SUPPLEMENT DATED MAY 10, 2000
TO THE PRINCIPAL SPECIAL MARKETS FUND, INC.
PROSPECTUS DATED APRIL 3, 2000
Effective immediately, the following changes have been made:
page 5 - International Emerging Markets Portfolio - Corydon Gilchrist is no
longer co-manager of the Portfolio; and
page 8 - International SmallCap Portfolio - the last sentence of the first
paragraph is deleted and replaced with "Under normal market conditions, the
Portfolio invests at least 65% of its assets in securities of companies having
market capitalizations of $1.5 billion or less."
FV 76 S-1
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PRINICPAL SPECIAL MARKETS FUND, INC. PROPSECTUS
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<H1 ALIGN=CENTER><FONT SIZE=3>PRINCIPAL SPECIAL MARKETS FUND, INC.</FONT></H1>
<H1 ALIGN=CENTER><FONT SIZE=3>PORTFOLIOS OF THE FUND</FONT></H1>
<H1 ALIGN=CENTER><FONT SIZE=3>International Emerging Markets Portfolio<BR>
International Securities Portfolio<BR>
International SmallCap Portfolio<BR>
Mortgage-Backed Securities Portfolio</FONT></H1>
<P><FONT SIZE=3>This Prospectus describes a mutual fund organized by Principal
Life Insurance Company. The Fund provides a choice of investment objectives
through International Growth-Oriented Portfolios and an Income-Oriented
Portfolio. </FONT></P>
<H1 ALIGN=CENTER><FONT SIZE=3>The date of this Prospectus is April 3, 2000.</FONT></H1>
<P><FONT SIZE=3>Neither the Securities and Exchange Commission nor any State
Securities Commission has approved or disapproved of these securities or
determined if this prospectus is accurate or complete. Any representation to the
contrary is a criminal offense. </FONT></P>
<H1 ALIGN=CENTER><FONT SIZE=3>TABLE OF CONTENTS</FONT></H1>
Fund Description........................................................3
International Growth-Oriented Portfolios
International Emerging Markets Portfolio............................4
International Securities Portfolio..................................6
International SmallCap Portfolio....................................8
Income-Oriented Portfolio
Mortgage-Backed Securities Portfolio...............................10
The Costs of Investing.................................................12
Certain Investment Strategies and Related Risks........................12
Management, Organization and Capital Structure.........................15
Management Discussion of Fund Performance..............................16
Pricing of Fund Shares.................................................20
Dividend and Distributions.............................................20
To Buy Shares..........................................................21
Offering Price of Shares ..............................................22
To Sell Shares.........................................................22
General Information about a Fund Account...............................24
Financial Highlights...................................................26
<H2 ALIGN=LEFT><FONT SIZE=3>FUND DESCRIPTION</FONT></H2>
The Principal Special Markets Fund, Inc. (the "Fund") is a no-load, open-end
management investment company. It consists of four Portfolios: International
Emerging Markets Portfolio, International Securities Portfolio, International
SmallCap Portfolio and Mortgage-Backed Securities Portfolio.
<P><FONT SIZE=3>In the description for each Portfolio, you will find important
information about the Portfolio’s: </FONT></P>
<H2 ALIGN=LEFT><FONT SIZE=3>Primary investment strategy</FONT></H2>
<P><FONT SIZE=3>This section summarizes how the Portfolio intends to achieve its
investment objective. It identifies the Portfolio’s primary investment
strategy including the type or types of securities in which the Portfolio
invests. </FONT></P>
<H2 ALIGN=LEFT><FONT SIZE=3>Annual operating expenses</FONT></H2>
<P><FONT SIZE=3>The annual operating expenses for each Portfolio are deducted
from its assets (stated as a percentage of the Portfolio’s assets) and are
shown as of the end of the most recent fiscal year. The examples are intended to
help you compare the cost of investing in a particular Portfolio with the cost
of investing in other mutual funds. The examples assume you invest $10,000 in a
Portfolio for the time period indicated. The examples also assume that your
investment had a 5% return each year and that the Portfolio’s operating
expenses are the same as the most recent fiscal year expenses. Although your
actual costs may be higher or lower, based on these assumptions your costs would
be as shown. </FONT></P>
<H2 ALIGN=LEFT><FONT SIZE=3>Day-to-day Portfolio management</FONT></H2>
<P><FONT SIZE=3>The investment professionals who manage the assets of each Portfolio are listed
with each Portfolio. Backed by their staffs of experienced securities analysts,
they provide the Portfolios with professional investment management.</FONT></P>
<P><FONT SIZE=3>Principal Management Corporation serves as the manager for the
Fund. It has signed a contract with Invista Capital Management LLC
(“Invista”). Under the contract, Invista provides investment advisory
services for the Portfolios (see <I>Management, Organization and Capital
Structure</I>). </FONT></P>
<H2 ALIGN=LEFT><FONT SIZE=3>Portfolio Performance</FONT></H2>
<P><FONT SIZE=3>Included in each Portfolio's description is a set of tables and a bar chart. Together, these provide an
indication of the risks involved when you invest.</FONT></P>
<P><FONT SIZE=3>The bar chart is included to provide you with an indication of the risks involved when you invest. The chart
shows changes in the Portfolio's performance from year to year. One of the tables compares the Portfolio's
average annual returns with:</FONT></P>
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<TD WIDTH=5%><FONT SIZE=3>•</FONT></TD>
<TD WIDTH=95%><FONT SIZE=3>
a broad-based securities market index (An index measures the market price of a
specific group of securities in particular securities in a market sector. You
cannot invest directly in an index. An index does not have an investment advisor
and does not pay any commissions or expenses. If an index had expenses, its
performance would be lower.); and</FONT></TD>
</TR>
</TABLE>
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<TR VALIGN=TOP>
<TD WIDTH=5%><FONT SIZE=3>•</FONT></TD>
<TD WIDTH=95%><FONT SIZE=3>
an average of mutual funds with a similar investment objective and management
style. The averages used are prepared by Lipper, Inc., an independent
statistical service.</FONT></TD>
</TR>
</TABLE>
<BR>
The other table provides the highest and lowest quarterly rate of return for the Portfolio's shares over the life
of the Portfolio.
<P><FONT SIZE=3>A Portfolio’s past performance is not necessarily an
indication of how the Portfolio will perform in the future. </FONT></P>
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<TD WIDTH=5%>NOTE:</TD>
<TD WIDTH=90%><FONT SIZE=3>
Investments in these Portfolios are not deposits of a bank and are not insured
or guaranteed by the Federal Deposit Insurance Corporation or any other
government agency.</FONT></TD>
</TR>
</TABLE>
<BR>
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<TD WIDTH=10%> </TD>
<TD WIDTH=90%><FONT SIZE=3>
No
salesperson, dealer or other person is authorized to give information or to make
representations about a Portfolio or the Fund other than those contained in this
Prospectus. Information or representations from unauthorized parties may not be
relied upon as having been made by a Portfolio, the Fund, the Manager or the
Sub-Advisor.</FONT></TD>
</TR>
</TABLE>
<BR>
<H2 ALIGN=LEFT><FONT SIZE=3>INTERNATIONAL GROWTH-ORIENTED PORTFOLIO</FONT></H2>
<H2 ALIGN=LEFT><FONT SIZE=3>International Emerging Markets Portfolio</FONT></H2>
<H2 ALIGN=LEFT><FONT SIZE=3>Main Strategies</FONT></H2>
<P><FONT SIZE=3>The International Emerging Markets Portfolio seeks to achieve
long-term growth of capital by investing primarily in equity securities of
issuers in emerging market countries. </FONT></P>
<P><FONT SIZE=3>For this Portfolio, the term “emerging market country”
means any country which is considered to be an emerging country by the
international financial community (including the International Bank for
Reconstruction and Development (also known as the World Bank) and the
International Financial Corporation). These countries generally include every
nation in the world except the United States, Canada, Japan, Australia, New
Zealand and most nations located in Western Europe. Investing in many emerging
market countries is not feasible or may involve unacceptable political risk.
Invista, the Sub-Advisor, focuses on those emerging market countries that it
believes have strongly developing economies and markets which are becoming more
sophisticated. </FONT></P>
<P><FONT SIZE=3>Under normal conditions, at least 65% of the Portfolio's assets are invested in emerging market country
equity securities. The Portfolio invests in securities of:</FONT></P>
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<TD WIDTH=5%><FONT SIZE=3>•</FONT></TD>
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companies with their principal place of business or principal office in emerging market countries;
</FONT></TD>
</TR>
</TABLE>
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<TR VALIGN=TOP>
<TD WIDTH=5%><FONT SIZE=3>•</FONT></TD>
<TD WIDTH=95%><FONT SIZE=3>
companies for which the principal securities trading market is an emerging market country; or</FONT></TD>
</TR>
</TABLE>
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<TD WIDTH=5%><FONT SIZE=3>•</FONT></TD>
<TD WIDTH=95%><FONT SIZE=3>
companies, regardless of where its securities are traded, that derive 50% or more of their total revenue
from either goods or services produced in emerging market countries or sales made in emerging market
countries.</FONT></TD>
</TR>
</TABLE>
<BR>
<H2 ALIGN=LEFT><FONT SIZE=3>Main Risks</FONT></H2>
<P><FONT SIZE=3>Investments in emerging market countries involve special risks.
Certain emerging market countries have historically experienced, and may
continue to experience, certain economic problems. These may include: high rates
of inflation, high interest rates, exchange rate fluctuations, large amounts of
debt, balance of payments and trade difficulties, and extreme poverty and
unemployment. In addition, there are risks involved with any investment in
foreign securities. These include the risk that a foreign security could lose
value as a result of political, financial and economic events in foreign
countries. In addition, foreign securities may be subject to securities
regulators with less stringent accounting and disclosure standards than are
required of U.S. companies. </FONT></P>
<P><FONT SIZE=3>Because foreign securities generally are denominated in foreign
currencies, the value of the net assets of the Fund as measured in U.S. dollars
will be affected by changed in exchange rates. To protect against future
uncertainties in foreign currency exchange rates, the Fund is authorized to
enter into certain foreign currency exchange transactions. In addition, the
Fund’s foreign investments may be less liquid and their price more volatile
than comparable investments in U.S. securities. Settlement periods may be longer
for foreign securities that may affect portfolio liquidity. </FONT></P>
<P><FONT SIZE=3><U><U><U> </U></U></U><U><U></U></U>Under unusual market or
economic conditions, the Portfolio may invest in securities issued by domestic
corporations, governments or governmental agencies, instrumentalities or
political subdivisions. The securities may be denominated in U.S. dollars or
other currencies. </FONT></P>
<P><FONT SIZE=3>The Portfolio is generally a suitable investment for investors
seeking long-term growth who want to invest a portion of their assets in
securities of companies in emerging market countries. Because the values of the
Portfolio’s assets may rise or fall dramatically, if you sell your shares
when their value is less than the price you paid, you will lose money. This
Portfolio is not an appropriate investment if you are seeking either
preservation of capital or high current income. You must be able to assume the
increased risks of higher price volatility and currency fluctuations associated
with investments in international stocks which trade in non-U.S. currencies. </FONT></P>
<H2 ALIGN=LEFT><FONT SIZE=3>Portfolio Performance Information</FONT></H2>
The Portfolio's past performance is not necessarily an indication of future performance. The bar chart and tables
provide some indication of the risks of investing in the Portfolio by showing changes in share performance from
year to year.
<BR>
<H1 ALIGN=CENTER><FONT SIZE=3>Annual Total Returns</FONT></H1>
<P><FONT SIZE=3>1998 -17.21<BR>
1999 63.37</FONT></P>
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<TD WIDTH=100%><FONT SIZE=3>
The portfolio’s highest/lowest quarterly results during this time period were:</FONT></TD>
</TR>
</TABLE>
<P><FONT SIZE=3>Highest 38.53% (12/31/1999)<BR>
Lowest -19.25% (9/30/1998 )</FONT></P>
<H1 ALIGN=CENTER><FONT SIZE=3>Average annual total returns for the period ending December 31, 1999</FONT></H1>
<P><FONT SIZE=3>This table shows
how the Portfolio’s average annual returns compare with those of a
broad-based securities market index and an index of funds with similar investment objectives.</FONT></P>
Past One Past Five Past One Past Five Past Ten
Portfolio Year Years Year Years Years
International Emerging Morgan Stanley Capital International EMF
Markets 63.37% 16.26%* (Emerging Markets Free) Index 66.41% 2.00% 11.04%
Lipper Emerging Markets Fund Average 70.77 5.11 7.47
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<TD WIDTH=5%>*</TD>
<TD WIDTH=95%><FONT SIZE=3>
Period from November 26, 1997, date shares first offered to
the public, through December 31, 1999. </FONT></TD>
</TR>
</TABLE>
<H1 ALIGN=CENTER><FONT SIZE=3>Portfolio Operating Expenses</FONT></H1>
Management Fees......................... 1.15%
Other Expenses*......................... 0.00
Total Portfolio Operating Expenses 1.15%
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<TD WIDTH=5%>*</TD>
<TD WIDTH=95%><FONT SIZE=3>
In addition to brokerage and extraordinary expenses, a Portfolio will pay only
taxes and interest expenses, which it is anticipated to be minimal or
nonexistent under normal circumstances.</FONT></TD>
</TR>
</TABLE>
<H1 ALIGN=CENTER><FONT SIZE=3>Examples</FONT></H1>
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<TD WIDTH=0%> </TD>
<TD WIDTH=100%><FONT SIZE=3>
The Examples assume that you invest $10,000 in the Portfolio for the time
periods indicated and then redeem all of your shares at the end of those
periods. The Examples also assume that your investment has a 5% return each year
and that the Portfolio’s operating expenses remain the same. Although your
actual costs may be higher or lower, based on these assumptions your cost would
be:</FONT></TD>
</TR>
</TABLE>
<BR>
1 Year 3 Years 5 Years 10 Years
- ----------------------------------------------------------
$117 $365 $633 $1,398
<H1 ALIGN=CENTER><FONT SIZE=3>Day-to-day Portfolio Management</FONT></H1>
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<TR VALIGN=TOP>
<TD WIDTH=25%>Since March 2000</TD>
<TD WIDTH=75%><FONT SIZE=3>
Co-Manager: Corydon Gilchrist, CFA. Mr. Gilchrist joined Invista Capital
Management in 1994. He holds an MBA and a BBA from the University of Iowa. He is
a Chartered Financial Analyst.</FONT></TD>
</TR>
</TABLE>
<BR>
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<TR VALIGN=TOP>
<TD WIDTH=25%>Since November 1997 (Portfolio's inception)</TD>
<TD WIDTH=75%><FONT SIZE=3>
Co-Manager: Kurtis D. Spieler, CFA. Mr. Spieler joined Invista Capital
Management in 1995. He holds an MBA from Drake University and a BBA from Iowa
State University. He is a Chartered Financial Analyst.</FONT></TD>
</TR>
</TABLE>
<BR>
<H2 ALIGN=LEFT><FONT SIZE=3>INTERNATIONAL GROWTH-ORIENTED PORTFOLIO</FONT></H2>
<H2 ALIGN=LEFT><FONT SIZE=3>International Securities Portfolio</FONT></H2>
<H2 ALIGN=LEFT><FONT SIZE=3>Main Strategies</FONT></H2>
<P><FONT SIZE=3>The International Securities Portfolio seeks long-term growth of capital by investing in a portfolio of
securities of companies domiciled in any of the nations of the world.</FONT></P>
<P><FONT SIZE=3>The International Securities Portfolio invests in common stocks of companies established outside of the
U.S. The Portfolio has no limitation on the percentage of assets that are invested in any one country or
denominated in any one currency. However under normal market conditions, the Portfolio intends to have at least
65% of its assets invested in companies in at least three different countries. One of those countries may be the
U.S. though currently the Portfolio does not intend to invest in equity securities of U.S. companies.</FONT></P>
<P><FONT SIZE=3>Investments may be made anywhere in the world. Primary consideration is given to securities of
corporations of Western Europe, North America and Australasia (Australia, Japan and Far East Asia). Changes in
investments are made as prospects change for particular countries, industries or companies.</FONT></P>
<P><FONT SIZE=3>In choosing investments for the Portfolio, the Sub-Advisor, Invista pays particular attention to the
long-term earnings prospects of the various companies under consideration. Invista then weighs those prospects
relative to the price of the security.</FONT></P>
<H2 ALIGN=LEFT><FONT SIZE=3>Main Risks</FONT></H2>
<P><FONT SIZE=3>The values of the stocks owned by the Portfolio change on a
daily basis. Stock prices reflect the activities of individual companies as well
as general market and economic conditions. In the short term, stock prices and
currencies can fluctuate dramatically in response to these factors. In addition,
there are risks involved with any investment in foreign securities that are not
generally found in securities of U.S. companies. These include the risk that a
foreign security could lose value as a result of political, financial and
economic events in foreign countries. In addition, foreign securities may be
subject to securities regulators with less stringent accounting and disclosure
standards than are required of U.S. companies. </FONT></P>
<P><FONT SIZE=3>Because foreign securities generally are denominated in foreign
currencies, the value of the net assets of the Fund as measured in U.S. dollars
will be affected by changed in exchange rates. To protect against future
uncertainties in foreign currency exchange rates, the Fund is authorized to
enter into certain foreign currency exchange transactions. In addition, the
Fund’s foreign investments may be less liquid and their price more volatile
than comparable investments in U.S. securities. Settlement periods may be longer
for foreign securities that may affect portfolio liquidity. </FONT></P>
<P><FONT SIZE=3>Under unusual market or economic conditions, the Portfolio may invest in securities issued by domestic
corporations, governments or governmental agencies, instrumentalities or political subdivisions. The securities
may be denominated in U.S. dollars or other currencies.</FONT></P>
<P><FONT SIZE=3>The Portfolio is generally a suitable investment for investors who seek long-term growth and who want to
invest in non-U.S. companies. This Portfolio is not an appropriate investment if you are seeking either
preservation of capital or high current income. Suitable investors must be able to assume the increased risks of
higher price volatility and currency fluctuations associated with investments in international stocks which trade
in non-U.S. currencies. As with all mutual funds, the value of the Fund's assets may rise or fall. If you sell
your shares when their value is less than the price you paid, you will lose money.</FONT></P>
<H2 ALIGN=LEFT><FONT SIZE=3>Portfolio Performance Information</FONT></H2>
<P><FONT SIZE=3>The Portfolio's past performance is not necessarily an indication of future performance. The bar chart and tables
provide some indication of the risks of investing in the Portfolio by showing changes in share performance from
year to year.</FONT></P>
<H1 ALIGN=CENTER><FONT SIZE=3>Annual Total Returns</FONT></H1>
<P><FONT SIZE=3>1994 -6.45<BR>
1995 12.02<BR>
1996 24.12<BR>
1997 12.55<BR>
1998 9.55<BR>
1999 27.89</FONT></P>
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<TR VALIGN=TOP>
<TD WIDTH=20%> </TD>
<TD WIDTH=100%><FONT SIZE=3>
The
portfolio’s highest/lowest quarterly results during this time period were:</FONT></TD>
</TR>
</TABLE>
<BR>
<P><FONT SIZE=3>Highest 18.06% (12/31/1999)<BR>
Lowest -17.48% (9/30/1998)</FONT></P>
<H1 ALIGN=CENTER><FONT SIZE=3>Average annual total returns for the period ending December 31, 1999</FONT></H1>
<P><FONT SIZE=3> This table shows
how the Portfolio’s average annual returns compare with those of a
broad-based securities market index and an index of funds with similar investment objectives.</FONT></P>
Past One Past FivePast Ten Past OnePast FivePast Ten
Portfolio Year Years Years Year Years Years
International Securities 27.89% 17.00% 15.88%* Morgan Stanley Capital International EAFE
(Europe, Australia and Far East) Index 26.96% 12.83% 7.01%
Lipper International Fund Average 40.80 15.37 10.54
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<TD WIDTH=5%>*</TD>
<TD WIDTH=95%><FONT SIZE=3>
Period from
May 7, 1993, date shares first offered to the public, through December 31, 1999. </FONT></TD>
</TR>
</TABLE>
<H1 ALIGN=CENTER><FONT SIZE=3>Portfolio Operating Expenses</FONT></H1>
Management Fees......................... 0.90%
Other Expenses*......................... 0.00
Total Portfolio Operating Expenses 0.90%
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<TD WIDTH=5%>*</TD>
<TD WIDTH=95%><FONT SIZE=3>
In addition to brokerage and extraordinary expenses, a Portfolio will pay only
taxes and interest expenses, which it is anticipated to be minimal or
nonexistent under normal circumstances.</FONT></TD>
</TR>
</TABLE>
<H1 ALIGN=CENTER><FONT SIZE=3>Examples</FONT></H1>
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<TR VALIGN=TOP>
<TD WIDTH=0%> </TD>
<TD WIDTH=100%><FONT SIZE=3>
The Examples assume that you invest $10,000 in the Portfolio for the time
periods indicated and then redeem all of your shares at the end of those
periods. The Examples also assume that your investment has a 5% return each year
and that the Portfolio’s operating expenses remain the same. Although your
actual costs may be higher or lower, based on these assumptions your cost would
be:</FONT></TD>
</TR>
</TABLE>
<BR>
1 Year 3 Years 5 Years 10 Years
- --------------------------------------------------------
$92 $287 $498 $1,108
<H1 ALIGN=CENTER><FONT SIZE=3>Day-to-day Portfolio Management</FONT></H1>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=25%>Since June 1993</TD>
<TD WIDTH=75%><FONT SIZE=3>
Co-Manager: Scott D. Opsal, CFA. Mr. Opsal is Chief Investment Officer of
Invista Capital Management and has been with the organization since 1993. He
holds an MBA from the University of Minnesota and BS from Drake University. He
is a Chartered Financial Analyst.</FONT></TD>
</TR>
</TABLE>
<BR>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=25%>Since March 2000</TD>
<TD WIDTH=75%><FONT SIZE=3>
Co-Manager: Kurtis D. Spieler, CFA. Mr. Spieler joined Invista Capital
Management in 1995. He holds an MBA from Drake University and a BBA from Iowa
State University. He is a Chartered Financial Analyst.</FONT></TD>
</TR>
</TABLE>
<BR>
<H2 ALIGN=LEFT><FONT SIZE=3>INTERNATIONAL GROWTH-ORIENTED PORTFOLIO</FONT></H2>
<H2 ALIGN=LEFT><FONT SIZE=3>International SmallCap Portfolio</FONT></H2>
<H2 ALIGN=LEFT><FONT SIZE=3>Main Strategies</FONT></H2>
<P><FONT SIZE=3>The International SmallCap Portfolio seeks to achieve long-term
growth of capital by investing primarily in equity securities of non-United
States companies with comparatively smaller market capitalizations. Market
capitalization is defined as total current market value of a company’s
outstanding common stock. Under normal market conditions, the Portfolio invests
at least 65% of its assets in securities of companies having market
capitalizations of $1 billion or less. </FONT></P>
<P><FONT SIZE=3>In selecting securities for the Portfolio, Invista, the
Sub-Advisor, diversifies the investments geographically. There is no limitation
of the percentage of assets that may be invested in one country or denominated
in any one currency. However, under normal market circumstances, the Portfolio
intends to have at least 65% of its assets invested in securities of companies
of at least three countries. </FONT></P>
<H2 ALIGN=LEFT><FONT SIZE=3>Main Risks</FONT></H2>
<P><FONT SIZE=3>Foreign stocks carry risks that are not generally found in
stocks of U.S. companies. These include the risk that a foreign security could
lose value as a result of political, financial and economic events in foreign
countries. In addition, foreign securities may be subject to securities
regulators with less stringent accounting and disclosure standards than are
required of U.S. companies. </FONT></P>
<P><FONT SIZE=3>Investments in companies with small market capitalizations carry
their own risks. Historically, small company securities have been more volatile
in price than larger company securities, especially over the short-term. While
small, unseasoned companies may offer greater opportunities for capital growth
than larger, more established companies, they also involve greater risks and
should be considered speculative. </FONT></P>
<P><FONT SIZE=3>Because foreign securities generally are denominated in foreign
currencies, the value of the net assets of the Fund as measured in U.S. dollars
will be affected by changed in exchange rates. To protect against future
uncertainties in foreign currency exchange rates, the Fund is authorized to
enter into certain foreign currency exchange transactions. In addition, the
Fund’s foreign investments may be less liquid and their price more volatile
than comparable investments in U.S. securities. Settlement periods may be longer
for foreign securities that may affect portfolio liquidity. </FONT></P>
<P><FONT SIZE=3>This Portfolio is not an appropriate investment if you are seeking either preservation of capital or
high current income. You must be able to assume the increased risks of higher price volatility and currency
fluctuations associated with investments in international stocks which trade in non-U.S. currencies.</FONT></P>
<P><FONT SIZE=3>The Portfolio is generally a suitable investment for investors seeking long-term growth who want to
invest a portion of their assets in smaller, non-U.S. companies. Because the values of the Portfolio's assets may
rise or fall, when shares of the Portfolio are sold they may be worth more or less than the amount paid for them.</FONT></P>
<H2 ALIGN=LEFT><FONT SIZE=3>Portfolio Performance Information</FONT></H2>
<P><FONT SIZE=3>The Portfolio's past performance is not necessarily an indication of future performance. The bar chart and tables
provide some indication of the risks of investing in the Portfolio by showing changes in share performance from
year to year.</FONT></P>
<H1 ALIGN=CENTER><FONT SIZE=3>Annual Total Returns</FONT></H1>
<P><FONT SIZE=3>1998 11.92<BR>
1999 85.93</FONT></P>
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<TR VALIGN=TOP>
<TD WIDTH=0%> </TD>
<TD WIDTH=100%><FONT SIZE=3>
The
portfolio’s highest/lowest quarterly results during this time period were:</FONT></TD>
</TR>
</TABLE>
<BR>
<P><FONT SIZE=3>Highest 36.97% (12/31/1999<BR>
Lowest -20.68% (9/30/1998)</FONT></P>
<H1 ALIGN=CENTER><FONT SIZE=3>Average annual total returns for the period ending December 31, 1999</FONT></H1>
<P><FONT SIZE=3>This table shows
how the Portfolio’s average annual returns compare with those of a
broad-based securities market index and an index of funds with similar investment objectives.</FONT></P>
Past One Past Five Past OnePast FivePast Ten
Portfolio Year Years Year Years Years
International SmallCap 85.93% 42.93%* Morgan Stanley Capital International EAFE
(Europe, Australia and Far East) Index 26.96% 12.83% 7.01%
Lipper International Small-Cap Fund Average 75.41 19.91 13.04
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%>*</TD>
<TD WIDTH=95%><FONT SIZE=3>
Period from
November 26, 1997, date first offered to the public, through December 31, 1999. </FONT></TD>
</TR>
</TABLE>
<H1 ALIGN=CENTER><FONT SIZE=3>Portfolio Operating Expenses</FONT></H1>
Management Fees......................... 1.00%
Other Expenses*......................... 0.00
Total Portfolio Operating Expenses 1.00%
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%>*</TD>
<TD WIDTH=95%><FONT SIZE=3>
In addition to brokerage and extraordinary expenses, a Portfolio will pay only
taxes and interest expenses, which it is anticipated to be minimal or
nonexistent under normal circumstances.</FONT></TD>
</TR>
</TABLE>
<H1 ALIGN=CENTER><FONT SIZE=3>Examples</FONT></H1>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=0%> </TD>
<TD WIDTH=100%><FONT SIZE=3>
The Examples assume that you invest $10,000 in the Portfolio for the time
periods indicated and then redeem all of your shares at the end of those
periods. The Examples also assume that your investment has a 5% return each year
and that the Portfolio’s operating expenses remain the same. Although your
actual costs may be higher or lower, based on these assumptions your cost would
be:</FONT></TD>
</TR>
</TABLE>
<BR>
1 Year 3 Years 5 Years 10 Years
- ----------------------------------------------------------
$102 $318 $552 $1,225
<H1 ALIGN=CENTER><FONT SIZE=3>Day-to-day Portfolio Management</FONT></H1>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=25%>Since March 2000</TD>
<TD WIDTH=75%><FONT SIZE=3>
Co-Manager: Dan J. Sherman, CFA. Mr. Sherman joined Invista Capital Management
in 1998. Prior to joining the firm, he led a regional research team for Salomon
Smith Barney. He holds an MBA from the University of Wisconsin. He is a
Chartered Financial Analyst.</FONT></TD>
</TR>
</TABLE>
<BR>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=25%>Since November 1997 (Portfolio's inception) </TD>
<TD WIDTH=75%><FONT SIZE=3>
Co-Manager: Darren K. Sleister, CFA. Mr. Sleister joined Invista Capital
Management as a Portfolio Strategist in 1993. He holds an MBA from the
University of Iowa, and an undergraduate degree from Central College. He is a
Chartered Financial Analyst.</FONT></TD>
</TR>
</TABLE>
<BR>
<H2 ALIGN=LEFT><FONT SIZE=3>INCOME-ORIENTED PORTFOLIO</FONT></H2>
<H2 ALIGN=LEFT><FONT SIZE=3>Mortgage-Backed Securities Portfolio</FONT></H2>
<H2 ALIGN=LEFT><FONT SIZE=3>Main Strategies</FONT></H2>
<P><FONT SIZE=3>The Mortgage-Backed Securities Portfolio seeks a high level of
current income, liquidity and safety of principal by purchasing obligations
issued or guaranteed by the United States Government or its agencies, with
emphasis on Government National Mortgage Associations Certificates. The
guarantees by the United States Government extends only to principal and
interest. There are certain risks unique to GNMA Certificates. </FONT></P>
<P><FONT SIZE=3>The Mortgage-Backed Securities Portfolio invests in U.S. Government securities, which include obligations issued
or guaranteed by the U.S. Government or its agencies or instrumentalities. The Portfolio may invest in securities
supported by:</FONT></P>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%><FONT SIZE=3>•</FONT></TD>
<TD WIDTH=95%><FONT SIZE=3>
full faith and credit of the U.S. Government (e.g. GNMA certificates); or</FONT></TD>
</TR>
</TABLE>
<BR>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%><FONT SIZE=3>•</FONT></TD>
<TD WIDTH=95%><FONT SIZE=3>
credit of the instrumentality (e.g. bonds issued by the Federal Home Loan Mortgage Corp.).
In addition, the Portfolio may invest in money market investments.</FONT></TD>
</TR>
</TABLE>
<P><FONT SIZE=3>In addition, the Portfolio may invest in money market investments.</FONT></P>
<P><FONT SIZE=3>Although some of the securities the Portfolio purchases are backed by the U.S. government and its
agencies, shares of the Portfolio are not guaranteed. Generally, when interest rates fall, the value of the
Portfolio's shares rises, and when rates rise, the value declines. Because of the fluctuation in values of the
Portfolio's shares, when sold, shares of the Portfolio may be worth more or less than the amount paid for them.</FONT></P>
<P><FONT SIZE=3>U.S. Government securities do not involve the degree of credit risk associated with investments in lower
quality fixed-income securities. As a result, the yields available from U.S. Government securities are generally
lower than the yields available from many other fixed-income securities. Like other fixed-income securities, the
values of U.S. Government securities change as interest rates fluctuate. Fluctuations in the value of the
Portfolio's securities do not effect interest income on securities already held by the Portfolio, but are
reflected in the Fund's price per share. Since the magnitude of these fluctuation generally are greater at times
when the Portfolio's average maturity is longer, under certain market conditions the Portfolio may invest in
short term investments yielding lower current income rather than investing in higher yielding longer term
securities.</FONT></P>
<P><FONT SIZE=3>GNMA Certificates are mortgage backed securities representing an interest in a pool of mortgage loans.
Various lenders make the loans which are then insured (by the Federal Housing Administration) or loans which are
guaranteed (by Veterans Administration or Farmers Home Administration). The lender or other security issuer
creates a pool of mortgages which it submits to GNMA for approval.</FONT></P>
<P><FONT SIZE=3>The Portfolio invests in modified pass-through GNMA Certificates. Owners of Certificates receive all
interest and principal payments owed on the mortgages in the pool, regardless of whether or not the mortgagor has
made the payment. Timely payment of interest and principal is guaranteed by the full faith and credit of the U.S.
Government.</FONT></P>
<H2 ALIGN=LEFT><FONT SIZE=3>Main Risks</FONT></H2>
<P><FONT SIZE=3>Mortgage backed securities are subject to prepayment risk. Prepayments, unscheduled principal payments,
may result from voluntary prepayment, refinancing or foreclosure of the underlying mortgage. When interest rates
decline, significant unscheduled prepayments may result. These prepayments must then be reinvested at lower
rates. Prepayments may also shorten the effective maturities of these securities, especially during periods of
declining interest rates. On the other hand, during period of rising interest rates, a reduction in prepayments
may increase the effective maturities of these securities, subjecting them to the risk of decline in market value
in response to rising interest and potentially increasing the volatility of the fund.</FONT></P>
<P><FONT SIZE=3>In addition, prepayments may cause losses on securities purchased at a premium (dollar amount by which
the price of the bond exceeds its face value). At times, mortgage backed securities may have higher than market
interest rates and are purchased at a premium. Unscheduled prepayments are made at par and cause the Portfolio to
experience a loss of some or all of the premium.</FONT></P>
<P><FONT SIZE=3>The Mortgaged-Backed Securities Portfolio is generally a
suitable investment for investors who want monthly dividends to provide income
or to be reinvested in additional Portfolio shares to produce growth. Such
investors prefer to have the repayment of principal and interest on most of the
securities in which the Portfolio invests to be backed by the U.S. Government,
its agencies or instrumentalities. </FONT></P>
<H2 ALIGN=LEFT><FONT SIZE=3>Portfolio Performance Information</FONT></H2>
<P><FONT SIZE=3>The Portfolio's past performance is not necessarily an indication of future performance. The bar chart and tables
provide some indication of the risks of investing in the Portfolio by showing changes in share performance from
year to year.</FONT></P>
<H1 ALIGN=CENTER><FONT SIZE=3>Annual Total Returns</FONT></H1>
<P><FONT SIZE=3>1994 -3.60<BR>
1995 19.26<BR>
1996 4.20<BR>
1997 10.18<BR>
1998 7.74<BR>
1999 0.30</FONT></P>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=20%> </TD>
<TD WIDTH=80%><FONT SIZE=3>
The
portfolio’s highest/lowest quarterly results during this time period were:</FONT></TD>
</TR>
</TABLE>
<BR>
<P><FONT SIZE=3>Highest 6.41% (6/30/1995)<BR>
Lowest -3.50% (3/30/1994)</FONT></P>
<H1 ALIGN=CENTER><FONT SIZE=3>Average annual total returns for the period ending December 31, 1999</FONT></H1>
<P><FONT SIZE=3>This table shows
how the Portfolio’s average annual returns compare with those of a
broad-based securities market index and an index of funds with similar investment objectives.</FONT></P>
Past One Past FivePast Ten Past OnePast FivePast Ten
Portfolio Year Years Years Year Years Years
Mortgage-Backed Lehman Brothers Mortgage Index 1.86% 7.98% 7.78%
Securities 0.30% 8.15% 6.17%* Lipper U.S. Mortgage Fund Average 0.65 7.00 6.95
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%>*</TD>
<TD WIDTH=95%><FONT SIZE=3>Period from
May 7, 1993, date shares first offered to the public, through December 31, 1999. </FONT></TD>
</TR>
</TABLE>
<H1 ALIGN=CENTER><FONT SIZE=3>Portfolio Operating Expenses</FONT></H1>
Management Fees......................... 0.45%
Other Expenses*......................... 0.00
Total Portfolio Operating Expenses 0.45%
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%>*</TD>
<TD WIDTH=95%><FONT SIZE=3>
In addition to brokerage and extraordinary expenses, a Portfolio will pay only
taxes and interest expenses, which it is anticipated to be minimal or
nonexistent under normal circumstances.</FONT></TD>
</TR>
</TABLE>
<H1 ALIGN=CENTER><FONT SIZE=3>Examples</FONT></H1>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=0%> </TD>
<TD WIDTH=100%><FONT SIZE=3>
The Examples assume that you invest $10,000 in the Portfolio for the time
periods indicated and then redeem all of your shares at the end of those
periods. The Examples also assume that your investment has a 5% return each year
and that the Portfolio’s operating expenses remain the same. Although your
actual costs may be higher or lower, based on these assumptions your cost would
be:</FONT></TD>
</TR>
</TABLE>
<BR>
1 Year 3 Years 5 Years 10 Years
- ---------------------------------------------------------
$46 $144 $252 $567
<H1 ALIGN=CENTER><FONT SIZE=3>Day-to-day Portfolio Management</FONT></H1>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=25%>Since May 1993 (Portfolio's inception) </TD>
<TD WIDTH=75%><FONT SIZE=3>
Martin J. Schafer. Mr. Schafer joined the Principal in 1977 and has broad
experience in residential mortgage related securities. He served as Director of
Investment Securities at the Principal prior to joining Invista Capital
Management in 1992. He holds a BBA in Accounting and Finance from the University
of Iowa.</FONT></TD>
</TR>
</TABLE>
<BR>
<H2 ALIGN=LEFT><FONT SIZE=3>THE COSTS OF INVESTING</FONT></H2>
<H2 ALIGN=LEFT><FONT SIZE=3>Sales charge</FONT></H2>
<P><FONT SIZE=3>There is no sales charge on purchases or sales of shares of the Portfolios.</FONT></P>
<H2 ALIGN=LEFT><FONT SIZE=3>Ongoing fees</FONT></H2>
<P><FONT SIZE=3>The Fund pays ongoing fees to its Manager, Underwriter and others who provide services to the Fund. They reduce
the value of each share you own.</FONT></P>
<H2 ALIGN=LEFT><FONT SIZE=3>CERTAIN INVESTMENT STRATEGIES AND RELATED RISKS</FONT></H2>
<P><FONT SIZE=3>The Statement of Additional Information (SAI) contains additional information about investment strategies and
their related risks.</FONT></P>
<H2 ALIGN=LEFT><FONT SIZE=3>Securities and Investment Practices</FONT></H2>
<P><FONT SIZE=3>Equity securities include common stocks, preferred stocks,
convertible securities and warrants. Common stocks, the most familiar type,
represent an equity (ownership) interest in a corporation. Although equity
securities have a history of long term growth in value, their prices fluctuate
based on changes in a company’s financial condition and on overall market
and economic conditions. Smaller companies are especially sensitive to these
factors. </FONT></P>
<P><FONT SIZE=3>Fixed-income securities include bonds and other debt instruments
that are used by issuers to borrow money from investors. The issuer generally
pays the investor a fixed, variable or floating rate of interest. The amount
borrowed must be repaid at maturity. Some debt securities, such as zero coupon
bonds, do not pay current interest, but are sold at a discount from their face
values. </FONT></P>
<P><FONT SIZE=3>Fixed-income securities are sensitive to changes in interest
rates. In general, bond prices rise when interest rates fall and fall when
interest rates rise. Longer term bonds and zero coupon bonds are generally more
sensitive to interest rate changes. </FONT></P>
<P><FONT SIZE=3>Bond prices are also affected by the credit quality of the
issuer. Investment grade debt securities are medium and high quality securities.
Some bonds may have speculative characteristics and be particularly sensitive to
economic conditions and the financial condition of the issuers. </FONT></P>
<H2 ALIGN=LEFT><FONT SIZE=3>Repurchase Agreements and Loaned Securities</FONT></H2>
<P><FONT SIZE=3>Each of the Fund’s Portfolios may invest a portion of its
assets in repurchase agreements. Repurchase agreements typically involve the
purchase of debt securities from a financial institution such as a bank, savings
and loan association or broker-dealer. A repurchase agreement provides that the
Portfolio sells back to the seller and that the seller repurchases the
underlying securities at a specified price on a specific date. Repurchase
agreements may be viewed as loans by a Portfolio collateralized by the
underlying securities. This arrangement results in a fixed rate of return that
is not subject to market fluctuation while the Portfolio holds the security. In
the event of a default or bankruptcy by a selling financial institution, the
affected Portfolio bears a risk of loss. To minimize such risks, the Portfolio
enters into repurchase agreements only with large, well-capitalized and
well-established financial institutions. In addition, the value of the
collateral underlying the repurchase agreement is always at least equal to the
repurchase price, including accrued interest. </FONT></P>
<P><FONT SIZE=3>Each of the Fund's Portfolios may lend its portfolio securities to unaffiliated broker-dealers and other
unaffiliated qualified financial institutions.</FONT></P>
<H2 ALIGN=LEFT><FONT SIZE=3>Currency Contracts</FONT></H2>
<P><FONT SIZE=3>The International Emerging Markets, International Securities and
International SmallCap Portfolios may each enter into forward currency
contracts, currency futures contracts and options, and options on currencies for
hedging and other non-speculative purposes. A forward currency contract involves
a privately negotiated obligation to purchase or sell a specific currency at a
future date at a price set in the contract. A Portfolio will not hedge currency
exposure to an extent greater than the aggregate market value of the securities
held or to be purchased by the Portfolio (denominated or generally quoted or
currently convertible into the currency). </FONT></P>
<P><FONT SIZE=3>Hedging is a technique used in an attempt to reduce risk. If a
Portfolio’s Manager or Sub-Advisor hedges market conditions incorrectly or
employs a strategy that does not correlate well with the Portfolio’s
investment, these techniques could result in a loss, regardless of whether the
intent was to reduce risk or to increase return. These techniques may increase
the volatility of a Portfolio and may involve a small investment of cash
relative to the magnitude of the risk assumed. In addition, these techniques
could result in a loss if the other party to the transaction does not perform as
promised. Additionally, there is the risk of government action through exchange
controls that would restrict the ability of the Portfolio to deliver or receive
currency. </FONT></P>
<H2 ALIGN=LEFT><FONT SIZE=3>Warrants</FONT></H2>
<P><FONT SIZE=3>Each of the Portfolios may invest up to 5% of its assets in
warrants. Up to 2% of a Portfolio’s assets may be invested in warrants
which are not listed on either the New York or American Stock Exchanges. For the
International, International Emerging Markets and International SmallCap Funds,
the 2% limitation also applies to warrants not listed on the Toronto Stock and
Chicago Board Options Exchanges. </FONT></P>
<H2 ALIGN=LEFT><FONT SIZE=3>Options</FONT></H2>
<P><FONT SIZE=3>Each of the Portfolios may buy and sell certain types of
options. Each type is more fully discussed in the SAI. </FONT></P>
<H2 ALIGN=LEFT><FONT SIZE=3>Foreign Securities</FONT></H2>
<P><FONT SIZE=3>The International Emerging Markets, International Securities and
International SmallCap Portfolios each may invest in foreign securities.
Investment in foreign securities presents certain risks including: fluctuations
in currency exchange rates, revaluation of currencies, the imposition of foreign
taxes, future political and economic developments including war, expropriations,
nationalization, the possible imposition of currency exchange controls and other
foreign governmental laws or restrictions. In addition, there may be reduced
availability of public information concerning issuers compared to domestic
issuers. Foreign issuers are not generally subject to uniform accounting,
auditing and financial reporting standards or to other regulatory practices and
requirements that apply to domestic issuers. Transactions in foreign securities
may be subject to higher costs. Each Portfolio’s investment in foreign
securities may also result in higher custodial costs and the costs associated
with currency conversions. </FONT></P>
<P><FONT SIZE=3>Securities of many foreign issuers may be less liquid and their
prices more volatile than those of comparable domestic issuers. Foreign
securities markets, particularly those in emerging market countries, are known
to experience long delays between the trade and settlement dates of securities
purchased and sold. Such delays may result in a lack of liquidity and greater
volatility in the price of securities on those markets. As a result of these
factors, the Board of Directors of the Fund has adopted Daily Pricing and
Valuation Procedures for the Portfolios. These procedures outline the steps to
be followed by the Manager and Sub-Advisor to establish a reliable market or
fair value if a reliable market value is not available through normal market
quotations. The Executive Committee of the Board of Directors oversees this
process. </FONT></P>
<H2 ALIGN=LEFT><FONT SIZE=3>Securities of Smaller Companies</FONT></H2>
<P><FONT SIZE=3>The Portfolios may invest in securities of companies with small-
or mid-sized market capitalizations. Market capitalization is defined as total
current market value of a company’s outstanding common stock. Investments
in companies with smaller market capitalizations may involve greater risks and
price volatility (wide, rapid fluctuations) than investments in larger, more
mature companies. Smaller companies may be less mature than older companies. At
this earlier stage of development, the companies may have limited product lines,
reduced market liquidity for their shares, limited financial resources or less
depth in management than larger or more established companies. Small companies
also may be less significant within their industries and may be at a competitive
disadvantage relative to their larger competitors. While smaller companies may
be subject to these additional risks, they may also realize more substantial
growth than larger or more established companies. </FONT></P>
<H2 ALIGN=LEFT><FONT SIZE=3>Unseasoned Issuers</FONT></H2>
<P><FONT SIZE=3>The Portfolios may invest in the securities of unseasoned
issuers. Unseasoned issuers are companies with a record of less than three years
continuous operation, including the operation of predecessors and parents.
Unseasoned issuers by their nature have only a limited operating history which
can be used for evaluating the companies growth prospects. As a result,
investment decisions for these securities may place a greater emphasis on
current or planned product lines and the reputation and experience of the
companies management and less emphasis on fundamental valuation factors than
would be the case for more mature growth companies. In addition, many unseasoned
issuers also may be small companies and involve the risks and price volatility
associated with smaller companies. </FONT></P>
<H2 ALIGN=LEFT><FONT SIZE=3>Temporary or Defensive Measures</FONT></H2>
<P><FONT SIZE=3>For temporary or defensive purposes in times of unusual or
adverse market conditions, the Portfolios may invest without limit in cash and
cash equivalents. For this purpose, cash equivalents include: bank certificates
of deposit, bank acceptances, repurchase agreements, commercial paper, and
commercial paper master notes which are floating rate debt instruments without a
fixed maturity. In addition, a Portfolio may purchase U.S. Government
securities, preferred stocks and debt securities, whether or not convertible
into or carrying rights for common stock. </FONT></P>
<H2 ALIGN=LEFT><FONT SIZE=3>Portfolio Turnover</FONT></H2>
<P><FONT SIZE=3>“Portfolio Turnover” is the term used in the industry
for measuring the amount of trading that occurs in a fund’s portfolio
during the year. For example, a 100% turnover rate means that on average every
security in the portfolio has been replaced once during the year. </FONT></P>
<P><FONT SIZE=3>Funds with high turnover rates (more than 100%) often have
higher transaction costs (which are paid by the fund) and may generate
short-term capital gains (on which you pay taxes even if you don’t sell any
of your shares during the year). You can find the turnover rate for each
Portfolio in the Portfolio’s Financial Highlights table. </FONT></P>
<P><FONT SIZE=3>Please consider all the factors when you compare the turnover
rates of different funds. A fund with consistently higher total returns and
higher turnover rates than another fund may actually be achieving better
performance precisely because the managers are active traders. You should also
be aware that the “total return” line in the Financial Highlights
already includes portfolio turnover costs. </FONT></P>
<H2 ALIGN=LEFT><FONT SIZE=3>MANAGEMENT, ORGANIZATION AND CAPITAL STRUCTURE</FONT></H2>
<H2 ALIGN=LEFT><FONT SIZE=3>The Manager</FONT></H2>
<P><FONT SIZE=3>Principal Management Corporation (the “Manager”)
serves as the manager for the Fund. In its handling of the business affairs of
each Portfolio, the Manager provides clerical, recordkeeping and bookkeeping
services, and keeps the financial and accounting records required for the Fund.
The Manager has signed sub-advisory agreements with Invista for portfolio
management functions for the Portfolios. The Manager compensates Invista for its
sub-advisory services as provided in the Sub-Advisory Agreement between Invista
and the Manager. </FONT></P>
<P><FONT SIZE=3>The Manager is an indirect subsidiary of Principal Financial Services, Inc. and has managed mutual funds since
1969. As of December 31, 1999, the Funds it managed had assets of approximately $6.4 billion. The Manager's
address is Principal Financial Group, Des Moines, Iowa 50392-0200.</FONT></P>
<P><FONT SIZE=3>Invista is an indirect wholly-owned subsidiary of Principal Life
Insurance Company and is an affiliate of the Manager. Invista has managed
investments for institutional investors, including Principal Life, since 1985.
As of December 31, 1999, it managed assets of approximately $35.3 billion.
Invista’s address is 1800 Hub Tower, 699 Walnut, Des Moines, Iowa 50309. </FONT></P>
<P><FONT SIZE=3>The Manager or Invista provides the Board of Directors of the
Fund a recommended investment program for each of the Portfolios. Each program
must be consistent with the Portfolio’s investment objective and policies.
Within the scope of the approved investment program, the Manager or Invista
advises each Portfolio on its investment policies and determines which
securities are bought and sold, and in what amounts. </FONT></P>
<P><FONT SIZE=3>The Manager is paid a fee by each Portfolio for its services,
which includes any fee paid to Invista. The fee paid by each Portfolio (as a
percentage of the average daily net assets) is determined using the following
rate: </FONT></P>
Fees Computed On Fees as a Percent of
Portfolio Net Asset Value of Portfolio Average Daily Net Assets
------------------------------------------------------------------------------------------
International Emerging Markets Portfolio First $250 million 1.15%
Next $250 million 1.05%
Over $500 million 0.95%
International Securities Portfolio Entire Portfolio 0.90%
International SmallCap Portfolio First $250 million 1.00%
Next $250 million 0.90%
Over $500 million 0.80%
Mortgage-Backed Securities Portfolio Entire Portfolio 0.45%
For the fiscal year ended December 31, 1999 the Management fee
for each Portfolio was:
International Emerging Markets Portfolio 1.15% International SmallCap Portfolio 1.00%
International Securities Portfolio 0.90% Mortgage-Backed Securities Portfolio 0.45%
<H2 ALIGN=LEFT><FONT SIZE=3>MANAGEMENT DISCUSSION OF FUND PERFORMANCE</FONT></H2>
<H2 ALIGN=LEFT><FONT SIZE=3>International Emerging Markets Portfolio</FONT></H2>
<P><FONT SIZE=3>Emerging markets had a strong run in 1999. EMEA (Eastern Europe,
Middle East, Africa) posted the largest gain as technology stocks soared and the
region finished up 79.6% for the year. Asia registered a gain of 79.6%, and
Latin America “lagged” the rest of the emerging world at 58.9%. The
International Emerging Markets Portfolio’s total return of 65.14% barely
under-performed the MSCI EMF Index at 66.41%, with similar regional returns. For
the year the Portfolio’s market selection was slightly negative, but a
majority of the lost ground was made up by selecting better stocks. The
following paragraphs highlight the most significant events from each emerging
markets region. </FONT></P>
<P><FONT SIZE=3>Despite their big run early in 1999, Asian countries continued
to show evidence of solid economic recovery throughout the year. The
Portfolio’s managers were cautious on entering the Asian region immediately
after the markets tumbled in late 1998 and by choosing to wait for evidence of
structural change before reinvesting ground was lost early in the year. Since
the initial rebound had been sparked by companies that were more speculative in
nature, Portfolio managers were able to capitalize on the turning economy by
purchasing stocks of companies with solid balance sheets and intriguing business
prospects. This strategy helped power the Portfolio’s relative
out-performance in the second half of the year. Although by year-end many Asian
current account surpluses had peaked, management still feels there is excess
capacity in some of the sectors including manufacturing and property. Thus it is
not expected Asia will experience the level of investment activity that was
typical before the financial downturn, even though certain countries are still
heavily leveraged. The Portfolio’s managers continue to favor companies in
the technology sector as well as look for global outsourcing opportunities that
will benefit from increased IT spending. Additionally, the Portfolio may now
invest locally in India, a country that is seeing explosive growth in the
technology sector. </FONT></P>
<P><FONT SIZE=3>Latin America was the relative laggard in the emerging markets
over the past year, due to devaluation concerns in Brazil and a recession in
Argentina. Brazil continues to weigh heavily on the region as concerns regarding
the fiscal deficit and social security remain. Other factors that continue to
weigh on the Latin American economy include the Mexican elections and excess
government spending. On a positive note, Latin American companies continue to
reduce their cost structure in response to the region’s weak economies.
With the prospects of economic recovery and cheap valuations, the region looks
attractive from a bottom up perspective. Latin American telecom and
Internet-related businesses are favored as the best ways to benefit from the
region’s growth. </FONT></P>
<P><FONT SIZE=3>EMEA (Eastern Europe, Middle East, Africa) faired well as
Israeli technology stocks kept pace with the NASDAQ, receiving an additional
boost from favorable governmental elections. The Greek stock market experienced
a bubble as investors were anticipating Greece would join the EU and the local
retail investors continued to provide a strong influx of capital. Toward the end
of 1999 this bubble gradually deflated, but the country’s economic outlook
is still favorable. The devastating earthquake in Turkey only marginally shook
investors and was more than offset by political change. It is anticipated Turkey
will enter a cycle of lower interest rates and less inflation that will bode
well for equity investors. Managers are also looking to Egypt as the economy is
positioned well for growth, remaining cheap on a valuation level. It is felt the
best investment opportunities in the EMEA region will come from wireless
telecom, technology, and media. </FONT></P>
<P><FONT SIZE=3>Comparison of Change in Value of $1.0 Million Investment in the International
Emerging Markets Portfolio, Lipper Emerging Markets Fund Average and MSCI EMF
Index.</FONT></P>
- -------------------------------------
Average Annual Total Returns
As of December 31, 1999
1 Year 5 Year 10 Year
63.37% 16.26* --
* - Since Inception Date 11/26/97
- -------------------------------------
MSCI Lipper Emerging
EMF ID Markets
Year Ended December 31, IEP INDEX Fund Avg.
1,000,000 1,000,000 1,000,000
1997 1,014,000 1,021,800 1,015,300
1998 839,491 740,601 742,895
1999 1,371,476 1,232,434 1,268,642
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%>Note:</TD>
<TD WIDTH=95%><FONT SIZE=3>Past performance is not predictive of future performance. </FONT></TD>
</TR>
</TABLE>
<H2 ALIGN=LEFT><FONT SIZE=3>International Securities Portfolio</FONT></H2>
<P><FONT SIZE=3>The return for the International Securities Portfolio in 1999
was 27.89%. This performance outpaced the 26.96% return posted by the EAFE
(Europe, Australia and Far East) Index. The largest positive contributions came
from the Portfolio’s exposure to emerging markets and the allocation of the
European investments. The Portfolio would have outperformed the benchmark by a
larger amount if not for the strength of the Japanese market and its currency.
Positive equity returns globally were driven by improving economies, low
inflation and the strong performance of the so-called ‘New Era’ stocks
in the telecommunications, technology and media industries. </FONT></P>
<P><FONT SIZE=3>Emerging markets performed very strongly in 1999 as economic
growth troughed and began to move up early in the year and accelerated as 1999
progressed. This specifically benefited the holdings in South Korea and South
Africa where the Portfolio held more cyclical companies. An additional benefit
came when one of the Portfolio’s largest holdings, an oil company in
Argentina, was taken over early in the year. </FONT></P>
<P><FONT SIZE=3>Strong stock specific performance in Europe, especially in the
UK and the Netherlands, aided relative outperformance. Several of the companies
held in the Portfolio were taken over by competitors in 1999. These takeovers
resulted in the rapid realization of value for shareholders. The
Portfolio’s returns benefited from this activity. 1999 was also
characterized by sluggish European markets in the first three quarters of the
year because of worries about rising interest rates. These worries impacted
media, technology and telecommunications stocks most severely. The Portfolio
took advantage of the weakness in stock prices in these industries to increase
the weighting in these higher growth areas of the economy. This strategy paid
off handsomely in the fourth quarter, as these growth sectors led the market
rally. The Portfolio’s overweight positions in media and technology and
underweight positions in insurance and utilities were the main drivers of the
positive relative performance. </FONT></P>
<P><FONT SIZE=3>The Portfolio increased its weighting in the Japanese market as
the economy began to show signs of improvement and companies in Japan began to
announce restructuring plans to raise profitability. The average weighting in
Japan in 1999 was still only 8%, significantly below the benchmark. This hurt
relative returns because of the strong market performance, but also because the
yen was the strongest major currency in the world last year. </FONT></P>
<P><FONT SIZE=3>The Portfolio continues to be underweight Japan (50% of the
benchmark) and overweight Europe. Europe is expected to grow its economy faster
than the rest of the world this year and European equities still offer good
value. Inflation is expected to remain subdued, but the efforts of central banks
in the US and Europe to prevent inflation will mean rising short-term interest
rates that may cause market volatility. There is still good value in some media,
technology and telecommunications stocks. Select financials and cyclicals also
offer good value. </FONT></P>
<P><FONT SIZE=3>Comparison of Change in Value of $1.0 Million Investment in the International
Securities Portfolio, Lipper International Fund Average and MSCI EAFE
Index.</FONT></P>
- --------------------------------------------
Average Annual Total Returns *
As of December 31, 1999
1 Year 5 Year 10 Year
27.89% 17.00% 15.88%**
** Since inception date 5/7/93
- --------------------------------------------
ISP* Morgan Stanley Lipper
Total EAFE International
Year Ended December 31 Return Index Index
1,000,000 1,000,000 1,000,000
1993 1,298,152 1,058,800 1,225,000
1994 1,214,388 1,141,175 1,216,303
1995 1,360,336 1,269,100 1,330,757
1996 1,688,511 1,345,881 1,487,520
1997 1,900,456 1,369,838 1,568,441
1998 2,082,034 1,643,805 1,772,652
1999 2,662,622 2,086,975 2,495,894
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%>Note:</TD>
<TD WIDTH=95%><FONT SIZE=3>Past performance is not predictive of future performance. </FONT></TD>
</TR>
</TABLE>
<H2 ALIGN=LEFT><FONT SIZE=3>International SmallCap Portfolio</FONT></H2>
<P><FONT SIZE=3>The international small cap arena saw impressive returns that
were unprecedented previous to 1999. The Lipper International SmallCap Fund
Average total return was 75.41% for the year. The International SmallCap
Portfolio’s return exceeded the Lipper average by 10.5% on a 1-year basis.
Earlier in 1999 Japan was a significant outperformer in the small cap world and
the Portfolio’s holdings outpaced the index returning, on average, some
60%. The Portfolio went from a zero weighting in Japan to one that more closely
matched the benchmark at mid-year, to lightening up during fourth quarter as the
Portfolio’s managers felt much of the Japanese market had simply run out of
steam. The fourth quarter saw investors taking gains in the Japanese small cap
stocks as the economy once again came into question as to what could be
delivered and how much restructuring was actually occurring. 1999 was a good
year for European start-up companies. Many were technology-oriented that soon
turned into mid-caps due to massive price appreciation in a short time span. A
fundamental change was seen in the liquidity flows as capital began to pour into
the European markets in the fourth quarter. The top performing sectors included
media, telecommunications and technology as those companies that had exposure in
these areas saw strong price appreciation in the fourth quarter as investors
scrambled to gain exposure to these industries. </FONT></P>
<P><FONT SIZE=3>Portfolio managers continue to look for market leaders in their
respective fields with good growth characteristics, a solid business strategy
and strong barriers to entry. 1999 was a year of stellar performance for
technology companies as the internet and e-commerce began to demonstrate that
they will revolutionize the business world. Managers identified some promising
companies that are global leaders and should benefit from the explosion of
growth in e-commerce. The Portfolio has rotated out of many of the stronger
performers and continues to look for new opportunities whose growth
opportunities are undervalued relative to their stock price. </FONT></P>
<P><FONT SIZE=3>The International SmallCap Portfolio continues to benefit from
themes such as outsourcing of electronic components, increasing advertising
expenditures, market research companies and indirect e-commerce solutions. At
the current time, growth companies offer the most attractive investments from a
risk/return trade-off compared to the more traditional value stocks. Portfolio
mangers continue to look for companies that are at attractive valuations and
also offer long-term earnings growth potential. </FONT></P>
<P><FONT SIZE=3>Comparison of Change in Value of $1.0 Million Investment in the International
SmallCap Portfolio, Lipper International SmallCap Fund Average and MSCI EAFE
Index.</FONT></P>
- -------------------------------------
Average Annual Total Returns*
As of December 31, 1999
1 Year 5 Year 10 Year
85.93% 42.93** --
** - Since Inception Date 11/26/97
- -------------------------------------
Lipper
MSCI International
EAFE ND SmallCap
Year Ended December 31, ICP* INDEX Fund Avg.
1,000,000 1,000,000 1,000,000
1997 1,015,900 1,008,700 985,500
1998 1,136,995 1,210,440 1,113,812
1999 2,114,015 1,536,775 1,953,738
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%>Note:</TD>
<TD WIDTH=95%><FONT SIZE=3>Past performance is not predictive of future performance. </FONT></TD>
</TR>
</TABLE>
<BR>
<P><FONT SIZE=3>Important Notes:</FONT></P>
<P><FONT SIZE=3>Lipper Emerging Markets Fund Average: This average consists of
funds which invest at least 65% of their total assets in emerging market equity
securities, where “emerging market” is defined by a country’s GNP
per capita or other economic measures. The one-year average currently contains
180 funds. </FONT></P>
<P><FONT SIZE=3>Morgan Stanley Capital International EMF (Emerging Markets Free)
Index: This market capitalization weighted index is composed of companies
representative of the market structure of 26 emerging market countries in
Europe, Latin America and the Pacific Basin. The Index excludes closed markets
and those shares in otherwise free markets that are not purchasable by
foreigners. These countries include: Argentina, Brazil, Chile, China Free,
Columbia, Czech Republic, Greece, Hungary, India, Indonesia Free, Israel,
Jordan, Korea, Malaysia (Free), Mexico (Free), Pakistan, Peru, Philippines
(Free), Poland, Russia, South Africa, Sri Lanka, Taiwan (at 50%), Thailand
(Free), Turkey and Venezuela. </FONT></P>
<P><FONT SIZE=3>Lipper International Small Cap Funds Average: This average
consists of funds which invest at least 65% of their assets in equity securities
of non-United States companies with market capitalizations less than U.S. $1
billion at the time of purchase. The one-year average currently contains 70
funds. </FONT></P>
<P><FONT SIZE=3>Morgan Stanley Capital International EAFE (Europe, Australia and
Far East) Index: This market capitalization weighted index is composed of
countries representative of the market structure of 20 developed market
countries in Europe, Australasia and the Far East. The countries include:
Australia, Austria, Belgium, Denmark, Finland, France, Germany, Hong Kong,
Ireland, Italy, Japan, Netherlands, New Zealand, Norway, Portugal, Singapore,
Spain, Sweden, Switzerland and United Kingdom. </FONT></P>
<P><FONT SIZE=3>Lipper International Fund Average: This average consists of
funds which invest in securities primarily traded in markets outside of the
United States. The one-year average currently contains 618 funds. </FONT></P>
<H2 ALIGN=LEFT><FONT SIZE=3>Mortgage-Backed Securities Portfolio</FONT></H2>
<P><FONT SIZE=3>Over the last 15 months the Federal Reserve has lowered interest
rates to stabilize the global financial turmoil, only to reverse course and
start raising rates as markets stabilized and global growth resumed. Fund
managers view these Federal Reserve actions as the equivalent of a doctor
prescribing aspirin to treat the economic patient. These are mild treatments,
needed to keep inflation low and growth reasonable. </FONT></P>
<P><FONT SIZE=3>On an absolute basis, the returns for the Mortgage-Backed
Securities Portfolio for the year were poor. Fixed income securities had no
momentum, especially with the Fed raising interest rates. This was especially
true during December as investors poured money into fast moving growth stocks
and out of fixed-income securities. </FONT></P>
<P><FONT SIZE=3>The Portfolio underperformed both the Lipper U.S. Mortgage Fund
Average and the Lehman Brothers Mortgage Index, primarily due to its slightly
longer duration. </FONT></P>
<P><FONT SIZE=3>Fund managers continue to believe the Portfolio will do well
into the future. Quality, liquidity, lack of credit volatility and the
participation of certain federal agencies are cited as the key drivers. Agency
participation is a significant factor. The Federal National Mortgage Association
(“FNMA”) and Federal Home Loan Mortgage Corporation
(“FHLMC”) are two major issuers of mortgage-backed securities
“MBS.” As stock companies, they are driven by stockholders and the
price of their stock. In order to grow earnings in the face of declining new
issue MBS (typically they earn their income by issuing new MBS), they are
arbitraging more of the outstanding MBS. These agencies arbitrage by issuing
debt and buying MBS to earn the “spread” for their stockholders. FNMA
and FHLMC are expected to buy 60% of net MBS issuance in 2000, strengthening the
MBS market. </FONT></P>
<P><FONT SIZE=3>The Portfolio continues to hold more discount MBS securities
than the Lehman MBS index (this leads to a bias of longer duration) as managers
believe the homeowner’s propensity to refinance and the mortgage
banker’s technology driven inducement to refinance loans puts great risk on
securities priced above par. This is especially true in a market when overall
volume is declining as higher interest rates impact both new and existing home
markets. </FONT></P>
<P><FONT SIZE=3>The Portfolio is expected to stay close to its duration
benchmarks. Currently it is a little long but is expected to be duration neutral
soon, and fund managers patiently wait for the opportunity to strategically
lengthen maturities. </FONT></P>
<P><FONT SIZE=3>Comparison of Change in Value of $1.0 Million Investment in the Mortgage-Backed
Securities Portfolio, Lipper U.S. Mortgage Fund Average and Lehman Brothers
Mortgage Index.</FONT></P>
- --------------------------------------------
Average Annual Total Returns*
As of December 31, 1999
1 Year 5 Year 10 Year
0.30% 8.15% 6.17%**
** Since Inception Date 5/7/93
- --------------------------------------------
Lehman Brothers Lipper U.S.
MBS* Mortgage Mortgage Fund
Year Ended December 31, Value Index Average
1,000,000 1,000,000 1,000,000
1993 1,045,260 1,032,308 1,033,900
1994 1,007,869 1,015,688 990,786
1995 1,201,901 1,186,323 1,151,591
1996 1,252,353 1,249,791 1,196,158
1997 1,380,077 1,368,397 1,298,788
1998 1,486,863 1,463,637 1,377,754
1999 1,491,417 1,490,861 1,386,710
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%>Note:</TD>
<TD WIDTH=95%><FONT SIZE=3>Past performance is not predictive of future performance. </FONT></TD>
</TR>
</TABLE>
<BR>
<P><FONT SIZE=3>Important Notes:</FONT></P>
<P><FONT SIZE=3>Lehman Brothers Mortgage Index: an unmanaged index of 15- and
30-year fixed rate securities backed by mortgage pools of the Government
National Mortgage Association (GNMA), Federal Home Loan Mortgage Corporation
(FHLMC), and Federal National Mortgage Association (FNMA). </FONT></P>
<P><FONT SIZE=3>Lipper U.S. Mortgage Fund Average: this average consists of mutual funds investing at least 65% of their assets
in mortgages/securities issued or guaranteed as to principal and interest by the U.S. Government and certain
federal agencies. The one-year average currently contains 62 mutual funds.</FONT></P>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%><FONT SIZE=3>Note:</FONT></TD>
<TD WIDTH=95%><FONT SIZE=3>
Mutual fund data from Lipper Services, Inc.</FONT></TD>
</TR>
</TABLE>
<H2 ALIGN=LEFT><FONT SIZE=3>PRICING OF FUND SHARES</FONT></H2>
<P><FONT SIZE=3>Each Portfolio’s shares are bought and sold at the current
share price. The share price of each Portfolio is calculated each day the New
York Stock Exchange is open. The share price is determined at the close of
business of the Exchange (normally at 3:00 p.m. Central Time). When Princor
receives your order to buy or sell shares, the share price used to fill the
order is the next price calculated after the order is placed. </FONT></P>
<P><FONT SIZE=3>For all Portfolios the share price is calculated by:</FONT></P>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%><FONT SIZE=3>•</FONT></TD>
<TD WIDTH=95%><FONT SIZE=3>
taking the current market value of the total assets of the Portfolio</FONT></TD>
</TR>
</TABLE>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%><FONT SIZE=3>•</FONT></TD>
<TD WIDTH=95%><FONT SIZE=3>
subtracting liabilities of the Portfolio</FONT></TD>
</TR>
</TABLE>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%><FONT SIZE=3>•</FONT></TD>
<TD WIDTH=95%><FONT SIZE=3>
dividing the remainder by the total number of shares owned</FONT></TD>
</TR>
</TABLE>
<H2 ALIGN=LEFT><FONT SIZE=3>NOTES:</FONT></H2>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%><FONT SIZE=3>•</FONT></TD>
<TD WIDTH=95%><FONT SIZE=3>
If current market values are not readily available for a security, its fair value is determined using a
policy adopted by the Fund's Board of Directors.</FONT></TD>
</TR>
</TABLE>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%><FONT SIZE=3>•</FONT></TD>
<TD WIDTH=95%><FONT SIZE=3>
The Portfolio’s securities may be traded on foreign securities markets
which generally complete trading at various times during the day prior to the
close of the New York Stock Exchange. The values of foreign securities used in
computing share price are determined at the time the foreign market closes.
Occasionally, events affecting the value of foreign securities occur when the
foreign market is closed and the New York Stock Exchange is open. If the Manager
believes the market value is materially affected, the share price will be
calculated using the policy adopted by the Fund.</FONT></TD>
</TR>
</TABLE>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%><FONT SIZE=3>•</FONT></TD>
<TD WIDTH=95%><FONT SIZE=3>
Foreign securities markets may trade on days when the New York Stock
Exchange is closed (such as customary U.S. holidays) and the Portfolio’s
share price is not calculated. As a result, the value of a Portfolio’s
assets may be significantly affected by such trading on days when you cannot
purchase or sell shares of the Portfolio.</FONT></TD>
</TR>
</TABLE>
<BR>
<H2 ALIGN=LEFT><FONT SIZE=3>DIVIDENDS AND DISTRIBUTIONS</FONT></H2>
<P><FONT SIZE=3>The International Growth-Oriented and Income-Oriented Portfolios
pay most of their net dividend income to you every year. The payment schedule
is:</FONT></P>
Portfolios Record Date Payable Date
- -----------------------------------------------------------------------------
International Emerging Markets, three business days before December 24
International Securities and each payable date (or previous
International SmallCap business day)
Mortgage-Backed Securities three business days before last business
each payable date day of each month
<P><FONT SIZE=3>Net realized capital gain for each of the Portfolios, if any,
are distributed annually, on the 24th of December (or the preceding business day
if the 24th is not a business day) to shareholders of record three business days
before the payable date. Payments are made to shareholders of record on the
third business day prior to the payable date. Capital gains may be taxable at
different rates, depending on the length of time that the Portfolio holds
it’s assets. </FONT></P>
<P><FONT SIZE=3>You can authorize income dividend and capital gain distributions to be:</FONT></P>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%><FONT SIZE=3>•</FONT></TD>
<TD WIDTH=95%><FONT SIZE=3>
invested in additional shares of the Portfolio you own; or</FONT></TD>
</TR>
</TABLE>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%><FONT SIZE=3>•</FONT></TD>
<TD WIDTH=95%><FONT SIZE=3>
paid in cash.</FONT></TD>
</TR>
</TABLE>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=10%>NOTE:</TD>
<TD WIDTH=90%><FONT SIZE=3>
Payment of income dividends and capital gains shortly after you buy shares has
the effect of reducing the share price by the amount of the payment.</FONT></TD>
</TR>
</TABLE>
<BR>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=10%> </TD>
<TD WIDTH=90%><FONT SIZE=3>
Distributions from a Portfolio, whether received in cash or reinvested in additional shares, may be
subject to federal (and state) income tax.</FONT></TD>
</TR>
</TABLE>
<BR>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=10%> </TD>
<TD WIDTH=90%><FONT SIZE=3>
You should consult your tax advisor as to the federal, state and local tax consequences of Portfolio
ownership.</FONT></TD>
</TR>
</TABLE>
<H2 ALIGN=LEFT><FONT SIZE=3>TO BUY SHARES</FONT></H2>
<P><FONT SIZE=3>Each Portfolio requires:</FONT></P>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%><FONT SIZE=3>•</FONT></TD>
<TD WIDTH=95%><FONT SIZE=3>
A minimum initial investment of $1,000,000 which may be invested over a
three month period. If the minimum investment has not been met within 3 months,
we will send you a notice. If following the notice, we do not receive sufficient
funds within 30 days to meet the required minimum, then we will redeem the
account and send you the proceeds.</FONT></TD>
</TR>
</TABLE>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%><FONT SIZE=3>•</FONT></TD>
<TD WIDTH=95%><FONT SIZE=3>
You may combine your investment with those of your spouse, dependent children and/or a trust for the benefit
of such persons to meet the requirement;</FONT></TD>
</TR>
</TABLE>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%><FONT SIZE=3>•</FONT></TD>
<TD WIDTH=95%><FONT SIZE=3>
Subsequent purchases are not subject to limitations.</FONT></TD>
</TR>
</TABLE>
<P><FONT SIZE=3>Fill out the Principal Mutual Fund application* completely. You must include:</FONT></P>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%><FONT SIZE=3>•</FONT></TD>
<TD WIDTH=95%><FONT SIZE=3>
the name(s) you want to appear on the account;</FONT></TD>
</TR>
</TABLE>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%><FONT SIZE=3>•</FONT></TD>
<TD WIDTH=95%><FONT SIZE=3>
the Portfolio(s) you want to invest in;</FONT></TD>
</TR>
</TABLE>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%><FONT SIZE=3>•</FONT></TD>
<TD WIDTH=95%><FONT SIZE=3>
the amount of the investment;</FONT></TD>
</TR>
</TABLE>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%><FONT SIZE=3>•</FONT></TD>
<TD WIDTH=95%><FONT SIZE=3>
your Social Security number or Taxpayer I.D. number;</FONT></TD>
</TR>
</TABLE>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%><FONT SIZE=3>•</FONT></TD>
<TD WIDTH=95%><FONT SIZE=3>
investor information (used to help your Registered Representative confirm that your investment selection is consistent
with your goals and circumstances) ; and</FONT></TD>
</TR>
</TABLE>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%><FONT SIZE=3>•</FONT></TD>
<TD WIDTH=95%><FONT SIZE=3>
other required information (may include corporate resolutions, trust agreements, etc.).</FONT></TD>
</TR>
</TABLE>
<P><FONT SIZE=3>* An application is included with this prospectus.</FONT></P>
<P><FONT SIZE=3>Invest by mail:</FONT></P>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%><FONT SIZE=3>•</FONT></TD>
<TD WIDTH=95%><FONT SIZE=3>Send a check and completed application to:</FONT></TD>
</TR>
</TABLE>
Principal Special Markets Fund, Inc.
P. O. Box 10423
Des Moines Iowa 50306
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%><FONT SIZE=3>•</FONT></TD>
<TD WIDTH=95%><FONT SIZE=3>
Make your check payable to Principal Special Markets Fund, Inc.</FONT></TD>
</TR>
</TABLE>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%><FONT SIZE=3>•</FONT></TD>
<TD WIDTH=95%><FONT SIZE=3>
Your purchase will be priced at the next share price
calculated after Fund receives your completed paperwork. </FONT></TD>
</TR>
</TABLE>
<P><FONT SIZE=3>Order by telephone:</FONT></P>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%><FONT SIZE=3>•</FONT></TD>
<TD WIDTH=95%><FONT SIZE=3>
Call us at 1-800-521-1502 between 7:00 a.m. and 7:00 p.m. Central Time on any day that the New York Stock
Exchange is open.</FONT></TD>
</TR>
</TABLE>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%><FONT SIZE=3>•</FONT></TD>
<TD WIDTH=95%><FONT SIZE=3>
To buy shares the same day, you need to call before 3:00 p.m. Central Time.</FONT></TD>
</TR>
</TABLE>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%><FONT SIZE=3>•</FONT></TD>
<TD WIDTH=95%><FONT SIZE=3>
We must receive your payment for the order within three business days (or the order will be canceled and you
may be liable for any loss).</FONT></TD>
</TR>
</TABLE>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%><FONT SIZE=3>•</FONT></TD>
<TD WIDTH=95%><FONT SIZE=3>
For new accounts, you also need to send a completed application.</FONT></TD>
</TR>
</TABLE>
<P><FONT SIZE=3>Wire money from your bank:</FONT></P>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%><FONT SIZE=3>•</FONT></TD>
<TD WIDTH=95%><FONT SIZE=3>
Have your Registered Representative call Principal Mutual Funds (1-800-521-1502)
for an account number and wiring instructions.</FONT></TD>
</TR>
</TABLE>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%><FONT SIZE=3>•</FONT></TD>
<TD WIDTH=95%><FONT SIZE=3>
For both initial and subsequent purchases, federal funds should be wired to:<BR>
Norwest Bank Iowa, N.A.<BR>
Des Moines, Iowa 50309<BR>
ABA No.: 073000228<BR>
For credit to: Principal Special Markets Fund<BR>
Account No.: 3000499968<BR>
For credit: Principal Special Markets Fund, Portfolios<BR>
Shareholder Account No. __________________<BR>
Shareholder Registration __________________</FONT></TD>
</TR>
</TABLE>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%><FONT SIZE=3>•</FONT></TD>
<TD WIDTH=95%><FONT SIZE=3>
Give the number and instructions to your bank (which may
charge a wire fee). </FONT></TD>
</TR>
</TABLE>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%><FONT SIZE=3>•</FONT></TD>
<TD WIDTH=95%><FONT SIZE=3>
To buy shares the same day, the wire must be received
before 3:00 p.m. Central Time. </FONT></TD>
</TR>
</TABLE>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%><FONT SIZE=3>•</FONT></TD>
<TD WIDTH=95%><FONT SIZE=3>
No wires are accepted on days when the New
York Stock Exchange is closed or when the Federal Reserve is
closed (because the bank that would receive your wire is closed).</FONT></TD>
</TR>
</TABLE>
<H2 ALIGN=LEFT><FONT SIZE=3>OFFERING PRICE OF SHARES</FONT></H2>
<P><FONT SIZE=3>The Fund offers shares of each Portfolio continuously through
Princor Financial Services Corporation which is the principal underwriter for
the Fund and sells shares as agent for the Fund. Shares are sold to the public
at net asset value, subject to the minimum investment requirements. In certain
circumstances, Princor Financial Services Corporation will compensate its
registered representatives or a selected dealer with whom it has entered into a
selling agreement for their efforts in distributing shares of the fund.
Compensation is an ongoing fee in an amount up to 0.10% on an annualized basis
of the average net asset value of shares held in your account the establishment
of which is attributable to the efforts of the registered representative or
selected dealer. </FONT></P>
<H2 ALIGN=LEFT><FONT SIZE=3>TO SELL SHARES</FONT></H2>
<P><FONT SIZE=3>After you place a sell order in proper form, shares are sold
using the next share price calculated. There is no charge for a sale. Generally,
the sale proceeds are sent out on the next business day after the sell order has
been placed. At your request, the check will be sent overnight (a $15 overnight
fee will be deducted from your account unless other arrangements are made). The
Fund can only sell shares after your check making the Fund investment has
cleared your bank. To avoid the inconvenience of a delay in obtaining sale
proceeds, shares may be purchased with a cashier’s check, money order or
certified check. A sell order from one owner is binding on all joint owners. </FONT></P>
<P><FONT SIZE=3>Selling shares may create a gain or a loss for federal (and
state) income tax purposes. You should maintain accurate records for use in
preparing your income tax returns. </FONT></P>
<P><FONT SIZE=3>Generally, sales proceeds checks are:</FONT></P>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%><FONT SIZE=3>•</FONT></TD>
<TD WIDTH=95%><FONT SIZE=3>
payable to all owners on the account (as shown in the account registration) and</FONT></TD>
</TR>
</TABLE>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%><FONT SIZE=3>•</FONT></TD>
<TD WIDTH=95%><FONT SIZE=3>
mailed to address on the account (if not changed within
last month) or previously authorized bank account. </FONT></TD>
</TR>
</TABLE>
<P><FONT SIZE=3>For other payment arrangements, please call Principal Mutual
Funds (1-800-521-1502). </FONT></P>
<P><FONT SIZE=3>You should also call Principal Mutual Funds (1-800-521-1502) for special instructions that may apply to sales
from accounts:</FONT></P>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%><FONT SIZE=3>•</FONT></TD>
<TD WIDTH=95%><FONT SIZE=3>
when an owner has died; or</FONT></TD>
</TR>
</TABLE>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%><FONT SIZE=3>•</FONT></TD>
<TD WIDTH=95%><FONT SIZE=3>
owned by corporations, partnerships, agents or fiduciaries.</FONT></TD>
</TR>
</TABLE>
<H2 ALIGN=LEFT><FONT SIZE=3>Sell shares by mail</FONT></H2>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%><FONT SIZE=3>•</FONT></TD>
<TD WIDTH=95%><FONT SIZE=3>
Send a letter (signed by the owner of the account) to
Principal Mutual Funds
P. O. Box 10423
Des Moines Iowa 50306-9780</FONT></TD>
</TR>
</TABLE>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%><FONT SIZE=3>•</FONT></TD>
<TD WIDTH=95%><FONT SIZE=3>
Specify the Fund and account number.</FONT></TD>
</TR>
</TABLE>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%><FONT SIZE=3>•</FONT></TD>
<TD WIDTH=95%><FONT SIZE=3>
Specify the Portfolio(s).</FONT></TD>
</TR>
</TABLE>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%><FONT SIZE=3>•</FONT></TD>
<TD WIDTH=95%><FONT SIZE=3>
Specify the number of shares or the dollar amount to be sold.</FONT></TD>
</TR>
</TABLE>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%><FONT SIZE=3>•</FONT></TD>
<TD WIDTH=95%><FONT SIZE=3>
A signature guarantee* will be required if the:</FONT></TD>
</TR>
</TABLE>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%><FONT SIZE=3></FONT></TD>
<TD WIDTH=5%><FONT SIZE=3>•</FONT></TD>
<TD WIDTH=95%><FONT SIZE=3>
account address has been changed within one month of the sell order; or</FONT></TD>
</TR>
</TABLE>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%><FONT SIZE=3></FONT></TD>
<TD WIDTH=5%><FONT SIZE=3>•</FONT></TD>
<TD WIDTH=90%><FONT SIZE=3>
check is payable to a party other than the account shareholder(s) or Principal
Life Insurance Company. * If required, the signature(s) must be guaranteed by a
commercial bank, trust company, credit union,</FONT></TD>
</TR>
</TABLE>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=15%> </TD>
<TD WIDTH=85%><FONT SIZE=3>
savings and loan, national securities exchange member or brokerage firm. A signature
guaranteed by a notary public or savings bank is not acceptable.</FONT></TD>
</TR>
</TABLE>
<BR>
<H2 ALIGN=LEFT><FONT SIZE=3>Sell shares by telephone* (1-800-521-1502)</FONT></H2>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%><FONT SIZE=3>•</FONT></TD>
<TD WIDTH=95%><FONT SIZE=3>
Address on account must not have been changed within the last month and
telephone privileges must apply to the account from which the shares are being
sold.</FONT></TD>
</TR>
</TABLE>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%><FONT SIZE=3>•</FONT></TD>
<TD WIDTH=95%><FONT SIZE=3>If our phone lines are busy, you may need to send in a written sell order.</FONT></TD>
</TR>
</TABLE>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%><FONT SIZE=3>•</FONT></TD>
<TD WIDTH=95%><FONT SIZE=3>
To sell shares the same day, the order must be received before the close of
normal trading on the New York Stock Exchange (generally 3:00 p.m. Central
Time).</FONT></TD>
</TR>
</TABLE>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%><FONT SIZE=3>•</FONT></TD>
<TD WIDTH=95%><FONT SIZE=3>
If previously authorized, checks can be sent to a shareholder's U.S. bank account.</FONT></TD>
</TR>
</TABLE>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%><FONT SIZE=3></FONT></TD>
<TD WIDTH=5%><FONT SIZE=3>*</FONT></TD>
<TD WIDTH=90%><FONT SIZE=3>
The Fund and transfer agent reserve the right to refuse telephone orders to sell
shares. The shareholder is liable for a loss resulting from a fraudulent
telephone order that the Fund reasonably believes is genuine. The Fund will use
reasonable procedures to assure instructions are genuine. If the procedures are
not followed, the Fund may be liable for loss due to unauthorized or fraudulent
transactions. The procedures include: recording all telephone instructions,
requesting personal identification information (name, phone number, social
security number, birth date, etc.) and sending written confirmation to the
address on the account.</FONT></TD>
</TR>
</TABLE>
<BR>
<H2 ALIGN=LEFT><FONT SIZE=3>Periodic withdrawal plans</FONT></H2>
<P><FONT SIZE=3>You may set up a periodic withdrawal plan on a monthly, quarterly, semiannual or annual basis to:</FONT></P>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%><FONT SIZE=3>•</FONT></TD>
<TD WIDTH=95%><FONT SIZE=3>
sell a fixed number of shares ($100 initial minimum amount), or</FONT></TD>
</TR>
</TABLE>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%><FONT SIZE=3>•</FONT></TD>
<TD WIDTH=95%><FONT SIZE=3>
sell enough shares to provide a fixed amount of money ($100 initial minimum amount).</FONT></TD>
</TR>
</TABLE>
<BR>
<P><FONT SIZE=3>You can set up a periodic withdrawal plan by:</FONT></P>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%><FONT SIZE=3>•</FONT></TD>
<TD WIDTH=95%><FONT SIZE=3>
completing the applicable section of the application; or</FONT></TD>
</TR>
</TABLE>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%><FONT SIZE=3>•</FONT></TD>
<TD WIDTH=95%><FONT SIZE=3>
sending us your written instructions (and share
certificate, if any, issued for the account). </FONT></TD>
</TR>
</TABLE>
<BR>
<P><FONT SIZE=3>Your periodic withdrawal plan continues until</FONT></P>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%><FONT SIZE=3>•</FONT></TD>
<TD WIDTH=95%><FONT SIZE=3>
you instruct us to stop, or</FONT></TD>
</TR>
</TABLE>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%><FONT SIZE=3>•</FONT></TD>
<TD WIDTH=95%><FONT SIZE=3>
your Fund account balance is zero.</FONT></TD>
</TR>
</TABLE>
<BR>
<P><FONT SIZE=3>When you set up the withdrawal plan, you select which day you
want the sale made (if none selected, the sale will be made on the 15th of the
month). If the selected date is not a trading day, the sale will take place on
the next trading day (if that day falls in the month after your selected date,
the transaction will take place on the trading day before your selected date. If
telephone privileges apply to the account, you may change the date or amount by
telephoning us at 1-800-521-1502. </FONT></P>
<H2 ALIGN=LEFT><FONT SIZE=3>GENERAL INFORMATION ABOUT A FUND ACCOUNT</FONT></H2>
<H2 ALIGN=LEFT><FONT SIZE=3>Statements</FONT></H2>
<P><FONT SIZE=3>You will receive quarterly statements. The statements provide
the number and value of shares you own, transactions during the quarter,
dividends declared or paid and other information. The year end statement
includes information for all transactions that took place during the year.
Please review your statement as soon as your receive it. Keep your statements as
you may need them for tax reporting purposes. </FONT></P>
<P><FONT SIZE=3>Generally, each time you buy, sell or exchange shares between
Portfolios, you will receive a confirmation in the mail shortly thereafter. It
summarizes all the key information; what you bought or sold, the amount of the
transaction, and other vital data. </FONT></P>
<P><FONT SIZE=3>Certain purchases and sales are only included on your quarterly statement. These include accounts when the only
activity during the quarter:</FONT></P>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%><FONT SIZE=3>•</FONT></TD>
<TD WIDTH=95%><FONT SIZE=3>
is purchase of shares from reinvested dividends and/or capital gains; and</FONT></TD>
</TR>
</TABLE>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%><FONT SIZE=3>•</FONT></TD>
<TD WIDTH=95%><FONT SIZE=3>
sales under a periodic withdrawal plan.</FONT></TD>
</TR>
</TABLE>
<BR>
<H2 ALIGN=LEFT><FONT SIZE=3>Signature Guarantees</FONT></H2>
<P><FONT SIZE=3>Certain transactions require that your signature be guaranteed.
If required, the signature(s) must be guaranteed by a commercial bank, trust
company, credit union, savings and loan, national securities exchange member or
brokerage firm. A signature guaranteed by a notary public or savings bank is not
acceptable. Signature guarantees are required: </FONT></P>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%><FONT SIZE=3>•</FONT></TD>
<TD WIDTH=95%><FONT SIZE=3>
if you sell more than $100,000 from any one Portfolio;</FONT></TD>
</TR>
</TABLE>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%><FONT SIZE=3>•</FONT></TD>
<TD WIDTH=95%><FONT SIZE=3>
if a sales proceeds check is payable to other than the account shareholder(s), Principal Life Insurance
Company or one of its affiliates;</FONT></TD>
</TR>
</TABLE>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%><FONT SIZE=3>•</FONT></TD>
<TD WIDTH=95%><FONT SIZE=3>
to change ownership of an account;</FONT></TD>
</TR>
</TABLE>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%><FONT SIZE=3>•</FONT></TD>
<TD WIDTH=95%><FONT SIZE=3>
to add telephone transaction services and/or wire
privileges to an existing account; </FONT></TD>
</TR>
</TABLE>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%><FONT SIZE=3>•</FONT></TD>
<TD WIDTH=95%><FONT SIZE=3>
to change bank account information
designated under an existing telephone withdrawal plan; </FONT></TD>
</TR>
</TABLE>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%><FONT SIZE=3>•</FONT></TD>
<TD WIDTH=95%><FONT SIZE=3>
to have a sales proceeds check mailed to an address other than the address on
the account or to the address on the account if it has been changed within the preceding month; and</FONT></TD>
</TR>
</TABLE>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%><FONT SIZE=3>•</FONT></TD>
<TD WIDTH=95%><FONT SIZE=3>
to exchange or transfer among accounts with different ownership.</FONT></TD>
</TR>
</TABLE>
<BR>
<H2 ALIGN=LEFT><FONT SIZE=3>Special Plans</FONT></H2>
<P><FONT SIZE=3>The Fund reserves the right to amend or terminate the special plans described in this prospectus. Such plans
include periodic withdrawal for certain purchasers. You would be notified of any such action to the extent
required by law.</FONT></P>
<H2 ALIGN=LEFT><FONT SIZE=3>Telephone Orders</FONT></H2>
<P><FONT SIZE=3>The Fund reserves the right to refuse telephone instructions.
You are liable for a loss resulting from a fraudulent telephone instruction that
we reasonably believe is genuine. We will use reasonable procedures to assure
instructions are genuine. If the procedures are not followed, we may be liable
for loss due to unauthorized or fraudulent transactions. The procedures include:
recording all telephone instructions, requesting personal identification
information (name, phone number, social security number, birth date, etc.) and
sending written confirmation to the shareholder’s address of record. </FONT></P>
<H2 ALIGN=LEFT><FONT SIZE=3>Financial Statements</FONT></H2>
<P><FONT SIZE=3>You will receive an annual financial statement for the Fund,
examined by the Fund’s independent auditors, Ernst & Young LLP. That
report is a part of this prospectus. You will also receive a semiannual
financial statement which is unaudited. The following financial highlights are
derived from financial statements which were audited by Ernst & Young LLP. </FONT></P>
<H2 ALIGN=LEFT><FONT SIZE=3>FINANCIAL HIGHLIGHTS</FONT></H2>
<P><FONT SIZE=3>Selected data for a share of Capital Stock outstanding
throughout each year ended December 31 (except as noted):</FONT></P>
<BR>
<H2 ALIGN=LEFT><FONT SIZE=3>INTERNATIONAL EMERGING MARKETS PORTFOLIO </FONT></H2>
1999 1998 1997(a)
-------------------------------------------------- ------------------------
Net Asset Value, Beginning of Period................... $8.21 $10.14 $9.94
Income from Investment Operations:
Net Investment Income............................... .09 .17 .01
Net Realized and Unrealized Gain (Loss) on Investments 5.10 (1.91) .21
Total from Investment Operations 5.19 (1.74) .22
Less Dividends and Distributions:
Dividends from Net Investment Income................ (.09) (.17) (.02)
Excess Distributions from Net Investment Income..... (.08) -- --
Distributions from Capital Gains....................... -- (.02) --
Total Dividends and Distributions (.17) (.19) (.02)
Net Asset Value, End of Period......................... $13.23 $8.21 $10.14
Total Return........................................... 63.37% (17.21)% 1.40%(b)
Ratio/Supplemental Data:
Net Assets, End of Period (in thousands)............ $129,575 $79,481 $32,488
Ratio of Expenses to Average Net Assets............. 1.15% 1.15% 1.15%(c)
Ratio of Net Investment Income to Average Net Assets .94% 2.11% .91%(c)
Portfolio Turnover Rate............................. 107.5% 36.5% 12.3%(c)
<H2 ALIGN=LEFT><FONT SIZE=3>INTERNATIONAL SECURITIES PORTFOLIO</FONT></H2>
1999 1998 1997 1996 1995
--------------------------------- ------------------------ ---- ----
Net Asset Value, Beginning of Period $14.90 $14.45 $13.67 $11.70 $11.29
Income from Investment Operations:
Net Investment Income............................... .40 .24 .24 .31 .19
Net Realized and Unrealized Gain on Investments..... 3.60 1.12 1.46 2.46 1.11
Total from Investment Operations 4.00 1.36 1.70 2.77 1.30
Less Dividends and Distributions:
Dividends from Net Investment Income................ (.41) (.23) (.24) (.16) (.10)
Excess Distributions from Net Investment Income..... -- -- -- (.07) (.07)
Distributions from Capital Gains.................... (1.66) (.68) (.68) (.57) (.72)
Excess Distributions from Capital Gains............. (.19) -- -- -- --
Total Dividends and Distributions (2.26) (.91) (.92) (.80) (.89)
Net Asset Value, End of Period......................... $16.64 $14.90 $14.45 $13.67 $11.70
Total Return........................................... 27.89% 9.55% 12.55% 24.12% 12.02%
Ratio/Supplemental Data:
Net Assets, End of Period (in thousands)............ $61,341 $47,912 $37,684 $28,161 $17,251
Ratio of Expenses to Average Net Assets............. .90% .90% .90% .90% .90%
Ratio of Net Investment Income to Average Net Assets 2.74% 1.60% 1.73% 1.90% 1.79%
Portfolio Turnover Rate............................. 71.4% 36.7% 30.8% 25.5% 46.0%
<H2 ALIGN=LEFT><FONT SIZE=3>INTERNATIONAL SMALLCAP PORTFOLIO</FONT></H2>
1999 1998 1997(a)
-------------------------------------------------------------
Net Asset Value, Beginning of Period................... $11.06 $9.97 $9.86
Income from Investment Operations:
Net Investment Income (Operating Loss).............. (.01) .07 .01
Net Realized and Unrealized Gain on Investments..... 9.25 1.11 .12
Total from Investment Operations 9.24 1.18 .13
Less Dividends and Distributions:
Dividends from Net Investment Income................ -- (.07) (.02)
Distributions from Capital Gains.................... (1.46) (.02) --
Total Dividends and Distributions (1.46) (.09) (.02)
Net Asset Value, End of Period......................... $18.84 $11.06 $9.97
Total Return........................................... 85.93% 11.92% 1.59%(b)
Ratio/Supplemental Data:
Net Assets, End of Period (in thousands)............ $154,892 $83,330 $31,968
Ratio of Expenses to Average Net Assets............. 1.00% 1.00% 1.00%(c)
Ratio of Net Investment Income (Operating Loss)
to Average Net Assets............................. (.06)% .78% .91%(c)
Portfolio Turnover Rate............................. 236.3% 88.5% 30.3%(c)
<H2 ALIGN=LEFT><FONT SIZE=3>MORTGAGE-BACKED SECURITIES PORTFOLIO</FONT></H2>
1999 1998 1997 1996 1995
--------------------------------------------------------- ---- ----
Net Asset Value, Beginning of Period $10.39 $10.27 $9.93 $10.17 $9.11
Income from Investment Operations:
Net Investment Income............................... .63 .65 .64 .64 .65
Net Realized and Unrealized Gain (Loss) on Investments (.60) .12 .34 (.24) 1.06
Total from Investment Operations .03 .77 .98 .40 1.71
Less Dividends from Net Investment Income.............. (.63) (.65) (.64) (.64) (.65)
Net Asset Value, End of Period......................... $9.79 $10.39 $10.27 $9.93 $10.17
Total Return........................................... .30% 7.74% 10.18% 4.20% 19.26%
Ratio/Supplemental Data:
Net Assets, End of Period (in thousands)............ $5,045 $14,861 $13,796 $14,968 $14,253
Ratio of Expenses to Average Net Assets............. .45% .45% .45% .45% .45%
Ratio of Net Investment Income to Average Net Assets 6.24% 6.28% 6.37% 6.51% 6.66%
Portfolio Turnover Rate............................. 17.0% 13.8% 15.5% 28.7% 41.8%
<H2 ALIGN=LEFT><FONT SIZE=3>Notes to Financial Highlights</FONT></H2>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%><FONT SIZE=3><SUP>(a)</SUP></FONT></TD>
<TD WIDTH=95%><FONT SIZE=3>
Period from November 26, 1997, date shares first offered to the public, through
December 31, 1997. Net investment income, aggregating $.02 per share for the
International Emerging Markets Portfolio and $.01 per share for the
International SmallCap Portfolio for the period from the initial purchase of
shares on November 17, 1997 through November 25, 1997, was recognized, none of
which was distributed to the sole shareholder, Principal Life Insurance Company.
Additionally, the portfolios incurred unrealized losses on investments of $.08
per share and $.15 per share respectively, during the interim period. This
represents activities of each portfolio prior to the initial offering.</FONT></TD>
</TR>
</TABLE>
<BR>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%><FONT SIZE=3><SUP>(b)</SUP></FONT></TD>
<TD WIDTH=95%><FONT SIZE=3>
Total return amounts have not been annualized.</FONT></TD>
</TR>
</TABLE>
<BR>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%><FONT SIZE=3><SUP>(c)</SUP></FONT></TD>
<TD WIDTH=95%><FONT SIZE=3>
Computed on an annualized basis.</FONT></TD>
</TR>
</TABLE>
<BR>
<P><FONT SIZE=3>Additional information about the Fund is available in the
Statement of Additional Information dated April 3, 2000 and which is part of
this prospectus. Information about the Fund’s investments is also available
in the Fund’s annual and semi-annual reports to shareholders. The Statement
of Additional Information and annual and semi-annual reports can be obtained
free of charge by writing or telephoning Princor Financial Services Corporation,
P.O. Box 10423, Des Moines, IA 50306. Telephone 1-800-451-5447. </FONT></P>
<P><FONT SIZE=3>Information about the Fund can be reviewed and copied at the
Securities and Exchange Commission’s Public Reference Room in Washington,
D.C. Information on the operation of the public reference room may be obtained
by calling the Commission at 1-800-SEC-0330. Reports and other information about
the Fund are available on the Commission’s internet site at
http://www.sec.gov. Copies of this information may be obtained, upon payment of
a duplicating fee, by writing the Public Reference Section of the Commission,
Washington, D.C. 20549-6009. </FONT></P>
<P><FONT SIZE=3>The U.S. Government does not insure or guarantee an investment in the Fund.</FONT></P>
<P><FONT SIZE=3>Shares of the Fund are not deposits or obligations of, or
guaranteed or endorsed by, any financial institution, nor are shares of the Fund
federally insured by the Federal Deposit Insurance Corporation, the Federal
Reserve Board, or any other agency. </FONT></P>
<P ALIGN=CENTER><FONT SIZE=3>Principal Special Markets Fund, Inc. SEC File 811-07572</FONT></P>
<PAGE>
<H1 ALIGN=CENTER><FONT SIZE=3>PART B</FONT></H1>
<H1 ALIGN=CENTER><FONT SIZE=3><U><U><U>PRINCIPAL SPECIAL MARKETS FUND, INC.</U></U></U><U><U></U></U></FONT></H1>
<H1 ALIGN=CENTER><FONT SIZE=3>INTERNATIONAL EMERGING MARKETS PORTFOLIO</FONT></H1>
<H1 ALIGN=CENTER><FONT SIZE=3>INTERNATIONAL SECURITIES PORTFOLIO</FONT></H1>
<H1 ALIGN=CENTER><FONT SIZE=3>INTERNATIONAL SMALLCAP PORTFOLIO</FONT></H1>
<H1 ALIGN=CENTER><FONT SIZE=3>MORTGAGE-BACKED SECURITIES PORTFOLIO</FONT></H1>
<H1 ALIGN=CENTER><FONT SIZE=3>Statement of Additional Information</FONT></H1>
<H1 ALIGN=CENTER><FONT SIZE=3>dated April 3, 2000</FONT></H1>
<P><FONT SIZE=3>This Statement of Additional Information provides information
about each Portfolio in addition to the information that is contained in the
Prospectus, dated April 3, 2000. </FONT></P>
<P><FONT SIZE=3>This Statement of Additional Information is not a prospectus. It
should be read in conjunction with the Prospectus, a copy of which can be
obtained free of charge by writing or telephoning: </FONT></P>
<H1 ALIGN=CENTER><FONT SIZE=2>Princor Financial Services Corporation<BR>
P.O. Box 10423<BR>
Des Moines, Iowa 50306-0423<BR>
Telephone: 1-800-451-5447</FONT></H1>
<P><FONT SIZE=1>FV 76 B-9</FONT></P>
<PAGE>
<H1 ALIGN=CENTER><FONT SIZE=3>TABLE OF CONTENTS</FONT></H1>
Investment Policies and Restrictions .................................... 2
Investments ............................................................. 4
Directors and Officers of the Fund....................................... 14
Manager and Sub-Advisor ................................................. 16
Cost of Manager's Services .............................................. 17
Brokerage on Purchases and Sales of Securities .......................... 20
Offering Price .......................................................... 23
Determination of Net Asset Value ........................................ 23
Performance Calculation ................................................. 24
Tax Treatment, Dividends and Distributions .............................. 26
Financial Statements..................................................... 27
<PAGE>
<H1 ALIGN=LEFT><FONT SIZE=3>INVESTMENT POLICIES AND RESTRICTIONS</FONT></H1>
<P><FONT SIZE=3>The following information supplements the information provided in the Prospectus under the caption "Certain
Investment Strategies and Related Risks."</FONT></P>
<H1 ALIGN=LEFT><FONT SIZE=3>INVESTMENT RESTRICTIONS</FONT></H1>
<P><FONT SIZE=3>In implementing the investment policies of the Portfolios, the
Fund is subject to fundamental and nonfundamental restrictions. Nonfundamental
restrictions may be changed by the Board of Directors without shareholder
approval. Fundamental restrictions may only be changed by a vote of the lesser
of (i) 67% or more of the shares represented at a meeting at which more than 50%
of the outstanding shares are represented or (ii) more than 50% of the
outstanding shares. The required shareholder approval shall be effective with
respect to a Portfolio if a majority of the outstanding voting securities of
that Portfolio votes to approve the matter, notwithstanding that the matter has
not been approved by a majority of the outstanding voting securities of the Fund
or of any other Portfolio affected by the matter. </FONT></P>
<P><FONT SIZE=3>The investment objective and investment policies and
restrictions of each Portfolio discussed in the Prospectus and the Statement of
Additional Information, except for those investment restrictions identified
below under the caption “Fundamental Restrictions,” are not
fundamental and may be changed by the Fund’s Board of Directors without
shareholder approval. Shareholders must be given 30 days prior written notice
before the investment objectives of the Portfolios may be amended at the
discretion of the Board of Directors. </FONT></P>
<P><FONT SIZE=3>All percentage limitations apply at the time of acquisition of a
security, and any subsequent change in any applicable percentage resulting from
changes in the values or nature of a Portfolio’s assets will not require
elimination of the security from the Portfolio. </FONT></P>
<P><FONT SIZE=3>Fundamental Restrictions. Each of the following restrictions is fundamental and may not be changed without
shareholder approval. Each Portfolio will not (unless specifically excepted):</FONT></P>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%><FONT SIZE=3> </FONT></TD>
<TD WIDTH=5%><FONT SIZE=3>(1)</FONT></TD>
<TD WIDTH=95%><FONT SIZE=3>
With respect to 75% of its total assets, purchase the securities of any issuer
if the purchase would cause more than 5% of the total assets of the Portfolio to
be invested in the securities of any one issuer (other than securities issued or
guaranteed by the United States Government or its agencies or instrumentalities)
or cause more than 10% of the outstanding voting securities of any one issuer to
be held by the Portfolio.</FONT></TD>
</TR>
</TABLE>
<BR>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%><FONT SIZE=3> </FONT></TD>
<TD WIDTH=5%><FONT SIZE=3>(2)</FONT></TD>
<TD WIDTH=95%><FONT SIZE=3>
Borrow money, except (a) for temporary or emergency purposes in an amount not to
exceed 5% of the value of the Portfolio's total assets at the time of the
borrowing and (b) for any purpose from banks in an amount not to exceed
one-third of the Portfolio's total assets (including the amount borrowed) less
all liabilities and indebtedness other than borrowings deemed to be senior
securities.</FONT></TD>
</TR>
</TABLE>
<BR>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%><FONT SIZE=3> </FONT></TD>
<TD WIDTH=5%><FONT SIZE=3>(3)</FONT></TD>
<TD WIDTH=95%><FONT SIZE=3>
Issue any senior securities as defined in the Investment Company Act of 1940.
For purposes of this restriction, purchasing and selling securities, currency
and futures contracts and options and borrowing money in accordance with
restrictions described herein do not involve the issuance of a senior security.</FONT></TD>
</TR>
</TABLE>
<BR>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%><FONT SIZE=3> </FONT></TD>
<TD WIDTH=5%><FONT SIZE=3>(4)</FONT></TD>
<TD WIDTH=95%><FONT SIZE=3>
Act as an underwriter of securities, except to the extent the Portfolio may be
deemed to be an underwriter in connection with the sale of securities held in
its portfolio.</FONT></TD>
</TR>
</TABLE>
<BR>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%><FONT SIZE=3> </FONT></TD>
<TD WIDTH=5%><FONT SIZE=3>(5)</FONT></TD>
<TD WIDTH=95%><FONT SIZE=3>
Concentrate its investments in any particular industry or industries, except
that the Portfolio may invest not more than 25% of the value of its total assets
in a single industry. For purposes of this restriction, foreign government and
supranational issuers are not considered members of any industry.</FONT></TD>
</TR>
</TABLE>
<BR>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%><FONT SIZE=3> </FONT></TD>
<TD WIDTH=5%><FONT SIZE=3>(6)</FONT></TD>
<TD WIDTH=95%><FONT SIZE=3>
Invest in real estate, although it may invest in securities that are secured by
real estate and securities of issuers that invest or deal in real estate.</FONT></TD>
</TR>
</TABLE>
<BR>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%><FONT SIZE=3> </FONT></TD>
<TD WIDTH=5%><FONT SIZE=3>(7)</FONT></TD>
<TD WIDTH=95%><FONT SIZE=3>
Invest in commodities or commodity contracts, but it may purchase and sell
currency and financial futures contracts and options on such contracts.</FONT></TD>
</TR>
</TABLE>
<BR>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%><FONT SIZE=3> </FONT></TD>
<TD WIDTH=5%><FONT SIZE=3>(8)</FONT></TD>
<TD WIDTH=95%><FONT SIZE=3>
Make loans, except that the Portfolio may (i) purchase and hold debt obligations
in accordance with its investment objective and policies, (ii) enter into
repurchase agreements, and (iii) lend its portfolio securities but not in excess
of 33% of the value of its total assets. The deposit of underlying securities
and other assets in escrow and other collateral arrangements in connection with
options, currency and futures transactions are not deemed to be the making of
loans.</FONT></TD>
</TR>
</TABLE>
<BR>
<P><FONT SIZE=3><U>Nonfundamental Restrictions. </U> Each of the following restrictions is nonfundamental and may be changed by the
Board of Directors without shareholder approval. Each Portfolio will not (unless specifically excepted):</FONT></P>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%><FONT SIZE=3> </FONT></TD>
<TD WIDTH=5%><FONT SIZE=3>(1)</FONT></TD>
<TD WIDTH=95%><FONT SIZE=3>
Invest more than 15% of its total assets in securities not readily marketable
and in repurchase agreements maturing in more than seven days. The value of any
options purchased in the over-the-counter market are included as part of this
15% limitation.</FONT></TD>
</TR>
</TABLE>
<BR>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%><FONT SIZE=3> </FONT></TD>
<TD WIDTH=5%><FONT SIZE=3>(2)</FONT></TD>
<TD WIDTH=95%><FONT SIZE=3>
Sell securities short (except where the Portfolio holds or has the right to
obtain at no added cost a long position in the securities sold that equals or
exceeds the securities sold short) or purchase any securities on margin, except
it may obtain such short-term credits as are necessary for the clearance of
transactions. The deposit or payment of margin in connection with options,
currency and futures transactions is not considered the purchase of securities
on margin.</FONT></TD>
</TR>
</TABLE>
<BR>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%><FONT SIZE=3> </FONT></TD>
<TD WIDTH=5%><FONT SIZE=3>(3)</FONT></TD>
<TD WIDTH=95%><FONT SIZE=3>
Invest in companies for the purpose of exercising control or management.</FONT></TD>
</TR>
</TABLE>
<BR>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%><FONT SIZE=3> </FONT></TD>
<TD WIDTH=5%><FONT SIZE=3>(4)</FONT></TD>
<TD WIDTH=95%><FONT SIZE=3>
Purchase puts, calls, straddles, spreads or any combination thereof if by reason
thereof the value of its aggregate investment in such classes of securities will
exceed 5% of its total assets. Options will be used solely for hedging purposes;
not for speculation.</FONT></TD>
</TR>
</TABLE>
<BR>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%><FONT SIZE=3> </FONT></TD>
<TD WIDTH=5%><FONT SIZE=3>(5)</FONT></TD>
<TD WIDTH=95%><FONT SIZE=3>
Invest more than 5% of its assets in initial margin and premiums on futures
contracts and options on such contracts.</FONT></TD>
</TR>
</TABLE>
<BR>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%><FONT SIZE=3> </FONT></TD>
<TD WIDTH=5%><FONT SIZE=3>(6)</FONT></TD>
<TD WIDTH=95%><FONT SIZE=3>
Purchase securities of other investment companies if the purchase would cause
more than 10% of its total assets to be invested in securities of other
investment companies or more than 5% of its total assets to be invested in the
securities of any investment company or would cause the Portfolio to own more
than 3% of the outstanding voting securities of any investment company. These
restrictions do not apply to purchases in connection with a merger,
consolidation, or plan of reorganization. [For purposes of these restrictions,
privately issued collateralized mortgage obligations will not be treated as
investment company securities if issued by "Exemptive Issuers." Exemptive
Issuers are defined as unmanaged, fixed-asset issuers that (i) invest primarily
in mortgage-backed securities, (ii) do not issue redeemable securities as
defined in section 2(a)(32) of the Investment Company Act of 1940, (iii) operate
under general exemptive orders exempting them from "all provisions of the
Investment Company Act of 1940," and (iv) are not registered or regulated under
the Investment Company Act of 1940 as investment companies.]</FONT></TD>
</TR>
</TABLE>
<BR>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%><FONT SIZE=3> </FONT></TD>
<TD WIDTH=5%><FONT SIZE=3>(7)</FONT></TD>
<TD WIDTH=95%><FONT SIZE=3>
Pledge, mortgage or hypothecate its assets, except to secure permitted
borrowings. The deposit of underlying securities and other assets in escrow and
other collateral arrangements in connection with options, currency and futures
transactions are not deemed to be pledges or other encumbrances.</FONT></TD>
</TR>
</TABLE>
<BR>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%><FONT SIZE=3> </FONT></TD>
<TD WIDTH=5%><FONT SIZE=3>(8)</FONT></TD>
<TD WIDTH=95%><FONT SIZE=3>
Purchase warrants in excess of 5% of its total assets, of which 2% may be
invested in warrants that are not listed on the New York, American or Toronto
Stock Exchanges or the Chicago Board Options Exchange. This restriction does not
apply to warrants included in units or attached to other securities.</FONT></TD>
</TR>
</TABLE>
<BR>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%><FONT SIZE=3> </FONT></TD>
<TD WIDTH=5%><FONT SIZE=3>(9)</FONT></TD>
<TD WIDTH=95%><FONT SIZE=3>
Invest in interests in oil, gas or other mineral exploration or development
programs, although the Portfolio may invest in securities of issuers that invest
in or sponsor such programs.</FONT></TD>
</TR>
</TABLE>
<BR>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%><FONT SIZE=3> </FONT></TD>
<TD WIDTH=5%><FONT SIZE=3>(10)</FONT></TD>
<TD WIDTH=95%><FONT SIZE=3>
Purchase securities of any issuer having less than three years' continuous
operation (including operations of any predecessors) if such purchase would
cause the value of the Portfolio's investments in all such issuers to exceed 5%
of the value of its total assets (this restriction does not apply to the
Mortgage-Backed Securities Portfolio).</FONT></TD>
</TR>
</TABLE>
<BR>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%><FONT SIZE=3> </FONT></TD>
<TD WIDTH=5%><FONT SIZE=3>(11)</FONT></TD>
<TD WIDTH=95%><FONT SIZE=3>
Purchase or retain in its portfolio securities of any issuer if those officers
or directors of the Fund or its Manager owning beneficially more than one-half
of 1% (0.5%) of the securities of the issuer together own beneficially more than
5% of such securities.</FONT></TD>
</TR>
</TABLE>
<BR>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%><FONT SIZE=3> </FONT></TD>
<TD WIDTH=5%><FONT SIZE=3>(12)</FONT></TD>
<TD WIDTH=95%><FONT SIZE=3>
Invest in arbitrage transactions.</FONT></TD>
</TR>
</TABLE>
<BR>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%><FONT SIZE=3> </FONT></TD>
<TD WIDTH=5%><FONT SIZE=3>(13)</FONT></TD>
<TD WIDTH=95%><FONT SIZE=3>
Invest in mineral leases.</FONT></TD>
</TR>
</TABLE>
<BR>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%><FONT SIZE=3> </FONT></TD>
<TD WIDTH=5%><FONT SIZE=3>(14)</FONT></TD>
<TD WIDTH=95%><FONT SIZE=3>
Invest in real estate limited partnership interests.</FONT></TD>
</TR>
</TABLE>
<BR>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%><FONT SIZE=3> </FONT></TD>
<TD WIDTH=5%><FONT SIZE=3>(15)</FONT></TD>
<TD WIDTH=95%><FONT SIZE=3>
Invest more than 25% of the value of its total assets (i) in the securities
issued by a single foreign government; or (ii) in securities issued by
supranational issuers.</FONT></TD>
</TR>
</TABLE>
<BR>
<P><FONT SIZE=3>The Manager will waive its management fee on Portfolio assets
invested in securities of other open-end investment companies and will generally
invest only in those open-end investment companies that have investment policies
requiring investment in securities comparable to those in which the Portfolio
invests. </FONT></P>
<H2 ALIGN=LEFT><FONT SIZE=3>INVESTMENTS</FONT></H2>
<P><FONT SIZE=3>The following information further supplements the discussion of
the investment objectives and policies in the Prospectus under the caption
“Certain Investment Strategies and Related Risks.” </FONT></P>
<P><FONT SIZE=3>In making selections of equity securities, the Sub-Advisor,
Invista Capital Management LLC (“Invista”) will use an approach
described broadly as fundamental analysis. Fundamental analysis consists of
three steps. First is the continuing study of basic economic factors in an
effort to conclude what the future general economic climate is likely to be over
the next one to two years. Second, given some conviction as to the likely
economic climate, Invista attempts to identify the prospects for the major
industrial, commercial and financial segments of the economy, by looking at such
factors as demand for products, capacity to produce, operating costs, pricing
structure, marketing techniques, adequacy of raw materials and components,
domestic and foreign competition, and research productivity, to ascertain
prospects for each industry for the near and intermediate term. Finally, Invista
determines what the earnings prospects are for individual companies within each
industry by considering the same types of factors described above. Invista
evaluates these earnings prospects in relation to the current price of the
securities of each company. </FONT></P>
<P><FONT SIZE=3>Although each Portfolio may pursue the investment practices
described under the captions Restricted Securities, Foreign Securities, Spread
Transactions, Options on Securities and Securities Indices, and Futures
Contracts and Options on Futures Contracts, Currency Contracts, Repurchase
Agreements, Lending of Portfolio Securities and When-Issued and Delayed Delivery
Securities, none of the Portfolios currently intends to commit during the
present fiscal year more than 5% of its net assets to any of the practices, with
the exception that the Mortgage-Backed Securities Portfolio may commit more than
5% of its net assets in When-Issued and Delayed Delivery Securities. The
International Emerging Markets Portfolio, International Securities Portfolio and
International SmallCap Portfolio will each invest more than 5% of its net assets
in foreign securities. Each Portfolio may commit more than 5% of its assets to
Currency Contracts. </FONT></P>
<H2 ALIGN=LEFT><FONT SIZE=3><U><U><U>Restricted Securities</U></U></U><U><U></U></U></FONT></H2>
<P><FONT SIZE=3>Each Portfolio is subject to an investment restriction that
limits its investments in illiquid securities to 15% of its net asset value. In
computing the Portfolio’s net asset value per share, illiquid securities
are valued at their fair value as determined in good faith by or under the
direction of the Board of Directors. </FONT></P>
<P><FONT SIZE=3>Each Portfolio may acquire securities that are subject to legal
or contractual restrictions upon resale. Securities subject to such restrictions
(“restricted securities”) are frequently treated as illiquid for
purposes of the 15% restriction. Such securities may be sold only in a public
offering with respect to which a registration statement is in effect under the
Securities Act of 1933 (“1933 Act”) or in a transaction which is
exempt from the registration requirements of that act. One such exemption is
provided by Rule 144A under the 1933 Act, pursuant to which certain restricted
securities may be sold at a readily ascertainable price. The Board of Directors
has adopted procedures to determine the liquidity of restricted securities
qualifying for Rule 144A treatment, and any such securities so determined to be
liquid will be excluded when applying the Portfolio’s limitation on
illiquid securities. To the extent Rule 144A securities held by a Portfolio
should become illiquid because of a lack of interest on the part of qualified
institutional investors, the overall liquidity of the Portfolio could be
adversely affected. </FONT></P>
<P><FONT SIZE=3>When registration of a restricted security is required, a
Portfolio may be obligated to pay all or a part of the registration expenses and
a considerable period may elapse between the time of the decision to sell and
the time the Portfolio may be permitted to sell the security under an effective
registration statement. If during such a period adverse market conditions were
to develop, the Portfolio might obtain a less favorable price than prevailed
when it decided to sell. </FONT></P>
<H2 ALIGN=LEFT><FONT SIZE=3><U><U><U>Foreign Securities</U></U></U><U><U></U></U></FONT></H2>
<P><FONT SIZE=3>Investment in foreign securities presents certain risks,
including those resulting from fluctuations in currency exchange rates,
revaluation of currencies, the imposition of foreign taxes, the withholding of
taxes on dividends at the source, future political and economic developments
including war, expropriations, nationalization, the possible imposition of
currency exchange controls and other foreign governmental laws or restrictions,
reduced availability of public information concerning issuers, and the fact that
foreign issuers are not generally subject to uniform accounting, auditing and
financial reporting standards or to other regulatory practices and requirements
comparable to those applicable to domestic issuers. Moreover, securities of many
foreign issuers may be less liquid and their prices more volatile than those of
comparable domestic issuers. In addition, transactions in foreign securities may
be subject to higher costs, and the time for settlement of transactions in
foreign securities may be longer than the settlement period for domestic
issuers. A Portfolio’s investment in foreign securities may also result in
higher custodial costs and the costs associated with currency conversions. </FONT></P>
<P><FONT SIZE=3>Securities of many foreign issuers may be less liquid and their
prices more volatile than those of comparable domestic issuers. In particular,
securities markets in emerging market countries are known to experience long
delays between the trade and settlement dates of securities purchased and sold,
potentially resulting in a lack of liquidity and greater volatility in the price
of securities on those markets. In addition, investments in smaller companies
may present greater opportunities for capital appreciation, but may also involve
greater risks than large, mature issuers. Such companies may have limited
product lines and financial resources. Their securities may trade in more
limited volume than larger companies and may therefore experience significantly
more price volatility and less liquidity than securities of larger companies. As
a result of these factors, the Boards of Directors of the Funds have adopted
Daily Pricing and Valuation Procedures for the Funds which set forth the steps
to be followed by the Manager and Sub-Advisor to establish a reliable market or
fair value if a reliable market value is not available through normal market
quotations. Oversight of this process is provided by the Executive Committee of
the Boards of Directors. </FONT></P>
<H2 ALIGN=LEFT><FONT SIZE=3><U><U><U>Spread Transactions, Options on Securities and
Securities Indices, Futures Contracts and Options on Futures Contracts, and
Currency Contracts</U></U></U><U><U></U></U></FONT></H2>
<P><FONT SIZE=3>Except as specifically indicated otherwise, each Portfolio may engage in the practices described under this
heading to attempt to hedge market value, interest rate and currency risks and, in certain cases, to enhance its
income.</FONT></P>
<H2 ALIGN=LEFT><FONT SIZE=3> <U><U><U>Spread Transactions</U></U></U><U><U></U></U></FONT></H2>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=10%> </TD>
<TD WIDTH=90%><FONT SIZE=3>
A Portfolio may purchase from securities dealers covered spread options. Such
covered spread options are not presently exchange listed or traded. The purchase
of a spread option gives the Portfolio the right to put, or sell, a security
that it owns at a fixed dollar spread or fixed yield spread in relationship to
another security that the Portfolio does not own, but which is used as a
benchmark. The risk to the Portfolio in purchasing covered spread options is the
cost of the premium paid for the spread option and any transaction costs. In
addition, there is no assurance that closing transactions will be available. The
purchase of spread options can be used to protect the Portfolio against adverse
changes in prevailing credit quality spreads, i.e., the yield spread between
high quality and lower quality securities. The security covering the spread
option will be maintained in a segregated account by the Portfolio’s
custodian. A security covered by a spread option is not considered to be
“pledged” as that term is used in the Portfolio’s policy limiting
the pledging or mortgaging of assets.</FONT></TD>
</TR>
</TABLE>
<BR>
<H2 ALIGN=LEFT><FONT SIZE=3> <U><U><U>Options on
Securities and Securities Indices</U></U></U><U><U></U></U></FONT></H2>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=10%> </TD>
<TD WIDTH=90%><FONT SIZE=3>
Each
Portfolio may write (sell) and purchase call and put options on securities in
which it may invest and on securities indices based on securities in which the
Portfolio may invest. The Portfolio may write call and put options to generate
additional revenue, and may write and purchase call and put options in seeking
to hedge against a decline in the value of securities owned or an increase in
the price of securities which the Portfolio plans to purchase.</FONT></TD>
</TR>
</TABLE>
<BR>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=10%> </TD>
<TD WIDTH=90%><FONT SIZE=3>
<U><U><U>Writing
Covered Call and Put Options</U></U></U><U><U></U></U>. When a Portfolio writes
a call option, it gives the purchaser of the option, in return for the premium
it receives, the right to buy from the Portfolio the underlying security at a
specified price at any time before the option expires. When a Portfolio writes a
put option, it gives the purchaser of the option, in return for the premium it
receives, the right to sell to the Portfolio the underlying security at a
specified price at any time before the option expires.</FONT></TD>
</TR>
</TABLE>
<BR>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=10%> </TD>
<TD WIDTH=90%><FONT SIZE=3>
The premium received by a Portfolio, when it writes a put or call option, reflects,
among other factors, the current market price of the underlying security, the
relationship of the exercise price to the market price, the time period until
the expiration of the option and interest rates. The premium will generate
additional income for the Portfolio if the option expires unexercised or is
closed out at a profit. By writing a call, a Portfolio limits its opportunity to
profit from any increase in the market value of the underlying security above
the exercise price of the option, but it retains the risk of loss if the price
of the security should decline. By writing a put, a Portfolio assumes the risk
that it may have to purchase the underlying security at a price that may be
higher than its market value at time of exercise.</FONT></TD>
</TR>
</TABLE>
<BR>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=10%> </TD>
<TD WIDTH=90%><FONT SIZE=3>
The Portfolios write only covered options and will comply with applicable regulatory
and exchange cover requirements. A Portfolio will own the underlying security
covered by any outstanding call option that it has written or will be able to
acquire such security through the exercise of conversion privileges on
convertible securities or otherwise at no additional cost. With respect to an
outstanding put option that it has written, each Portfolio will deposit and
maintain with its custodian cash, U.S. Government securities or other liquid
securities with a value at least equal to the exercise price of the option.</FONT></TD>
</TR>
</TABLE>
<BR>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=10%> </TD>
<TD WIDTH=90%><FONT SIZE=3>
Once a Portfolio has written an option, it may terminate its obligation, before the
option is exercised, by effecting a closing transaction, which is accomplished
by the Portfolio’s purchasing an option of the same series as the option
previously written. The Portfolio will have a gain or loss depending on whether
the premium received when the option was written exceeds the closing purchase
price plus related transaction costs.</FONT></TD>
</TR>
</TABLE>
<BR>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=10%> </TD>
<TD WIDTH=90%><FONT SIZE=3>
<U><U><U>Purchasing
Call and Put Options</U></U></U><U><U></U></U>. When a Portfolio purchases a
call option, it receives, in return for the premium it pays, the right to buy
from the writer of the option the underlying security at a specified price at
any time before the option expires. The Portfolio may purchase call options in
anticipation of an increase in the market value of securities that it intends
ultimately to buy. During the life of the call option, the Portfolio would be
able to buy the underlying security at the exercise price regardless of any
increase in the market price of the underlying security. In order for a call
option to result in a gain, the market price of the underlying security must
rise to a level that exceeds the sum of the exercise price, the premium paid and
transaction costs. If the option expires unexercised, the Portfolio will lose
the premium paid and any transaction costs incurred.</FONT></TD>
</TR>
</TABLE>
<BR>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=10%> </TD>
<TD WIDTH=90%><FONT SIZE=3>
When a Portfolio purchases a put option, it receives, in return for the premium it
pays, the right to sell to the writer of the option the underlying security at a
specified price at any time before the option expires. The Portfolio may
purchase put options in anticipation of a decline in the market value of the
underlying security. During the life of the put option, the Portfolio would be
able to sell the underlying security at the exercise price regardless of any
decline in the market price of the underlying security. In order for a put
option to result in a gain, the market price of the underlying security must
decline, during the option period, below the exercise price sufficiently to
cover the premium and transaction costs.</FONT></TD>
</TR>
</TABLE>
<BR>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=10%> </TD>
<TD WIDTH=90%><FONT SIZE=3>
Once a Portfolio has purchased an option, it may close out its position by
selling an option of the same series as the option previously purchased. The
Portfolio will have a gain or loss depending on whether the closing sale price
exceeds the initial purchase price plus related transaction costs.</FONT></TD>
</TR>
</TABLE>
<BR>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=10%> </TD>
<TD WIDTH=90%><FONT SIZE=3>
<U><U><U>Options
on Securities Indices</U></U></U><U><U></U></U>. Each Portfolio may purchase and
sell put and call options on any securities index based on securities in which
the Portfolio may invest. Securities index options are designed to reflect price
fluctuations in a group of securities or segment of the securities market rather
than price fluctuations in a single security. Options on securities indices are
similar to options on securities, except that the exercise of securities index
options requires cash payments and does not involve the actual purchase or sale
of securities. A Portfolio would engage in transactions in put and call options
on securities indices for the same purposes, as it would engage in transactions
in options on securities. When a Portfolio writes call options on securities
indices, it will hold in its portfolio underlying securities which, in the
judgment of Invista, correlate closely with the securities index and which have
a value at least equal to the aggregate amount of the securities index options.</FONT></TD>
</TR>
</TABLE>
<BR>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=10%> </TD>
<TD WIDTH=90%><FONT SIZE=3>
<U><U><U>Risks
Associated with Options Transactions</U></U></U><U><U></U></U>. An options
position may be closed out only on an exchange which provides a secondary market
for an option of the same series. Although a Portfolio will generally purchase
or write only those options for which there appears to be an active secondary
market, there is no assurance that a liquid secondary market on an exchange will
exist for any particular option, or at any particular time. For some options, no
secondary market on an exchange or elsewhere may exist. If a Portfolio is unable
to effect closing sale transactions in options it has purchased, the Portfolio
would have to exercise its options in order to realize any profit and may incur
transaction costs upon the purchase or sale of underlying securities pursuant
thereto. If a Portfolio is unable to effect a closing purchase transaction for a
covered option that it has written, it will not be able to sell the underlying
securities, or dispose of the assets held in a segregated account, until the
option expires or is exercised. A Portfolio’s ability to terminate option
positions established in the over-the-counter market may be more limited than
for exchange-traded options and may also involve the risk that broker-dealers
participating in such transactions might fail to meet their obligations.</FONT></TD>
</TR>
</TABLE>
<BR>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=10%> </TD>
<TD WIDTH=90%><FONT SIZE=3>
A Portfolio’s hedging strategy that employs options on a securities index may
be unsuccessful due to imperfect correlation between the securities in the index
and the securities owned by the Portfolio. In addition, if Invista is incorrect
in predicting the direction of stock prices, interest rates and other economic
factors, hedging through the use of options could result in a lower return than
if the Portfolio had not hedged its investments.</FONT></TD>
</TR>
</TABLE>
<BR>
<H2 ALIGN=LEFT><FONT SIZE=3> <U><U><U>Futures
Contracts and Options on Futures</U></U></U><U><U></U></U></FONT></H2>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=10%> </TD>
<TD WIDTH=90%><FONT SIZE=3>
Each Portfolio may purchase and sell financial futures contracts and options on those
contracts. Financial futures contracts are commodities contracts based on
financial instruments such as U.S. Treasury bonds or bills or on securities
indices such as the S&P 500 Index. Futures contracts, options on futures
contracts and the commodity exchanges on which they are traded are regulated by
the Commodity Futures Trading Commission (“CFTC”). Through the
purchase and sale of futures contracts and related options, a Portfolio may seek
to hedge against a decline in securities owned by the Portfolio or an increase
in the price of securities, which the Portfolio plans to purchase.</FONT></TD>
</TR>
</TABLE>
<BR>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=10%> </TD>
<TD WIDTH=90%><FONT SIZE=3>
<U><U><U>Futures
Contracts</U></U></U><U><U></U></U>. When a Portfolio sells a futures contract
based on a financial instrument, the Portfolio becomes obligated to deliver that
kind of instrument at a specified future time for a specified price. When a
Portfolio purchases the futures contract, it becomes obligated to take delivery
of the instrument at a specified time and to pay the specified price. In most
instances, these contracts are closed out by entering into an offsetting
transaction before the settlement date, thereby canceling the obligation to make
or take delivery of specific securities. The Portfolio realizes a gain or loss
depending on whether the price of an offsetting purchase plus transaction costs
are less or more than the price of the initial sale or on whether the price of
an offsetting sale is more or less than the price of the initial purchase plus
transaction costs. Although a Portfolio will usually liquidate futures contracts
on financial instruments in this manner, it may instead make or take delivery of
the underlying securities whenever it appears economically advantageous to do
so.</FONT></TD>
</TR>
</TABLE>
<BR>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=10%> </TD>
<TD WIDTH=90%><FONT SIZE=3>
A futures contract based on a securities index provides for the purchase or sale
of a group of securities at a specified future time for a specified price. These
contracts do not require actual delivery of securities, but result in a cash
settlement based upon the difference in value of the index between the time the
contract was entered into and the time it is liquidated, which may be at its
expiration or earlier if it is closed out by entering into an offsetting
transaction.</FONT></TD>
</TR>
</TABLE>
<BR>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=10%> </TD>
<TD WIDTH=90%><FONT SIZE=3>
When a futures contract is purchased or sold a brokerage commission is paid, but
unlike the purchase or sale of a security or option, no price or premium is paid
or received. Instead, an amount of cash or U.S. Government securities, which
varies, but is generally about 5% of the contract amount, is deposited by the
Portfolio with its custodian for the benefit of the futures commission merchant
through which the Portfolio engages in the transaction. This amount is known as
“initial margin.” It does not involve the borrowing of funds by the
Portfolio to finance the transaction, but instead represents a “good
faith” deposit assuring the performance of both the purchaser and the
seller under the futures contract. It is returned to the Portfolio upon
termination of the futures contract, if all the Portfolio’s contractual
obligations have been satisfied.</FONT></TD>
</TR>
</TABLE>
<BR>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=10%> </TD>
<TD WIDTH=90%><FONT SIZE=3>
Subsequent payments to and from the broker, known as “variation
margin,” are required to be made on a daily basis as the price of the
futures contract fluctuates, making the long or short positions in the futures
contract more or less valuable, a process known as “marking to
market.” If the position is closed out by taking an opposite position prior
to the settlement date of the futures contract, a final determination of
variation margin is made, additional cash is required to be paid to or released
by the broker, and the Portfolio realizes a loss or gain.</FONT></TD>
</TR>
</TABLE>
<BR>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=10%> </TD>
<TD WIDTH=90%><FONT SIZE=3>
In using futures contracts, a Portfolio will seek to establish more certainly
than would otherwise be possible the effective price of or rate of return on
portfolio securities or securities that the Portfolio proposes to acquire. A
Portfolio, for example, may sell futures contracts in anticipation of a rise in
interest rates which would cause a decline in the value of its debt investments.
When this kind of hedging is successful, the futures contracts should increase
in value when the Portfolio’s debt securities decline in value and thereby
keep the Portfolio’s net asset value from declining as much as it otherwise
would. A Portfolio may also sell futures contracts on securities indices in
anticipation of or during a stock market decline in an endeavor to offset a
decrease in the market value of its equity investments. When a Portfolio is not
fully invested and anticipates an increase in the cost of securities it intends
to purchase, it may purchase financial futures contracts. When increases in the
prices of equities are expected, a Portfolio may purchase futures contracts on
securities indices in order to gain rapid market exposure that may partially or
entirely offset increases in the cost of the equity securities it intends to
purchase.</FONT></TD>
</TR>
</TABLE>
<BR>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=10%> </TD>
<TD WIDTH=90%><FONT SIZE=3>
<U><U><U>Options
on Futures</U></U></U><U><U></U></U>. A Portfolio may also purchase and write
call and put options on futures contracts. A call option on a futures contract
gives the purchaser the right, in return for the premium paid, to purchase a
futures contract (assume a long position) at a specified exercise price at any
time before the option expires. A put option gives the purchaser the right, in
return for the premium paid, to sell a futures contract (assume a short
position), for a specified exercise price, at any time before the option
expires.</FONT></TD>
</TR>
</TABLE>
<BR>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=10%> </TD>
<TD WIDTH=90%><FONT SIZE=3>
Upon the exercise of a call, the writer of the option is obligated to sell the
futures contract (to deliver a long position to the option holder) at the option
exercise price, which will presumably be lower than the current market price of
the contract in the futures market. Upon exercise of a put, the writer of the
option is obligated to purchase the futures contract (deliver a short position
to the option holder) at the option exercise price, which will presumably be
higher than the current market price of the contract in the futures market.
However, as with the trading of futures, most options are closed out prior to
their expiration by the purchase or sale of an offsetting option at a market
price that will reflect an increase or a decrease from the premium originally
paid.</FONT></TD>
</TR>
</TABLE>
<BR>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=10%> </TD>
<TD WIDTH=90%><FONT SIZE=3>
Options on futures can be used to hedge substantially the same risks as might be
addressed by the direct purchase or sale of the underlying futures contracts.
For example, if a Portfolio anticipated a rise in interest rates and a decline
in the market value of the debt securities in its portfolio, it might purchase
put options or write call options on futures contracts instead of selling
futures contracts.</FONT></TD>
</TR>
</TABLE>
<BR>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=10%> </TD>
<TD WIDTH=90%><FONT SIZE=3>
If a Portfolio purchases an option on a futures contract, it may obtain benefits
similar to those that would result if it held the futures position itself. But
in contrast to a futures transaction, the purchase of an option involves the
payment of a premium in addition to transaction costs. In the event of an
adverse market movement, however, the Portfolio will not be subject to a risk of
loss on the option transaction beyond the price of the premium it paid plus its
transaction costs.</FONT></TD>
</TR>
</TABLE>
<BR>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=10%> </TD>
<TD WIDTH=90%><FONT SIZE=3>
When a Portfolio writes an option on a futures contract, the premium paid by the
purchaser is deposited with the Portfolio’s custodian, and the Portfolio
must maintain with its custodian all or a portion of the initial margin
requirement on the underlying futures contract. The Portfolio assumes a risk of
adverse movement in the price of the underlying futures contract comparable to
that involved in holding a futures position. Subsequent payments to and from the
broker, similar to variation margin payments, are made as the premium and the
initial margin requirement are marked to market daily. The premium may partially
offset an unfavorable change in the value of portfolio securities, if the option
is not exercised, or it may reduce the amount of any loss incurred by the
Portfolio if the option is exercised.</FONT></TD>
</TR>
</TABLE>
<BR>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=10%> </TD>
<TD WIDTH=90%><FONT SIZE=3>
<U><U><U>Risks
Associated with Futures Transactions</U></U></U><U><U></U></U>. There are a
number of risks associated with transactions in futures contracts and related
options. A Portfolio’s successful use of futures contracts is subject to
Invista’s ability to predict correctly the factors affecting the market
values of the Portfolio’s portfolio securities. For example, if a Portfolio
was hedged against the possibility of an increase in interest rates which would
adversely affect debt securities held by the Portfolio and the prices of those
debt securities instead increased, the Portfolio would lose part or all of the
benefit of the increased value of its securities which it hedged because it
would have offsetting losses in its futures positions. Other risks include
imperfect correlation between price movements in the financial instrument or
securities index underlying the futures contract, on the one hand, and the price
movements of either the futures contract itself or the securities held by the
Portfolio, on the other hand. If the prices do not move in the same direction or
to the same extent, the transaction may result in trading losses.</FONT></TD>
</TR>
</TABLE>
<BR>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=10%> </TD>
<TD WIDTH=90%><FONT SIZE=3>
Prior to exercise or expiration, a position in futures may be terminated only by
entering into a closing purchase or sale transaction. This requires a secondary
market on the relevant contract market. The Portfolio will enter into a futures
contract or related option only if there appears to be a liquid secondary
market. There can be no assurance, however, that such a liquid secondary market
will exist for any particular futures contract or related option at any specific
time. Thus, it may not be possible to close out a futures position once it has
been established. Under such circumstances, the Portfolio would continue to be
required to make daily cash payments of variation margin in the event of adverse
price movements. In such situations, if the Portfolio has insufficient cash, it
may be required to sell portfolio securities to meet daily variation margin
requirements at a time when it may be disadvantageous to do so. In addition, the
Portfolio may be required to perform under the terms of the futures contracts it
holds. The inability to close out futures positions also could have an adverse
impact on a Portfolio’s ability effectively to hedge its portfolio.</FONT></TD>
</TR>
</TABLE>
<BR>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=10%> </TD>
<TD WIDTH=90%><FONT SIZE=3>
Most United States futures exchanges limit the amount of fluctuation permitted
in futures contract prices during a single trading day. This daily limit
establishes the maximum amount that the price of a futures contract may vary
either up or down from the previous day’s settlement price at the end of a
trading session. Once the daily limit has been reached in a particular type of
contract, no more trades may be made on that day at a price beyond that limit.
The daily limit governs only price movements during a particular trading day and
therefore does not limit potential losses because the limit may prevent the
liquidation of unfavorable positions. Futures contract prices have occasionally
moved to the daily limit for several consecutive trading days with little or no
trading, thereby preventing prompt liquidation of futures positions and
subjecting some futures traders to substantial losses.</FONT></TD>
</TR>
</TABLE>
<BR>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=10%> </TD>
<TD WIDTH=90%><FONT SIZE=3>
<U><U><U>Limitations
on the Use of Futures and Options on Futures</U></U></U><U><U></U></U>. The Fund
intends that each Portfolio will come within an exclusion from the definition of
“commodity pool operator” provided by CFTC regulations by complying
with certain limitations on the use of futures and related options prescribed by
those regulations.</FONT></TD>
</TR>
</TABLE>
<BR>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=10%> </TD>
<TD WIDTH=90%><FONT SIZE=3>
No Portfolio will purchase or sell futures contracts or options thereon if
immediately thereafter the aggregate initial margin and premiums exceed 5% of
the fair market value of the Portfolio’s assets, after taking into account
unrealized profits and unrealized losses on any such contracts it has entered
into (except that in the case of an option that is in-the-money at the time of
purchase, the in-the-money amount generally may be excluded in computing the
5%).</FONT></TD>
</TR>
</TABLE>
<BR>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=10%> </TD>
<TD WIDTH=90%><FONT SIZE=3>
The Portfolios will enter into futures contracts and related options
transactions only for <U><U><U>bona fide </U></U></U><U><U></U></U> s permitted
by the CFTC and for other appropriate risk management purposes, if any, which
the CFTC may deem appropriate for mutual funds excluded from the regulations
governing commodity pool operators. A Portfolio is not permitted to engage in
speculative futures trading. Invista will determine that the price fluctuations
in the futures contracts and options on futures used for hedging or risk
management purposes for a Portfolio are substantially related to price
fluctuations in securities held by the Portfolio or which it expects to
purchase. In pursuing traditional hedging activities, each Portfolio will sell
futures contracts or acquire puts to protect against a decline in the price of
securities that the Portfolio owns, and each Portfolio will purchase futures
contracts or calls on futures contracts to protect the Portfolio against an
increase in the price of securities the Portfolio intends to purchase before it
is in a position to do so.</FONT></TD>
</TR>
</TABLE>
<BR>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=10%> </TD>
<TD WIDTH=90%><FONT SIZE=3>
When a Portfolio purchases a futures contract, or purchases a call option on a
futures contract, it will comply with applicable cover requirements, such as
maintaining an amount of cash, cash equivalents or short-term high grade fixed
income securities in a segregated account with the Portfolio’s custodian,
so that the amount so segregated plus the amount of initial margin held for the
account of its broker equals the market value of the futures contract.</FONT></TD>
</TR>
</TABLE>
<BR>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=10%> </TD>
<TD WIDTH=90%><FONT SIZE=3>
A Portfolio will not maintain open short positions in futures contracts, call
options written on futures contracts, and call options written on securities
indices if, in the aggregate, the value of the open positions (marked to market)
exceeds the current market value of that portion of its securities portfolio
being hedged by those futures and options plus or minus the unrealized gain or
loss on those open positions, adjusted for the historical volatility
relationship between that portion of the portfolio and the contracts
(<U><U><U>i.e.</U></U></U><U><U></U></U>, the Beta volatility factor). To the
extent a Portfolio has written call options on specific securities in that
portion of its portfolio, the value of those securities will be deducted from
the current market value of that portion of the securities portfolio. If this
limitation should be exceeded at any time, the Portfolio will take prompt action
to close out the appropriate number of open short positions to bring its open
futures and options positions within this limitation.</FONT></TD>
</TR>
</TABLE>
<BR>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=10%> </TD>
<TD WIDTH=90%><FONT SIZE=3>
<U><U><U>Currency Contracts</U></U></U><U><U></U></U></FONT></TD>
</TR>
</TABLE>
<BR>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=10%> </TD>
<TD WIDTH=90%><FONT SIZE=3>
The International Emerging Markets Portfolio, International Securities Portfolio and
International SmallCap Portfolio each may engage in currency transactions with
securities dealers, financial institutions or other parties that are deemed
credit worthy by Invista to hedge the value of portfolio securities denominated
in particular currencies against fluctuations in relative value. Currency
transactions include forward currency contracts, exchange-listed currency
futures contracts and options thereon and exchange-listed and over-the-counter
options on currencies. A forward currency contract involves a privately
negotiated obligation to purchase or sell (with delivery generally required) a
specific currency at a future date, which may be any fixed number of days from
the date of the contract agreed upon the parties, at a price set at the time of
the contract.</FONT></TD>
</TR>
</TABLE>
<BR>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=10%> </TD>
<TD WIDTH=90%><FONT SIZE=3>
A Portfolio will engage in currency transactions only for hedging and other
non-speculative purposes, including transaction hedging and position hedging.
Transaction hedging is entering into a currency transaction with respect to
specific assets or liabilities of a Portfolio, which will generally arise in
connection with the purchase or sale of the Portfolio’s portfolio
securities or the receipt of income from them. Position hedging is entering into
a currency transaction with respect to portfolio securities positions
denominated or generally quoted in that currency. A Portfolio will not enter
into a transaction to hedge currency exposure to an extent greater, after
netting all transactions intended wholly or partially to offset other
transactions, than the aggregate market value (at the time of entering into the
transaction) of the securities held by the Portfolio that are denominated or
generally quoted in or currently convertible into the currency, other than with
respect to proxy hedging as described below.</FONT></TD>
</TR>
</TABLE>
<BR>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=10%> </TD>
<TD WIDTH=90%><FONT SIZE=3>
A Portfolio may cross-hedge currencies by entering into transactions to purchase
or sell one or more currencies that are expected to increase or decline in value
relative to other currencies to which the Portfolio has or in which the
Portfolio expects to have exposure. To reduce the effect of currency
fluctuations on the value of existing or anticipated holdings of its securities,
a Portfolio may also engage in proxy hedging. Proxy hedging is often used when
the currency to which a Portfolio’s holding is exposed is difficult to
hedge generally or difficult to hedge against the dollar. Proxy hedging entails
entering into a forward contract to sell a currency, the changes in the value of
which are generally considered to be linked to a currency or currencies in which
some or all of a Portfolio’s securities are or are expected to be
denominated, and to buy dollars. The amount of the contract would not exceed the
market value of the Portfolio’s securities denominated in linked
currencies.</FONT></TD>
</TR>
</TABLE>
<BR>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=10%> </TD>
<TD WIDTH=90%><FONT SIZE=3>
Except when a Portfolio enters into a forward contract in connection with the
purchase or sale of a security denominated in a foreign currency or for other
non-speculative purposes, which requires no segregation, a currency contract
that obligates the Portfolio to buy or sell a foreign currency will generally
require the Portfolio to place any asset, including equity securities and
non-investment grade debt, in a segregated account, so long as the asset is
liquid and marked to the market daily. The amount so segregated shall be equal
to the amount of the Portfolio’s obligation.</FONT></TD>
</TR>
</TABLE>
<BR>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=10%> </TD>
<TD WIDTH=90%><FONT SIZE=3>
Currency hedging involves some of the same risks and considerations as other
transactions with similar instruments. Currency transactions can result in
losses to a Portfolio if the currency being hedged fluctuates in value to a
degree or in a direction that is not anticipated. Further, the risk exists that
the perceived linkage between various currencies may not be present or may not
be present during the particular time that a Portfolio is engaging in proxy
hedging. Currency transactions are also subject to risks different from those of
other portfolio transactions. Because currency control is of great importance to
the issuing governments and influences economic planning and policy, purchases
and sale of currency and related instruments can be adversely affected by
government exchange controls, limitations or restrictions on repatriation of
currency, and manipulations or exchange restrictions imposed by governments.
These forms of governmental actions can result in losses to a Portfolio if it is
unable to deliver or receive currency or monies in settlement of obligations and
could also cause hedges it has entered into to be rendered useless, resulting in
full currency exposure as well as incurring transaction costs. Currency exchange
rates may also fluctuate based on factors extrinsic to a country’s economy.
Buyers and sellers of currency futures contracts are subject to the same risks
that apply to the use of futures contracts generally. Further, settlement of a
currency futures contract for the purchase of most currencies must occur at a
bank based in the issuing nation. Trading options on currency futures contracts
is relative new, and the ability to establish and close out positions on these
options is subject to the maintenance of a liquid market that may not always be
available.</FONT></TD>
</TR>
</TABLE>
<BR>
<H2 ALIGN=LEFT><FONT SIZE=3>
<U><U><U>Repurchase Agreements</U></U></U><U><U></U></U></FONT></H2>
<P><FONT SIZE=3>Each Portfolio may invest in repurchase agreements. No Portfolio
will enter into repurchase agreements that do not mature within seven days if
any such investment, together with other illiquid securities held by the
Portfolio, would amount to more than 15% of its assets. Repurchase agreements
will typically involve the acquisition by the Portfolio of debt securities from
a selling financial institution such as a bank, savings and loan association or
broker-dealer. A repurchase agreement provides that the Portfolio will sell back
to the seller and that the seller will repurchase the underlying securities at a
specified price and at a fixed time in the future. Repurchase agreements may be
viewed as loans by a Portfolio collateralized by the underlying securities
(“collateral”). This arrangement results in a fixed rate of return
that is not subject to market fluctuation during the Portfolio’s holding
period. Although repurchase agreements involve certain risks not associated with
direct investments in debt securities, each Portfolio follows procedures
established by the Board of Directors that are designed to minimize such risks.
These procedures include entering into repurchase agreements only with large,
well-capitalized and well-established financial institutions, which have been
approved by the Board of Directors and which Invista believes present minimum
credit risks. In addition, the value of the collateral underlying the repurchase
agreement will always be at least equal to the repurchase price, including
accrued interest. In the event of a default or bankruptcy by a selling financial
institution, the affected Portfolio bears a risk of loss. In seeking to
liquidate the collateral, a Portfolio may be delayed in or prevented from
exercising its rights and may incur certain costs. Further to the extent that
proceeds from any sale upon a default of the obligation to repurchase were less
than the repurchase price, the Portfolio could suffer a loss. </FONT></P>
<H2 ALIGN=LEFT><FONT SIZE=3>
<U><U><U>Lending of Portfolio Securities</U></U></U><U><U></U></U></FONT></H2>
<P><FONT SIZE=3>All Portfolios may lend their portfolio securities. None of the
Portfolios will lend its portfolio securities if as a result the aggregate of
such loans made by the Portfolio would exceed the limits established by the
Investment Company Act. Portfolio securities may be lent to unaffiliated
broker-dealers and other unaffiliated qualified financial institutions provided
that such loans are callable at any time on not more than five business
days’ notice and that cash or government securities equal to at least 100%
of the market value of the securities loaned, determined daily, is deposited by
the borrower with the Portfolio and is maintained each business day. While such
securities are on loan, the borrower pays the Portfolio any income accruing
thereon. The Portfolio may invest any cash collateral, thereby earning
additional income, and may receive an agreed-upon fee from the borrower.
Borrowed securities must be returned when the loan terminates. Any gain or loss
in the market value of the borrowed securities which occurs during the term of
the loan belongs to the Portfolio and its shareholders. A Portfolio pays
reasonable administrative, custodial and other fees in connection with such
loans and may pay a negotiated portion of the interest earned on the cash or
government securities pledged as collateral to the borrower or placing broker. A
Portfolio does not normally retain voting rights attendant to securities it has
lent, but it may call a loan of securities in anticipation of an important vote. </FONT></P>
<H2 ALIGN=LEFT><FONT SIZE=3>
<U><U><U>When-Issued and Delayed Delivery Securities</U></U></U><U><U></U></U></FONT></H2>
<P><FONT SIZE=3>Each of the Portfolios may from time to time purchase securities
on a when-issued basis and may purchase or sell securities on a delayed delivery
basis. The price of such a transaction is fixed at the time of the commitment,
but delivery and payment take place on a later settlement date, which may be a
month or more after the date of the commitment. No interest accrues to the
purchaser during this period, and the securities are subject to market
fluctuation, which involves the risk for the purchaser that yields available in
the market at the time of delivery may be higher than those obtained in the
transaction. Each Portfolio will only purchase securities on a when-issued or
delayed delivery basis for the purpose of acquiring the securities and not for
the purpose of investment leverage or to speculate on interest rate changes, but
a Portfolio may sell the securities before the settlement date, if such action
is deemed advisable. At the time a Portfolio makes the commitment to purchase
securities on a when-issued or delayed delivery basis, the Fund will record the
transaction and thereafter reflect the value, each day, of the securities in
determining the net asset value of the Portfolio. Each Portfolio will also
establish a segregated account with its custodian bank in which it will maintain
cash or cash equivalents, United States Government securities and other high
grade debt obligations equal in value to the Portfolio’s commitments for
such when-issued or delayed delivery securities. The availability of liquid
assets for this purpose and the effect of asset segregation on a
Portfolio’s ability to meet its current obligations, to honor requests for
redemption and to have its investment portfolio managed properly will limit the
extent to which the Portfolio may engage in forward commitment agreements.
Except as may be imposed by these factors, there is no limit on the percent of a
Portfolio’s total assets that may be committed to transactions in such
agreements. </FONT></P>
<H2 ALIGN=LEFT><FONT SIZE=3><U><U><U>Portfolio
Turnover</U></U></U><U><U></U></U></FONT></H2>
<P><FONT SIZE=3>Portfolio turnover will normally differ for each Portfolio, may
vary from year to year, as well as within a year, and may be affected by
portfolio sales necessary to meet cash requirements for redemption of Portfolio
shares. The portfolio turnover rate for a Portfolio is calculated by dividing
the lesser of purchases or sales of its portfolio securities during the fiscal
year by the monthly average of the value of its portfolio securities (excluding
from the computation all securities, including options, with maturities at the
time of acquisition of one year or less). A high rate of portfolio turnover
generally involves correspondingly greater brokerage commission expenses, which
must be borne directly by the Portfolio. </FONT></P>
<P><FONT SIZE=3>The Mortgage-Backed Securities Portfolio intends to be active in
the forward commitment market when the return from holding forward positions
appears to be greater than the return from holding the actual securities. The
Portfolio will enter into forward commitment contracts to purchase securities
for the purpose of acquiring those securities and not for the purpose of
investment leverage or to speculate on interest rate changes, but as delivery
dates approach, a determination will be made whether to take delivery of a
specific forward position, or sell that position and purchase another forward
position. Because of this strategy, it is anticipated that its annual portfolio
turnover rate should generally exceed 100% and may be as much as 600% or more,
although this rate should not be construed as a limiting factor. The effect of a
high turnover rate would be to incur more transaction expenses than would be
incurred at a lower turnover rate, and there is no assurance that the additional
transactions that cause the higher turnover rate would result in gains for the
Portfolio or in sufficient gains to offset the increased transaction expenses.
The annualized portfolio turnover rates for each portfolio for its most recent
and immediately preceding fiscal year were as follows (annualized when reporting
period is less than one year): International Emerging Markets 107.5% and 36.5%;
International Securities 71.4% and 36.7%; International SmallCap Portfolio
236.3% and 88.5%; Mortgage-Backed Securities 17.0% and 13.8%. </FONT></P>
<H1 ALIGN=LEFT><FONT SIZE=3>DIRECTORS AND OFFICERS OF THE FUND</FONT></H1>
<P><FONT SIZE=3>The following listing discloses the principal occupations and
other principal business affiliations of the Fund’s Officers and Directors
during the past five years. All Directors and Officers listed here also hold
similar positions with each of the other mutual funds sponsored by Principal
Life Insurance Company. All mailing addresses are The Principal Financial Group,
Des Moines, Iowa 50392, unless otherwise indicated. </FONT></P>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%><FONT SIZE=3></FONT></TD>
<TD WIDTH=5%><FONT SIZE=3>@</FONT></TD>
<TD WIDTH=90%><FONT SIZE=3>
James D. Davis, 66, Director. 4940 Center Court, Bettendorf, Iowa. Attorney.
Vice President, Deere and Company, retired.</FONT></TD>
</TR>
</TABLE>
<BR>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%><FONT SIZE=3></FONT></TD>
<TD WIDTH=5%><FONT SIZE=3>*&</FONT></TD>
<TD WIDTH=90%><FONT SIZE=3>
Ralph C. Eucher, 47, Director and President. Vice President, Principal Life
Insurance Company since 1999. Director and President, Princor Financial Services
Corporation and Principal Management Corporation since 1999. Prior thereto,
Second Vice President, Principal Life Insurance Company.</FONT></TD>
</TR>
</TABLE>
<BR>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%><FONT SIZE=3></FONT></TD>
<TD WIDTH=5%><FONT SIZE=3>@</FONT></TD>
<TD WIDTH=90%><FONT SIZE=3>
Pamela A. Ferguson, 56, Director, 4112 River Oaks Drive, Des Moines, Iowa.
Professor of Mathematics, Grinnell College since 1998. Prior thereto, President,
Grinnell College.</FONT></TD>
</TR>
</TABLE>
<BR>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%><FONT SIZE=3></FONT></TD>
<TD WIDTH=5%><FONT SIZE=3>*&</FONT></TD>
<TD WIDTH=90%><FONT SIZE=3>
J. Barry Griswell, 51, Director and Chairman of the Board. President and CEO,
Principal Life Insurance Company since 2000; President, 1998-2000; Executive
Vice President, 1996-1998. Senior Vice President, 1991-1996. Director and
Chairman of the Board, Principal Management Corporation and Princor Financial
Services Corporation.</FONT></TD>
</TR>
</TABLE>
<BR>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%><FONT SIZE=3></FONT></TD>
<TD WIDTH=5%><FONT SIZE=3>@&</FONT></TD>
<TD WIDTH=90%><FONT SIZE=3>
Barbara A. Lukavsky, 59, Director. 13731 Bay Hill Court, Clive, Iowa. President
and CEO, Barbican Enterprises, Inc. since 1997. President and CEO, Lu San ELITE
USA, L.C., 1985-1998.</FONT></TD>
</TR>
</TABLE>
<BR>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%><FONT SIZE=3></FONT></TD>
<TD WIDTH=5%><FONT SIZE=3>*</FONT></TD>
<TD WIDTH=90%><FONT SIZE=3>
Craig L. Bassett, 48, Treasurer. Second Vice President and Treasurer, Principal
Life Insurance Company since 1998. Director - Treasury, 1996-1998. Prior
thereto, Associate Treasurer.</FONT></TD>
</TR>
</TABLE>
<BR>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%><FONT SIZE=3></FONT></TD>
<TD WIDTH=5%><FONT SIZE=3>*</FONT></TD>
<TD WIDTH=90%><FONT SIZE=3>
Michael J. Beer, 39, Executive Vice President. Executive Vice President, Princor
Financial Services Corporation and Principal Management Corporation since 1999.
Senior Vice President and Chief Operating Officer, 1997-1999. Vice President and
Chief Operating Officer, 1995-1997. Prior thereto, Financial Officer.</FONT></TD>
</TR>
</TABLE>
<BR>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%><FONT SIZE=3></FONT></TD>
<TD WIDTH=5%><FONT SIZE=3>*</FONT></TD>
<TD WIDTH=90%><FONT SIZE=3>
Arthur S. Filean, 61, Senior Vice President and Secretary. Senior Vice
President, Princor Financial Services Corporation and Principal Management
Corporation since 2000. Vice President, Princor Financial Services Corporation,
1990-2000. Vice President, Principal Management Corporation, 1996-2000.</FONT></TD>
</TR>
</TABLE>
<BR>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%><FONT SIZE=3></FONT></TD>
<TD WIDTH=5%><FONT SIZE=3>*</FONT></TD>
<TD WIDTH=90%><FONT SIZE=3>
Ernest H. Gillum, 44, Vice President and Assistant Secretary. Vice President -
Product Development, Princor Financial Services Corporation and Principal
Management Corporation since 2000. Vice President - Compliance and Product
Development, Princor Financial Services Corporation and Principal Management
Corporation, 1998-2000. Assistant Vice President, Registered Products,
1995-1998. Prior thereto, Product Development and Compliance Officer.</FONT></TD>
</TR>
</TABLE>
<BR>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%><FONT SIZE=3></FONT></TD>
<TD WIDTH=5%><FONT SIZE=3></FONT></TD>
<TD WIDTH=90%><FONT SIZE=3>
Jane E. Karli, 43, Assistant Treasurer. Assistant Treasurer, Principal Life
Insurance Company since 1998. Senior Accounting and Custody Administrator,
1994-1998; Prior thereto, Senior Investment Cost Accountant.</FONT></TD>
</TR>
</TABLE>
<BR>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%><FONT SIZE=3></FONT></TD>
<TD WIDTH=5%><FONT SIZE=3>*</FONT></TD>
<TD WIDTH=90%><FONT SIZE=3>
Michael D. Roughton, 48, Counsel. Vice President and Senior Securities Counsel,
Principal Life Insurance Company since 1999. Counsel, 1994-1999. Counsel,
Invista Capital Management, LLC, Princor Financial Services Corporation and
Principal Management Corporation.</FONT></TD>
</TR>
</TABLE>
<BR>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%><FONT SIZE=3></FONT></TD>
<TD WIDTH=5%><FONT SIZE=3>*</FONT></TD>
<TD WIDTH=90%><FONT SIZE=3>
Layne Rasmussen, 41, Controller. Controller, Principal Mangement Corp. and
Princor Financial Services Corp. since 1995. Prior thereto, Manager - Mutual
Fund Accounting.</FONT></TD>
</TR>
</TABLE>
<BR>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%><FONT SIZE=3></FONT></TD>
<TD WIDTH=5%><FONT SIZE=3>*</FONT></TD>
<TD WIDTH=90%><FONT SIZE=3>
Jean B. Schustek, 48, Assistant Vice President and Assistant Secretary.
Assistant Vice President - Registered Products, Princor Financial Services
Corporation since 2000. Prior thereto, Compliance Officer - Registered Products.</FONT></TD>
</TR>
</TABLE>
<BR>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%><FONT SIZE=3></FONT></TD>
<TD WIDTH=5%><FONT SIZE=3>*</FONT></TD>
<TD WIDTH=90%><FONT SIZE=3>
Traci Weldon, 34, Assistant Counsel. Counsel, Principal Life Insurance Company
since 1999. Assistant Counsel 1998-1999. Assistant State Attorney General, Iowa
Attorney General's Office, 1994-1998. Prior thereto, Investment Banker,
Kirkpatrick Pettis.</FONT></TD>
</TR>
</TABLE>
<BR>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%><FONT SIZE=3></FONT></TD>
<TD WIDTH=5%><FONT SIZE=3>@</FONT></TD>
<TD WIDTH=90%><FONT SIZE=3>
Member of Audit and Nominating Committee.</FONT></TD>
</TR>
</TABLE>
<BR>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%><FONT SIZE=3></FONT></TD>
<TD WIDTH=5%><FONT SIZE=3>*</FONT></TD>
<TD WIDTH=90%><FONT SIZE=3>
Affiliated with the Manager of the Fund or its parent and considered an
“Interested Persons,” as defined in the Investment Company Act of
1940, as amended.</FONT></TD>
</TR>
</TABLE>
<BR>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%><FONT SIZE=3></FONT></TD>
<TD WIDTH=5%><FONT SIZE=3>&</FONT></TD>
<TD WIDTH=90%><FONT SIZE=3>
Member of the Executive Committee. The Executive Committee is elected by the
Board of Directors and may exercise all the powers of the Board of Directors,
with certain exceptions, when the Board is not in session and shall report its
actions to the Board.</FONT></TD>
</TR>
</TABLE>
<BR>
COMPENSATION TABLE*
fiscal year ended December 31, 1999 Compensation
Director Compensation from the Fund from Fund Complex
-------- ----------------------------------- -----------------
James D. Davis $2,400 $55,050
Pamela A. Ferguson $2,400 $50,850
Barbara A. Lukavsky $2,400 $50,250
* The Fund does not provide retirement benefits for any of the directors.
<P><FONT SIZE=3>As of March 6, 2000, Principal Life Insurance Company, a life
insurance company organized in 1879 under the laws of Iowa, its subsidiaries and
affiliates owned of record and beneficially the following number of shares or
percentage of the outstanding shares of each Portfolio: </FONT></P>
<HR SIZE=5 NOSHADE>
% of Outstanding
Portfolio Shares
--------- ------
International Emerging Markets Portfolio 83.5%
International Securities Portfolio 43.1%
International SmallCap Portfolio 98.6%
Mortgage-Backed Securities Portfolio 100.0%
<HR SIZE=5 NOSHADE>
<P><FONT SIZE=3>As of March 6, 2000, the Officers and Directors of the Fund as a
group owned less than 1% of the outstanding shares of any Portfolio of the
Fund.</FONT></P>
<P><FONT SIZE=3>As of March 6, 2000, the following shareholders of the Fund
owned 5% or more of the outstanding shares of any Portfolio of the
Fund:</FONT></P>
<HR SIZE=5 NOSHADE>
Percentage
Name Address of Ownership
---- ------- ------------
International Emerging Markets Portfolio
ConAgra Master Pension Trust 1 Enterprise Drive 15.4%
Quincy, MA 02171-2126
International Securities Portfolio
Centurion Life Insurance Company 206 8th Street 16.6%
Des Moines, IA 50309-3805
Norwest Financial Pension Trust 206 8th Street 7.3%
Des Moines, IA 50309-3805
Miter & Co. P.O. Box 2977 7.3%
Milwaukee, WI 53201-2977
Pigeon & Co. P.O. Box 2479 12.6%
San Antonio, TX 78298-2479
<HR SIZE=5 NOSHADE>
<H2 ALIGN=LEFT><FONT SIZE=3>MANAGER AND SUB-ADVISOR</FONT></H2>
<P><FONT SIZE=3>The Manager of each Portfolio of the Fund is Principal
Management Corporation, a wholly-owned subsidiary of Princor Financial Services
Corporation which is an affiliate of Principal Life Insurance Company, a life
insurance company organized in 1879 under the laws of the state of Iowa. The
address of the Manager is The Principal Financial Group, Des Moines, Iowa
50392-0200. The Manager was organized on January 10, 1969 and since that
time has managed various mutual funds sponsored by Principal Life Insurance
Company. </FONT></P>
<P><FONT SIZE=3>The Manager has executed an agreement with Invista Capital
Management, Inc. (“Invista”) under which Invista has agreed to assume
the obligations of the Manager to provide investment advisory services for each
Portfolio and to reimburse the Manager for the other costs it incurs under the
Management Agreement. Invista, an indirectly wholly-owned subsidiary of
Principal Life Insurance Company and an affiliate of the Manager, was founded in
1985 and manages investments for institutional investors, including Principal
Life. Assets under management at December 31, 1999 were approximately $35.3
billion. Invista’s address is 1800 Hub Tower, 699 Walnut, Des Moines, Iowa
50309. </FONT></P>
<P><FONT SIZE=3>Each of the persons affiliated with the Fund who is also an
affiliated person of the Manager or Invista is named below, together with the
capacities in which such person is affiliated with the Fund, Invista and the
Manager: </FONT></P>
Office Held With Office Held With
Name Each Fund The Manager/Invista
---- ------------------- -------------------
Craig L. Bassett Treasurer Treasurer (Manager)
Michael J. Beer Executive Vice President Executive Vice President and
Chief Operating Officer
(Manager)
Ralph C. Eucher Director and Director and President
President (Manager)
Arthur S. Filean Senior Vice President and Senior Vice President
Secretary (Manager)
Ernest H. Gillum Vice President and Vice President - Product
Assistant Secretary Development (Manager)
J. Barry Griswell Director and Chairman Director and Chairman of
of the Board the Board (Manager)
Layne Rasmussen Controller Controller - Mutual Funds
(Manager)
Michael D. Roughton Counsel Counsel (Manager; Invista)
Jean B. Schustek Assistant Vice President and Assistant Vice President -
Assistant Secretary Registered Products
(Manager)
<H2 ALIGN=LEFT><FONT SIZE=3>COST OF MANAGER'S SERVICES</FONT></H2>
<P><FONT SIZE=3>The Manager has entered into a Management Agreement with the
Fund that requires the Manager to act as investment adviser and manager of each
Portfolio. As compensation for its services and other responsibilities, the
Manager receives a fee computed and accrued daily and payable monthly. Under a
Sub-Advisory Agreement between Invista and the Manager, Invista performs all
investment advisory responsibilities of the Manger under the Management
Agreement and receive the full amount of the compensation paid by the Fund to
the Manager. </FONT></P>
<P><FONT SIZE=3>The Management Fees are computed at the following annual rates:</FONT></P>
Fees as a
Percent of
Fees Computed On Average Daily
Portfolio Net Asset Value of Portfolio Net Assets
---------------------------------------------------------------------
International Emerging
Markets Portfolio First $250 million 1.15%
Next $250 million 1.05%
Over $500 million 0.95%
International Securities
Portfolio Entire Portfolio 0.90%
International SmallCap
Portfolio First $250 million 1.00%
Next $250 million 0.90%
Over $500 million 0.80%
Mortgage-Backed Securities
Portfolio Entire Portfolio 0.45%
<P><FONT SIZE=3>The net assets of each portfolio on December 31, 1999 and the
rate of the fee for each portfolio for investment management services as
provided in the Management Agreement for the fiscal year then ended were as
follows: </FONT></P>
<HR SIZE=5 NOSHADE>
Management Fee for
Net Assets as of Fiscal Year Ended
Portfolio December 31, 1999 December 31, 1999
--------- ----------------- -----------------
International Emerging Markets $129,574,687 1.15%
International Securities 61,340,966 .90%
International SmallCap 154,892,162 1.00%
Mortgage Backed Securities 5,044,844 .45%
<HR SIZE=5 NOSHADE>
<P><FONT SIZE=3>Fees paid for investment management services during the periods
indicated were as follows: </FONT></P>
<HR SIZE=5 NOSHADE>
Management Fees for Fiscal
Year Ended December 31,
Portfolio except as noted
--------- ----------------------
1999 1998 1997
---- ---- ----
International Emerging Markets $ 1,092,430 $856,612 $ 43,775*
International 463,180 413,285 311,027
Securities 1,045,204 731,367 37,932*
International SmallCap 43,225 64,195 67,721
Mortgage-Backed Securities
<HR SIZE=5 NOSHADE>
<TABLE WIDTH=100% CELLPADDING=0 CELLSPACING=0>
<TR VALIGN=TOP>
<TD WIDTH=5%><FONT SIZE=3></FONT></TD>
<TD WIDTH=5%><FONT SIZE=3>*</FONT></TD>
<TD WIDTH=90%><FONT SIZE=3>
Period beginning November 26, 1997 and ended December 31, 1997</FONT></TD>
</TR>
</TABLE>
<P><FONT SIZE=3>In addition to investment advisory services, the
responsibilities of the Manager under the Management Agreement include various
corporate and administrative services, including furnishing the services of its
officers and employees that are elected to serve as officers or directors of the
Fund; furnishing office space and all necessary office facilities and equipment
for the general corporate functions of the Fund; furnishing the services of
supervisory and clerical personnel necessary to perform such functions;
determining the net asset value per share for the shares of each Portfolio;
acting as and performing the services of transfer and paying agent (including
preparing and distributing prospectuses, shareholder reports, tax information,
notices and proxy statements, making dividend payments, maintaining shareholder
records in an open account system and processing redemptions, repurchases and
remittances to shareholders); and qualifying Fund shares for sale in various
jurisdictions. </FONT></P>
<P><FONT SIZE=3>In addition, the Manager is responsible for all expenses of each
Portfolio except (i) the management fee paid to it by the Fund, (ii) taxes,
including in case of redeemed shares any initial transfer taxes, (iii) portfolio
brokerage fees and incidental brokerage expenses, (iv) interest and (v)
extraordinary expenses. Since brokerage fees are treated as part of the price
paid or received upon the purchase or sale of securities and since taxes,
interest and extraordinary expenses are expected to be minimal, the management
fee should tend to give shareholders an idea as to the expected level of
operating expenses of the Portfolios in which they invest. This arrangement is
different from the fee structures of most mutual funds where one fee is paid to
the investment adviser for advisory services and many or all other expenses
involved with the operation of the fund are paid directly by the fund. </FONT></P>
<P><FONT SIZE=3>Under the terms of the Sub-Advisory Agreement with the Manager,
Invista has agreed to reimburse the Manager for all of its costs in performing
corporate and administrative services and to pay all expenses of the Fund that
the Manager has undertaken to pay under the Management Agreement. </FONT></P>
<P><FONT SIZE=3>The Management Agreement and Sub-Advisory Agreement
(“Agreements”) were last approved by the Fund’s Board of
Directors on September 13, 1999. Both agreements provide that each will continue
in effect as to any Portfolio from year to year only so long such continuance is
specifically approved at least annually either by the Board of Directors of the
Fund or by a vote of a majority of the outstanding voting securities of the Fund
and in either event by vote of a majority of the directors of the Fund who are
not interested persons of the Manager, Principal Life Insurance Company
(“Principal Life”), the Fund and, in the case of the Sub-Advisory
Agreement, Invista, cast in person at a meeting called for the purpose of voting
on such approval. Each Agreement may, on sixty days’ written notice, be
terminated at any time without the payment of any penalty, by the Board of
Directors of the Fund, by vote of a majority of the outstanding voting
securities of the Fund, as to any Portfolio by the vote of a majority of the
outstanding voting securities of that Portfolio, by the Manager, and in the case
of the Sub-Advisory Agreement by Invista. Each Agreement shall automatically
terminate in the event of its assignment. </FONT></P>
<P><FONT SIZE=3>The required shareholder approval of any continuance of either
Agreement shall be effective with respect to any Portfolio if a majority of the
outstanding voting securities of that Portfolio votes to approve the
continuance, notwithstanding that the amendment may not have been approved by a
majority of the outstanding voting securities of the Fund or of any other
Portfolio affected by the amendment. If the shareholders of any Portfolio of the
Fund fail to approve the continuance of either Agreement and that failure causes
the Agreement to be invalid with respect to that Portfolio, the Manager and
Invista will continue to act as investment adviser and sub-adviser with respect
to that Portfolio pending the required approval of the Agreement’s
continuance or of a new contract or other definitive action, provided that the
compensation received by each of the Manager and Invista, in case of the
invalidity of the Management Agreement, or by Invista, in case of the invalidity
of the Sub-Advisory Agreement, in respect of that Portfolio during such period
will be no more than its actual costs incurred in furnishing services to that
Portfolio or the amount it would have received under the Agreement in respect of
that Portfolio, whichever is less. </FONT></P>
<P><FONT SIZE=3>The Management Agreement may be amended but such amendment will
not be effective until specifically approved by vote of the holders of a
majority of the Fund’s outstanding voting securities and by vote of a
majority of the directors of the Fund who are not interested persons of the
Manager, Principal Life or the Fund cast in person at a meeting called for the
purpose of voting on such approval. The required shareholder approval of any
amendment to the Management Agreement shall be effective with respect to any
Portfolio if a majority of the outstanding voting securities of that Portfolio
votes to approve the amendment, notwithstanding that the amendment may not have
been approved by a majority of the outstanding voting securities of the Fund or
of any other Portfolio affected by the matter. </FONT></P>
<P><FONT SIZE=3>The Manager has entered into an Investment Service Agreement
with Principal Life whereby Principal Life has agreed to provide on a part-time
basis such employees as the parties may agree are reasonably needed by the
Manager and Invista in the performance of investment advisory services (but not
corporate or administrative services) under the Management Agreement. Principal
Life also agreed to permit such employees, in performing services for the
Manager and Invista, full access to statistical and economic data, investment
research reports and other non-confidential materials in the files of its
Investment Department. For the services of Principal Life employees, the Manager
will reimburse Principal Life for the direct and indirect costs fairly
attributable to their services performed for the Manager, and the Manager will
be reimbursed for such costs by Invista. The Investment Service Agreement
contains provisions on continuation and termination comparable to those
described above for the Management Agreement. The Management Agreement was last
approved by the Funds Board of Directors on September 13, 1999. </FONT></P>
<H1 ALIGN=LEFT><FONT SIZE=3>BROKERAGE ON PURCHASES AND SALES OF SECURITIES</FONT></H1>
<P><FONT SIZE=3>In distributing brokerage business arising out of the placement
of orders for the purchase and sale of securities for any Portfolio,
Invista’s objective is to obtain the best overall terms. In pursuing this
objective, Invista considers all matters it deems relevant, including the
breadth of the market in the security, the price of the security, the financial
condition and executing capability of the broker or dealer and the
reasonableness of the commission, if any (for the specific transaction and on a
continuing basis). This may mean in some instances that Invista will pay a
broker commissions that are in excess of the amount of commission another broker
might have charged for executing the same transaction when Invista believes that
such commissions are reasonable in light of (a) the size and difficulty of
transactions (b) the quality of the execution provided and (c) the level of
commissions paid relative to commissions paid by other institutional investors.
(Such factors are viewed both in terms of that particular transaction and in
terms of all transactions that broker executes for accounts over which Invista
exercises investment discretion. Invista may purchase securities in the
over-the-counter market, utilizing the services of principal market matters,
unless better terms can be obtained by purchases through brokers or dealers, and
may purchase securities listed on the New York Stock Exchange from non-Exchange
members in transactions off the Exchange.) </FONT></P>
<P><FONT SIZE=3>Invista gives consideration in the allocation of business to
services performed by a broker (e.g. the furnishing of statistical data and
research generally consisting of information of the following types: analyses
and reports concerning issuers, industries, economic factors and trends,
portfolio strategy and performance of client accounts). If any such allocation
is made, the primary criteria used will be to obtain the best overall terms for
such transactions. Invista may pay additional commission amounts for research
services but generally does not do so. Such statistical data and research
information received from brokers or dealers may be useful in varying degrees
and Invista may use it in servicing some or all of the accounts it manages. Some
statistical data and research information may not be useful to Invista in
managing the client account, brokerage for which resulted in Invista’s
receipt of the statistical data and research information. However, in
Invista’s opinion, the value thereof is not determinable and it is not
expected that Invista’s expenses will be significantly raised since the
receipt of such statistical data and research information is only supplementary
to Invista’s own research efforts. The Manager, or Sub-advisor, allocated
portfolio transactions for the International Emerging Markets, International
Securities and International SmallCap Portfolios to certain brokers during the
fiscal year ended December 31, 1999 due to research services provided by such
brokers. These portfolio transactions resulted in commissions paid to the
International Emerging Markets, International and International SmallCap
Portfolios broker by the Fund in the amount of $4,210, $9,381 and $2,690,
respectively. </FONT></P>
<P><FONT SIZE=3>Some products and services brokers provide to Invista (such as
computer hardware) may perform an administrative function (e.g. client
accounting) as well as a research function. In such cases, Invista makes a
reasonable allocation of the cost of the product or service according to
Invista’s use. Invista pays for the portion of the product or service that
consists of research in commission dollars. Invista pays for the portion that
provides it with administrative or non-research assistance with its own money.
Invista’s allocation of such products and services between research and
non-research functions poses a conflict of interest between Invista and its
clients. </FONT></P>
<P><FONT SIZE=3>Annually the officers of Invista call a meeting to determine
dollar limits on business done with brokers who provide useful research
information. A list of products, research and services is kept in Invista’s
office. </FONT></P>
<P><FONT SIZE=3>Purchases and sales of debt securities and money market
instruments usually will be principal transactions and will normally be
purchased directly from the issuer or from an underwriter or marketmaker for the
securities. Such transactions are usually conducted on a net basis with a
Portfolio paying no brokerage commissions. Purchases from underwriters will
include a commission or concession paid by the issuer to the underwriter and the
purchases from dealers serving as marketmakers will include the spread between
the bid and asked prices. </FONT></P>
<P><FONT SIZE=3>The following table shows the brokerage commissions paid during
the periods indicated. In each year, 100% of the commissions paid by each Fund
went to broker-dealers that provided research, statistical or other factual
information. </FONT></P>
<HR SIZE=5 NOSHADE>
Total Brokerage Commissions
Paid During Fiscal Year
Portfolio Ended December 31
--------- -----------------
1999 1998 1997
---- ---- ----
International Emerging Markets $ 678,304 $373,096 $99,367
International Securities 198,432 101,586 78,786
International SmallCap 1,330,219 417,318 80,568
Mortgage-Backed Securities -0- -0- -0-
<HR SIZE=5 NOSHADE>
<P><FONT SIZE=3>Brokerage commissions paid to affiliates during the year ended
December 31 were as follows: </FONT></P>
<H3 ALIGN=CENTER><FONT SIZE=3><U><U><U>Commissions Paid to Goldman Sachs & Co.</U></U></U><U><U></U></U></FONT></H3>
Percent
of Dollar
Total As Percent Amount of
Dollar of Total Commissionable
Portfolio Amount Commissions Transactions
--------- ------ ----------- ------------
International Emerging Markets
1999 $27,048 3.99% 4.17%
1998 17,124 4.59 6.15
International Securities
1999 10,237 5.16 4.70
1998 6,290 6.19 4.66
International SmallCap
1999 102,707 7.72 8.52
1998 11,465 2.75 3.02
<H3 ALIGN=CENTER><FONT SIZE=3><U><U><U>Commissions Paid to J.P. Morgan Securities</U></U></U><U><U></U></U></FONT></H3>
Percent
of Dollar
Total As Percent Amount of
Dollar of Total Commissionable
Portfolio Amount Commissions Transactions
--------- ------ ----------- ------------
International Emerging Markets
1999 $30,030 4.33% 5.86%
1998 16,910 4.59 6.15
International Securities
1999 4,465 2.25 2.62
1998 2,320 2.28 1.65
International SmallCap
1999 1,604 0.12 0.14
<H3 ALIGN=CENTER><FONT SIZE=3><U><U><U>Commissions Paid to Morgan Stanley & Co.</U></U></U><U><U></U></U></FONT></H3>
Percent
of Dollar
Total As Percent Amount of
Dollar of Total Commissionable
Portfolio Amount Commissions Transactions
--------- ------ ----------- ------------
International Emerging Markets
1999 $12,683 1.87% 2.89%
1998 20,062 5.38 5.45
1997 10,074 10.14 16.63
International Securities
1999 18,818 9.48 12.04
1998 7,322 7.21 7.48
1997 1,394 1.77 1.99
International SmallCap
1999 74,405 5.59 7.17
1998 24,089 5.77 9.80
<P><FONT SIZE=3>Goldman Sachs Asset Management, a separate operating division of
Goldman Sachs & Co., acts as sub-advisor for an account of the Principal
Variable Contracts Fund, Inc. In addition, J.P. Morgan Investment Management
Inc., an affiliate of J.P. Morgan Securities, acts as a sub-advisor of an
account of the Principal Variable Contracts Fund, Inc.</FONT></P>
<P><FONT SIZE=3>Morgan Stanley and Co. is affiliated with Morgan Stanley Asset
Management, Inc., which acts as sub-advisor to two accounts of the Principal
Variable Contracts Fund and one fund included in the Fund Complex. On December
1, 1998 Morgan Stanley Asset Management, Inc. changed its name to Morgan Stanley
Dean Witter Investment Management, Inc. but continues to do business in certain
instances using the name Morgan Stanley Asset Management.</FONT></P>
<P><FONT SIZE=3>The Manager acts as investment advisor for each of the funds
sponsored by Principal Life Insurance Company. The Manager or Sub-Advisor, if
any, places orders to trade portfolio securities for each of these funds. If, in
carrying out the investment objectives of the funds, occasions arise when
purchases or sales of the same equity securities are to be made for two or more
of the funds at the same time (or, in the case of accounts managed by Invista as
Sub-Advisor, for two or more funds and any other accounts managed by Invista),
the Manager or Invista may submit the orders to purchase or, whenever possible,
to sell, to a broker/dealer for execution on an aggregate or “bunched”
basis (including orders for accounts in which Registrant, its affiliates and/or
its personnel have beneficial interests). The Manager or Invista may create
several aggregate or “bunched” orders relating to a single security at
different times during the same day. On such occasions, the Manager or Invista
shall compose, before entering an aggregated order, a written Allocation
Statement as to how the order will be allocated among the various accounts.
Securities purchased or proceeds of sales received on each trading day with
respect to each such aggregate or “bunched” order shall be allocated
to the various funds (or, in the case of Invista, the various funds and other
client accounts) whose individual orders for purchase or sale make up the
aggregate or “bunched” order by filling each fund’s (or, in the
case of Invista, each fund’s or other client account’s) order in
accordance with the Allocation Statement. If the order is partially filled, it
shall be allocated pro rata based on the Allocation Statement. Securities
purchased for funds (or, in the case of Invista, funds and other client
accounts) participating in an aggregate or “bunched” order will be
placed into those funds and, where applicable, other client accounts at a price
equal to the average of the prices achieved in the course of filling that
aggregate or “bunched” order. </FONT></P>
<P><FONT SIZE=3>If purchases or sales of the same debt securities are to be made
for two or more of the funds at the same time, the securities will be purchased
or sold proportionately in accordance with the amount of such security sought to
be purchased or sold at that time for each fund. </FONT></P>
<P><FONT SIZE=3>Invista expects aggregation or “bunching” of orders,
on average, to reduce slightly the cost of execution. Invista will not aggregate
a client’s order if, in a particular instance, it believes that aggregation
will increase the client’s cost of execution. In some cases, aggregation or
“bunching” of orders may increase the price a client pays or receives
for a security or reduce the amount of securities purchased or sold for a client
account. </FONT></P>
<P><FONT SIZE=3>Invista may enter aggregated orders for shares issued in an
initial public offering (IPO). In determining whether to enter an order for an
IPO for any client account, Invista considers the account’s investment
restrictions, risk profile, asset composition and cash level. Accordingly, it is
unlikely that every client account will participate in every available IPO.
Partially filled orders for IPOs will be allocated to participating accounts in
accordance with the procedures set out above. Often, however, the amount of
shares designated by an underwriter for Invista’s clients are insufficient
to provide a meaningful allocation to each participating account. In such cases,
Invista will employ an allocation system it feels treats all participating
accounts fairly and equitably over time. </FONT></P>
<H1 ALIGN=LEFT><FONT SIZE=3>OFFERING PRICE</FONT></H1>
<P><FONT SIZE=3>Each Portfolio offers its shares continuously through Princor
Financial Services Corporation, which is principal underwriter for the Fund and
sells shares as agent for the Fund. Shares are sold at net asset value, without
a sales charge. In certain circumstances, Princor Financial Services Corporation
will compensate its registered representatives or a selected dealer with whom it
has entered into a selling agreement for their efforts in distributing shares
held in a customer account the establishment of which is attributable to the
efforts of the registered representatives or selected dealer. </FONT></P>
<H1 ALIGN=LEFT><FONT SIZE=3>DETERMINATION OF NET ASSET VALUE</FONT></H1>
<P><FONT SIZE=3>The net asset value of the shares of each Portfolio is
determined daily, Monday through Friday, as of the close of trading on the New
York Stock Exchange, except on days on which changes in the value of a
Portfolio’s portfolio securities will not materially affect the current net
asset value of that Portfolio’s redeemable securities, on days during which
a Portfolio receives no order for the purchase or sale of its redeemable
securities and no tender of such a security for redemption, and on customary
national business holidays. The Portfolios treat as customary national business
holidays those days on which the New York Stock Exchange is closed for New
Year’s Day, Martin Luther King, Jr. Day, Presidents’ Day, Good Friday,
Memorial Day, Independence Day, Labor Day, Thanksgiving Day, and Christmas Day.
The net asset value per share for each Portfolio is determined by dividing the
value of securities in the Portfolio’s investment portfolio plus all other
assets, less all liabilities, by the number of Portfolio shares outstanding.
Securities for which market quotations are readily available, including options
and futures traded on an exchange, are valued at market value, which is for
exchanged-listed securities, the closing sale price; for United Kingdom-listed
securities, the market-maker provided price; and for non-listed equity
securities, the bid price. Non-listed corporate debt securities and government
securities are usually valued using an evaluated bid price provided by a pricing
service. If closing prices are unavailable for exchange-listed securities,
generally the bid price, or in the case of debt securities an evaluated bid
price, is used to value such securities. When reliable market quotations are not
considered to be readily available, which may be the case, for example, with
respect to certain debt securities, preferred stocks, foreign securities and
over-the-counter options, the investments are valued by using market quotations,
prices provided by market makers, which may include dealers with which the
Portfolio has executed transactions, or estimates of market values obtained from
yield data and other factors relating to instruments or securities with similar
characteristics in accordance with procedures established in good faith by the
Board of Directors. Securities with remaining maturities of 60 days or less are
valued at amortized cost. Other assets are valued at fair value as determined in
good faith through procedures established by the Board of Directors. </FONT></P>
<P><FONT SIZE=3>Generally, trading in foreign securities is substantially
completed each day at various times prior to the close of the New York Stock
Exchange. The values of such securities used in computing net asset value per
share are usually determined as of such times. Occasionally, events which affect
the values of such securities and foreign currency exchange rates may occur
between the times at which they are generally determined and the close of the
New York Stock Exchange and would therefore not be reflected in the computation
of the net asset values of the Portfolios. If events materially affecting the
value of such securities occur during such period, then these securities will be
valued at their fair value as determined in good faith by the Manager or Invista
under procedures established and regularly reviewed by the Board of Directors.
To the extent the Portfolio invests in foreign securities listed on foreign
exchanges which trade on days on which the Portfolio does not determine its net
asset value, for example Saturdays and other customary national U.S. holidays,
the Portfolio’s net asset value could be significantly affected on days
when shareholders have no access to the Portfolio. </FONT></P>
<H1 ALIGN=LEFT><FONT SIZE=3>PERFORMANCE CALCULATION</FONT></H1>
<P><FONT SIZE=3>Each Portfolio may from time to time advertise its performance
in terms of total return or yield. The figures used for total return and yield
are based on the historical performance of a Portfolio, show the performance of
a hypothetical investment and are not intended to indicate future performance.
Total return and yield will vary from time to time depending upon market
conditions, the composition of a Portfolio’s portfolio and operating
expenses. These factors and possible differences in the methods used in
calculating performance figures should be considered when comparing a
Portfolio’s performance to the performance of some other kind of
investment. </FONT></P>
<P><FONT SIZE=3>A Portfolio may also include in its advertisements performance
rankings and other performance-related information published by independent
statistical services or publishers, such as Lipper Analytical Services,
Weisenberger Investment Companies Services, Money Magazine, Forbes, The Wall
Street Journal, Baron’s and Changing Times, and comparisons of the
performance of a Portfolio to that of various market indices, such as the
S&P 500 Index, Dow Jones Industrials Index, Morgan Stanley Capital
International EAFE (Europe, Australia and Far East) Index and World Index,
Morgan Stanley Capital International EMF (Emerging Markets Free) Index, Lehman
Brothers U.S. Mortgage Index and the Salomon Brothers Investment Grade Bond
Index. </FONT></P>
<H2 ALIGN=LEFT><FONT SIZE=3><U><U><U>Total Return</U></U></U><U><U></U></U></FONT></H2>
<P><FONT SIZE=3>When advertising total return figures, each Portfolio will
include its average annual total return for each of the one, five and ten year
periods (or if shorter, the period during which its registration statement has
been in effect) that end on the last day of the most recent calendar quarter.
Average annual total return is computed by calculating the average annual
compounded rate of return over the stated period that would equate an initial
$1,000 investment to the ending redeemable value assuming the reinvestment of
all dividends and capital gains distributions at net asset value. In its
advertising, a Portfolio may also include average annual total return for some
other period or cumulative total return for a specified period. Cumulative total
return is computed by dividing the difference between the ending redeemable
value (assuming the reinvestment of all dividends and capital gains
distributions) and the initial investment by the initial investment. </FONT></P>
<P><FONT SIZE=3>The following table shows as of December 31, 1999 average annual
return for each of the Portfolios for the periods indicated:</FONT></P>
Portfolio 1-Year 5-Year 10-Year
----------------------------------------------------------------------------
International Emerging Markets 63.37% 16.26%(1)
International Securities 27.89% 17.00% 15.88%(2)
International SmallCap Portfolio 85.93% 42.93%(1)
Mortgage-Backed Securities 0.30% 8.15% 6.17%(2)
(1) Period beginning November 26, 1997 and ending December 31, 1999.
(2) Period beginning May 7, 1993 and ending December 31, 1999.
<H2 ALIGN=LEFT><FONT SIZE=3><U><U><U>Yield</U></U></U><U><U></U></U></FONT></H2>
<P><FONT SIZE=3>The Mortgage-Backed Securities Portfolio calculates its yield by
determining its net investment income per share for a 30-day (or one month)
period, annualizing that figure (assuming semi-annual compounding) and dividing
the result by the net asset value per share for the last day of the same period.
The yield for the Mortgage-Backed Securities Portfolio as of December 31, 1999
was 6.77%. </FONT></P>
<P><FONT SIZE=3>A Portfolio may include in its advertisements the compounding
effect of reinvested dividends over an extended period of time as illustrated
below.</FONT></P>
<H2 ALIGN=LEFT><FONT SIZE=3>The Power of Compounding</FONT></H2>
Years 6% 8% 10%
0 $10,000 $10,000 $10,000
20 $32,071 $46,610 $67,275
<P><FONT SIZE=3>Shareholders who choose to reinvest their distributions get the
advantage of compounding. Here’s what happens to a $10,000 investment with
monthly income reinvested at 6 percent, 8 percent and 10 percent over 20 years. </FONT></P>
<P><FONT SIZE=3>These figures assume no fluctuation in the value of principal.
This chart is for illustration purposes only and is not intended as an
indication of the results a shareholder may receive as a shareholder of a
specific Portfolio. The return and capital value of an investment in a Portfolio
will fluctuate so that the value, when redeemed, may be worth more or less than
the original cost. </FONT></P>
<P><FONT SIZE=3>A Portfolio may also include in its advertisements an
illustration of the impact of income taxes and inflation on earnings from bank
certificates of deposit (“CD’s”). The interest rate on the
hypothetical CD will be based upon average CD rates for a stated period as
reported in the Federal Reserve Bulletin. The illustrated annual rate of
inflation will be the core inflation rate as measured by the Consumer Price
Index for the 12-month period ended as of the most recent month prior to the
advertisement’s publication. The illustrated income tax rate may include
any federal income tax rate applicable to individuals at the time the
advertisement is published. Any such advertisement will indicate that, unlike
bank CD’s, an investment in the Fund is not insured nor is there any
guarantee that the Fund’s net asset value or any stated rate of return will
remain constant. </FONT></P>
<P><FONT SIZE=3>An example of a typical calculation included in such
advertisements is as follows: the after-tax and inflation-adjusted earnings on a
bank CD, assuming a $10,000 investment in a six-month bank CD with an annual
interest rate of 6.07% (average six-month CD rate for the month of December,
1999, as reported in the Federal Reserve Bulletin) and an inflation rate of 2.7%
(rate of inflation for the 12-month period ended December 31, 1999 as measured
by the Consumer Price Index) and an income tax bracket of 28% would be $(84). </FONT></P>
($10,000 x 6.07%) / 2 = $304 Interest for six-month period
- 85 Federal income taxes (28%)
- 135 Inflation's impact on invested principal
($10,000 x 2.7%) / 2
------
($84) After-tax, inflation-adjusted earnings
<H1 ALIGN=LEFT><FONT SIZE=3>TAX TREATMENT, DIVIDENDS AND DISTRIBUTIONS</FONT></H1>
<P><FONT SIZE=3>It is the policy of each Portfolio to distribute substantially
all net investment income and net realized gains. Through such distributions,
and by satisfying certain other requirements, the Fund intends to qualify each
portfolio for the tax treatment accorded to regulated investment companies under
the applicable provisions of the Internal Revenue Code. This means that in each
year in which a Portfolio so qualifies, it will be exempt from federal income
tax upon the amount so distributed to investors. The Tax Reform Act of 1986
imposed an excise tax on mutual funds that fail to distribute net investment
income and capital gains by the end of the calendar year in accordance with the
provisions of the Act. Each Portfolio intends to comply with the Act’s
requirements and to avoid this excise tax. </FONT></P>
<P><FONT SIZE=3>Distributions from the International Emerging Markets Portfolio,
International Securities Portfolio, International SmallCap Portfolio and
Mortgage-Backed Securities Portfolio will generally not be eligible for the 70%
corporate dividends received deduction. All taxable dividends and capital gains
are taxable in the year in which distributed, whether received in cash or
reinvested in additional shares. Dividends declared with a record date in
December and paid in January will be deemed to have been distributed to
shareholders in December. Each Portfolio will inform its shareholders of the
amount and nature of their taxable income dividends and capital gain
distributions. Dividends from a Portfolio’s net income and distributions of
capital gains, if any, may also be subject to state and local taxation. </FONT></P>
<P><FONT SIZE=3>As previously discussed, a Portfolio may invest in futures
contracts or options thereon, index options or options traded on qualified
exchanges. For federal income tax purposes, capital gains and losses on futures
contracts or options thereon, index options or options traded on qualified
exchanges are generally treated as 60% long-term and 40% short-term. In
addition, a Portfolio must recognize any unrealized gains and losses on such
positions held at the end of the fiscal year. A Portfolio may elect out of such
tax treatment, however, for a futures or options position that is part of an
“identified mixed straddle” such as a put option purchased with
respect to a portfolio security. Gains and losses on futures and options
included in an identified mixed straddle will be considered 100% short-term and
unrealized gain or loss on such positions will not be realized at year end. The
straddle provisions of the Code may require the deferral of realized losses to
the extent that a Portfolio has unrealized gains in certain offsetting positions
at the end of the fiscal year, and may also require recharacterization of all or
a part of losses on certain offsetting positions from short-term to long-term,
as well as adjustment of the holding periods of straddle positions. </FONT></P>
<P><FONT SIZE=3>Each Portfolio is required by law under certain circumstances to
withhold 31% of dividends paid to investors who do not furnish their correct
taxpayer identification number (in the case of individuals, their social
security number).</FONT></P>
<P><FONT SIZE=3>Shareholders should consult their own tax advisors as to the
federal, state and local tax consequences of ownership of shares of the
Portfolios in their particular circumstances. </FONT></P>
<H2 ALIGN=LEFT><FONT SIZE=3><U><U><U>Special Tax Considerations</U></U></U><U><U></U></U></FONT></H2>
<H2 ALIGN=LEFT><FONT SIZE=3><U><U><U>International Emerging Markets Portfolio,
International Securities Portfolio and International SmallCap Portfolio</U></U></U><U><U></U></U></FONT></H2>
<P><FONT SIZE=3>When at the close of a fiscal year more than 50% of the value of
a Portfolio’s total assets are invested in securities of foreign
corporations, the Fund may elect pursuant to Section 853 of the Code to permit
its Shareholders to take a credit (or a deduction) for foreign income taxes paid
by the Portfolio. In that case, Shareholders should include in their report of
gross income in their federal income tax returns both cash dividends received
from the Portfolio and also the amount which the Portfolio advises is their pro
rata portion of foreign income taxes paid with respect to, or withheld from,
dividends and interest paid to the Portfolio from its foreign investments.
Shareholders would then be entitled to subtract from their federal income taxes
the amount of such taxes withheld, or treat such foreign taxes as a deduction
from gross income, if that should be more advantageous. As in the case of
individuals receiving income directly from foreign sources, the above-described
tax credit or tax deduction is subject to certain limitations. Shareholders or
prospective shareholders should consult their tax advisors on how these
provisions apply to them. </FONT></P>
<H1 ALIGN=LEFT><FONT SIZE=3>FINANCIAL STATEMENTS</FONT></H1>
<P><FONT SIZE=3>The financial statements of the Fund for the year ended December
31, 1999 appearing in the Annual Report to Shareholders and the report thereon
of Ernst & Young LLP, independent auditors, appearing therein are
incorporated by reference in this Statement of Additional Information. The
Annual Report will be furnished without charge, to investors who request copies
of the Statement of Additional Information. </FONT></P>
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