure
to an asset class without purchasing or selling the underlying securities either
as a hedge or to enhance return or realize gains.
Futures strategies also can be used to manage the average duration of a
fund's portfolio. If Mitchell Hutchins or the applicable sub-adviser wishes to
shorten the average duration of a fund's portfolio, the fund may sell a futures
contract or a call option thereon, or purchase a put option on that futures
contract. If Mitchell Hutchins or the sub-adviser wishes to lengthen the average
duration of the fund's portfolio, the fund may buy a futures contract or a call
option thereon, or sell a put option thereon.
A fund may also write put options on 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 fund will engage in this
strategy only when it is more advantageous to a fund than is purchasing the
futures contract.
No price is paid upon entering into a futures contract. Instead, at the
inception of a futures contract a fund 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 a call 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 a fund at the termination of the transaction if all
contractual obligations have been satisfied. Under certain circumstances, such
as periods of high volatility, a fund may be required by an exchange to increase
36
<PAGE>
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 each fund's obligations to or from a futures
broker. When a fund purchases an option on a future, the premium paid plus
transaction costs is all that is at risk. In contrast, when a fund 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 a fund 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.
The funds intend 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 fund 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. A fund would continue to be
subject to market risk with respect to the position. In addition, except in the
case of purchased options, a fund would continue to be required to make daily
variation margin payments and might be required to maintain the position being
hedged by the future or option or to maintain cash or securities in a segregated
account.
Certain characteristics of the futures market might increase the risk
that movements in the prices of futures contracts or related options might not
correlate perfectly with movements in the prices of the investments being
hedged. For example, all participants in the futures and related options markets
are subject to daily variation margin calls and might be compelled to liquidate
futures or related options positions whose prices are moving unfavorably to
avoid being subject to further calls. These liquidations could increase price
volatility of the instruments and distort the normal price relationship between
the futures or options and the investments being hedged. Also, because initial
margin deposit requirements in the futures market are less onerous than margin
requirements in the securities markets, there might be increased participation
by speculators in the futures markets. This participation also might cause
temporary price distortions. In addition, activities of large traders in both
the futures and securities markets involving arbitrage, "program trading" and
other investment strategies might result in temporary price distortions.
LIMITATIONS ON THE USE OF FUTURES AND RELATED OPTIONS. The use of
futures and related options is governed by the following guidelines, which can
be changed by the board without shareholder vote:
(1) The aggregate initial margin and premiums on futures contracts and related
options that are not for bona fide hedging purposes (as defined by the CFTC),
excluding the amount by which options are "in-the-money", may not exceed 5% of a
fund's net assets.
(2) The aggregate premiums paid on all options (including options on securities,
foreign currencies and securities indices and options on futures contracts)
purchased by a fund 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 fund will not exceed 5% of its total assets.
37
<PAGE>
FOREIGN CURRENCY HEDGING STRATEGIES -- SPECIAL CONSIDERATIONS. Each
fund 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 fund's securities are denominated. These currency hedges
can protect against price movements in a security a fund owns or intends to
acquire that are attributable to changes in the value of the currency in which
it is denominated. These hedges do not, however, protect against price movements
in the securities that are attributable to other causes.
A fund 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 considered expensive. In such cases, the fund may
hedge against price movements in that currency by entering into transactions
using Derivative Instruments on another currency or a basket of currencies, the
value of which Mitchell Hutchins or the applicable sub-adviser believes will
have a positive correlation to the value of the currency being hedged. In
addition, a fund may use forward currency contracts to shift exposure to foreign
currency fluctuations from one country to another. For example, if a fund owned
securities denominated in a foreign currency and Mitchell Hutchins or the
sub-adviser believed that currency would decline relative to another currency,
it might enter into a forward contract to sell an appropriate amount of the
first foreign currency, with payment to be made in the second foreign currency.
Transactions that use two foreign currencies are sometimes referred to as "cross
hedging." Use of a different foreign currency magnifies the risk that movements
in the price of the Derivative Instrument will not correlate or will correlate
unfavorably with the foreign currency being hedged.
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, a fund 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.
Settlement of Derivative Instruments involving foreign currencies might
be required to take place within the country issuing the underlying currency.
Thus, the funds 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. Funds 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 fund may purchase a
forward currency contract to lock in the U.S. dollar price of a security
denominated in a foreign currency that the fund intends to acquire. Forward
currency contract transactions may also serve as short hedges -- for example, a
fund 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 cost to a fund 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 fund enters into a forward currency contract, it relies on the
counterparty to make or take delivery of the underlying currency at the maturity
of the contract. Failure by the counterparty to do so would result in the loss
of any expected benefit of the transaction.
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<PAGE>
As is the case with futures 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 purchased or sold, 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 counterparty. Thus, there can be no assurance
that a fund 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 counterparty, a fund might be unable to close out a forward currency
contract at any time prior to maturity. In either event, the fund would continue
to be subject to market risk with respect to the position, and would continue to
be required to maintain a position 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 fund 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 fund 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 fund to deliver an amount of foreign currency
in excess of the value of the position being hedged by such contracts or (2) the
fund segregates with its custodian cash or liquid securities 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 marked to market daily.
SWAP TRANSACTIONS. Swap transactions include swaps, caps, floors and
collars relating to interest rates, currencies, securities or other instruments.
Interest rate swaps involve an agreement between two parties to exchange
payments that are based, for example, on variable and fixed-rates of interest
and that are calculated on the basis of a specified amount of principal (the
"notional principal amount") for a specified period of time. Interest rate cap
and floor transactions involve an agreement between two parties in which the
first party agrees to make payments to the counterparty when a designated market
interest rate goes above (in the case of a cap) or below (in the case of a
floor) a designated level on predetermined dates or during a specified time
period. Interest rate collar transactions involve an agreement between two
parties in which payments are made when a designated market interest rate either
goes above a designated ceiling level or goes below a designated floor level on
predetermined dates or during a specified time period. Currency swaps, caps,
floors and collars are similar to interest rate swaps, caps, floors and collars,
but they are based on currency exchange rates rather than interest rates. Equity
swaps or other swaps relating to securities or other instruments are also
similar, but they are based on changes in the value of the underlying securities
or instruments. For example, an equity swap might involve an exchange of the
value of a particular security or securities index in a certain notional amount
for the value of another security or index or for the value of interest on that
notional amount at a specified fixed or variable rate.
A fund may 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. A fund may use interest rate swaps, caps, floors and
collars as a hedge on either an asset-based or liability-based basis, depending
on whether it is hedging its assets or liabilities. Interest rate swap
transactions are subject to risks comparable to those described above with
respect to other derivatives strategies.
A fund will usually enter into interest rate swaps on a net basis,
i.e., the two payment streams are netted out, with a fund receiving or paying,
as the case may be, only the net amount of the two payments. Because segregated
accounts will be established with respect to these transactions, Mitchell
Hutchins and the sub-advisers (if applicable) believe such obligations do not
constitute senior securities and, accordingly, will not treat them as being
subject to a fund's borrowing restrictions. The net amount of the excess, if
any, of a fund's obligations over its entitlements with respect to each interest
rate swap will be accrued on a daily basis, and appropriate fund 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 "The Funds'
Investments, Related Risks and Limitations--Segregated Accounts." A fund also
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<PAGE>
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 written by the fund.
A fund will enter swap transactions only with banks or recognized
securities dealers or their affiliates believed by Mitchell Hutchins or the
applicable sub-adviser to present minimal credit risk in accordance with
guidelines established by the fund's board. If there is a default by the other
party to such a transaction, a fund 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.
ORGANIZATION; TRUSTEES AND OFFICERS; PRINCIPAL HOLDERS AND MANAGEMENT
OWNERSHIP OF SECURITIES
The Trust was formed on November 21, 1986 as a business trust under the
laws of the Commonwealth of Massachusetts and has thirteen operating series. The
Trust is governed by a board of trustees, which is authorized to establish
additional series and to issue an unlimited number of shares of beneficial
interest of each existing or future series, par value $0.001 per share. The
board oversees each fund's operations.
The trustees and executive officers of the Trust, their ages, business
addresses and principal occupations during the past five years are:
<TABLE>
<CAPTION>
NAME AND ADDRESS; AGE POSITION WITH TRUST BUSINESS EXPERIENCE; OTHER DIRECTORSHIPS
--------------------- ------------------- ----------------------------------------
<S> <C> <C>
Margo N. Alexander*+; 53 Trustee and President Mrs. Alexander is Chairman (since March 1999),
chief executive officer and a director of
Mitchell Hutchins (since January 1995), and an
executive vice president and director of
PaineWebber (since March 1984). Mrs. Alexander is
president and a director or trustee of 31
investment companies for which Mitchell Hutchins,
PaineWebber or one of their affiliates serves as
investment adviser.
Richard Q. Armstrong; 65 Trustee Mr. Armstrong is chairman and principal of
R.Q.A. Enterprises R.Q.A. Enterprises (management consulting firm)
One Old Church Road (since April 1991 and principal occupation since
Unit #6 March 1995). Mr. Armstrong was chairman of the
Greenwich, CT 06830 board, chief executive officer and co-owner of
Adirondack Beverages (producer and distributor of
soft drinks and sparkling/still waters) (October
1993-March 1995). He was a partner of The New
England Consulting Group (management consulting
firm) (December 1992-September 1993). He was
managing director of LVMH U.S. Corporation (U.S.
subsidiary of the French luxury goods
conglomerate, Louis Vuitton Moet Hennessey
Corporation) (1987-1991) and chairman of its wine
and spirits subsidiary, Schieffelin & Somerset
Company (1987-1991). Mr. Armstrong is a director
or trustee of 30 investment companies for which
Mitchell Hutchins, PaineWebber or one of their
affiliates serves as investment adviser.
40
<PAGE>
NAME AND ADDRESS; AGE POSITION WITH TRUST BUSINESS EXPERIENCE; OTHER DIRECTORSHIPS
--------------------- ------------------- ----------------------------------------
E. Garrett Bewkes, Jr.**+; 73 Trustee and Mr. Bewkes is a director of Paine Webber Group
Chairman of the Inc. ("PW Group") (holding company of PaineWebber
Board of Trustees and Mitchell Hutchins). Prior to 1996, he was a
consultant to PW Group. As of May 1, 1999, he
serves as a consultant to PaineWebber. Prior to
1988, he was chairman of the board, president and
chief executive officer of American Bakeries
Company. Mr. Bewkes is a director of Interstate
Bakeries Corporation. Mr. Bewkes is a director or
trustee of 39 investment companies for which
Mitchell Hutchins, PaineWebber or one of their
affiliates serves as investment adviser.
Richard R. Burt; 53 Trustee Mr. Burt is chairman of IEP Advisors, LLP
1275 Pennsylvania Ave, N.W. (international investments and consulting firm)
Washington, DC 20004 (since March 1994)and a partner of McKinsey &
Company (management consulting firm) (since
1991). He is also a director of
Archer-Daniels-Midland Co. (agricultural
commodities), Hollinger International Co.
(publishing), Homestake Mining Corp. (gold
mining), six investment companies in the Deutsche
Bank family of funds, nine investment companies
in the Flag Investors family of funds, The
Central European Fund, Inc. and The Germany Fund,
Inc., vice chairman of Anchor Gaming (provides
technology to gaming and wagering industry)
(since July 1999) and chairman of Weirton Steel
Corp. (makes and finishes steel products) (since
April 1996). He was the chief negotiator in the
Strategic Arms Reduction Talks with the former
Soviet Union (1989-1991) and the U.S. Ambassador
to the Federal Republic of Germany (1985-1989).
Mr. Burt is a director or trustee of 30
investment companies for which Mitchell Hutchins,
PaineWebber or one of their affiliates serves as
investment adviser.
Mary C. Farrell**+; 50 Trustee Ms. Farrell is a managing director, senior
investment strategist and member of the
Investment Policy Committee of PaineWebber. Ms.
Farrell joined PaineWebber in 1982. She is a
member of the Financial Women's Association 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 investment companies for which Mitchell
Hutchins, PaineWebber or one of their affiliates
serves as investment adviser.
41
<PAGE>
NAME AND ADDRESS; AGE POSITION WITH TRUST BUSINESS EXPERIENCE; OTHER DIRECTORSHIPS
--------------------- ------------------- ----------------------------------------
Meyer Feldberg; 58 Trustee Mr. Feldberg is Dean and Professor of Management
Columbia University of the Graduate School of Business, Columbia
101 Uris Hall University. Prior to 1989, he was president of
New York, NY 10027 the Illinois Institute of Technology. Dean
Feldberg is also a director of Primedia Inc.
(publishing), Federated Department Stores, Inc.
(operator of department stores) and Revlon, Inc.
(cosmetics). Dean Feldberg is a director or
trustee of 36 investment companies for which
Mitchell Hutchins, PaineWebber or one of their
affiliates serves as investment adviser.
George W. Gowen; 70 Trustee Mr. Gowen is a partner in the law firm of
666 Third Avenue Dunnington, Bartholow & Miller. Prior to May
New York, NY 10017 1994, he was a partner in the law firm of Fryer,
Ross & Gowen. Mr. Gowen is a director or trustee
of 36 investment companies for which Mitchell
Hutchins, PaineWebber or one of their affiliates
serves as investment adviser.
Frederic V. Malek; 63 Trustee Mr. Malek is chairman of Thayer Capital Partners
1455 Pennsylvania Ave, N.W. (merchant bank) and chairman of Thayer Hotel
Suite 350 Investors II and Lodging Opportunities Fund
Washington, DC 20004 (hotel investment partnerships). From January
1992 to November 1992, he was campaign manager of
Bush-Quayle '92. From 1990 to 1992, he was vice
chairman and, from 1989 to 1990, he was president
of Northwest Airlines Inc. and NWA Inc. (holding
company of Northwest Airlines Inc.). Prior to
1989, he was employed by the Marriott Corporation
(hotels, restaurants, airline catering and
contract feeding), where he most recently was an
executive vice president and president of
Marriott Hotels and Resorts. Mr. Malek is also a
director of Aegis Communications, Inc.
(tele-services), American Management Systems,
Inc. (management consulting and computer related
services), Automatic Data Processing, Inc.,
(computing services), CB Richard Ellis, Inc.
(real estate services), FPL Group, Inc. (electric
services), Global Vacation Group (packaged
vacations), HCR/Manor Care, Inc. (health care),
SAGA Systems, Inc. (software company) and
Northwest Airlines Inc. Mr. Malek is a director
or trustee of 30 investment companies for which
Mitchell Hutchins, PaineWebber or one of their
affiliates serves as investment adviser.
42
<PAGE>
NAME AND ADDRESS; AGE POSITION WITH TRUST BUSINESS EXPERIENCE; OTHER DIRECTORSHIPS
--------------------- ------------------- ----------------------------------------
Carl W. Schafer; 64 Trustee Mr. Schafer is president of the Atlantic
66 Witherspoon Street, #1100 Foundation (charitable foundation supporting
Princeton, NJ 08542 mainly oceanographic exploration and research).
He is a director of Labor Ready, Inc. (temporary
employment), Roadway Express, Inc. (trucking),
The Guardian Group of Mutual Funds, the Harding,
Loevner Funds, E.I.I. Realty Trust (investment
company), Evans Systems, Inc. (motor fuels,
convenience store and diversified company),
Electronic Clearing House, Inc. (financial
transactions processing), Frontier Oil
Corporation and Nutraceutix, Inc. (biotechnology
company). Prior to January 1993, he was chairman
of the Investment Advisory Committee of the
Howard Hughes Medical Institute. Mr. Schafer is a
director or trustee of 30 investment companies
for which Mitchell Hutchins, PaineWebber or one
of their affiliates serves as investment adviser.
Brian M. Storms*+; 45 Trustee Mr. Storms is president and chief operating
officer of Mitchell Hutchins (since March 1999).
Mr. Storms was president of Prudential
Investments (1996-1999). Prior to joining
Prudential he was a managing director at Fidelity
Investments. Mr. Storms is a director or trustee
of 30 investment companies for which Mitchell
Hutchins, PaineWebber or one of their affiliates
serves as investment adviser.
T. Kirkham Barneby*; 54 Vice President Mr. Barneby is a managing director and chief
investment officer--quantitative investments of
Mitchell Hutchins. Mr. Barneby is a vice
president of seven investment companies for which
Mitchell Hutchins, PaineWebber or one of their
affiliates serves as investment adviser.
Thomas Disbrow***; 34 Vice President and Mr. Disbrow is a first vice president and
Assistant Treasurer a senior manager of the mutual fund finance
department of Mitchell Hutchins. Prior to
November 1999, he was a vice president of
Zweig/Glaser Advisers. Mr. Disbrow is a vice
president and assistant treasurer of 31
investment companies for which Mitchell Hutchins,
PaineWebber or one of their affiliates serves as
investment adviser.
Ellen R. Harris*; 54 Vice President Ms. Harris is a managing director and a
portfolio manager of Mitchell Hutchins. Ms.
Harris is a vice president of two investment
companies for which Mitchell Hutchins,
PaineWebber or one of their affiliates serves as
investment adviser.
Donald R. Jones*; 39 Vice President Mr. Jones is a senior vice president and a
portfolio manager of Mitchell Hutchins. Prior
to February 1996, he was a vice president in the
asset management group of First Fidelity
Bancorporation. Mr. Jones is a vice president of
two investment companies for which Mitchell
Hutchins, PaineWebber or one of their affiliates
serves as investment adviser.
43
<PAGE>
NAME AND ADDRESS; AGE POSITION WITH TRUST BUSINESS EXPERIENCE; OTHER DIRECTORSHIPS
--------------------- ------------------- ----------------------------------------
James F. Keegan*; 39 Vice President Mr. Keegan is a managing director and a portfolio
manager of Mitchell Hutchins. Prior to March
1996, he was director of fixed income strategy
and research of Merrion Group, L.P. Mr. Keegan is
a vice president of six investment companies for
which Mitchell Hutchins, PaineWebber or one of
their affiliates serves as investment adviser.
John J. Lee***; 31 Vice President and Mr. Lee is a vice president and a manager of
Assistant Treasurer the mutual fund finance department of Mitchell
Hutchins. Prior to September 1997, he was an
audit manager in the financial services practice
of Ernst & Young LLP. Mr. Lee is a vice president
and assistant treasurer of 31 investment
companies for which Mitchell Hutchins,
PaineWebber or one of their affiliates serves as
investment adviser.
Kevin J. Mahoney***; 34 Vice President and Mr. Mahoney is a first vice president and a
Assistant Treasurer senior manager of the mutual fund finance
department of Mitchell Hutchins. From August 1996
through March 1999, he was the manager of the
mutual fund internal control group of Salomon
Smith Barney. Prior to August 1996, he was an
associate and assistant treasurer for BlackRock
Financial Management L.P. Mr. Mahoney is a vice
president and assistant treasurer of 31
investment companies for which Mitchell Hutchins,
PaineWebber or one of their affiliates serves as
investment adviser.
Dennis McCauley*; 53 Vice President Mr. McCauley is a managing director and chief
investment officer--fixed income of Mitchell
Hutchins. Mr. McCauley is a vice president of 21
investment companies for which Mitchell Hutchins,
PaineWebber or one of their affiliates serves as
investment adviser.
Ann E. Moran***; 42 Vice President and Ms. Moran is a vice president and a manager of
Assistant Treasurer the mutual fund finance department of Mitchell
Hutchins. Ms. Moran is a vice president and
assistant treasurer of 31 investment companies
for which Mitchell Hutchins, PaineWebber or one
of their affiliates serves as investment adviser.
Dianne E. O'Donnell**; 48 Vice President and Ms. O'Donnell is a senior vice president and
Secretary deputy general counsel of Mitchell Hutchins.
Ms. O'Donnell is a vice president and secretary
of 31 investment companies for which Mitchell
Hutchins, PaineWebber or one of their affiliates
serves as investment adviser.
Susan Ryan; 40* Vice President Ms. Ryan is a senior vice president and a
portfolio manager of Mitchell Hutchins. Ms. Ryan
is a vice president of six investment companies
for which Mitchell Hutchins, PaineWebber or one
of their affiliates serves as investment adviser.
44
<PAGE>
NAME AND ADDRESS; AGE POSITION WITH TRUST BUSINESS EXPERIENCE; OTHER DIRECTORSHIPS
--------------------- ------------------- ----------------------------------------
Paul H. Schubert***; 37 Vice President and Mr. Schubert is a senior vice president and
Treasurer director of the mutual fund finance department
of Mitchell Hutchins. Mr. Schubert is a vice
president and treasurer of 31 investment
companies for which Mitchell Hutchins,
PaineWebber or one of their affiliates serves as
investment adviser.
Nirmal Singh*; 44 Vice President Mr. Singh is a senior vice president and a
portfolio manager of Mitchell Hutchins. Mr. Singh
is a vice president of four investment companies
for which Mitchell Hutchins, PaineWebber or one
of their affiliates serves as investment adviser.
Barney A. Taglialatela***; 39 Vice President and Mr. Taglialatela is a vice president and a
Assistant Treasurer manager of the mutual fund finance department
of Mitchell Hutchins. Mr. Taglialatela is a vice
president and assistant treasurer of 31
investment companies for which Mitchell Hutchins,
PaineWebber or one of their affiliates serves as
investment adviser.
Mark A. Tincher*; 44 Vice President Mr. Tincher is a managing director and chief
investment officer--equities of Mitchell
Hutchins. Mr. Tincher is a vice president of 10
investment companies for which Mitchell Hutchins,
PaineWebber or one of their affiliates serves as
investment adviser.
Stuart Waugh*; 45 Vice President Mr. Waugh is a managing director and a portfolio
manager of Mitchell Hutchins responsible for
global fixed income investments and currency
trading. Mr. Waugh is a vice president of five
investment companies for which Mitchell Hutchins,
PaineWebber or one of their affiliates serves as
investment adviser.
Keith A. Weller**; 38 Vice President and Mr. Weller is a first vice president and
Assistant Secretary associate general counsel of Mitchell Hutchins.
Mr. Weller is a vice president and assistant
secretary of 30 investment companies for which
Mitchell Hutchins, PaineWebber or one of their
affiliates serves as investment adviser.
</TABLE>
-------------
* This person's business address is 51 West 52nd Street, New York, New York
10019-6114.
** This person's business address is 1285 Avenue of the Americas, New York,
New York 10019.
*** This person's business address is Newport Center III, 499 Washington
Blvd., 14th Floor, Jersey City, New Jersey 07310-1998.
+ Mrs. Alexander, Mr. Bewkes, Ms. Farrell and Mr. Storms are "interested
persons" of each fund as defined in the Investment Company Act by virtue
of their positions with Mitchell Hutchins, PaineWebber, and/or PW Group.
The Trust pays each board member who is not an "interested person" of
the Trust $500 annually for each fund and an additional up to $150 per fund for
each board meeting and each separate meeting of a board committee. The Trust
presently has 13 operating series 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 board members are reimbursed for
any expenses incurred in attending meetings. Because PaineWebber, Mitchell
Hutchins and, as applicable, a sub-adviser perform substantially all the
services necessary for the operation of the Trust and each fund, the Trust
45
<PAGE>
requires no employees. No officer, director or employee of Mitchell Hutchins or
PaineWebber presently receives any compensation from the Trust for acting as a
board member or officer.
The table below includes certain information relating to the
compensation of the current board members and the compensation of those board
members from all PaineWebber funds during the year ended December 31, 1999.
COMPENSATION TABLE+
TOTAL COMPENSATION
AGGREGATE COMPENSATION FROM THE TRUST AND
NAME OF PERSON, POSITION FROM THE TRUST* THE FUND COMPLEX**
------------------------ ---------------------- -------------------
Richard Q. Armstrong,
Trustee......................... $16,640 $ 104,650
Richard R. Burt,
Trustee......................... 16,250 102,850
Meyer Feldberg,
Trustee......................... 16,640 119,650
George W. Gowen,
Trustee......................... 21,806 119,650
Frederic V. Malek,
Trustee......................... 16,640 104,650
Carl W. Schafer,
Trustee.................... 16,640 104,650
--------------------
+ Only independent board members are compensated by the Trust and identified
above; board members who are "interested persons," as defined by the
Investment Company Act, do not receive compensation.
* Represents fees paid to each Trustee from the Trust for the year ended
December 31, 1999.
** Represents total compensation paid during the calendar year ended December
31, 1999 to each board member by 31 investment companies (34 in the case
of Messrs. Feldberg and Gowen) for which Mitchell Hutchins, PaineWebber or
one of their affiliates served as investment adviser. No fund within the
PaineWebber fund complex has a bonus, pension, profit sharing or
retirement plan.
PRINCIPAL HOLDERS AND MANAGEMENT OWNERSHIP OF SECURITIES
As of March 3, 2000, trustees and officers owned in the aggregate less
than 1% of the outstanding shares of any class of each fund.
The following shareholders are shown in the Trust's records as owning
more than 5% of the outstanding Class H and Class I shares of the funds as of
March 3, 2000, as indicated below.
<TABLE>
<CAPTION>
FUND PERCENTAGE OWNED SHAREHOLDER
---- ---------------- -----------
<S> <C> <C>
AGGRESSIVE GROWTH PORTFOLIO
--Class H shares 100% PaineWebber Life Insurance Co.
BALANCED PORTFOLIO
--Class H shares 32.58% American Republic Insurance Company
58.02% PaineWebber Life Insurance Co.
6.45% AIG Life Paradigm Variable Annuity
--Class I shares 100% Keyport Life Insurance
46
<PAGE>
FUND PERCENTAGE OWNED SHAREHOLDER
---- ---------------- -----------
GLOBAL EQUITY PORTFOLIO
--Class H shares 32.73% American Republic Insurance Company
66.42% PaineWebber Life Insurance Co.
--Class I shares 100% Keyport Life Insurance
GLOBAL INCOME PORTFOLIO
--Class H shares 49.89% American Republic Insurance Company
43.45% PaineWebber Life Insurance Co.
GROWTH AND INCOME PORTFOLIO
--Class H shares 24.26% American Republic Insurance Company
39.88% PaineWebber Life Insurance Co.
28.93% AIG Life Paradigm Variable Annuity
--Class I shares 61.30% Hartford Life Insurance Company
Separate Account Two
13.43% Aetna Life Insurance & Annuity Co.
14.10% Keyport Life Insurance
11.15% The Ohio National Life Insurance Co.
GROWTH PORTFOLIO
--Class H shares 48.11% American Republic Insurance Company
44.60% PaineWebber Life Insurance Co.
6.01% AIG Life Paradigm Variable Annuity
--Class I shares 99.70% Keyport Life Insurance
HIGH GRADE FIXED INCOME
PORTFOLIO
--Class H shares 100% PaineWebber Life Insurance Co.
HIGH INCOME PORTFOLIO
--Class H shares 10.16% AIG Life Paradigm Variable Annuity
88.01% PaineWebber Capital
MONEY MARKET PORTFOLIO
--Class H shares 25.27% American Republic Insurance Company
73.27% PaineWebber Life Insurance Co.
SMALL CAP PORTFOLIO
--Class H shares 11.48% AIG Life Paradigm Variable Annuity
86.15% PaineWebber Capital
--Class I shares 53.16% The Ohio National Life Insurance Co.
46.83% Aetna Life Insurance & Annuity Co.
STRATEGIC FIXED INCOME PORTFOLIO
--Class H shares 40.49% American Republic Insurance Company
56.62% PaineWebber Life Insurance Co.
STRATEGIC INCOME PORTFOLIO
--Class H shares 8.10% AIG Life Paradigm Variable Annuity
90.93% PaineWebber Capital
--Class I shares 75.43% Hartford Life Insurance Company
Separate Account Two
12.23% Keyport Life Insurance
12.32% The Ohio National Life Insurance Co.
47
<PAGE>
FUND PERCENTAGE OWNED SHAREHOLDER
---- ---------------- -----------
TACTICAL ALLOCATION PORTFOLIO
--Class H shares 85.39% AIG Life Paradigm Variable Annuity
13.27% AIG Life Paradigm ADB Variable Annuity
--Class I shares 41.18% Hartford Life Insurance Company
Separate Account Two
12.49% Aetna Life Insurance & Annuity Co.
41.10% Keyport Life Insurance
5.20% The Ohio National Life Insurance Co.
</TABLE>
INVESTMENT ADVISORY; ADMINISTRATION AND DISTRIBUTION ARRANGEMENTS
INVESTMENT ADVISORY AND ADMINISTRATION ARRANGEMENTS. Mitchell Hutchins
acts as the investment adviser and administrator of each fund pursuant to
contracts (each an "Advisory Contract") with the Trust. Under the applicable
Advisory Contract, the Trust pays Mitchell Hutchins a fee (expressed as a
percentage of the fund's average daily net assets), computed daily and paid
monthly, at the annual rates indicated below. The table also shows the advisory
fees earned or accrued (prior to any waivers) by Mitchell Hutchins during the
periods shown.
<TABLE>
<CAPTION>
ANNUAL RATE OF ADVISORY
FEE AS A PERCENTAGE OF
FUND'S AVERAGE DAILY ADVISORY FEES PAID OR ACCRUED
NET ASSETS FOR THE YEARS ENDED DECEMBER 31,
---------- --------------------------------
1999 1998 1997
---- ---- ----
<S> <C> <C> <C> <C>
Money Market Portfolio................. 0.50% $ 35,628 $ 47,751 $ 56,346
High Grade Fixed Income Portfolio...... 0.50% 30,260 38,332 39,763
Strategic Fixed Income Portfolio....... 0.50% 40,308 52,424 53,270
Strategic Income Portfolio *........... 0.75% 87,217 16,271 n/a
Global Income Portfolio................ 0.75% 88,569 127,634 165,480
High Income Portfolio *................ 0.50% 61,666 12,017 n/a
Balanced Portfolio..................... 0.75% 198,050 249,460 252,729
Growth and Income Portfolio............ 0.70% 180,762 167,394 138,089
Tactical Allocation Portfolio *........ 0.50% 221,102 18,444 n/a
Growth Portfolio....................... 0.75% 278,216 286,582 299,373
Aggressive Growth Portfolio............ 0.80% 137,591 172,407 170,723
Small Cap Portfolio *.................. 1.00% 41,972 8,635 n/a
Global Equity Portfolio................ 0.75% 115,797 151,440 182,141
</TABLE>
-------------------
* These funds commenced operations on September 28, 1998.
For the fiscal year ended December 31, 1999, Mitchell Hutchins
voluntarily waived the portion of its fee shown below under the applicable
Advisory Contracts in connection with certain funds' investment of cash
collateral from securities lending in a private investment vehicle managed by
Mitchell Hutchins.
48
<PAGE>
AMOUNT OF FEE WAIVED
UNDER ADVISORY CONTRACT
-----------------------
Money Market Portfolio................. $ 0
High Grade Fixed Income Portfolio...... 0
Strategic Fixed Income Portfolio....... 0
Strategic Income Portfolio ............ 0
Global Income Portfolio................ 0
High Income Portfolio ................. 0
Balanced Portfolio..................... 80
Growth and Income Portfolio............ 23
Tactical Allocation Portfolio ......... 451
Growth Portfolio....................... 196
Aggressive Growth Portfolio............ 0
Small Cap Portfolio ................... 14
Global Equity Portfolio................ 72
The Advisory Contracts authorize Mitchell Hutchins to retain one or
more sub-advisers but do not require Mitchell Hutchins to do so. Mitchell
Hutchins has entered into sub-advisory contracts ("Sub-Advisory Contracts") with
respect to Strategic Fixed Income Portfolio, Aggressive Growth Portfolio and for
the foreign investment segment of Global Equity Portfolio, as described further
below.
Mitchell Hutchins has entered into a Sub-Advisory Contract with Pacific
Investment Management Company ("PIMCO") pursuant to which PIMCO serves as
sub-adviser for Strategic Fixed Income Portfolio. Mitchell Hutchins (not the
fund) pays PIMCO for its services under the Sub-Advisory Contract a fee in the
annual amount of 0.25% of the fund's average daily net assets. For the years
ended December 31, 1999, December 31, 1998 and December 31, 1997, Mitchell
Hutchins paid or accrued sub-advisory fees to PIMCO of $20,153, $26,212 and
$26,635, respectively. PIMCO, a Delaware general partnership, is a registered
investment adviser and a subsidiary partnership of PIMCO Advisors L.P. ("PIMCO
Advisors"). The general partners of PIMCO Advisors are PIMCO Advisors Holding
L.P. ("PAH"), a publicly traded company listed on the New York Stock Exchange
under the symbol "PA", and PIMCO Partners, G.P., a general partnership between
Pacific Life Insurance Company and PIMCO Partners, LLC, a limited liability
company controlled by the PIMCO managing directors. In a previously announced
transaction which was approved by PAH unitholders on April 28, 2000 and
completed on May 5, 2000, Allianz AG ("Allianz") acquired all of PAH, the
publicly traded general partner of PIMCO Advisors, and majority ownership of
PIMCO Advisors and its subsidiaries, including PIMCO. PAH will be fully
consolidated into Allianz in the second quarter of 2000. PIMCO is one of the
largest fixed income management firms in the nation. Included among PIMCO's
institutional clients are many "Fortune 500" companies.
Mitchell Hutchins has entered into a Sub-Advisory Contract with
Nicholas-Applegate Capital Management ("Nicholas-Applegate") pursuant to which
Nicholas-Applegate serves as sub-adviser for Aggressive Growth Portfolio.
Mitchell Hutchins (not the fund) pays Nicholas-Applegate for its services under
the Sub-Advisory Contract a fee in the annual amount of 0.50% of the fund's
average daily net assets. For the years ended December 31, 1999, December 31,
1998 and December 31, 1997, Mitchell Hutchins paid or accrued sub-advisory fees
to Nicholas-Applegate of $85,994, $107,754 and $106,702, respectively.
Nicholas-Applegate is a California limited partnership. Its general partner is
Nicholas-Applegate Capital Management Holdings, L.P., a California limited
partnership controlled by Arthur E. Nicholas.
Mitchell Hutchins has entered into a Sub-Advisory Contract with Invista
Capital Management, LLC ("Invista") pursuant to which Invista serves as
sub-adviser for the foreign investments segment of Global Equity Portfolio.
Mitchell Hutchins (not the fund) pays Invista for its services under the
Sub-Advisory Contract a fee in the annual amount of 0.29% of the fund's average
daily net assets. For the year ended December 31, 1999 and for the period
November 2, 1998 to December 31, 1998, Mitchell Hutchins paid or accrued
sub-advisory fees to Invista of $27,039 and $4,556, respectively. Invista, which
was founded in 1984, is an indirect wholly owned subsidiary of Principal Life
Insurance Company and manages substantially all of Principal Life Insurance
Company's equity accounts, in addition to providing investment advice to other
affiliated and non-affiliated customers.
49
<PAGE>
Prior to November 2, 1998, GE Investment Management Incorporated
("GEIM") served as investment sub-adviser for all investments of Global Equity
Portfolio and Mitchell Hutchins (not the fund) paid GEIM for its services under
this prior Sub-Advisory Contract a fee in the annual amount of 0.29% of the
fund's average daily net assets. For the period January 1, 1998 to November 1,
1998 and the year ended December 31, 1997, Mitchell Hutchins paid or accrued
sub-advisory fees to GEIM of $49,623 and $70,428, respectively.
Under the terms of the Advisory Contracts, each fund bears all expenses
incurred in its operation that are not specifically assumed by Mitchell
Hutchins. General expenses of the Trust not readily identifiable as belonging to
one of the funds are allocated among the funds by or under the direction of the
Trust's board in such manner as the board determines to be fair and equitable.
Expenses borne by each fund include the following (or the fund's allocable share
of the following): (1) the cost (including brokerage commissions) of securities
purchased or sold by the fund and any losses incurred in connection therewith;
(2) fees payable to and expenses incurred on behalf of the fund by Mitchell
Hutchins; (3) organizational expenses; (4) filing fees and expenses relating to
the registration and qualification of the fund's shares under federal and state
securities laws and maintenance of such registrations and qualifications; (5)
fees and salaries payable to board members and officers who are not interested
persons (as defined in the Investment Company Act) of the Trust or Mitchell
Hutchins; (6) all expenses incurred in connection with the board members'
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 or fidelity bonds; (9) any
costs, expenses or losses arising out of a liability of or claim for damages or
other relief asserted against the Trust or fund for violation of any law; (10)
legal, accounting and auditing expenses, including legal fees of special counsel
for the independent board members; (11) charges of custodians, transfer agents
and other agents; (12) costs of preparing share certificates; (13) expenses of
setting in type and printing prospectuses, 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;
(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 board members and officers; and (18) costs of mailing,
stationery and communications equipment.
Under each Advisory Contract, Mitchell Hutchins will not be liable for
any error of judgment or mistake of law or for any loss suffered by the Trust or
a 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. Each Advisory Contract
terminates automatically upon assignment and is terminable with respect to a
fund at any time without penalty by the board or by vote of the holders of a
majority of the fund's outstanding voting securities on 60 days' written notice
to Mitchell Hutchins, or by Mitchell Hutchins on 60 days' written notice to the
Trust.
Under each Sub-Advisory Contract, the sub-adviser will not be liable
for any error of judgment or mistake of law or for any loss suffered by the
Trust, the fund, its shareholders or Mitchell Hutchins in connection with the
Sub-Advisory Contract, except any liability to any of them to which the
sub-adviser would otherwise be subject by reason of willful misfeasance, bad
faith or 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. 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
applicable fund'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. Each Sub-Advisory Contract also may be terminated by Mitchell Hutchins
(1) upon material breach by the sub-adviser of its representations and
warranties, which breach shall not have been cured within a 20 day period after
notice of such breach; (2) if the sub-adviser becomes unable to discharge its
duties and obligations under the Sub-Advisory Contract; or (3) upon 120 days'
notice to the sub-adviser.
SECURITIES LENDING. During the fiscal years ended December 31, 1999,
December 31, 1998 and December 31, 1997, the indicated fund paid (or accrued)
the following fees to PaineWebber for its services as securities lending agent:
50
<PAGE>
FISCAL YEAR ENDED DECEMBER 31,
1999 1998 1997
---- ---- ----
Money Market Portfolio............ $ 0 $ 0 $ 0
High Grade Fixed Income Portfolio. 0 0 0
Strategic Fixed Income Portfolio.. 0 0 0
Strategic Income Portfolio*....... 0 0 n/a
Global Income Portfolio........... 0 171 213
High Income Portfolio*............ 0 0 n/a
Balanced Portfolio................ 512 1,725 867
Growth and Income Portfolio....... 100 420 437
Tactical Allocation Portfolio*.... 1,039 0 n/a
Growth Portfolio.................. 2,898 2,936 9,945
Aggressive Growth Portfolio....... 1,428 555 2,060
Small Cap Portfolio*.............. 164 0 n/a
Global Equity Portfolio........... 708 1,377 809
------------------
* These funds commenced operations on September 28, 1998.
NET ASSETS. The following table shows the approximate net assets as of
February 29, 2000, sorted by category of investment objective, of the investment
companies as to which Mitchell Hutchins serves as adviser or sub-adviser. An
investment company may fall into more than one of the categories below.
NET ASSETS
INVESTMENT CATEGORY ($MIL)
------------------- ----------
Domestic (excluding Money Market............................ $9,931.5
Global...................................................... 4,757.8
Equity/Balanced............................................. 10,115.9
Fixed Income (excluding Money Market........................ 4,573.4
Taxable Fixed Income............................... 3,146.1
Tax-Free Fixed Income.............................. 1,427.3
Money Market Funds.......................................... 39,977.1
PERSONAL TRADING POLICIES. The funds, their investment adviser and
their principal underwriter each have adopted a code of ethics under rule 17j-1
of the Investment Company Act, which permits personnel covered by the Code to
invest in securities that may be purchased or held by a fund, but prohibits
fraudulent, deceptive or manipulative conduct in connection with that personal
investing. Each sub-adviser also has adopted a code of ethics under rule 17j-1.
DISTRIBUTION ARRANGEMENTS. Mitchell Hutchins acts as the distributor of
the Class I shares of each fund under a distribution contract with the Trust
("Distribution Contract"). The Distribution Contract requires Mitchell Hutchins
to use its best efforts, consistent with its other businesses, to sell Class I
shares of each fund. Class H shares have no distributor or distribution
contract. Class H and Class I shares of each fund are offered continuously to
separate accounts of insurance companies. Mitchell Hutchins is located at 51
West 52nd Street, New York, New York 10019-6114.
51
<PAGE>
Under a plan of distribution pertaining to the Class I shares of each
fund adopted by the Trust in the manner prescribed under Rule 12b-1 under the
Investment Company Act ("Class I Plan" or "Plan"), each fund 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. Mitchell Hutchins uses these distribution fees to pay insurance
companies whose separate accounts purchase Class I shares for
distribution-related services that the insurance companies provide with respect
to the Class I shares. These services include (1) the printing and mailing of
fund prospectuses, SAIs, related supplements and shareholder reports to current
and prospective contract owners, (2) the development and preparation of sales
material, including sales literature, relating to Class I shares, (3) materials
and activities intended to educate and train insurance company sales personnel
concerning the funds and Class I shares, (4) obtaining information and providing
explanations to contract owners concerning the funds, (5) compensating insurance
company sales personnel with respect to services that result in the sale or
retention of Class I shares, (6) providing personal services and/or account
maintenance services to contract owners with respect to insurance company
separate accounts that hold Class I shares, and (7) financing other activities
that the board determines are primarily intended to result in the sale of Class
I shares.
The Plan and the related Distribution Contract for Class I shares
specify that the distribution fees paid to Mitchell Hutchins are not
reimbursements for specific expenses incurred. Therefore, even if Mitchell
Hutchins' expenses exceed the distribution fees it receives, the funds will not
be obligated to pay more than those fees. On the other hand, if Mitchell
Hutchins' expenses are less than such fees, it will retain its full fees and
realize a profit. Expenses in excess of distribution fees received or accrued
through the termination date of the Class I Plan will be Mitchell Hutchins' sole
responsibility and not that of the funds. The board reviews the Class I Plan and
Mitchell Hutchins' corresponding expenses annually.
Among other things, the Class I Plan provides that (1) Mitchell
Hutchins will submit to the board at least quarterly, and the board members 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 board
members who are not "interested persons" of the Trust and who have no direct or
indirect financial interest in the operation of the Plan or any agreement
related to the Plan, acting in person at a meeting called for that purpose, (3)
payments by a fund under the Class I Plan shall not be materially increased
without the affirmative vote of the holders of a majority of the outstanding
shares of the relevant class and (4) while the Class I Plan remains in effect,
the selection and nomination of board members who are not "interested persons"
of the Trust shall be committed to the discretion of the board members who are
not "interested persons" of that Trust.
During the year ended December 31, 1999, the funds paid or accrued the
following distribution fees to Mitchell Hutchins for their Class I shares under
the Plan, and Mitchell Hutchins waived the amounts shown:
FEES PAID OR ACCRUED FEES WAIVED BY
FUND (BEFORE WAIVERS) MITCHELL HUTCHINS
---- ---------------- -----------------
Money Market Portfolio............... $ 0 $ 0
High Grade Fixed Income Portfolio.... 0 0
Strategic Fixed Income Portfolio..... 0 0
Strategic Income Portfolio .......... 1,524 1,524
Global Income Portfolio.............. 0 0
High Income Portfolio................ 0 0
Balanced Portfolio................... 364 364
Growth and Income Portfolio.......... 6,549 6,549
Tactical Allocation Portfolio........ 43,639 43,639
Growth Portfolio..................... 1,461 1,461
Aggressive Growth Portfolio.......... 0 0
Small Cap Portfolio.................. 181 181
Global Equity Portfolio.............. 107 107
52
<PAGE>
In approving the Class I Plan for each fund, 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 fund and to compensate their
agents for selling Class I shares and (4) the need to encourage those
unaffiliated insurance companies to educate their contract owners concerning the
fund and to provide personal and account maintenance services to contract owners
with respect to the fund's Class I shares 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
upon a percentage of the average net assets of a fund, which fees would increase
if the Class I Plan were successful and the fund 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 each fund's portfolio
transactions and the allocation of brokerage transactions. In executing
portfolio transactions, Mitchell Hutchins or the sub-adviser seeks to obtain the
best net results for a fund, taking into account such factors as the price
(including the applicable brokerage commission or dealer spread), size of order,
difficulty of execution and operational facilities of the firm involved. While
Mitchell Hutchins or the 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 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 the time. Generally, bonds are traded on the over-the-counter market on a
"net" basis without a stated commission through dealers acting for their own
accounts and not through brokers. Each fund may invest in securities traded in
the over-the-counter markets and will engage primarily with the dealers who make
markets in such securities, unless a better price or execution could be obtained
by using a broker.
During the fiscal years indicated, the funds paid the brokerage
commissions set forth below:
FOR THE YEARS ENDED DECEMBER 31,
--------------------------------
1999 1998 1997
---- ---- ----
Money Market Portfolio.............. $ 0 $ 0 $ 0
High Grade Fixed Income Portfolio... 0 0 0
Strategic Fixed Income Portfolio.... 0 64 1,149
Strategic Income Portfolio*......... 0 0 n/a
Global Income Portfolio............. 0 0 0
High Income Portfolio*.............. 0 0 n/a
Balanced Portfolio.................. 33,068 47,323 51,556
Growth and Income Portfolio......... 34,313 33,107 39,178
Tactical Allocation Portfolio*...... 40,444 7,579 n/a
Growth Portfolio.................... 26,525 45,109 71,334
Aggressive Growth Portfolio......... 47,965 46,977 47,838
Small Cap Portfolio*................ 8,737 6,471 n/a
Global Equity Portfolio............. 11,456 137,373 113,093
------------------
* These funds commenced operations on September 28, 1998.
The funds have no obligation to deal with any broker or group of
brokers in the execution of portfolio transactions. The funds contemplate that,
consistent with the policy of obtaining the best net results, brokerage
transactions may be conducted through Mitchell Hutchins or its affiliates,
53
<PAGE>
including PaineWebber, or brokerage affiliates of a fund's sub-adviser. The
board has adopted procedures in conformity with Rule 17e-1 under the Investment
Company Act to ensure that all brokerage commissions paid to PaineWebber or
brokerage affiliates of a fund's sub-adviser are reasonable and fair. Specific
provisions in the Advisory Contracts and the Sub-Advisory Contracts authorize
Mitchell Hutchins and each sub-adviser, respectively, and any of their
affiliates that is a member of a national securities exchange, to effect
portfolio transactions for the applicable fund on such exchange and to retain
compensation in connection with such transactions. Any such transactions will be
effected and related compensation paid only in accordance with applicable SEC
regulations.
During the fiscal years indicated, the funds paid brokerage commissions
to PaineWebber or, as applicable, brokerage affiliates of the sub-adviser as
follows:
FOR THE YEARS ENDED DECEMBER 31,
--------------------------------
1999 1998 1997
---- ---- ----
Money Market Portfolio................. $ 0 $ 0 $ 0
High Grade Fixed Income Portfolio...... 0 0 0
Strategic Fixed Income Portfolio....... 0 0 0
Strategic Income Portfolio*............ 0 0 n/a
Global Income Portfolio................ 0 0 0
High Income Portfolio*................. 0 0 n/a
Balanced Portfolio..................... 1,674 54 1,992
Growth and Income Portfolio............ 2,009 714 558
Tactical Allocation Portfolio*......... 12 0 n/a
Growth Portfolio....................... 1,996 4,212 4,020
Aggressive Growth Portfolio............ 3,306 0 1,621
Small Cap Portfolio*................... 0 0 n/a
Global Equity Portfolio................ 589 12 0
------------------
* These funds commenced operations on September 28, 1998.
These brokerage commissions paid for the year ended December 31, 1999
represented for each fund the percentages of total brokerage commissions paid
and of the dollar amount representing the fund's transactions involving the
payment of brokerage commissions set forth below.
<TABLE>
<CAPTION>
PERCENTAGE OF DOLLAR
PERCENTAGE OF TOTAL AMOUNT OF TRANSACTIONS
BROKERAGE COMMISSIONS INVOLVING PAYMENT OF
PAID BROKERAGE COMMISSIONS
---- ---------------------
<S> <C> <C>
Money Market Portfolio.............. 0 0
High Grade Fixed Income Portfolio... 0 0
Strategic Fixed Income Portfolio.... 0 0
Strategic Income Portfolio.......... 0 0
Global Income Portfolio............. 0 0
High Income Portfolio............... 0 0
Balanced Portfolio.................. 5.06% 4.29%
Growth and Income Portfolio......... 5.85% 5.14%
Tactical Allocation Portfolio ...... 0.03% 0.02%
Growth Portfolio.................... 7.52% 7.11%
Aggressive Growth Portfolio......... 9.84% 8.48%
Small Cap Portfolio................. 0 0
Global Equity Portfolio............. 5.14% 4.45%
</TABLE>
Transactions in futures contracts are executed through futures
commission merchants ("FCMs"), who receive brokerage commissions for their
services. The funds' procedures in selecting FCMs to execute their transactions
54
<PAGE>
in futures contracts, including procedures permitting the use of Mitchell
Hutchins and its affiliates or brokerage affiliates of the sub-adviser, are
similar to those in effect with respect to brokerage transactions in securities.
In selecting brokers, Mitchell Hutchins or a sub-adviser will consider
the full range and quality of a broker's services. Consistent with the interests
of the funds and subject to the review of each board, Mitchell Hutchins or a
sub-adviser may cause a fund to purchase and sell portfolio securities through
brokers who provide Mitchell Hutchins or the sub-adviser with brokerage or
research services. The funds may pay those brokers a higher commission than may
be charged by other brokers, provided that Mitchell Hutchins or the 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 sub-adviser, as applicable, to that fund and its other clients.
Research services obtained from brokers may include written reports,
pricing and appraisal services, analysis of issues raised in proxy statements,
educational seminars, subscriptions, portfolio attribution and monitoring
services, and computer hardware, software and access charges which are directly
related to investment research. Research services may be received in the form of
written reports, online services, telephone contacts and personal meetings with
securities analysts, economists, corporate and industry spokespersons and
government representatives.
For the year ended December 31, 1999, the funds directed the portfolio
transactions indicated below to brokers chosen because they provide research,
analysis, advice and similar services, for which the funds paid the brokerage
commissions indicated below:
AMOUNT OF PORTFOLIO BROKERAGE
TRANSACTIONS COMMISSIONS PAID
------------ ----------------
Money Market Portfolio............. $ 0 $ 0
High Grade Fixed Income Portfolio.. 0 0
Strategic Fixed Income Portfolio... 0 0
Strategic Income Portfolo.......... 0 0
Global Income Portfolio............ 0 0
High Income Portfolio.............. 0 0
Balanced Portfolio................. 9,336,209 12,330
Growth and Income Portfolio........ 4,719,694 6,336
Tactical Allocation Portfolio...... 0 0
Growth Portfolio................... 7,482,683 8,688
Aggressive Growth Portfolio........ 29,177,544 40,735
Small Cap Portfolio................ 184,294 344
Global Equity Portfolio............ 536,737 1,661
For purchases or sales with broker-dealer firms that act as principal,
Mitchell Hutchins or the applicable sub-adviser seeks best execution. Although
Mitchell Hutchins or a sub-adviser may receive certain research or execution
services in connection with these transactions, Mitchell Hutchins and the
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. Mitchell Hutchins or the sub-adviser
may engage in agency transactions in over-the-counter 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.
Research services obtained from brokers may include written reports,
pricing and appraisal services, analysis of issues raised in proxy statements,
educational seminars, subscriptions, portfolio attribution and monitoring
services, and computer hardware, software and access charges which are directly
related to investment research. Research services may be received in the form of
written reports, online services, telephone contacts and personal meetings with
securities analysts, economists, corporate and industry spokespersons and
government representatives.
55
<PAGE>
Investment decisions for a fund and for other investment accounts
managed by Mitchell Hutchins or by 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
fund 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 that fund and such other account(s) as to amount according to a formula
deemed equitable to the fund 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 fund 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 fund.
The funds will not purchase securities that are offered in
underwritings in which PaineWebber, an applicable sub-adviser or any of their
affiliates is a member of the underwriting or selling group, except pursuant to
procedures adopted by the board pursuant to Rule 10f-3 under the Investment
Company Act. Among other things, these procedures require that the spread or
commission paid in connection with such a purchase be reasonable and fair, 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 PaineWebber or
any affiliate thereof or an affiliate of the sub-adviser not participate in or
benefit from the sale to the funds.
As of December 31, 1999, the funds owned securities issued by the
following companies which are regular broker-dealers for the funds:
Money Market Portfolio: None.
High Grade Fixed Income Portfolio: Bonds of Lehman Brothers Holdings
Inc. ($92,032), Merrill Lynch & Company Inc. ($126,056) and Morgan
Stanley Group Inc. ($136,892); collateralized mortgage obligations of
Morgan Stanley Capital Inc. ($126,282).
Strategic Fixed Income Portfolio: Collateralized mortgage obligations
of Merrill Lynch Mortgage Investors Inc. ($429,344) and Prudential Home
Mortgage Securities Corp. ($345,845); repurchase agreement with State
Street Bank and Trust Co. ($185,000).
Strategic Income Portfolio: None.
Global Income Portfolio: None.
High Income Portfolio: None.
Balanced Portfolio: Common stock of AXA Financial Inc. (121,950), Chase
Manhattan Corp. ($248,600), Mellon Financial Corp. ($34,062), Morgan
Stanley Dean Witter & Co. ($328,325); bonds of Lehman Brothers Holdings
Inc. ($140,469), Merrill Lynch & Company Inc. ($121,007), Morgan
Stanley Dean Witter & Co. ($193,538); collateralized mortgage
obligations of CS First Boston Mortgage Securities Corp. ($55,105) and
Morgan Stanley Capital Inc. ($90,785).
Growth and Income Portfolio: Common stock of Morgan Stanley Dean Witter
& Co. ($485,350).
Tactical Allocation Portfolio: Common stock of Bear Stearns Company,
Inc. ($34,200), Lehman Brothers Holdings, Inc. ($59,281) and Morgan
Stanley Dean Witter & Co. ($456,800).
Growth Portfolio: Common stock of Charles Schwab Corp. ($115,125) and
Citigroup Inc. ($105,569).
Aggressive Growth Portfolio: None.
Small Cap Portfolio: None
56
<PAGE>
Global Equity Portfolio: Common stock of AXA UAP ($83,650), Deutsche
Bank AG ($109,805), UBS AG ($136,645), Chase Manhattan Corp.
($118,706), Mellon Financial Corp. ($52,048), AXA Financial Inc.
($39,431), Morgan Stanley Dean Witter & Co. ($80,368).
PORTFOLIO TURNOVER. The funds' annual portfolio turnover rates may vary
greatly from year to year, but they will not be a limiting factor when
management deems portfolio changes appropriate. The portfolio turnover rate is
calculated by dividing the lesser of a fund'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 securities in the portfolio during the year.
The funds' respective portfolio turnover rates for the fiscal years
shown were:
PORTFOLIO TURNOVER RATES FOR THE
YEARS ENDED DECEMBER 31,
------------------------
1999 1998
---- ----
Money Market Portfolio.................. n/a n/a
High Grade Fixed Income Portfolio....... 166% 101%
Strategic Fixed Income Portfolio........ 503% 245%
Strategic Income Portfolio*............. 403% 81%
Global Income Portfolio................. 43% 104%
High Income Portfolio*.................. 69% 21%
Balanced Portfolio...................... 206% 177%
Growth and Income Portfolio............. 65% 69%
Tactical Allocation Portfolio*.......... 110% 6%
Growth Portfolio........................ 23% 50%
Aggressive Growth Portfolio............. 135% 73%
Small Cap Portfolio*.................... 98% 17%
Global Equity Portfolio................. 63% 154%
------------------
* These funds commenced operations on September 28, 1998.
Strategic Fixed Income Portfolio experienced a significant increase in
portfolio turnover in 1999 because its sub-adviser took advantage of several
mispricings in the mortgage-backed securities market.
ADDITIONAL PURCHASE AND REDEMPTION INFORMATION
The insurance company separate accounts purchase and redeem shares of
the funds on each day on which the New York Stock Exchange 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 New York Stock Exchange is
closed on the observance of the following holidays: New Year's Day, Martin
Luther King, Jr. Day, Presidents' Day, Good Friday, Memorial Day, Independence
Day, Labor Day, Thanksgiving Day and Christmas Day. Purchases and redemptions of
the shares of each fund are effected at their respective net asset values per
share determined as of the close of regular trading (usually 4:00 p.m., Eastern
time) on the New York Stock Exchange on that Business Day. Payment for
redemptions are made by the funds within seven days thereafter. No fee is
charged the separate accounts when they purchase or redeem fund shares.
The funds may suspend redemption privileges or postpone the date of
payment during any period (1) when the New York Stock Exchange is closed or
trading on the New York Stock Exchange is restricted as determined by the SEC,
(2) when an emergency exists, as defined by the SEC, that makes it not
reasonably practicable for a 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 a fund's portfolio at the time.
57
<PAGE>
VALUATION OF SHARES
Each fund determines its net asset value per share separately for each
class of shares, normally as of the close of regular trading (usually 4:00 p.m.,
Eastern time) on the New York Stock Exchange on each Monday through Friday when
the New York Stock Exchange is open. Prices will be calculated earlier when the
New York Stock Exchange closes early because trading has been halted for the
day.
Securities that are listed on U.S. and foreign stock exchanges normally
are valued at the last sale price on the day the securities are valued or,
lacking any sales on that day, at the last available bid price. In cases where
securities are traded on more than one exchange, the securities are generally
valued on the exchange considered by Mitchell Hutchins or the applicable
sub-adviser as the primary market. Securities traded in the over-the-counter
market and listed on The Nasdaq Stock Market ("Nasdaq") normally are valued at
the last available sale price on Nasdaq prior to valuation; other
over-the-counter securities are valued at the last bid price available prior to
valuation, other than short-term investments that mature in 60 days or less.
Where market quotations are readily available, bonds of the funds
(other than Money Market Portfolio) are valued based upon market quotations,
provided those quotations adequately reflect, in the judgment of Mitchell
Hutchins or the applicable sub-adviser, the fair value of the securities. Where
those market quotations are not readily available, bonds are valued based upon
appraisals received from a pricing service using a computerized matrix system or
based upon appraisals derived from information concerning the security or
similar securities received from recognized dealers in those securities. The
amortized cost method of valuation generally is used to value debt obligations
with 60 days or less remaining until maturity, unless the board determines that
this does not represent fair value. All other securities and other assets are
valued at fair value as determined in good faith by or under the direction of
the board.
It should be recognized that judgment often plays a greater role in
valuing thinly traded securities and lower rated bonds 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 currency will be valued daily in U.S.
dollars on the basis of the foreign currency exchange rate prevailing at the
time such valuation is determined by a fund's custodian. Foreign currency
exchange rates are generally determined prior to the close of regular trading on
the New York Stock Exchange. Occasionally events affecting the value of foreign
investments and such exchange rates occur between the time at which they are
determined and the close of trading on the New York Stock Exchange, which events
would not be reflected in the computation of a fund's net asset value on that
day. If events materially affecting the value of such investments or currency
exchange rates occur during such time period, the investments will be valued at
their fair value as determined in good faith by or under the direction of the
board. The foreign currency exchange transactions of the funds conducted on a
spot (that is, cash) basis are valued at the spot rate for purchasing or selling
currency prevailing on the foreign exchange market. Under normal market
conditions this rate differs from the prevailing exchange rate by less than
one-tenth of one percent due to the costs of converting from one currency to
another.
MONEY MARKET PORTFOLIO. Money Market Portfolio values its portfolio
securities in accordance with the amortized cost method of valuation under Rule
2a-7 under the Investment Company Act. To use amortized cost to value its
portfolio securities, the fund must adhere to certain conditions under that Rule
relating to its investments. 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 fund 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
58
<PAGE>
shares in kind, selling portfolio securities prior to maturity, reducing or
withholding dividends and utilizing a net asset value per share as determined by
using available market quotations. Money Market Portfolio will maintain a dollar
weighted average portfolio maturity of 90 days or less and will not purchase any
instrument with a remaining maturity greater than 13 months (as calculated under
Rule 2a-7) and except that securities subject to repurchase agreements may have
maturities in excess of 13 months. Money Market Portfolio 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 value per share 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 instruments,
the Trust 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
Fund shares are offered only to insurance company separate accounts
that fund benefits under certain variable annuity contracts and/or variable life
insurance contracts. See the applicable contract prospectus for a discussion of
the special taxation of insurance companies with respect to those accounts and
the contract holders.
QUALIFICATION AS REGULATED INVESTMENT COMPANIES. Each fund is treated
as a separate corporation for federal income tax purposes. To continue to
qualify for treatment as a regulated investment company ("RIC") under Subchapter
M of the Internal Revenue Code ("Code"), each fund 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 gains and net gains from certain foreign currency transactions)
("Distribution Requirement") and must meet several additional requirements. For
each fund, these requirements include the following: (1) the fund 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 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 fund'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 fund'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 fund'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. By
qualifying as a RIC, a fund (but not its shareholders) will be relieved of
federal income tax on the part of its investment company taxable income and net
capital gain (i.e., the excess of net long-term capital gain over net short-term
capital loss) that it distributes to its shareholders.
If a fund failed to qualify for treatment as a RIC for any taxable
year, (1) it would be taxed as an ordinary corporation on the full amount of its
taxable income for that year (even if it distributed that income to its
shareholders), (2) all distributions out of its earnings and profits, including
distributions of net capital gain, would be taxable to its shareholders as
dividends (that is, ordinary income) and (3) most importantly, each insurance
company separate account invested in the fund would fail to satisfy the
diversification requirements of section 817(h) of the Code described in the next
paragraph, with the result that the variable annuity and/or life insurance
contracts supported by that account would no longer be eligible for tax
deferral. In addition, the fund could be required to recognize unrealized gains,
pay substantial taxes and interest and make substantial distributions before
requalifying for RIC treatment.
ADDITIONAL DIVERSIFICATION REQUIREMENTS. Each fund intends to continue
to satisfy the diversification requirements indirectly imposed on it by section
817(h) of the Code and the regulations thereunder, which are in addition to the
diversification requirements described above. These requirements place certain
59
<PAGE>
limitations on the assets of each insurance company separate account that may be
invested in the securities of a single issuer. Because section 817(h) and the
regulations thereunder treat the assets of each fund as assets of the related
separate account, the funds must also meet these requirements. Specifically, the
regulations under section 817(h) provide that, except as permitted by the "safe
harbor" described below, as of the end of each calendar quarter or within 30
days thereafter, no more than 55% of the total assets of a fund may be
represented by any one investment, no more than 70% by any two investments, no
more than 80% by any three investments and no more than 90% by any four
investments. For this purpose, all securities of the same issuer are considered
a single investment, and each U.S. government agency and instrumentality is
considered a separate issuer. Section 817(h) provides, as a safe harbor, that a
separate account will be treated as being adequately diversified if the
diversification requirements under Subchapter M are satisfied and no more than
55% of the value of the separate account's total assets are cash and cash items,
government securities and securities of other RICs. Failure of a fund to satisfy
the section 817(h) requirements would result in (1) taxation of the insurance
company issuing the variable contracts, the benefits under which are funded by
the separate account(s) investing in the fund, and (2) treatment of the contract
owners other than as described in the applicable contract prospectus.
OTHER INFORMATION. The use of hedging strategies, such as writing
(selling) 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 fund realizes in connection therewith. Gains from the disposition of foreign
currencies (except certain gains that may be excluded by future regulations),
and gains from options, futures and forward currency contracts derived by a fund
with respect to its business of investing in securities or foreign currencies,
will be treated as qualifying income under the Income Requirement.
Investment income earned and gains realized by a fund on foreign
securities may be subject to income, withholding or other taxes imposed by
foreign countries and U.S. possessions that would reduce the return on those
securities. Tax treaties between the United States and certain foreign
countries, however, may reduce or eliminate these taxes, and many foreign
countries do not impose taxes on capital gains in respect of investments by
foreign investors.
A fund may invest in the stock of "passive foreign investment
companies" ("PFICs") if that stock is a permissible investment. A PFIC is any
foreign corporation (with certain exceptions) 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 fund 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 that stock (collectively
"PFIC income"), plus interest thereon, even if the fund distributes the PFIC
income as a taxable dividend to its shareholders. The balance of the PFIC income
will be included in the fund's investment company taxable income and,
accordingly, will not be taxable to it to the extent it distributes that income
to its shareholders.
If a fund 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 fund will be required to include in income each year
its pro rata share of the QEF's annual ordinary earnings and net capital gain --
which it may have to distribute to satisfy the Distribution Requirement and
avoid imposition of the Excise Tax -- even if the QEF did not distribute those
earnings and gain to the fund. In most instances it will be very difficult, if
not impossible, to make this election because of certain of its requirements.
Each fund 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 fund's adjusted basis therein as of the end of that year. Pursuant to the
election, a fund 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 fund for
prior taxable years under the election (and under regulations proposed in 1992
that provided a similar election with respect to the stock of certain PFICs). A
fund's adjusted basis in each PFIC's stock with respect to which it has made
this election will be adjusted to reflect the amounts of income included and
deductions taken thereunder.
60
<PAGE>
Certain futures and foreign currency contracts and listed non-equity
options (such as those on a securities index) in which a fund may invest may be
subject to section 1256 of the Internal Revenue Code ("section 1256 contracts").
Any section 1256 contracts a fund holds at the end of each taxable year
generally must be "marked-to-market" (that is, treated as having been sold at
that time for their fair market value) for federal income tax purposes, with the
result that unrealized gains or losses will be treated as though they were
realized. Sixty percent of any net gain or loss recognized on these deemed
sales, and 60% of any net realized gain or loss from any actual sales of section
1256 contracts, will be treated as long-term capital gain or loss, and the
balance will be treated as short-term capital gain or loss. These rules may
operate to increase the amount that a fund must distribute to satisfy the
Distribution Requirement (i.e., with respect to the portion treated as
short-term capital gain), which will be taxable to its shareholders as ordinary
income, and to increase the net capital gain a fund recognizes, without in
either case increasing the cash available to the fund. A fund may elect not to
have the foregoing rules apply to any "mixed straddle" (that is, a straddle,
clearly identified by the fund in accordance with applicable regulations, at
least one (but not all) the positions of which are section 1256 contracts),
although doing so may have the effect of increasing the relative proportion of
net short-term capital gain (taxable as ordinary income) and thus increasing the
amount of dividends that must be distributed.
Offsetting positions in any actively traded security, option, futures
or forward currency contract entered into or held by a fund may constitute a
"straddle" for federal income tax purposes. Straddles are subject to certain
rules that may affect the amount, character and timing of a fund's gains and
losses with respect to positions of the straddle by requiring, among other
things, that (1) loss realized on disposition of one position of a straddle be
deferred to the extent of any unrealized gain in an offsetting position until
the latter position is disposed of, (2) the fund's holding period in certain
straddle positions not begin until the straddle is terminated (possibly
resulting in gain being treated as short-term rather than long-term capital
gain) and (3) losses recognized with respect to certain straddle positions, that
otherwise would constitute short-term capital losses, be treated as long-term
capital losses. Applicable regulations also provide certain "wash sale" rules,
which apply to transactions where a position is sold at a loss and a new
offsetting position is acquired within a prescribed period, and "short sale"
rules applicable to straddles. Different elections are available to the funds,
which may mitigate the effects of the straddle rules, particularly with respect
to mixed straddles.
When a covered call option written (sold) by a fund expires, it will
realize a short-term capital gain equal to the amount of the premium it received
for writing the option. When a fund terminates its obligations under such an
option by entering into a closing transaction, it will realize a short-term
capital gain (or loss), depending on whether the cost of the closing transaction
is less (or more) than the premium it received when it wrote the option. When a
covered call option written by a fund is exercised, the fund will be treated as
having sold the underlying security, producing long-term or short-term capital
gain or loss, depending on the holding period of the underlying security and
whether the sum of the option price received on the exercise plus the premium it
received when it wrote the option is more or less than the basis of the
underlying security.
If a fund has an "appreciated financial position" -- generally, an
interest (including an interest through an option, futures or forward currency
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 position, the
fund 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 a futures or forward
currency contract entered into by a fund or a related person with respect to the
same or substantially identical property. In addition, if the appreciated
financial position is itself a short sale or such a contract, acquisition of the
underlying property or substantially identical property will be deemed a
constructive sale. The foregoing will not apply, however, to a fund's
transaction during any taxable year that otherwise would be treated as a
constructive sale if the transaction is closed within 30 days after the end of
that year and the fund holds the appreciated financial position unhedged for 60
days after that closing (i.e., at no time during that 60-day period is the
fund's risk of loss regarding that position reduced by reason of certain
specified transactions with respect to substantially identical or related
property, such as having an option to sell, being contractually obligated to
sell, making a short sale or granting an option to buy substantially identical
stock or securities).
A fund may acquire (1) zero coupon or other securities issued with
original issue discount ("OID") or (2) Treasury inflation-protected securities
61
<PAGE>
("TIPS"), on which principal is adjusted based on changes in the Consumer Price
Index. A fund 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 fund receives no corresponding payment on them during
the year. Similarly, a fund that invests in payment-in-kind ("PIK") securities
must include in its gross income securities it receives as "interest" on those
securities. Each fund has elected similar treatment with respect to securities
purchased at a discount from their face value ("market discount"). Because a
fund annually must distribute substantially all of its investment company
taxable income, including any accrued OID, market discount 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 would have to be
made from the fund's cash assets or from the proceeds of sales of portfolio
securities, if necessary. A fund might realize capital gains or losses from
those sales, which would increase or decrease its investment company taxable
income and/or net capital gain.
The foregoing is only a general summary of some of the important
federal income tax considerations generally affecting the funds and their
shareholders. No attempt is made to present a complete explanation of the
federal tax treatment of the funds' 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 funds and to dividends and other distributions therefrom.
DIVIDENDS
MONEY MARKET PORTFOLIO. Shares of Money Market Portfolio begin earning
dividends on the day of purchase; dividends are accrued to shareholder accounts
daily and are automatically invested in additional fund shares monthly. The fund
does not expect to realize net capital gain. If a shareholder redeems all of its
Money Market Portfolio shares, 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 fund 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
MASSACHUSETTS BUSINESS TRUST. The Trust is an entity of the type
commonly known as a "Massachusetts business trust." Under Massachusetts law,
shareholders of a fund could, under certain circumstances, be held personally
liable for the obligations of the fund or the Trust. However, the Trust's
Declaration of Trust disclaims shareholder liability for acts or obligations of
the Trust or a fund and requires that notice of such disclaimer be given in each
note, bond, contract, instrument, certificate or undertaking made or issued by
the board members or by any officers or officer by or on behalf of the Trust or
the fund, the board members or any of them in connection with the Trust. The
Declaration of Trust provides for indemnification from the relevant fund's
property for all losses and expenses of any shareholder held personally liable
for the obligations of the fund. Thus, the risk of a shareholder incurring
financial loss on account of shareholder liability is limited to circumstances
in which the fund 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 solely by reason of being or having been a
shareholder, the shareholder paying such liability would be entitled to
reimbursement from the general assets of the relevant fund. The board members
intend to conduct each fund's operations in such a way as to avoid, as far as
possible, ultimate liability of the shareholders for liabilities of the fund.
VOTING RIGHTS. The insurance company separate accounts that fund
benefits under variable annuity or variable life insurance contracts are the
shareholders of the funds -- not the individual owners of those contracts.
However, the separate accounts may pass through voting rights to contract
owners.
Shareholders of each fund are entitled to one vote for each full share
held and fractional votes for fractional shares held. Voting rights are not
cumulative and, as a result, the holders of more than 50% of all the shares of
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the Trust may elect all of the board members of the Trust. The shares of a fund
will be voted together, except that only the shareholders of a particular class
of a fund may vote on matters affecting only that class, such as the terms of
the Class I Plan as it relates to the Class I shares. The shares of each series
will be voted separately, except when an aggregate vote of all the series is
required by law.
The fund does not hold annual meetings. Shareholders of record of no
less than two-thirds of the outstanding shares of the Trust may remove a board
member through a declaration in writing or by vote cast in person or by proxy at
a meeting called for that purpose. A meeting will be called to vote on the
removal of a board member at the written request of holders of 10% of the
outstanding shares of the Trust.
POSSIBLE CONFLICTS. Shares of the funds may serve as the underlying
investments for separate accounts of unaffiliated insurance companies ("shared
funding") as well as for both annuity and life insurance contracts ("mixed
funding"). Due to differences in tax treatment or other considerations, the
interests of various contract owners might at some time be in conflict. The
Trust does not currently foresee any conflict. However, the Trust's board
intends to monitor events to identify any material irreconcilable conflict that
may arise and to determine what action, if any, should be taken in response to
such conflict. If such a conflict were to occur, one or more insurance
companies' separate accounts might be required to withdraw its investments in
one or more funds. This might force a fund to sell securities at disadvantageous
prices.
CLASSES OF SHARES. A share of each class of a fund represents an
identical interest in that fund's investment portfolio and has the same rights,
privileges and preferences. However, each class may differ with respect to
distribution fees, if any, other expenses allocable exclusively to each class,
voting rights on matters exclusively affecting that class, and its exchange
privilege, if any. The different expenses applicable to the different classes of
shares of the funds will affect the performance of those classes. Each share of
a fund is entitled to participate equally in dividends, other distributions and
the proceeds of any liquidation of that fund. However, due to the differing
expenses of the classes, dividends and liquidation proceeds on Class H and I
shares will differ.
PRIOR NAMES. Prior to November 19, 1997, the Trust was known as
"PaineWebber Series Trust." Prior to January 26, 1996, Balanced Portfolio was
known as "Asset Allocation Portfolio." Prior to September 21, 1995, Strategic
Fixed Income Portfolio was known as "Government Portfolio" and High Grade Fixed
Income Portfolio was known as "Fixed Income Portfolio." Prior to August 14,
1995, Growth and Income Portfolio was known as "Dividend Growth Portfolio."
Prior to July 28, 1999, Global Equity Portfolio was known as "Global Growth
Portfolio."
CUSTODIAN AND RECORDKEEPING AGENT; TRANSFER AND DIVIDEND AGENT. Brown
Brothers Harriman & Co., 40 Water Street, Boston, Massachusetts 02109 is
custodian of the assets of Global Income Portfolio. State Street Bank and Trust
Company, located at One Heritage Drive, North Quincy, Massachusetts 02171,
serves as custodian and recordkeeping agent for the other funds. Both custodians
employ foreign sub-custodians approved by the board in accordance with
applicable requirements under the Investment Company Act to provide custody of
the foreign assets of those funds that invest outside the United States. PFPC
Inc., a subsidiary of PNC Bank, N.A., serves as each fund's transfer and
dividend disbursing agent. It is located at 400 Bellevue Parkway, Wilmington, DE
19809.
COUNSEL. The law firm of Kirkpatrick & Lockhart LLP, 1800 Massachusetts
Avenue, N.W., Washington, D.C. 20036-1800, serves as counsel to the Trust and
the funds. Kirkpatrick & Lockhart LLP also acts as counsel to PaineWebber and
Mitchell Hutchins in connection with other matters.
AUDITORS. Ernst & Young LLP, 787 Seventh Avenue, New York, New York
10019, serves as independent auditors for the Trust.
FINANCIAL STATEMENTS
Each fund's Annual Report to Shareholders for its last fiscal year is a
separate document supplied with this SAI, and the financial statements,
accompanying notes and report of independent auditors appearing therein are
incorporated herein by reference.
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APPENDIX
RATINGS INFORMATION
DESCRIPTION OF MOODY'S CORPORATE BOND RATINGS
Aaa. Bonds which are rated Aaa are judged to be of the best quality.
They carry the smallest degree of investment risk and are generally referred to
as "gilt edged." Interest payments are protected by a large or by an
exceptionally stable margin and principal is secure. While the various
protective elements are likely to change, such changes as can be visualized are
most unlikely to impair the fundamentally strong position of such issues; Aa.
Bonds which are rated Aa are judged to be of high quality by all standards.
Together with the Aaa group they comprise what are generally known as high grade
bonds. They are rated lower than the best bonds because margins of protection
may not be as large as in Aaa securities or fluctuation of protective elements
may be of greater amplitude or there may be other elements present which make
the long term risk appear somewhat larger than in Aaa securities; A. Bonds which
are rated A possess many favorable investment attributes and are to be
considered as upper-medium-grade obligations. Factors giving security to
principal and interest are considered adequate, but elements may be present
which suggest a susceptibility to impairment sometime in the future; Baa. Bonds
which are rated Baa are considered as medium-grade obligations, i.e., they are
neither highly protected nor poorly secured. Interest payment and principal
security appear adequate for the present but certain protective elements may be
lacking or may be characteristically unreliable over any great length of time.
Such bonds lack outstanding investment characteristics and in fact have
speculative characteristics as well; Ba. Bonds which are rated Ba are judged to
have speculative elements; their future cannot be considered as well-assured.
Often the protection of interest and principal payments may be very moderate and
thereby not well safeguarded during both good and bad times over the future.
Uncertainty of position characterizes bonds in this class; B. Bonds which are
rated B generally lack characteristics of the desirable investment. Assurance of
interest and principal payments or of maintenance of other terms of the contract
over any long period of time may be small; Caa. Bonds which are rated Caa are of
poor standing. Such issues may be in default or there may be present elements of
danger with respect to principal or interest; Ca. Bonds which are rated Ca
represent obligations which are speculative in a high degree. Such issues are
often in default or have other marked shortcomings; C. Bonds which are rated C
are the lowest rated class of bonds, and issues so rated can be regarded as
having extremely poor prospects of ever attaining any real investment standing.
Note: Moody's applies numerical modifiers, 1, 2 and 3 in each generic
rating classification from Aa through Caa. The modifier 1 indicates that the
obligation ranks in the higher end of its generic rating category, the modifier
2 indicates a mid-range ranking, and the modifier 3 indicates a ranking in the
lower end of that generic rating category.
DESCRIPTION OF S&P Corporate Debt Ratings
AAA. An obligation rated AAA has the highest rating assigned by S&P.
The obligor's capacity to meet its financial commitment on the obligation is
extremely strong; AA. An obligation rated AA differs from the highest rated
obligations only in small degree. The obligor's capacity to meet its financial
commitment on the obligation is very strong; A. An obligation rated A is
somewhat more susceptible to the adverse effects of changes in circumstances and
economic conditions than obligations in higher rated categories. However, the
obligor's capacity to meet its financial commitment on the obligation is still
strong; BBB. An obligation rated BBB exhibits adequate protection parameters.
However, adverse economic conditions or changing circumstances are more likely
to lead to a weakened capacity of the obligor to meet its financial commitment
on the obligation; BB, B, CCC, CC, C. Obligations rated BB, B, CCC, CC and C are
regarded as having significant speculative characteristics. BB indicates the
least degree of speculation and C the highest. While such obligations will
likely have some quality and protective characteristics, these may be outweighed
by large uncertainties or major exposures to adverse conditions; BB. An
obligation rated BB is less vulnerable to nonpayment than other speculative
issues. However, it faces major ongoing uncertainties or exposure to adverse
business, financial, or economic conditions which could lead to the obligor's
inadequate capacity to meet its financial commitment on the obligation; B. An
obligation rated B is more vulnerable to nonpayment than obligations rated BB,
but the obligor currently has the capacity to meet its financial commitment on
the obligation. Adverse business, financial, or economic conditions will likely
impair the obligor's capacity or willingness to meet its financial commitment on
the obligation; CCC. An obligation rated CCC is currently vulnerable to
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nonpayment and is dependent upon favorable business, financial and economic
conditions for the obligor to meet its financial commitment on the obligation.
In the event of adverse business, financial, or economic conditions, the obligor
is not likely to have the capacity to meet its financial commitment on the
obligation; CC. An obligation rated CC is currently highly vulnerable to
nonpayment; C. The C rating may be used to cover a situation where a bankruptcy
petition has been filed or similar action has been taken, but payments on this
obligation are being continued; D. An obligation rated D is in payment default.
The D rating category is used when payments on an obligation are not made on the
date due even if the applicable grace period has not expired, unless S&P
believes that such payments will be made during such grace period. The D rating
also will be used upon the filing of a bankruptcy petition or the taking of a
similar action if payments on an obligation are jeopardized.
CI. The rating CI is reserved for income bonds on which no interest is
being paid.
Plus (+) or Minus (-): The ratings from "AA" to "CCC" may be modified
by the addition of a plus or minus sign to show relative standing within the
major rating categories.
r. This symbol is attached to the ratings of instruments with
significant noncredit risks. It highlights risks to principal or volatility of
expected returns which are not addressed in the credit rating. Examples include:
obligations linked or indexed to equities, currencies, or commodities;
obligations exposed to severe prepayment risk--such as interest only or
principal only mortgage securities; and obligations with unusually risky
interest terms, such as inverse floaters.
DESCRIPTION OF MOODY'S COMMERCIAL PAPER RATINGS
Prime-1. Issuers assigned this highest rating have a superior ability
for repayment of senior short-term debt obligations. Prime-1 repayment ability
will often be evidenced by the following characteristics: Leading market
positions in well established industries; high rates of return on funds
employed; conservative capitalization structures with moderate reliance on debt
and ample asset protection; broad margins in earnings coverage of fixed
financial charges and high internal cash generation; well established access to
a range of financial markets and assured sources of alternate liquidity.
Prime-2. Issuers assigned this rating have a strong ability for
repayment of senior short-term debt obligations. This will normally be evidenced
by many of the characteristics cited above, but to a lesser degree. Earnings
trends and coverage ratios, while sound, will be more subject to variation.
Capitalization characteristics, while still appropriate, may be more affected by
external conditions. Ample alternate liquidity is maintained.
Prime-3. Issuers assigned this rating have an acceptable capacity for
repayment of senior short-term obligations. The effect of industry
characteristics and market composition may be more pronounced. Variability in
earnings and profitability may result in changes in the level of debt protection
measurements and may require relatively high financial leverage. Adequate
alternate liquidity is maintained.
Not Prime. Issuers assigned this rating do not fall within any of the
Prime rating categories.
DESCRIPTION OF S&P COMMERCIAL PAPER RATINGS
A-1. A short-term obligation rated A-1 is rated in the highest category
by S&P. The obligor's capacity to meet its financial commitment on the
obligation is strong. Within this category, certain obligations are designated
with a plus sign (+). This indicates that the obligor's capacity to meet its
financial commitment on these obligations is extremely strong. A-2. A short-term
obligation rated A-2 is somewhat more susceptible to the adverse effects of
changes in circumstances and economic conditions than obligations in higher
rating categories. However, the obligor's capacity to meet its financial
commitment on the obligation is satisfactory. A-3. A short-term obligation rated
A-3 exhibits adequate protection parameters. However, adverse economic
conditions or changing circumstances are more likely to lead to a weakened
capacity of the obligor to meet its financial commitment on the obligation. B. A
short-term obligation rated B is regarded as having significant speculative
characteristics. The obligor currently has the capacity to meet its financial
commitment on the obligation; however, it faces major ongoing uncertainties
which could lead to the obligor's inadequate capacity to meet its financial
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commitments on the obligation. C. A short-term obligation rated C is currently
vulnerable to nonpayment and is dependent upon favorable business, financial and
economic conditions for the obligor to meet its financial commitment on the
obligation. D. A short-term obligation rated D is in payment default. The D
rating category is used when payments on an obligation are not made on the date
due even if the applicable grace period has not expired, unless S&P believes
that such payments will be made during such grace period. The D rating also will
be used upon the filing of a bankruptcy petition or the taking of a similar
action if payments on an obligation are jeopardized.
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You should rely only on the information
contained or referred to in the
Prospectus and this Statement of
Additional Information. The funds and
their distributor have not authorized
anyone to provide you with information
that is different. The Prospectus and
this Statement of Additional Information
are not an offer to sell shares of the
funds in any jurisdiction where the
funds or their distributor may not
lawfully sell those shares.
------------
Mitchell Hutchins
Series Trust
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Statement of Additional Information
May 1, 2000, as revised July 24, 2000
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(C)2000 PaineWebber Incorporated. All rights reserved.
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