Exhibit 17(a)
MERCURY HW INTERNATIONAL VALUE VIP PORTFOLIO
Supplement to the prospectus dated May 1, 2000
Change in Portfolio Manager. Effective January 8, 2001, James Doyle
became a portfolio manager of Mercury HW International Value VIP Portfolio,
joining existing portfolio managers Harry Hartford and Sarah Ketterer. Mr. Doyle
has been a portfolio manager of the Mercury HW Global Value Fund since July 1,
2000. He is a Vice President of the investment adviser and has been an
investment professional with the firm since 1997. From 1992 to 1995, Mr. Doyle
was a financial analyst at LaSalle Partners, a real estate investment firm. Mr.
Doyle replaced David Chambers as a portfolio manager of the Mercury HW
International Value VIP Portfolio.
January 19, 2001
HOTCHKIS AND WILEY VARIABLE TRUST
INTERNATIONAL VIP PORTFOLIO
SUPPLEMENT TO PROSPECTUS
DATED MAY 1, 2000
Investment Adviser Name Change. Effective June 30, 2000, the investment
adviser changed its name to Mercury Advisors. (Mercury Advisors is a trading
name of Merrill Lynch Investment Managers, L.P., which is the new name of
Merrill Lynch Asset Management, L.P., of which Hotchkis and Wiley was formerly a
division.)
Name Change of Portfolio and Trust. The Board of Trustees of Hotchkis
and Wiley Variable Trust (the "Trust") has adopted the recommendation of Mercury
Advisors to change the name of the Trust and the Portfolio of the Trust
effective on or about October 5, 2000. The name of the Trust and Portfolio will
change as follows:
CURRENT NAME NEW NAME
- ------------ --------
Hotchkis and Wiley Variable Trust Mercury HW Variable Trust
Hotchkis and Wiley International VIP Portfolio Mercury HW International Value VIP Portfolio
July 13, 2000
PROSPECTUS
MAY 1, 2000
HOTCHKIS AND WILEY VARIABLE TRUST [LOGO]
The Fund is a portfolio of the Hotchkis and Wiley Variable Trust. It is an
investment for variable annuity contracts and variable life insurance contracts
issued by insurance companies that have contracts with the Fund.
INTERNATIONAL VIP PORTFOLIO
Seeks current income and long-term growth of income, accompanied by growth of
capital. The Fund invests primarily in international stocks.
The Securities and Exchange Commission has not approved or disapproved these
securities or the accuracy of this Prospectus. It is a criminal offense to state
otherwise.
TABLE OF CONTENTS
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KEY FACTS.............................................. 3
INVESTMENT OBJECTIVE AND POLICIES...................... 5
INVESTMENT RISKS....................................... 7
THE ADVISOR AND PORTFOLIO MANAGERS..................... 10
HOW TO BUY AND REDEEM SHARES........................... 11
DIVIDENDS AND TAXES.................................... 12
FINANCIAL HIGHLIGHTS................................... 13
INFORMATION ABOUT THE FUND.........................back cover
Hotchkis & Wiley logo
KEY FACTS
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INVESTMENT OBJECTIVE AND MAIN STRATEGIES
This section highlights important information about the Fund. Use this summary
to compare the Fund to other mutual funds that fund a portion of a variable
annuity or insurance contract. More detailed information follows the summary.
VALUE INVESTING
In investing the Fund's assets, Hotchkis and Wiley (the "Advisor") follows a
value style. This means that the Advisor buys stocks that it believes are
currently undervalued by the market and thus have a lower price than their true
worth. Typical value characteristics include:
- - low price-to-earnings ratio relative to the market
- - high yield relative to the market
- - low price-to-book value ratio relative to the market
- - financial strength
Stocks may be "undervalued" because they are part of an industry that is out of
favor with investors generally. Even in those industries, though, individual
companies may have high rates of growth of earnings and be financially sound. At
the same time, the price of their common stock may be depressed because
investors associate the companies with their industries.
This value discipline sometimes prevents investments in stocks that are in
well-known indexes, like the MSCI EAFE Index. Also, the return of the Fund will
not necessarily be similar to the return of the MSCI EAFE Index.
INTERNATIONAL VIP PORTFOLIO
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OBJECTIVE - current income
- long-term growth of income
- growth of capital
MAIN INVESTMENTS - international stocks
MAIN RISKS
As with any mutual fund, the value of the Fund's investments, and therefore the
value of Fund shares, may go up or down. These changes may occur because the
stock market is rising or falling. At other times, there are specific factors
that may affect the value of a particular investment. If the value of the Fund's
investments goes down, you may lose money.
Investing in foreign securities has additional risks. For example, the
securities may go up or down in value depending on foreign exchange rates,
foreign political and economic developments and U.S. and foreign laws relating
to foreign investment. Foreign securities may also be less liquid, more volatile
and harder to value than U.S. securities. These risks are heightened when the
issuer of the securities is a country or is in a country with an emerging
capital market.
See "Investment Risks" for more information about the risks associated with the
Fund.
3
The Fund is an investment for variable annuity contracts and variable life
insurance contracts offered by separate accounts of insurance companies that
have contracts with the Fund ("Participating Insurance Companies"). The Fund
intends to operate in compliance with current state insurance laws and
regulations regarding such things as its concentration of investments and
purchase and sale of futures contracts, and this may impose limits on portfolio
management.
THE FUND'S PERFORMANCE
The bar chart and table below provide some indication of the risks of investing
in the Fund by showing changes in the Fund's performance and by showing how the
Fund's average annual total returns for 1 year and the life of the Fund (which
is less than 5 years) compare with those of a broad measure of market
performance. How the Fund has performed in the past is not necessarily an
indication of how the Fund will perform in the future. The bar chart and table
do not reflect insurance-related fees and expenses which, if reflected, would
lower the returns shown below.
INTERNATIONAL VIP PORTFOLIO
TOTAL RETURN
------------
1999 21.68%
Total return for the three months ended March 31, 2000: -1.83%.
Best quarter: 11.38% (2nd Quarter of 1999).
Worst quarter: 0.73% (1st Quarter of 1999).
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AVERAGE ANNUAL TOTAL RETURNS LIFE
(FOR THE PERIODS ENDED DECEMBER 31, 1999) 1 YEAR 6/10/98
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International VIP Portfolio 21.68% 10.20%
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MSCI EAFE Index 27.30% 19.73%*
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This chart compares the International VIP Portfolio's performance with the
returns of the Morgan Stanley Capital International Europe, Australia, Far East
Index (MSCI EAFE Index), an arithmetic average weighted by market value of the
performance of over 1,000 non-U.S. companies representing 20 stock markets in
Europe, Australia, New Zealand and the Far East. The Fund's value disciplines
often prevent investments in major stocks in the Index and the Fund's returns
may not be similar to the Index's returns.
* Since June 1, 1998.
4
INVESTMENT OBJECTIVE AND POLICIES
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The Fund's investment objective is to provide CURRENT INCOME and LONG-TERM
GROWTH OF INCOME, accompanied by GROWTH OF CAPITAL.
The Fund invests at least 65% of its total assets in stocks in at least ten
foreign markets. Ordinarily, the Fund invests in stocks of companies located in
the developed foreign markets and invests at least 80% of its total assets in
stocks that pay dividends. It also may invest in stocks that don't pay dividends
or interest, but have growth potential unrecognized by the market or changes in
business or management that indicate growth potential.
MONEY MARKET INVESTMENTS
To meet redemptions and when waiting to invest cash receipts, the Fund may
invest in short-term, investment grade bonds and other money market instruments.
Also, the Fund temporarily can invest up to 100% of its assets in short-term,
investment grade bonds and other money market instruments in response to adverse
market, economic or political conditions. The Fund may not achieve its objective
using this type of investing.
OTHER STRATEGIES
The Fund uses certain other investment strategies:
- - BOND INVESTMENTS IN THE FUND: the Fund buys common stocks and securities with
common stock characteristics, like convertible preferred stocks, convertible
bonds or warrants. It also may buy bonds. Convertible securities and bonds
will be rated investment grade (the four highest grades) by a major rating
agency like Moody's Investors Service or Standard & Poor's or, if unrated, be
of comparable quality in the Advisor's opinion. After the Fund buys a bond or
convertible security, it may be given a lower rating or stop being rated. This
would not require the Fund to sell the security, but the Advisor will consider
the change in rating in deciding whether the Fund should keep the security.
- - REPURCHASE AGREEMENTS: the Fund can enter into repurchase agreements involving
U.S. Government securities with commercial banks or broker-dealers. This is a
method of short-term investment of cash where the Fund would buy securities
from a bank or broker-dealer and sell them back a short time later (usually
overnight) for a slightly higher price. The Fund intends to be fully
"collateralized" as to such agreements, and the collateral will be
marked-to-market daily. But if the person obligated to repurchase from the
Fund defaults, there may be possible delays and expenses in liquidating the
securities, a decline in their value and loss of interest income.
- - REAL ESTATE INVESTMENT TRUSTS: the Fund can invest in securities of real
estate investment trusts or REITs.
- - DERIVATIVES: the Fund may use "derivatives," whose performance is derived from
the performance of an underlying asset. The Fund may use derivatives to hedge
against changes in foreign currency exchange rates or securities prices; for
liquidity; or as part of its overall investment strategies. Types of
derivatives that the Fund may use include forward contracts, swap agreements
and options. Derivatives allow the Fund to increase or decrease the level of
risk to which the Fund is exposed more quickly and efficiently than
transactions in other types of instruments. Derivatives, however, are volatile
and involve significant risks, including credit risk, currency risk, leverage
risk, liquidity risk and index risk. The Fund will mark liquid assets as
segregated or enter offsetting positions to cover its obligations, if any,
under forward contracts, swap agreements and options to avoid leveraging the
Fund.
5
- - BORROW MONEY: the Fund can borrow up to 10% of the value of its total assets.
- - SHORT SALES AGAINST-THE-BOX: the Fund can borrow and sell "short" securities
when it also owns an equal amount of those securities (or their equivalent).
No more than 25% of the Fund's total assets can be held as collateral for
short sales at any one time.
- - WHEN-ISSUED or DELAYED DELIVERY: the Fund can buy securities on a when-issued
or delayed delivery basis. The Fund will mark liquid assets as segregated in
an amount equal to the when-issued securities.
- - CORPORATE LOANS: the Fund can invest in corporate loans. Commercial banks and
other financial institutions make corporate loans to companies that need
capital to grow or restructure. Borrowers generally pay interest on corporate
loans at rates that change in response to changes in market interest rates
such as the London Interbank Offered Rate ("LIBOR") or the prime rates of U.S.
banks. As a result, the value of corporate loan investments is generally less
responsive to shifts in market interest rates. Because the trading market for
corporate loans is less developed than the secondary market for bonds and
notes, the Fund may experience difficulties from time to time in selling its
corporate loans. Borrowers frequently provide collateral to secure repayment
of these obligations. Leading financial institutions often act as agent for a
broader group of lenders, generally referred to as a "syndicate". The
syndicate's agent arranges the corporate loans, holds collateral and accepts
payments of principal and interest. If the agent developed financial problems,
the Fund may not recover its investment, or there might be a delay in the
Fund's recovery. By investing in a corporate loan, the Fund becomes a member
of the syndicate.
- - ILLIQUID INVESTMENTS: the Fund may invest up to 15% of its net assets in
illiquid securities that it cannot easily resell within seven days at current
value or that have contractual or legal restrictions on resale. If the Fund
buys illiquid securities, it may be unable to quickly resell them or may be
able to sell them only at a price below current value. Illiquid securities and
restricted securities involve liquidity risk, market risk and selection risk.
- restricted securities: Restricted securities have contractual or legal
restrictions on their resale. They include private placement securities that
the Fund buys directly from the issuer. Private placement and other
restricted securities may not be listed on an exchange and may have no
active trading market.
Restricted securities may be illiquid. The Fund may be unable to sell them
on short notice or may be able to sell them only at a price below current
value. The Fund may get only limited information about the issuer, so it may
be less able to predict a loss. In addition, if Fund management receives
material adverse non-public information about the issuer, the Fund will not
be able to sell the security.
- 144A: Rule 144A securities are restricted securities that can be resold to
qualified institutional buyers but not the general public. Rule 144A
securities may have an active trading market but carry the risk that the
active trading market may not continue. Under policies adopted by the
Trustees, Rule 144A securities with active trading markets are considered
liquid.
6
INVESTMENT RISKS
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This section contains a summary discussion of the general risks of investing in
the Fund. As with any mutual fund, there can be no guarantee that the Fund will
meet its goals or that the Fund's performance will be positive for any period of
time.
MARKET AND SELECTION RISK
Market risk is the risk that the stock or bond market will go down in value,
including the possibility that the market will go down sharply and
unpredictably. Selection risk is the risk that the investments that Fund
management selects will underperform the market or other funds with similar
investment objectives and investment strategies.
FOREIGN MARKET RISK
Since the Fund invests in foreign securities, it offers the potential for more
diversification than an investment only in the U.S. This is because stocks
traded on foreign markets have often (though not always) performed differently
than stocks in the U.S. However, such investments involve special risks not
present in U.S. investments that can increase the chances that the Fund will
lose money. In particular, investments in foreign securities involve the
following risks, which are generally greater for investments in emerging
markets:
- - The economies of some foreign markets often do not compare favorably with that
of the U.S. in areas such as growth of gross national product, reinvestment of
capital, resources, and balance of payments. Some of these economies may rely
heavily on particular industries or foreign capital. They may be more
vulnerable to adverse diplomatic developments, the imposition of economic
sanctions against a particular country or countries, changes in international
trading patterns, trade barriers and other protectionist or retaliatory
measures.
- - Investments in foreign markets may be adversely affected by governmental
actions such as the imposition of capital controls, nationalization of
companies or industries, expropriation of assets or the imposition of punitive
taxes.
- - The governments of certain countries may prohibit or impose substantial
restrictions on foreign investing in their capital markets or in certain
industries. Any of these actions could severely affect security prices. They
could also impair the Fund's ability to purchase or sell foreign securities or
transfer its assets or income back into the U.S., or otherwise adversely
affect the Fund's operations.
- - Other foreign market risks include foreign exchange controls, difficulties in
pricing securities, defaults on foreign government securities, difficulties in
enforcing favorable legal judgments in foreign courts and political and social
instability. Legal remedies available to investors in some foreign countries
may be less extensive than those available to investors in the U.S.
- - Because there are generally fewer investors on foreign exchanges and a smaller
number of shares traded each day, it may be difficult for the Fund to buy and
sell securities on those exchanges. In addition, prices of foreign securities
may go up and down more than prices of securities traded in the U.S.
- - Foreign markets may have different clearance and settlement procedures. In
certain markets, settlements may be unable to keep pace with the volume of
securities transactions. If this occurs, settlement may be delayed and the
Fund's assets may be uninvested and not earning returns. The Fund also may
miss investment opportunities or be unable to sell an investment because of
these delays.
7
- - The value of the Fund's foreign holdings (and hedging transactions in foreign
currencies) will be affected by changes in currency exchange rates.
- - The costs of foreign securities transactions tend to be higher than those of
U.S. transactions.
- - International trade barriers or economic sanctions against certain foreign
countries may adversely affect the Fund's foreign holdings.
- - If the Fund purchases a bond issued by a foreign government, the government
may be unwilling or unable to make payments when due. There may be no formal
bankruptcy proceeding by which the Fund would be able to collect amounts owed
by a foreign government.
EUROPEAN ECONOMIC AND MONETARY UNION (EMU)
A number of European countries have entered into EMU in an effort to reduce
trade barriers between themselves and eliminate fluctuations in their
currencies. EMU establishes a single European currency (the euro), which was
introduced on January 1, 1999 and is expected to replace the existing national
currencies of all initial EMU participants by July 1, 2002. Certain securities
(beginning with government and corporate bonds) were redenominated in the euro.
These securities trade and make dividend and other payments only in euros. Like
other investment companies and business organizations, including the companies
in which the Fund invests, the Fund could be adversely affected:
- - If the transition to euro, or EMU as a whole, does not take effect as planned.
- - If a participating country withdraws from EMU.
- - If the computing, accounting and trading systems used by the Fund's service
providers, or by other entities with which the Fund or its service providers
do business, are not capable of recognizing the euro as a distinct currency.
RISKS OF CONVERTIBLE SECURITIES
Convertibles are generally bonds or preferred stocks that may be converted into
common stock. Convertibles typically pay current income, as either interest
(bond convertibles) or dividends (preferred stocks). A convertible's value
usually reflects both the stream of current income payments and the value of the
underlying common stock. The market value of a convertible performs like regular
bonds; that is, if market interest rates rise, the value of a convertible
usually falls. Since it is convertible into common stock, the convertible also
has the same types of market and issuer risk as the underlying common stock.
ADDITIONAL BOND RISKS
- - CREDIT RISK -- Credit risk is the risk that the issuer of bonds will be unable
to pay the interest or principal when due. The degree of credit risk depends
on both the financial condition of the issuer and on the terms of the specific
bonds.
- - INTEREST RATE RISK -- Interest rate risk is the risk that prices of bonds
generally increase when interest rates decline and decrease when interest
rates increase. Prices of longer term securities generally change more in
response to interest rate changes than do prices of shorter term securities.
8
- - CALL AND REDEMPTION RISK -- Investments in bonds carry the risk that a bond's
issuer will call the bond for redemption prior to the bond's maturity. If
there is an early call of a bond, the Fund may lose income and may have to
invest the proceeds of the redemption in bonds with lower yields than the
called bond.
- - WHEN-ISSUED SECURITIES, DELAYED-DELIVERY SECURITIES AND FORWARD
COMMITMENTS -- When-issued, delayed-delivery securities and forward
commitments involve the risk that the security the Fund buys will lose value
prior to its delivery to the Fund. There also is the risk that the security
will not be issued or that the other party will not meet its obligation, in
which case the Fund loses the investment opportunity of the assets it has set
aside to pay for the security and any gain in the security's price.
When-issued and delayed-delivery securities and forward commitments involve
market risk, selection risk and leverage risk.
- - CORPORATE LOANS -- Corporate loans are subject to the risk of loss of
principal and income. Borrowers do not always provide collateral for corporate
loans and the value of the collateral may not completely cover the borrower's
obligations at the time of a default. If a borrower files for protection from
its creditors under the U.S. bankruptcy laws, these laws may limit the Fund's
rights to its collateral. In addition, the value of collateral may erode
during a bankruptcy case. In the event of a bankruptcy, the holder of a
corporate loan may not recover its principal, may experience a long delay in
recovering its investment and may not receive interest during the delay.
RISKS OF DERIVATIVES
Derivatives involve the following risks:
- - CREDIT RISK -- Credit risk is the risk that the counterparty on a derivative
transaction will be unable to honor its financial obligation to the Fund.
- - CURRENCY RISK -- Currency risk is the risk that changes in the exchange rate
between two currencies will adversely affect the value (in U.S. dollar terms)
of an investment.
- - LEVERAGE RISK -- Leverage risk is the risk associated with certain types of
investments or trading strategies that relatively small market movements may
result in large changes in the value of an investment. Certain investments or
trading strategies that involve leverage can result in losses that greatly
exceed the amount originally invested.
- - LIQUIDITY RISK -- Liquidity risk is the risk that certain securities may be
difficult or impossible to sell at the time that the seller would like or at
the price that the seller believes the security is currently worth.
- - INDEX RISK -- If the derivative is linked to the performance of an index, it
will be subject to the risks associated with changes in that index. If the
index changes, the Fund could receive lower interest payments or experience a
reduction in the value of the derivative to below what the Fund paid. Certain
indexed securities, including inverse securities (which move in an opposite
direction to the index), may create leverage, to the extent that they increase
or decrease in value at a rate that is a multiple of the changes in the
applicable index.
Please see the Statement of Additional Information (SAI) for detailed
information regarding the types of derivatives that can be used by the Fund and
the risks associated with these instruments.
9
THE ADVISOR AND PORTFOLIO MANAGERS
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THE ADVISOR
Hotchkis and Wiley, 725 South Figueroa Street, Suite 4000, Los Angeles,
California 90017-5400, has been the Fund's investment advisor since 1998. The
Advisor is a division of Merrill Lynch Asset Management, L.P., a Delaware
limited partnership. The Advisor supervises and arranges the purchase and sale
of securities held in the Fund's portfolio and administers the Fund. The Advisor
also manages other mutual funds and separate investment advisory accounts.
The Fund paid an annualized fee to the Advisor for the fiscal year ended
December 31, 1999 of .75% of its average net assets. The Advisor has agreed to
make reimbursements so that the regular annual operating expenses of the Fund
will not exceed 1.35% of its average net assets. The Advisor has agreed to
continue this expense limit through April 30, 2001, and will thereafter give
shareholders prior notice if this reimbursement policy will change. No
reimbursement was made to the Fund for the fiscal year ended December 31, 1999.
The Advisor may pay administrative service fees to Participating Insurance
Companies. The Advisor also is allowed to allocate brokerage based on sales of
shares of funds managed by the Advisor but has not done so.
SUBADVISORS
The Advisor has entered into a subadvisory agreement with Mercury Asset
Management International Ltd., 33 King William Street, London, England EC4R 9AS,
and Merrill Lynch Asset Management U.K. Limited, Ropemaker Place, 25 Ropemaker
Street, London, England E2Y 9LY, affiliated investment advisors that are
indirect subsidiaries of Merrill Lynch & Co., Inc. The subadvisory arrangements
are for investment research, recommendations and other investment-related
services to be provided to the Fund. There is no increase in the aggregate fees
paid by the Fund for these services.
PORTFOLIO MANAGERS
The portfolio managers who have responsibility for the day-to-day management of
the Fund's portfolio are Sarah Ketterer, Harry Hartford and David Chambers. Ms.
Ketterer is a managing director of the Advisor and has served as portfolio
manager of the Fund since it began operations in June 1998. Before joining the
Advisor, Ms. Ketterer was with Bankers Trust Company as an Associate from 1987
to 1990 and a Financial Analyst with Dean Witter Reynolds from 1983 to 1985. Mr.
Hartford is a managing director of the Advisor and has served as a portfolio
manager of the Fund since June 1998. Before joining the Advisor, Mr. Hartford
was with the Investment Bank of Ireland (now Bank of Ireland Asset Management)
as a Senior Manager, International and Global Equities, from 1985 to 1994. Mr.
Chambers is a managing director of the Advisor and has served as a portfolio
manager of the Fund since June 1998. He has been associated with Mercury Asset
Management International in London since July 1998. Before joining the Advisor,
Mr. Chambers was with Baring Asset Management, Inc. as Senior Vice President,
Global Equities from 1992 to 1995 and Baring Brothers, London, England as
Assistant Director, Corporate Finance from 1990 to 1991.
10
HOW TO BUY AND REDEEM SHARES
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Investors may not purchase or redeem shares of the Fund directly, but only
through variable annuity contracts and variable life insurance policies offered
through the separate accounts of Participating Insurance Companies. You should
refer to the prospectus or private placement memorandum ("prospectus") of the
Participating Insurance Company's separate account for information on how to
purchase a variable annuity contract or variable life insurance policy, how to
select the Fund as an investment option for the applicable contract or policy
and how to redeem money from the applicable contract or policy.
The separate accounts of the Participating Insurance Companies place orders to
purchase and redeem shares of the Fund based on, among other things, the amount
of premium payments to be invested and the amount of surrender and transfer
requests (as defined in the Participating Insurance Companies' prospectuses) to
be effected on that day under variable annuity contracts and variable life
insurance policies. Orders received by the Fund are processed on business days
only. The Fund prices orders for the purchase of shares at the net asset value
per share next calculated after an order is received in proper form by the Fund
or its designee so long as payment for the shares is received by the end of the
next business day. The Fund prices redemptions at the net asset value per share
next calculated after receipt in proper form of a redemption request by the Fund
or its designee. The separate account of a Participating Insurance Company is a
designee of the Fund for receipt of purchase and redemption orders. Receipt by a
Participating Insurance Company is receipt by the Fund, so long as the Fund
receives timely notice of the order by the next business day. Separate accounts
must transmit purchase and redemption orders promptly. The Fund pays redemptions
within seven days after the request is received. The Fund may suspend the right
of redemption under certain extraordinary circumstances in accordance with the
rules of the Securities and Exchange Commission.
The Fund does not charge any sales charges or redemption fees. Participating
Insurance Companies may charge mortality and expense risk fees and other charges
under the variable annuity contracts or variable life insurance policies. The
Participating Insurance Companies are required to describe these fees in the
prospectuses for the contracts or policies.
Shares of the Fund are sold to and held by separate accounts that fund variable
annuity and variable life insurance contracts issued by Participating Insurance
Companies. The Fund currently does not foresee any disadvantages to the holders
of variable annuity contracts and variable life insurance policies of
Participating Insurance Companies arising from the fact that interests of such
holders may differ due to differences of tax treatment or other considerations
or due to conflicts between the Participating Insurance Companies. Nevertheless,
the Trustees will monitor events to seek to identify any material irreconcilable
conflicts which may possibly arise and to determine what action, if any, should
be taken in response to such conflicts. Should a material irreconcilable
conflict arise between the holders of variable annuity contracts and variable
life insurance policies of Participating Insurance Companies, the Participating
Insurance Companies may be required to withdraw the assets allocable to some or
all of the separate accounts from the Fund. Any such withdrawal could disrupt
orderly portfolio management to the potential detriment of such holders. The
variable annuity contracts and variable life insurance policies are described in
the separate prospectuses issued by the Participating Insurance Companies. The
Fund assumes no responsibility for such prospectuses.
11
DIVIDENDS AND TAXES
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DIVIDENDS AND DISTRIBUTIONS
The Fund pays income dividends, if any, yearly.
The Fund pays distributions of any net realized short-term gains and any net
capital gains at least annually.
See the prospectuses for variable annuity contracts or variable life insurance
policies issued by Participating Insurance Companies for additional information.
TAXES
The Fund has elected to qualify and intends to remain qualified as a regulated
investment company under Subchapter M of the Internal Revenue Code. If so
qualified, the Fund will not be subject to federal income taxes on its net
investment income and capital gains, if any, realized during any fiscal year in
which it distributes to its shareholders at least 90% of its net investment
income earned in the fiscal year.
A segregated asset account upon which a variable annuity contract or variable
life insurance policy is based must meet certain diversification tests in the
Code and U.S. Treasury regulations. If, as is intended, the Fund meets these
tests and complies with certain other conditions, a segregated asset account
investing solely in shares of the Fund will also be deemed to meet these
diversification requirements. A failure of the Fund to qualify as a regulated
investment company or to meet these conditions and to comply with these tests
could cause the owners of variable annuity contracts and variable life insurance
policies based on such accounts to recognize ordinary income each year in the
amount of any net appreciation of their contracts or policies during the year
(including the annual costs of life insurance, if any, provided under such
policies).
The terms of the variable annuity or variable life insurance plan through which
you invest and the tax rules governing such annuities and plans govern the tax
consequences of an investment in the Fund. Please refer to the prospectus for
the variable annuity or variable life insurance plan through which you are
investing.
12
FINANCIAL HIGHLIGHTS
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The financial highlights table is intended to help you understand the Fund's
financial performance for the periods since it began operations. Certain
information reflects financial results for a single Fund share. The total return
in the table represents the rate that an investor would have earned (or lost) on
an investment in the Fund (assuming reinvestment of all dividends and
distributions, but excluding insurance-related fees and expenses). These
financial highlights were audited by PricewaterhouseCoopers LLP. The
accountants' report and the Fund's financial statements are included in the SAI
and the Fund's annual report, which are available upon request. Further
performance information is contained in the annual report.
June 10, 1998*
Year Ended through
INTERNATIONAL VIP PORTFOLIO December 31, 1999 December 31, 1998
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Net Asset Value, Beginning of Period........................ $ 9.52 $ 10.00
INCOME FROM INVESTMENT OPERATIONS:
Net investment income................................... 0.15 0.04
Net realized and unrealized gain (loss) on
investments........................................... 1.91 (0.48)
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Total from investment operations.................... 2.06 (0.44)
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LESS DISTRIBUTIONS:
Dividends (from net investment income).................. (0.06) (0.04)
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Net Asset Value, End of Period.............................. $ 11.52 $ 9.52
============ ============
TOTAL RETURN(1)............................................. 21.68% (4.38)%(1)
RATIOS/SUPPLEMENTAL DATA:
Net assets, end of period................................... $284,833,863 $289,134,958
Ratio of expenses to average net assets..................... 1.01% 1.05%(2)
Ratio of net investment income to average net assets........ 1.63% 1.09%(2)
Portfolio turnover rate..................................... 71% 24%(1)
* Commencement of operations.
(1) Not annualized.
(2) Annualized.
13
HOTCHKIS AND WILEY VARIABLE TRUST
725 SOUTH FIGUEROA STREET
SUITE 4000
LOS ANGELES, CALIFORNIA 90017
800-236-4479
INFORMATION ABOUT THE FUND
Please read this Prospectus before you invest in the Fund. Keep the Prospectus
for future reference. You can get additional information about the Fund in:
- - Statement of Additional Information (SAI) (incorporated by reference
into -- legally a part of -- this Prospectus)
- - Annual Report (contains a discussion of market conditions and investment
strategies that affected Fund performance)
- - Semi-annual Report
To get this information free of charge or for shareholder questions, contact:
The Fund's transfer agent
(800) 236-4479
Securities and Exchange Commission
Public Reference Section
Washington, DC 20549-0102
- - call 1-202-942-8090 for information on the Commission's Public Reference Room,
where documents can be reviewed and copied
- - the information is available at the SEC's Internet site on the EDGAR Database
at http://www.sec.gov
- - copies of the information retrievable from the SEC's Internet site are
available for a fee by writing to the SEC's Public Reference Section or by
electronic request at publicinfo@sec.gov
You should rely only on the information contained in this Prospectus when
deciding whether to invest. No one is authorized to provide you with information
that is different.
Investment Company Act File No. 811-08163
PROSPECTUS
MAY 1, 2000
[LOGO]
HOTCHKIS AND WILEY VARIABLE TRUST
-------------------------------------------------------
---------------------------------------------------
INTERNATIONAL
VIP PORTFOLIO
---------------------------------------------------
-------------------------------------------------------
HOTCHKIS AND WILEY VARIABLE TRUST
STATEMENT OF ADDITIONAL INFORMATION
DATED MAY 1, 2000
The Hotchkis and Wiley Variable Trust (the "Trust") is an investment company
which offers shares of four investment funds -- Equity Income VIP Portfolio,
International VIP Portfolio, Total Return Bond VIP Portfolio and Low Duration
VIP Portfolio (each, a "Fund" and collectively, the "Funds"). The Equity Income
VIP Portfolio and the International VIP Portfolio are sometimes referred to as
the "Stock Funds." The Total Return Bond VIP Portfolio and the Low Duration VIP
Portfolio are sometimes referred to as the "Bond Funds." The shares of the Funds
are offered only to separate accounts of participating life insurance companies
("Participating Insurance Companies") for the purpose of funding variable
annuity contracts and variable life insurance contracts.
This Statement of Additional Information is not a prospectus, and it should be
read in conjunction with the prospectuses dated May 1, 2000 of the Funds. Copies
of the prospectuses may be obtained at no charge from the Trust, 725 S. Figueroa
Street, Suite 4000, Los Angeles, CA 90017-5400. Hotchkis and Wiley (the
"Advisor") is the investment advisor to the Funds.
TABLE OF CONTENTS
PAGE
----
Trust History............................................... B-2
Description of the Funds, Their Investments and Risks....... B-2
Investment Restrictions................................... B-2
Repurchase Agreements..................................... B-3
U.S. Government Securities................................ B-3
Municipal Obligations..................................... B-4
Corporate Debt Securities................................. B-6
Convertible Securities.................................... B-6
Mortgage-Related Securities............................... B-6
Asset-Backed Securities................................... B-10
Risk Factors Relating to Investing in Mortgage-Related and
Asset-Backed Securities................................. B-10
Duration.................................................. B-11
Effective Maturity........................................ B-12
Derivative Instruments.................................... B-12
Foreign Securities........................................ B-16
Foreign Currency Options and Related Risks................ B-18
Forward Foreign Currency Exchange Contracts............... B-19
Foreign Investment Risks.................................. B-21
Risk Factors Relating to Investing in High Yield
Securities.............................................. B-23
Illiquid Securities....................................... B-23
Reverse Repurchase Agreements............................. B-24
Dollar Rolls.............................................. B-25
Borrowing................................................. B-25
Loans of Portfolio Securities............................. B-25
When-Issued Securities.................................... B-26
Real Estate Investment Trusts............................. B-26
Temporary Defensive Position.............................. B-26
Shares of Other Investment Companies...................... B-26
Management.................................................. B-27
The Advisor............................................... B-29
Subadvisors............................................... B-30
The Distributor........................................... B-30
Code of Ethics............................................ B-30
Other Service Providers................................... B-31
Portfolio Transactions and Brokerage...................... B-31
Trust Shares................................................ B-33
Net Asset Value............................................. B-34
Dividends and Tax Status.................................... B-35
Performance Information..................................... B-36
General Information About the Trust's Shareholders.......... B-37
Appendix -- Description of Ratings.......................... A-1
Financial Statements
TRUST HISTORY
The Trust was organized on February 4, 1997 as a Massachusetts business trust.
The Trust is a diversified, open-end, management investment company currently
consisting of four separate series.
DESCRIPTION OF THE FUNDS, THEIR INVESTMENTS AND RISKS
The investment objective of the Equity Income VIP Portfolio is to provide
current income and long-term growth of income, accompanied by growth of capital.
The investment objective of the International VIP Portfolio is to provide
current income and long-term growth of income, accompanied by growth of capital.
The investment objective of the Total Return Bond VIP Portfolio is to maximize
long-term total return.
The investment objective of the Low Duration VIP Portfolio is to maximize total
return, consistent with preservation of capital.
The portfolio and strategies with respect to the composition of each Fund are
described in that Fund's prospectus.
INVESTMENT RESTRICTIONS
Each Fund has adopted the following restrictions (in addition to their
investment objectives) as fundamental policies, which may not be changed without
the favorable vote of the holders of a "majority" of that Fund's outstanding
voting securities, as defined in the Investment Company Act of 1940 (the "1940
Act"). Under the 1940 Act, the vote of the holders of a "majority" of a Fund's
outstanding voting securities means the vote of the holders of the lesser of (1)
67% of the shares of the Fund represented at a meeting at which the holders of
more than 50% of its outstanding shares are represented or (2) more than 50% of
the outstanding shares.
Except as noted, none of the Funds may:
1. Purchase any security, other than obligations of the U.S. Government, its
agencies, or instrumentalities ("U.S. Government securities"), if as a
result: (i) with respect to 75% of its total assets, more than 5% of the
Fund's total assets (determined at the time of investment) would then be
invested in securities of a single issuer; or (ii) more than 25% of the
Fund's total assets (determined at the time of investment) would be invested
in one or more issuers having their principal business activities in a
single industry.
2. Purchase securities on margin (but any Fund may obtain such short-term
credits as may be necessary for the clearance of transactions), provided
that the deposit or payment by a Fund of initial or maintenance margin in
connection with futures or options is not considered the purchase of a
security on margin.
3. Make short sales of securities or maintain a short position, unless at all
times when a short position is open it owns an equal amount of such
securities or securities convertible into or exchangeable, without payment
of any further consideration, for securities of the same issue as, and equal
in amount to, the securities sold short (short sale against-the-box), and
unless not more than 25% of the Fund's net assets (taken at current value)
is held as collateral for such sales at any one time.
4. Issue senior securities, borrow money or pledge its assets except that any
Fund may borrow from a bank for temporary or emergency purposes in amounts
not exceeding 10% (taken at the lower of cost or current value) of its total
assets (not including the amount borrowed) and pledge its assets to secure
such borrowings; none of
B-2
the Funds (except the Bond Funds) will purchase any additional portfolio
securities while such borrowings are outstanding. (The Bond Funds may borrow
from banks or enter into reverse repurchase agreements and pledge assets in
connection therewith, but only if immediately after each borrowing there is
asset coverage of 300%.)
5. Purchase any security (other than U.S. Government securities) if as a
result, with respect to 75% of the Fund's total assets, the Fund would then
hold more than 10% of the outstanding voting securities of an issuer.
6. Buy or sell commodities or commodity contracts or real estate or interests
in real estate, although it may purchase and sell securities which are
secured by real estate and securities of companies which invest or deal in
real estate. (For the purposes of this restriction, forward foreign currency
exchange contracts are not deemed to be commodities or commodity contracts.
This restriction does not apply to the Bond Funds.)
7. Act as underwriter except to the extent that, in connection with the
disposition of portfolio securities, it may be deemed to be an underwriter
under certain federal securities laws.
8. Make investments for the purpose of exercising control or management.
9. Participate on a joint or joint and several basis in any trading account in
securities.
10. Make loans, except through repurchase agreements. (This restriction does not
apply to the Bond Funds, which may lend portfolio securities having an
aggregate market value of up to one-third of the total assets of the Fund.)
Any percentage limitation on a Fund's investments is determined when the
investment is made, unless otherwise noted.
REPURCHASE AGREEMENTS
Each of the Funds may invest in repurchase agreements collaterized by U.S.
Government securities. A repurchase agreement is an agreement where the seller
agrees to repurchase a security from a Fund at a mutually agreed-upon time and
price. The period of maturity is usually quite short, possibly overnight or a
few days, although it may extend over a number of months. The resale price is
more than the purchase price, reflecting an agreed-upon rate of return effective
for the period of time a Fund's money is invested in the repurchase agreement. A
Fund's repurchase agreements will at all times be fully collateralized in an
amount at least equal to the resale price. The instruments held as collateral
are valued daily, and if the value of instruments declines, a Fund will require
additional collateral. In the event of a default, insolvency or bankruptcy by a
seller, the Fund will promptly seek to liquidate the collateral. In such
circumstances, the Fund could experience a delay or be prevented from disposing
of the collateral. To the extent that the proceeds from any sale of such
collateral upon a default in the obligation to repurchase are less than the
repurchase price, the Fund will suffer a loss.
U.S. GOVERNMENT SECURITIES
U.S. Government agencies or instrumentalities which issue or guarantee
securities include, but are not limited to, the Federal National Mortgage
Association, Government National Mortgage Association, Federal Home Loan Banks,
Federal Home Loan Mortgage Corporation, Federal Intermediate Credit Banks,
Federal Land Banks, Tennessee Valley Authority, Inter-American Development Bank,
Asian Development Bank, Student Loan Marketing Association and the International
Bank for Reconstruction and Development.
B-3
Except for U.S. Treasury securities, obligations of U.S. Government agencies and
instrumentalities may or may not be supported by the full faith and credit of
the United States. Some are backed by the right of the issuer to borrow from the
Treasury; others by discretionary authority of the U.S. Government to purchase
the agencies' obligations; while still others, such as the Student Loan
Marketing Association, are supported only by the credit of the instrumentality.
In the case of securities not backed by the full faith and credit of the United
States, the investor must look principally to the agency or instrumentality
issuing or guaranteeing the obligation for ultimate repayment, and may not be
able to assert a claim against the United States itself in the event the agency
or instrumentality does not meet its commitment. Each Fund will invest in
securities of such instrumentality only when the Advisor is satisfied that the
credit risk with respect to any instrumentality is acceptable.
The Funds may invest in component parts of U.S. Treasury notes or bonds, namely,
either the corpus (principal) of such Treasury obligations or one of the
interest payments scheduled to be paid on such obligations. These obligations
may take the form of: (1) Treasury obligations from which the interest coupons
have been stripped; (2) the interest coupons that are stripped; (3) book-entries
at a Federal Reserve member bank representing ownership of Treasury obligation
components; or (4) receipts evidencing the component parts (corpus or coupons)
of Treasury obligations that have not actually been stripped. Such receipts
evidence ownership of component parts of Treasury obligations (corpus or
coupons) purchased by a third party (typically an investment banking firm) and
held on behalf of the third party in physical or book-entry form by a major
commercial bank or trust company pursuant to a custody agreement with the third
party. These custodial receipts are known by various names, including "Treasury
Receipts," "Treasury Investment Growth Receipts" ("TIGRs") and "Certificates of
Accrual on Treasury Securities" ("CATS"), and are not issued by the U.S.
Treasury; therefore they are not U.S. Government securities, although the
underlying bonds represented by these receipts are debt obligations of the U.S.
Treasury.
MUNICIPAL OBLIGATIONS
The Bond Funds may invest in municipal obligations. The two principal
classifications of municipal bonds, notes and commercial paper are "general
obligation" and "revenue" bonds, notes or commercial paper. General obligation
bonds, notes or commercial paper are secured by the issuer's pledge of its
faith, credit and taxing power for the payment of principal and interest.
Issuers of general obligation bonds, notes or commercial paper include states,
counties, cities, towns and other governmental units. Revenue bonds, notes and
commercial paper are payable from the revenues derived from a particular
facility or class of facilities or, in some cases, from specific revenue
sources. Revenue bonds, notes or commercial paper are issued for a wide variety
of purposes, including the financing of electric, gas, water and sewer systems
and other public utilities; industrial development and pollution control
facilities; single and multifamily housing units; public buildings and
facilities; air and marine ports; transportation facilities such as toll roads,
bridges and tunnels; and health and educational facilities such as hospitals and
dormitories. They rely primarily on user fees to pay debt service, although the
principal revenue source is often supplemented by additional security features
which are intended to enhance the creditworthiness of the issuer's obligations.
In some cases, particularly revenue bonds issued to finance housing and public
buildings, a direct or implied "moral obligation" of a governmental unit may be
pledged to the payment of debt service. In other cases, a special tax or other
charge may augment user fees.
Included within the revenue bonds category are participations in municipal lease
obligations or installment purchase contracts of municipalities (collectively,
"lease obligations"). State and local governments issue lease obligations to
acquire equipment leases and facilities. Lease obligations may have risks not
normally associated with general obligation or other revenue bonds. Leases and
installment purchase or conditional sale contracts (which may provide
B-4
for title to the leased asset to pass eventually to the issuer) have developed
as a means for governmental issuers to acquire property and equipment without
the necessity of complying with the constitutional and statutory requirements
generally applicable for the issuance of debt. Certain lease obligations contain
"non-appropriation" clauses that provide that the governmental issuer has no
obligation to make future payments under the lease or contract unless money is
appropriated for such purpose by the appropriate legislative body on an annual
or other periodic basis. Consequently, continued lease payments on those lease
obligations containing "non-appropriation" clauses are dependent on future
legislative actions. If such legislative actions do not occur, the holders of
the lease obligations may experience difficulty in exercising their rights,
including disposition of the property.
Private activity obligations are issued to finance, among other things,
privately operated housing facilities, pollution control facilities, convention
or trade show facilities, mass transit, airport, port or parking facilities and
certain facilities for water supply, gas, electricity, sewage or solid waste
disposal. Private activity obligations are also issued to privately held or
publicly owned corporations in the financing of commercial or industrial
facilities. The principal and interest on these obligations may be payable from
the general revenues of the users of such facilities. Shareholders, depending on
their individual tax status, may be subject to the federal alternative minimum
tax on the portion of a distribution attributable to these obligations. Interest
on private activity obligations will be considered exempt from federal income
taxes; however, shareholders should consult their own tax advisors to determine
whether they may be subject to the federal alternative minimum tax.
Resource recovery obligations are a type of municipal revenue obligation issued
to build facilities such as solid waste incinerators or waste-to-energy plants.
Usually, a private corporation will be involved and the revenue cash flow will
be supported by fees or units paid by municipalities for the use of the
facilities. The viability of a resource recovery project, environmental
protections regulations and project operator tax incentives may affect the value
and credit quality of these obligations.
Tax, revenue or bond anticipation notes are issued by municipalities in
expectation of future tax or other revenues which are payable from these
specific taxes or revenues. Bond anticipation notes usually provide interim
financing in advance of an issue of bonds or notes, the proceeds of which are
used to repay the anticipation notes. Tax-exempt commercial paper is issued by
municipalities to help finance short-term capital or operating needs in
anticipation of future tax or other revenue.
A variable rate obligation is one whose terms provide for the adjustment of its
interest rate on set dates and which, upon such adjustment, can reasonably be
expected to have a market value that approximates its par value. A floating rate
obligation has terms which provide for the adjustment of its interest rate
whenever a specified interest rate changes and which, at any time, can
reasonably be expected to have a market value that approximates its par value.
Variable or floating rate obligations may be secured by bank letters of credit.
Variable rate auction and residual interest obligations are created when an
issuer or dealer separates the principal portion of a long-term, fixed-rate
municipal bond into two long-term, variable-rate instruments. The interest rate
on one portion reflects short-term interest rates, while the interest rate on
the other portion is typically higher than the rate available on the original
fixed-rate bond.
Yields on municipal securities are dependent on a variety of factors, including
the general conditions of the municipal bond and municipal note markets, the
size of a particular offering, the maturity of the obligation and the rating of
the issue. The achievement of the Bond Funds' investment objectives is dependent
in part on the continuing ability of the issuers of municipal securities in
which the Bond Funds invest to meet their obligations for the payment of
principal and interest when due. Obligations of issuers of municipal securities
are subject to the
B-5
provisions of bankruptcy, insolvency and other laws affecting the rights and
remedies of creditors, such as the Bankruptcy Reform Act of 1978, as amended.
Therefore, the possibility exists that, as a result of litigation or other
conditions, the ability of any issuer to pay, when due, the principal of and
interest on its municipal securities may be materially affected.
CORPORATE DEBT SECURITIES
A Fund's investments in U.S. dollar or foreign currency-denominated corporate
debt securities of domestic or foreign issuers are limited to corporate debt
securities (corporate bonds, debentures, notes and other similar corporate debt
instruments) which meet the minimum ratings criteria set forth for the Fund, or,
if unrated, are in the Advisor's opinion comparable in quality to corporate debt
securities in which the Fund may invest. The rate of return or return of
principal on some debt obligations may be linked or indexed to the level of
exchange rates between the U.S. dollar and a foreign currency or currencies.
CONVERTIBLE SECURITIES
The Funds may invest in convertible securities of domestic or foreign issuers,
which meet the ratings criteria set forth in the prospectus. A convertible
security is a fixed-income security (a bond or preferred stock) which may be
converted at a stated price within a specified period of time into a certain
quantity of common stock or other equity securities of the same or a different
issuer. Convertible securities rank senior to common stock in a corporation's
capital structure but are usually subordinated to similar non-convertible
securities. While providing a fixed income stream (generally higher in yield
than the income derivable from common stock but lower than that afforded by a
similar non-convertible security), a convertible security also affords an
investor the opportunity, through its conversion feature, to participate in the
capital appreciation attendant upon a market price advance in the convertible
security's underlying common stock.
In general, the market value of a convertible security is at least the higher of
its "investment value" (that is, its value as a fixed-income security) or its
"conversion value" (that is, its value upon conversion into its underlying
stock). As a fixed-income security, a convertible security tends to increase in
market value when interest rates decline and tends to decrease in value when
interest rates rise. However, the price of a convertible security is also
influenced by the market value of the security's underlying common stock. The
price of a convertible security tends to increase as the market value of the
underlying stock rises, whereas it tends to decrease as the market value of the
underlying stock declines. While no securities investment is without some risk,
investments in convertible securities generally entail less risk than
investments in the common stock of the same issuer.
MORTGAGE-RELATED SECURITIES
The Bond Funds may invest in residential or commercial mortgage-related
securities, including mortgage pass-through securities, collateralized mortgage
obligations ("CMOs"), adjustable rate mortgage securities, CMO residuals,
stripped mortgage-related securities, floating and inverse floating rate
securities and tiered index bonds.
Mortgage Pass-Through Securities. Mortgage pass-through securities represent
interests in pools of mortgages in which payments of both principal and interest
on the securities are generally made monthly, in effect "passing through"
monthly payments made by borrowers on the residential or commercial mortgage
loans which underlie the securities (net of any fees paid to the issuer or
guarantor of the securities). Mortgage pass-through securities differ from other
forms of debt securities, which normally provide for periodic payment of
interest in fixed amounts with principal payments at maturity or specified call
dates. Early repayment of principal on mortgage pass-through securities (arising
from prepayments of
B-6
principal due to the sale of underlying property, refinancing, or foreclosure,
net of fees and costs which may be incurred) may expose a Fund to a lower rate
of return upon reinvestment of principal. Also, if a security subject to
repayment has been purchased at a premium, in the event of prepayment, the value
of the premium would be lost.
There are currently three types of mortgage pass-through securities: (1) those
issued by the U.S. Government or one of its agencies or instrumentalities, such
as the Government National Mortgage Association ("Ginnie Mae"), the Federal
National Mortgage Association ("Fannie Mae") and the Federal Home Loan Mortgage
Corporation ("Freddie Mac"); (2) those issued by private issuers that represent
an interest in or are collateralized by pass-through securities issued or
guaranteed by the U.S. Government or one of its agencies or instrumentalities;
and (3) those issued by private issuers that represent an interest in or are
collateralized by whole mortgage loans or pass-through securities without a
government guarantee but usually having some form of private credit enhancement.
Ginnie Mae is a wholly-owned United States Government corporation within the
Department of Housing and Urban Development. Ginnie Mae is authorized to
guarantee, with the full faith and credit of the United States Government, the
timely payment of principal and interest on securities issued by the
institutions approved by Ginnie Mae (such as savings and loan institutions,
commercial banks and mortgage banks), and backed by pools of FHA-insured or
VA-guaranteed mortgages.
Obligations of Fannie Mae and Freddie Mac are not backed by the full faith and
credit of the United States Government. In the case of obligations not backed by
the full faith and credit of the United States Government, the Fund must look
principally to the agency issuing or guaranteeing the obligation for ultimate
repayment. Fannie Mae and Freddie Mac may borrow from the U.S. Treasury to meet
its obligations, but the U.S. Treasury is under no obligation to lend to Fannie
Mae or Freddie Mac.
Private mortgage pass-through securities are structured similarly to Ginnie Mae,
Fannie Mae, and Freddie Mac mortgage pass-through securities and are issued by
originators of and investors in mortgage loans, including depository
institutions, mortgage banks, investment banks and special purpose subsidiaries
of the foregoing.
Pools created by private mortgage pass-through issuers generally offer a higher
rate of interest than government and government-related pools because there are
no direct or indirect government or agency guarantees of payments in the private
pools. However, timely payment of interest and principal of these pools may be
supported by various forms of insurance or guarantees, including individual
loan, title, pool and hazard insurance and letters of credit. The insurance and
guarantees are issued by governmental entities, private insurers and the
mortgage poolers. The insurance and guarantees and the creditworthiness of the
issuers thereof will be considered in determining whether a mortgage-related
security meets the Funds' investment quality standards. There can be no
assurance that the private insurers or guarantors can meet their obligations
under the insurance policies or guarantee arrangements. Private mortgage
pass-through securities may be bought without insurance or guarantees if,
through an examination of the loan experience and practices of the
originator/servicers and poolers, the Advisor determines that the securities
meet the Fund's quality standards.
Collateralized Mortgage Obligations. CMOs are debt obligations collateralized by
residential or commercial mortgage loans or residential or commercial mortgage
pass-through securities. Interest and prepaid principal are generally paid
monthly. CMOs may be collateralized by whole mortgage loans or private mortgage
pass-through securities but are more typically collateralized by portfolios of
mortgage pass-through securities guaranteed by Ginnie Mae, Freddie Mac, or
Fannie Mae. The issuer of a series of CMOs may elect to be treated as a Real
Estate Mortgage Investment Conduit ("REMIC"). All future references to CMOs also
include REMICs.
CMOs are structured into multiple classes, each bearing a different stated
maturity. Actual maturity and average life will depend upon the prepayment
experience of the collateral which is ordinarily unrelated to the stated
maturity
B-7
date. CMOs often provide for a modified form of call protection through a de
facto breakdown of the underlying pool of mortgages according to how quickly the
loans are repaid. Monthly payment of principal received from the pool of
underlying mortgages, including prepayments, is first returned to investors
holding the shortest maturity class. Investors holding the longer maturity
classes usually receive principal only after the first class has been retired.
An investor may be partially protected against a sooner than desired return of
principal because of the sequential payments.
Certain issuers of CMOs are not considered investment companies pursuant to a
rule adopted by the Securities and Exchange Commission ("SEC"), and the Funds
may invest in the securities of such issuers without the limitations imposed by
the 1940 Act on investments by the Fund in other investment companies. In
addition, in reliance on an earlier SEC interpretation, the Fund's investments
in certain other qualifying CMOs, which cannot or do not rely on the rule, are
also not subject to the limitation of the 1940 Act on acquiring interests in
other investment companies. In order to be able to rely on the SEC's
interpretation, these CMOs must be unmanaged, fixed asset issuers, that: (1)
invest primarily in mortgage-backed securities; (2) do not issue redeemable
securities; (3) operate under general exemptive orders exempting them from all
provisions of the 1940 Act; and (4) are not registered or regulated under the
1940 Act as investment companies. To the extent that the Funds select CMOs that
cannot rely on the rule or do not meet the above requirements, the Funds may not
invest more than 10% of their assets in all such entities and may not acquire
more than 3% of the voting securities of any single such entity.
The Bond Funds may also invest in, among other things, parallel pay CMOs,
Planned Amortization Class CMOs ("PAC bonds"), sequential pay CMOs, and floating
rate CMOs. Parallel pay CMOs are structured to provide payments of principal on
each payment date to more than one class. PAC bonds generally require payments
of a specified amount of principal on each payment date. Sequential pay CMOs
generally pay principal to only one class while paying interest to several
classes. Floating rate CMOs are securities whose coupon rate fluctuates
according to some formula related to an existing market index or rate. Typical
indices would include the eleventh district cost-of-funds index ("COFI"), the
London Interbank Offered Rate ("LIBOR"), one-year Treasury yields, and ten-year
Treasury yields.
Adjustable Rate Mortgage Securities. Adjustable rate mortgage securities
("ARMs") are pass-through securities collateralized by mortgages with adjustable
rather than fixed rates. ARMs eligible for inclusion in a mortgage pool
generally provide for a fixed initial mortgage interest rate for either the
first three, six, twelve, thirteen, thirty-six, or sixty scheduled monthly
payments. Thereafter, the interest rates are subject to periodic adjustment
based on changes to a designated benchmark index.
The ARMs contain maximum and minimum rates beyond which the mortgage interest
rate may not vary over the lifetime of the security. In addition, certain ARMs
provide for additional limitations on the maximum amount by which the mortgage
interest rate may adjust for any single adjustment period. In the event that
market rates of interest rise more rapidly to levels above that of the ARM's
maximum rate, the ARM's coupon may represent a below market rate of interest. In
these circumstances, the market value of the ARM security will likely have
fallen.
Certain ARMs contain limitations on changes in the required monthly payment. In
the event that a monthly payment is not sufficient to pay the interest accruing
on an ARM, any such excess interest is added to the principal balance of the
mortgage loan, which is repaid through future monthly payments. If the monthly
payment for such an instrument exceeds the sum of the interest accrued at the
applicable mortgage interest rate and the principal payment required at such
point to amortize the outstanding principal balance over the remaining term of
the loan, the excess is then utilized to reduce the outstanding principal
balance of the ARM.
B-8
CMO Residuals. CMO residuals are derivative mortgage securities issued by
agencies or instrumentalities of the U.S. Government or by private originators
of, or investors in, mortgage loans, including savings and loan associations,
homebuilders, mortgage banks, commercial banks, investment banks, and special
purpose entities of the foregoing.
The cash flow generated by the mortgage assets underlying a series of CMOs is
applied first to make required payments of principal and interest on the CMOs
and second to pay the related administrative expenses of the issuer. The
residual in a CMO structure generally represents the interest in any excess cash
flow remaining after making the foregoing payments. Each payment of such excess
cash flow to a holder of the related CMO residual represents income and/or a
return of capital. The amount of residual cash flow resulting from a CMO will
depend on, among other things, the characteristics of the mortgage assets, the
coupon rate of each class of CMO, prevailing interest rates, the amount of
administrative expenses and the prepayment experience on the mortgage assets. In
part, the yield to maturity on the CMO residuals is extremely sensitive to
prepayments on the related underlying mortgage assets, in the same manner as an
interest-only ("IO") class of stripped mortgage-related securities. See
"Stripped Mortgage-Related Securities" below. In addition, if a series of a CMO
includes a class that bears interest at an adjustable rate, the yield to
maturity on the related CMO residual will also be extremely sensitive to changes
in the level of the index upon which interest rate adjustments are based. As
described below with respect to stripped mortgage-related securities, in certain
circumstances the Fund may fail to recoup fully its initial investment in a CMO
residual.
CMO residuals are generally purchased and sold by institutional investors
through several investment banking firms acting as brokers or dealers. The CMO
residual market has recently developed and CMO residuals currently may not have
the liquidity of other more established securities trading in other markets.
Transactions in CMO residuals are generally completed only after careful review
of the characteristics of the securities in question. In addition, CMO residuals
may or, pursuant to an exemption therefrom, may not have been registered under
the Securities Act. CMO residuals, whether or not registered under such Act, may
be subject to certain restrictions on transferability, and may be deemed
"illiquid" and subject to a Fund's limitations on investment in illiquid
securities.
Stripped Mortgage-Related Securities. Stripped mortgage-related securities
("SMBS") are derivative multi-class mortgage securities. SMBS may be issued by
agencies or instrumentalities of the U.S. Government, or by private originators
of, or investors in, mortgage loans, including savings and loan associations,
mortgage banks, commercial banks, investment banks, and special purpose entities
of the foregoing.
SMBS are usually structured with two classes that receive different proportions
of the interest and principal distributions on a pool of mortgage assets. A
common type of SMBS will have one class receiving some of the interest and most
of the principal from the mortgage assets, while the other class will receive
most of the interest and the remainder of the principal. In the most extreme
case, one class will receive all of the interest (the IO class), while the other
class will receive all of the principal (the PO class). The yield to maturity on
an IO class is extremely sensitive to the rate of principal payments (including
prepayments) on the related underlying mortgage assets, and a rapid rate of
principal payments may have a material adverse effect on a Fund's yield to
maturity from these securities. If the underlying mortgage assets experience
greater than anticipated prepayments of principal, a Fund may fail to fully
recoup its initial investment in these securities even if the security is in one
of the highest rating categories.
Although SMBSs are purchased and sold by institutional investors through several
investment banking firms acting as brokers or dealers, these securities were
only recently introduced. As a result, established trading markets have not
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yet been fully developed and accordingly, these securities may be deemed
"illiquid" and subject to a Fund's limitations on investment in illiquid
securities.
Inverse Floaters. An inverse floater is a debt instrument with a floating or
variable interest rate that moves in the opposite direction to the interest rate
on another security or index level. Changes in the interest rate on the other
security or index inversely affect the residual interest rate paid on the
inverse floater, with the result that the inverse floater's price will be
considerably more volatile than that of a fixed rate bond. Inverse floaters may
experience gains when interest rates fall and may suffer losses in periods of
rising interest rates. The market for inverse floaters is relatively new.
Tiered Index Bonds. Tiered index bonds are relatively new forms of
mortgage-related securities. The interest rate on a tiered index bond is tied to
a specified index or market rate. So long as this index or market rate is below
a predetermined "strike" rate, the interest rate on the tiered index bond
remains fixed. If, however, the specified index or market rate rises above the
"strike" rate, the interest rate of the tiered index bond will decrease. Thus,
under these circumstances, the interest rate on a tiered index bond, like an
inverse floater, will move in the opposite direction of prevailing interest
rates, with the result that the price of the tiered index bond may be
considerably more volatile than that of a fixed rate bond.
ASSET-BACKED SECURITIES
The Bond Funds may invest in various types of asset-backed securities. Through
the use of trusts and special purpose corporations, various types of assets,
primarily automobile and credit card receivables and home equity loans, are
being securitized in pass-through structures similar to the mortgage
pass-through or in a pay-through structure similar to the CMO structure.
Investments in these and other types of asset-backed securities must be
consistent with the investment objectives and policies of the Funds.
RISK FACTORS RELATING TO INVESTING IN MORTGAGE-RELATED AND ASSET-BACKED
SECURITIES
The yield characteristics of mortgage-related and asset-backed securities differ
from traditional debt securities. Among the major differences are that interest
and principal payments are made more frequently, usually monthly, and that
principal may be prepaid at any time because the underlying mortgage loans or
other assets generally may be prepaid at any time. As a result, if the Funds
purchase such a security at a premium, a prepayment rate that is faster than
expected will reduce yield to maturity, while a prepayment rate that is slower
than expected will have the opposite effect of increasing yield to maturity.
Alternatively, if the Funds purchase these securities at a discount, faster than
expected prepayments will increase, while slower than expected prepayments will
reduce, yield to maturity. The Funds may invest a portion of their assets in
derivative mortgage-related securities which are highly sensitive to changes in
prepayment and interest rates. The Advisor will seek to manage these risks (and
potential benefits) by diversifying its investments in such securities and
through hedging techniques.
During periods of declining interest rates, prepayment of mortgages underlying
mortgage-related securities can be expected to accelerate. Accordingly, a Fund's
ability to maintain positions in high-yielding mortgage-related securities will
be affected by reductions in the principal amount of such securities resulting
from such prepayments, and its ability to reinvest the returns of principal at
comparable yields is subject to generally prevailing interest rates at that
time. Conversely, slower than expected prepayments may effectively change a
security that was considered short or intermediate-term at the time of purchase
into a long-term security. Long-term securities tend to fluctuate more in
response to interest rate changes, leading to increased net asset value
volatility. Prepayments may also result in the
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realization of capital losses with respect to higher yielding securities that
had been bought at a premium or the loss of opportunity to realize capital gains
in the future from possible future appreciation.
Asset-backed securities involve certain risks that are not posed by
mortgage-related securities, resulting mainly from the fact that asset-backed
securities do not usually contain the complete benefit of a security interest in
the related collateral. For example, credit card receivables generally are
unsecured and the debtors are entitled to the protection of a number of state
and federal consumer credit laws, some of which may reduce the ability to obtain
full payment. In the case of automobile receivables, due to various legal and
economic factors, proceeds from repossessed collateral may not always be
sufficient to support payments on these securities.
DURATION
In selecting securities for the Bond Funds, the Advisor makes use of the concept
of duration for fixed-income securities. Duration is a measure of the expected
life of a fixed-income security. Duration incorporates a bond's yield, coupon
interest payments, final maturity and call features into one measure. Most debt
obligations provide interest ("coupon") payments in addition to a final ("par")
payment at maturity. Some obligations also have call provisions. Depending on
the relative magnitude of these payments, the market values of debt obligations
may respond differently to changes in the level and structure of interest rates.
Duration is a measure of the expected life of a fixed-income security on a
present value basis. Duration takes the length of the time intervals between the
present time and the time that the interest and principal payments are scheduled
or, in the case of a callable bond, expected to be received, and weights them by
the present values of the cash to be received at each future point in time. For
any fixed-income security with interest payments occurring prior to the payment
of principal, duration is always less than maturity. In general, all other
things being the same, the lower the stated or coupon rate of interest of a
fixed-income security, the longer the duration of the security; conversely, the
higher the stated or coupon rate of interest of a fixed-income security, the
shorter the duration of the security.
Futures, options and options on futures have durations which, in general, are
closely related to the duration of the securities which underlie them. Holding
long futures or call option positions (backed by a segregated account of cash
and cash equivalents) will lengthen a Fund's duration by approximately the same
amount that holding an equivalent amount of the underlying securities would.
Short futures or put options positions have durations roughly equal to the
negative duration of the securities that underlie those positions, and have the
effect of reducing portfolio duration by approximately the same amount that
selling an equivalent amount of the underlying securities would.
There are some situations where even the standard duration calculation does not
properly reflect the interest rate exposure of a security. For example, floating
and variable rate securities often have final maturities of ten or more years;
however, their interest rate exposure corresponds to the frequency of the coupon
reset. Another example where the interest rate exposure is not properly captured
by duration is the case of mortgage pass-through securities. The stated final
maturity of such securities is generally 30 years, but current prepayment rates
are more critical in determining the securities' interest rate exposure. In
these and other similar situations, the Advisor will use more sophisticated
analytical techniques that incorporate the economic life of a security into the
determination of its interest rate exposure.
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EFFECTIVE MATURITY
The Bond Funds each invest in a diversified portfolio of fixed-income securities
of varying maturities. The effective maturity is the weighted average period
over which a security's principal is expected to be paid. Stated maturity is the
date when the issuer is scheduled to make the final payment of principal.
Effective maturity differs from stated maturity in that it estimates the
anticipated effect of expected principal prepayments and call provisions.
The effective maturity of a debt security will be the stated maturity, except:
(1) in the case of a security with a call provision, the maturity date will be
considered the call date if there is a high probability, in the opinion of the
Advisor, that the security will be called; (2) in the case of securities with
unconditional put provisions entitling the security holder to receive the
security's approximate amortized cost, the maturity will be considered to be the
next put date; (3) in the case of mortgage-backed or other amortizing
securities, the maturity will be considered to be the average life remaining
(the length of time it is expected to take to retire half of the remaining
principal through amortizing payments) based on prepayment assumptions that the
Advisor believes appropriate; and (4) in the case of a variable or floating rate
investment grade security which, in the Advisor's opinion, will have a market
value approximating amortized cost on the next interest rate reset date, the
maturity will be considered to be the next reset date. However, no Bond Fund
will invest more than 5% of its net assets at the time of purchase in floating
or variable rate instruments of any one issuer, nor invest more than 20% of its
net assets at the time of purchase in floating or variable rate instruments of
issuers within the same industry.
DERIVATIVE INSTRUMENTS
As indicated in the prospectuses, to the extent consistent with their investment
objectives and policies and the investment restrictions listed in this Statement
of Additional Information, the Funds may purchase and write call and put options
on securities, securities indexes and foreign currencies and enter into futures
contracts and use options on futures contracts. The Funds also may enter into
swap agreements with respect to foreign currencies, interest rates and
securities indexes. The Funds may use these techniques to hedge against changes
in interest rates, foreign currency exchange rates, or securities prices or as
part of their overall investment strategies. The International VIP Portfolio and
the Bond Funds may also purchase and sell options relating to foreign currencies
for the purpose of increasing exposure to a foreign currency or to shift
exposure to foreign currency fluctuations from one country to another. Each Fund
will maintain segregated accounts consisting of cash, U.S. Government
securities, equity securities or other liquid, unencumbered assets,
marked-to-market daily (or, as permitted by applicable regulation, enter into
certain offsetting positions), to cover its obligations under options and
futures contracts to avoid leveraging of the Fund.
Options on Securities and on Securities Indexes. A Fund may purchase put options
on securities to protect holdings in an underlying or related security against a
substantial decline in market value. A Fund may purchase call options on
securities to protect against substantial increases in prices of securities the
Fund intends to purchase pending its ability to invest in such securities in an
orderly manner. A Fund may sell put or call options it has previously purchased,
which could result in a net gain or loss depending on whether the amount
realized on the sale is more or less than the premium and other transaction
costs paid on the put or call option which is sold. A Fund may write a call or
put option only if the option is "covered" by the Fund holding a position in the
underlying securities or by other means which would permit immediate
satisfaction of the Fund's obligation as writer of the option. Prior to exercise
or expiration, an option may be closed out by an offsetting purchase or sale of
an option of the same series.
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The purchase and writing of options involves certain risks. During the option
period, the covered call writer has, in return for the premium on the option,
given up the opportunity to profit from a price increase in the underlying
securities above the exercise price, but, as long as its obligation as a writer
continues, has retained the risk of loss should the price of the underlying
securities decline. The writer of an option has no control over the time when it
may be required to fulfill its obligation as a writer of the option. Once an
option writer has received an exercise notice, it cannot effect a closing
purchase transaction in order to terminate its obligation under the option and
must deliver the underlying securities at the exercise price. If a put or call
option purchased by the Fund is not sold when it has remaining value, and if the
market price of the underlying security, in the case of a put, remains equal to
or greater than the exercise price or, in the case of a call, remains less than
or equal to the exercise price, the Fund will lose its entire investment in the
option. Also, where a put or call option on a particular security is purchased
to hedge against price movements in a related security, the price of the put or
call option may move more or less than the price of the related security. There
can be no assurance that a liquid market will exist when a Fund seeks to close
out an option position. Furthermore, if trading restrictions or suspensions are
imposed on the options markets, a Fund may be unable to close out a position.
There are several risks associated with transactions in options on securities
and on indexes. For example, there are significant differences between the
securities and options markets that could result in an imperfect correlation
between these markets, causing a given transaction not to achieve its
objectives. A decision as to whether when and how to use options involves the
exercise of skill and judgment, and even a well-conceived transaction may be
unsuccessful to some degree because of market behavior or unexpected events.
There can be no assurance that a liquid market will exist when a Fund seeks to
close out an option position. If a Fund were unable to close out an option that
it had purchased on a security, it would have to exercise the option in order to
realize any profit or the option may expire worthless. If a Fund were unable to
close out a covered call option that it had written on a security, it would not
be able to sell the underlying security unless the option expired without
exercise. As the writer of a covered call option, a Fund forgoes, during the
option's life, the opportunity to profit from increases in the market value of
the security covering the call option above the sum of the premium and the
exercise price of the call.
If trading were suspended in an option purchased by a Fund, the Fund would not
be able to close out the option. If restrictions on exercise were imposed, the
Fund might be unable to exercise an option it had purchased. Except to the
extent that a call option on an index written by the Fund is covered by an
option on the same index purchased by the Fund, movements in the index may
result in a loss to the Fund; however, such losses may be mitigated by changes
in the value of the Fund's securities during the period the option was
outstanding.
Futures Contracts and Options on Futures Contracts. A Fund may use interest
rate, foreign currency or index futures contracts, as specified for that Fund in
its prospectus and if permitted by its investment restrictions. An interest
rate, foreign currency or index futures contract provides for the future sale by
one party and purchase by another party of a specified quantity of a financial
instrument, foreign currency or the cash value of an index at a specified price
and time. A futures contract on an index is an agreement pursuant to which two
parties agree to take or make delivery of an amount of cash equal to the
difference between the value of the index at the close of the last trading day
of the contract and the price at which the index contract was originally
written. Although the value of an index might be a function of the value of
certain specified securities, no physical delivery of these securities is made.
A Fund may purchase and write call and put options on futures. Options on
futures possess many of the same characteristics as options on securities and
indexes (discussed above). An option on a futures contract gives the
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holder the right, in return for the premium paid, to assume a long position
(call) or short position (put) in a futures contract at a specified exercise
price at any time during the period of the option. Upon exercise of a call
option, the holder acquires a long position in the futures contract and the
writer is assigned the opposite short position. In the case of a put option, the
opposite is true.
Each Fund will use futures contracts and options on futures contracts in
accordance with the rules of the Commodity Futures Trading Commission ("CFTC").
For example, a Fund might use futures contracts to hedge against anticipated
changes in interest rates that might adversely affect either the value of the
Fund's securities or the price of the securities which the Fund intends to
purchase. A Fund's hedging activities may include sales of futures contracts as
an offset against the effect of expected increases in interest rates, and
purchases of futures contracts as an offset against the effect of expected
declines in interest rates. Although other techniques could be used to reduce
that Fund's exposure to interest rate fluctuations, the Fund may be able to
hedge its exposure more effectively and perhaps at a lower cost by using futures
contracts and options on futures contracts.
A Fund will only enter into futures contracts and options on futures contracts
which are standardized and traded on a U.S. or foreign exchange, board of trade,
or similar entity, or quoted on an automated quotation system.
When a purchase or sale of a futures contract is made by a Fund, the Fund is
required to deposit with its custodian (or broker, if legally permitted) a
specified amount of cash or U.S. Government securities ("initial margin"). The
margin required for a futures contract is set by the exchange on which the
contract is traded and may be modified during the term of the contract. The
initial margin is in the nature of a performance bond or good faith deposit on
the futures contract which is returned to the Fund upon termination of the
contract, assuming all contractual obligations have been satisfied. Each Fund
expects to earn interest income on its initial margin deposits. A futures
contract held by a Fund is valued daily at the official settlement price of the
exchange on which it is traded. Each day the Fund pays or receives cash, called
"variation margin," equal to the daily change in value of the futures contract.
This process is known as "marking to market." Variation margin does not
represent a borrowing or loan by a Fund but is instead a settlement between the
Fund and the broker of the amount one would owe the other if the futures
contract expired. In computing daily net asset value, each Fund will mark to
market its open futures positions.
A Fund is also required to deposit and maintain margin with respect to put and
call options on futures contracts written by it. Such margin deposits will vary
depending on the nature of the underlying futures contract (and the related
initial margin requirements), the current market value of the option, and other
futures positions held by the Fund.
Although some futures contracts call for making or taking delivery of the
underlying securities, generally these obligations are closed out prior to
delivery by offsetting purchases or sales of matching futures contracts (same
exchange, underlying security or index and delivery month). If an offsetting
purchase price is less than the original sale price, the Fund realizes a capital
gain, or if it is more, the Fund realizes a capital loss. Conversely, if an
offsetting sale price is more than the original purchase price, the Fund
realizes a capital gain, or if it is less, the Fund realizes a capital loss. The
transaction costs must also be included in these calculations.
Limitations on Use of Futures and Options Thereon. When purchasing a futures
contract, a Fund will maintain with its custodian (and mark-to-market on a daily
basis) cash, U.S. Government securities, equity securities or other liquid,
unencumbered assets that, when added to the amounts deposited with a futures
commission merchant as margin, are equal to the market value of the futures
contract. Alternatively, the Fund may "cover" its position by purchasing a
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put option on the same futures contract with a strike price as high or higher
than the price of the contract held by the Fund.
When selling a futures contract, a Fund will maintain with its custodian (and
mark-to-market on a daily basis) liquid assets that, when added to the amount
deposited with a futures commission merchant as margin, are equal to the market
value of the instruments underlying the contract. Alternatively, the Fund may
"cover" its position by owning the instruments underlying the contract (or, in
the case of an index futures contract, a portfolio with a volatility
substantially similar to that of the index on which the futures contract is
based), or by holding a call option permitting the Fund to purchase the same
futures contract at a price no higher than the price of the contract written by
the Fund (or at a higher price if the difference is maintained in liquid assets
with the Trust's custodian).
When selling a call option on a futures contract, a Fund will maintain with its
custodian (and mark-to-market on a daily basis) cash, U.S. Government
securities, equity securities or other liquid, unencumbered assets that, when
added to the amounts deposited with a futures commission merchant as margin,
equal the total market value of the futures contract underlying the call option.
Alternatively, the Fund may cover its position by entering into a long position
in the same futures contract at a price no higher than the strike price of the
call option, by owning the instruments underlying the futures contract, or by
holding a separate call option permitting the Fund to purchase the same futures
contract at a price not higher than the strike price of the call option sold by
the Fund.
When selling a put option on a futures contract, a Fund will maintain with its
custodian (and mark-to-market on a daily basis) cash, U.S. Government
securities, equity securities or other liquid, unencumbered assets that equal
the purchase price of the futures contract, less any margin on deposit.
Alternatively, the Fund may cover the position either by entering into a short
position in the same futures contract, or by owning a separate put option
permitting it to sell the same futures contract so long as the strike price of
the purchased put option is the same or higher than the strike price of the put
option sold by the Fund.
In order to comply with current applicable regulations of the CFTC pursuant to
which the Trust avoids being deemed a "commodity pool operator," the Funds are
limited in their futures trading activities to positions which constitute "bona
fide hedging" positions within the meaning and intent of applicable CFTC rules,
or to non-hedging positions for which the aggregate initial margin and premiums
will not exceed 5% of the liquidation value of the Fund's assets.
Risk Factors in Futures Transactions and Options. Investment in futures
contracts involves the risk of imperfect correlation between movements in the
price of the futures contract and the price of the security being hedged. The
hedge will not be fully effective when there is imperfect correlation between
the movements in the prices of two financial instruments. For example, if the
price of the futures contract moves more than the price of the hedged security,
a Fund will experience either a loss or gain on the futures contract which is
not completely offset by movements in the price of the hedged securities. To
compensate for imperfect correlations, the Fund may purchase or sell futures
contracts in a greater dollar amount than the hedged securities if the
volatility of the hedged securities is historically greater than the volatility
of the futures contracts. Conversely, the Fund may purchase or sell fewer
futures contracts if the volatility of the price of the hedged securities is
historically less than that of the futures contracts.
The particular securities comprising the index underlying the index financial
futures contract may vary from the securities held by a Fund. As a result, the
Fund's ability to hedge effectively all or a portion of the value of its
securities through the use of such financial futures contracts will depend in
part on the degree to which price movements in the index underlying the
financial futures contract correlate with the price movements of the securities
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held by the Fund. The correlation may be affected by disparities in the Fund's
investments as compared to those comprising the index and general economic or
political factors. In addition, the correlation between movements in the value
of the index may be subject to change over time as additions to and deletions
from the index alter its structure. The correlation between futures contracts on
U.S. Government securities and the securities held by a Fund may be adversely
affected by similar factors and the risk of imperfect correlation between
movements in the prices of such futures contracts and the prices of securities
held by the Fund may be greater. The trading of futures contracts also is
subject to certain market risks, such as inadequate trading activity, which
could at times make it difficult or impossible to liquidate existing positions.
Each Fund expects to liquidate a majority of the futures contracts it enters
into through offsetting transactions on the applicable contract market. There
can be no assurance, however, that a liquid secondary market will exist for any
particular futures contract at any specific time. Thus, it may not be possible
to close out a futures position. In the event of adverse price movements, the
Fund would continue to be required to make daily cash payments of variation
margin. In such situations, if the Fund 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. The inability to
close out futures positions also could have an adverse impact on the Fund's
ability to hedge effectively its investments. The liquidity of a secondary
market in a futures contract may be adversely affected by "daily price
fluctuation limits" established by commodity exchanges which limit the amount of
fluctuation in a futures contract price during a single trading day. Once the
daily limit has been reached in the contract, no trades may be entered into at a
price beyond the limit, thus preventing the liquidation of open futures
positions. Prices have in the past moved beyond the daily limit on a number of
consecutive trading days. A Fund will enter into a futures position only if, in
the judgment of the Advisor, there appears to be an actively traded secondary
market for such futures contracts.
The successful use of transactions in futures and related options also depends
on the ability of the Advisor to forecast correctly the direction and extent of
interest rate movements within a given time frame. To the extent interest rates
remain stable during the period in which a futures contract or option is held by
a Fund or such rates move in a direction opposite to that anticipated, the Fund
may realize a loss on a hedging transaction which is not fully or partially
offset by an increase in the value of portfolio securities. As a result, the
Fund's total return for such period may be less than if it had not engaged in
the hedging transaction.
Because of low initial margin deposits made upon the opening of a futures
position, futures transactions involve substantial leverage. As a result,
relatively small movements in the price of the futures contracts can result in
substantial unrealized gains or losses. There is also the risk of loss by a Fund
of margin deposits in the event of the bankruptcy of a broker with whom the Fund
has an open position in a financial futures contract.
The amount of risk a Fund assumes when it purchases an option on a futures
contract is the premium paid for the option plus related transaction costs. In
addition to the correlation risks discussed above, the purchase of an option on
a futures contract also entails the risk that changes in the value of the
underlying futures contract will not be fully reflected in the value of the
option purchased.
FOREIGN SECURITIES
The Funds may invest in American Depositary Receipts ("ADRs"), European
Depositary Receipts ("EDRs") or other securities convertible into securities of
issuers based in foreign countries. These securities may not necessarily be
denominated in the same currency as the securities into which they may be
converted. ADRs are receipts, usually issued by a U.S. bank or trust company,
evidencing ownership of the underlying securities; EDRs are European
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receipts evidencing a similar arrangement. Generally, ADRs are issued in
registered form, denominated in U.S. dollars, and are designed for use in the
U.S. securities markets; EDRs are issued in bearer form, denominated in other
currencies, and are designed for use in European securities markets.
The Bond Funds may also invest in fixed-income securities of issuers located in
emerging foreign markets. Emerging markets generally include every country in
the world other than the United States, Canada, Japan, Australia, Malaysia, New
Zealand, Hong Kong, South Korea, Singapore and most Western European countries.
In determining what countries constitute emerging markets, the Advisor will
consider, among other things, data, analysis and classification of countries
published or disseminated by the International Bank for Reconstruction and
Development (commonly known as the World Bank) and the International Finance
Corporation. Currently, investing in many emerging markets may not be desirable
or feasible, because of the lack of adequate custody arrangements for a Fund's
assets, overly burdensome repatriation and similar restrictions, the lack of
organized and liquid securities markets, unacceptable political risks or other
reasons. As opportunities to invest in securities in emerging markets develop,
the Fund expects to expand and further broaden the group of emerging markets in
which it invests.
From time to time, emerging markets have offered the opportunity for higher
returns in exchange for a higher level of risk. Accordingly, the Advisor
believes that a Bond Fund's ability to invest in emerging markets throughout the
world may enable the achievement of results superior to those produced by funds,
with similar objectives to those of these Funds, that invest solely in
securities in developed markets. There is no assurance that any Bond Fund will
achieve these results.
The Bond Funds may invest in the following types of emerging market fixed-income
securities: (1) fixed-income securities issued or guaranteed by governments,
their agencies, instrumentalities or political subdivisions, or by government
owned, controlled or sponsored entities, including central banks (collectively,
"Sovereign Debt"), including Brady Bonds (described below); (2) interests in
issuers organized and operated for the purpose of restructuring the investment
characteristics of Sovereign Debt; (3) fixed-income securities issued by banks
and other business entities; and (4) fixed-income securities denominated in or
indexed to the currencies of emerging markets. Fixed-income securities held by a
Fund may take the form of bonds, notes, bills, debentures, bank debt
obligations, short-term paper, loan participations, assignments and interests
issued by entities organized and operated for the purpose of restructuring the
investment characteristics of any of the foregoing. There is no requirement with
respect to the maturity of fixed-income securities in which the Fund may invest.
The Bond Funds may invest in Brady Bonds and other Sovereign Debt of countries
that have restructured or are in the process of restructuring Sovereign Debt
pursuant to the Brady Plan. "Brady Bonds" are debt securities issued under the
framework of the Brady Plan, an initiative announced by former U.S. Treasury
Secretary Nicholas F. Brady in 1989 as a mechanism for debtor nations to
restructure their outstanding external commercial bank indebtedness. In
restructuring its external debt under the Brady Plan framework, a debtor nation
negotiates with its existing bank lenders as well as multilateral institutions
such as the World Bank and the International Monetary Fund ("IMF"). The Brady
Plan framework, as it has developed, contemplates the exchange of commercial
bank debt for newly issued Brady Bonds. Brady Bonds may also be issued in
respect of new money being advanced by existing lenders in connection with the
debt restructuring. The World Bank and/or the IMF support the restructuring by
providing funds pursuant to loan agreements or other arrangements which enable
the debtor nation to collateralize the new Brady Bonds or to repurchase
outstanding bank debt at a discount.
Emerging market fixed-income securities generally are considered to be of a
credit quality below investment grade, even though they often are not rated by
any nationally recognized statistical rating organizations. Investment in
emerging market fixed-income securities will be allocated among various
countries based upon the Advisor's analysis
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of credit risk and its consideration of a number of factors, including:
prospects for relative economic growth among the different countries in which
the Bond Funds may invest; expected levels of inflation; government policies
influencing business conditions; the outlook for currency relationships; and the
range of the individual investment opportunities available to international
investors. The Advisor's emerging market sovereign credit analysis includes an
evaluation of the issuing country's total debt levels, currency reserve levels,
net exports/imports, overall economic growth, level of inflation, currency
fluctuation, political and social climate and payment history. Particular fixed-
income securities will be selected based upon a credit risk analysis of
potential issuers, the characteristics of the security, the interest rate
sensitivity of the various debt issues available with respect to a particular
issuer, an analysis of the anticipated volatility and liquidity of the
particular debt instruments, and the tax implications to the Fund. The emerging
market fixed-income securities in which the Bond Funds may invest are not
subject to any minimum credit quality standards.
FOREIGN CURRENCY OPTIONS AND RELATED RISKS
The Funds may take positions in options on foreign currencies to hedge against
the risk that foreign exchange rate fluctuations will affect the value of
foreign securities the Funds hold in their portfolios or intend to purchase. For
example, if a Fund were to enter into a contract to purchase securities
denominated in a foreign currency, it could effectively fix the maximum U.S.
dollar cost of the securities by purchasing call options on that foreign
currency. Similarly, if a Fund held securities denominated in a foreign currency
and anticipated a decline in the value of that currency against the U.S. dollar,
it could hedge against such a decline by purchasing a put option on the currency
involved. The markets in foreign currency options are relatively new, and a
Fund's ability to establish and close out positions in such options is subject
to the maintenance of a liquid secondary market. There can be no assurance that
a liquid secondary market will exist for a particular option at any specific
time. In addition, options on foreign currencies are affected by all of those
factors that influence foreign exchange rates and investments generally.
The quantities of currencies underlying option contracts represent odd lots in a
market dominated by transactions between banks, and as a result extra
transaction costs may be incurred upon exercise of an option.
There is no systematic reporting of last sale information for foreign currencies
or any regulatory requirement that quotations be firm or revised on a timely
basis. Quotation information is generally representative of very large
transactions in the interbank market and may not reflect smaller transactions
where rates may be less favorable. Option markets may be closed while
round-the-clock interbank currency markets are open, and this can create price
and rate discrepancies.
Risks of Options Trading. The Funds may effectively terminate their rights or
obligations under options by entering into closing transactions. Closing
transactions permit a Fund to realize profits or limit losses on its options
positions prior to the exercise or expiration of the option. The value of a
foreign currency option depends on the value of the underlying currency relative
to the U.S. dollar. Other factors affecting the value of an option are the time
remaining until expiration, the relationship of the exercise price to market
price, the historical price volatility of the underlying currency and general
market conditions. As a result, changes in the value of an option position may
have no relationship to the investment merit of a foreign security. Whether a
profit or loss is realized on a closing transaction depends on the price
movement of the underlying currency and the market value of the option.
Options normally have expiration dates of up to nine months. The exercise price
may be below, equal to or above the current market value of the underlying
currency. Options that expire unexercised have no value, and a Fund will realize
a loss of any premium paid and any transaction costs. Closing transactions may
be effected only by
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negotiating directly with the other party to the option contract, unless a
secondary market for the options develops. Although the Funds intend to enter
into foreign currency options only with dealers which agree to enter into, and
which are expected to be capable of entering into, closing transactions with the
Funds, there can be no assurance that a Fund will be able to liquidate an option
at a favorable price at any time prior to expiration. In the event of insolvency
of the counter-party, a Fund may be unable to liquidate a foreign currency
option. Accordingly, it may not be possible to effect closing transactions with
respect to certain options, with the result that a Fund would have to exercise
those options that it had purchased in order to realize any profit.
FORWARD FOREIGN CURRENCY EXCHANGE CONTRACTS
The Funds may use forward contracts to protect against uncertainty in the level
of future exchange rates. The Funds will not speculate with forward contracts or
foreign currency exchange rates.
A Fund may enter into forward contracts with respect to specific transactions.
For example, when a Fund enters into a contract for the purchase or sale of a
security denominated in a foreign currency, or when a Fund anticipates the
receipt in a foreign currency of dividend or interest payments on a security
that it holds, the Fund may desire to "lock in" the U.S. dollar price of the
security or the U.S. dollar equivalent of the payment, by entering into a
forward contract for the purchase or sale, for a fixed amount of U.S. dollars or
foreign currency, of the amount of foreign currency involved in the underlying
transaction. A Fund will thereby be able to protect itself against a possible
loss resulting from an adverse change in the relationship between the currency
exchange rates during the period between the date on which the security is
purchased or sold, or on which the payment is declared, and the date on which
such payments are made or received.
A Fund also may use forward contracts in connection with portfolio positions to
lock in the U.S. dollar value of those positions, to increase the Fund's
exposure to foreign currencies that the Advisor believes may rise in value
relative to the U.S. dollar or to shift the Fund's exposure to foreign currency
fluctuations from one country to another. For example, when the Advisor believes
that the currency of a particular foreign country may suffer a substantial
decline relative to the U.S. dollar or another currency, it may enter into a
forward contract to sell the amount of the former foreign currency approximating
the value of some or all of the Fund's portfolio securities denominated in such
foreign currency. This investment practice generally is referred to as
"cross-hedging" when another foreign currency is used.
The precise matching of the forward contract amounts and the value of the
securities involved will not generally be possible because the future value of
such securities in foreign currencies will change as a consequence of market
movements in the value of those securities between the date the forward contract
is entered into and the date it matures. Accordingly, it may be necessary for a
Fund to purchase additional foreign currency on the spot (i.e., cash) market
(and bear the expense of such purchase) if the market value of the security is
less than the amount of foreign currency the Fund is obligated to deliver and if
a decision is made to sell the security and make delivery of the foreign
currency. Conversely, it may be necessary to sell on the spot market some of the
foreign currency received upon the sale of the portfolio security if its market
value exceeds the amount of foreign currency the Fund is obligated to deliver.
The projection of short-term currency market movements is extremely difficult,
and the successful execution of a short-term hedging strategy is highly
uncertain. Forward contracts involve the risk that anticipated currency
movements will not be accurately predicted, causing the Fund to sustain losses
on these contracts and transaction costs. A Fund may enter into forward
contracts or maintain a net exposure to such contracts only if (1) the
consummation of the contracts would not obligate the Fund to deliver an amount
of foreign currency in excess of the value of the Fund's portfolio securities or
other assets denominated in that currency or
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(2) the Fund maintains in a segregated account cash, U.S. Government securities,
equity securities or other liquid, unencumbered assets, marked-to-market daily,
in an amount not less than the value of the Fund's total assets committed to the
consummation of the contracts. Under normal circumstances, consideration of the
prospect for currency parities will be incorporated into the longer term
investment decisions made with regard to overall diversification strategies.
However, the Advisor believes it is important to have the flexibility to enter
into such forward contracts when it determines that the best interests of the
Fund will be served.
At or before the maturity date of a forward contract that requires a Fund to
sell a currency, the Fund may either sell a portfolio security and use the sale
proceeds to make delivery of the currency or retain the security and offset its
contractual obligation to deliver the currency by purchasing a second contract
pursuant to which the Fund will obtain, on the same maturity date, the same
amount of the currency that it is obligated to deliver. Similarly, a Fund may
close out a forward contract requiring it to purchase a specified currency by
entering into a second contract entitling it to sell the same amount of the same
currency on the maturity date of the first contract. The Fund would realize a
gain or loss as a result of entering into such an offsetting forward contract
under either circumstance to the extent the exchange rate between the currencies
involved moved between the execution dates of the first and second contracts.
The cost to the Fund of engaging in forward contracts varies with factors such
as the currencies involved, the length of the contract period and the market
conditions then prevailing. Because forward contracts are usually entered into
on a principal basis, no fees or commissions are involved. The use of forward
contracts does not eliminate fluctuations in the prices of the underlying
securities the Fund owns or intends to acquire, but it does fix a rate of
exchange in advance. In addition, although forward contracts limit the risk of
loss due to a decline in the value of the hedged currencies, at the same time
they limit any potential gain that might result should the value of the
currencies increase.
Although the Funds value their assets daily in terms of U.S. dollars, they do
not intend to convert holdings of foreign currencies into U.S. dollars on a
daily basis. The Funds may convert foreign currency from time to time, and
investors should be aware of the costs of currency conversion. Although foreign
exchange dealers do not charge a fee for conversion, they do realize a profit
based on the difference between the prices at which they are buying and selling
various currencies. Thus, a dealer may offer to sell a foreign currency to a
Fund at one rate, while offering a lesser rate of exchange should the Fund
desire to resell that currency to the dealer.
Swap Agreements. The Funds may enter into interest rate, index and currency
exchange rate swap agreements for purposes of attempting to obtain a particular
desired return at a lower cost to the Fund than if the Fund had invested
directly in an instrument that yielded the desired return. Swap agreements are
two party contracts entered into primarily by institutional investors for
periods ranging from a few weeks to more than one year. In a standard "swap"
transaction, two parties agree to exchange the returns (or differentials in
rates of return) earned or realized on particular predetermined investments or
instruments. The gross returns to be exchanged or "swapped" between the parties
are calculated with respect to a "notional amount," i.e., the return on or
increase in value of a particular dollar amount invested at a particular
interest rate, in a particular foreign currency, or in a "basket" of securities
representing a particular index. The "notional amount" of the swap agreement is
only a fictive basis on which to calculate the obligations which the parties to
a swap agreement have agreed to exchange. A Fund's obligations (or rights) under
a swap agreement will generally be equal only to the net amount to be paid or
received under the agreement based on the relative values of the positions held
by each party to the agreement (the "net amount"). A Fund's obligations under a
swap agreement will be accrued daily (offset against any amounts owing to the
Fund) and any accrued but unpaid net amounts owed to a swap counter-party will
be covered by segregating cash, U.S.
B-20
Government securities, equity securities or other liquid, unencumbered assets
marked-to-market daily, to avoid any potential leveraging of the Fund's
portfolio. A Fund will not enter into a swap agreement with any single party if
the net amount owed or to be received under existing contracts with that party
would exceed 5% of the Fund's assets.
Whether a Fund's use of swap agreements will be successful in furthering its
investment objective of total return will depend on the Advisor's ability
correctly to predict whether certain types of investments are likely to produce
greater returns than other investments. Because they are two party contracts and
because they may have terms of greater than seven days, swap agreements may be
considered to be illiquid. Moreover, a Fund bears the risk of loss of the amount
expected to be received under a swap agreement in the event of the default or
bankruptcy of a swap agreement counter-party. Restrictions imposed by the
Internal Revenue Code may limit the Funds' ability to use swap agreements. The
swaps market is a relatively new market and is largely unregulated. It is
possible that developments in the swaps market, including potential government
regulation, could adversely affect a Fund's ability to terminate existing swap
agreements or to realize amounts to be received under such agreements.
FOREIGN INVESTMENT RISKS
Foreign Market Risk. Because the Funds may invest in foreign securities, the
Funds offer you more diversification than an investment only in the United
States since prices of securities traded on foreign markets have often, though
not always, moved counter to prices in the United States. Foreign security
investment, however, involves special risks not present in U.S. investments that
can increase the chances that the Funds will lose money. In particular, the
Stock Funds are subject to the risk that because there are generally fewer
investors on foreign exchanges and a smaller number of shares traded each day,
it may be difficult for a Fund to buy and sell securities on those exchanges. In
addition, prices of foreign securities may fluctuate more than prices of
securities traded in the United States.
Foreign Economy Risk. The economies of certain foreign markets often do not
compare favorably with that of the United States with respect to such issues as
growth of gross national product, reinvestment of capital, resources, and
balance of payments position. Certain such economies may rely heavily on
particular industries or foreign capital and are more vulnerable to diplomatic
developments, the imposition of economic sanctions against a particular country
or countries, changes in international trading patterns, trade barriers, and
other protectionist or retaliatory measures. Investments in foreign markets may
also be adversely affected by governmental actions such as the imposition of
capital controls, nationalization of companies or industries, expropriation of
assets, or the imposition of punitive taxes. In addition, the governments of
certain countries may prohibit or impose substantial restrictions on foreign
investing in their capital markets or in certain industries. Any of these
actions could severely affect security prices, impair a Fund's ability to
purchase or sell foreign securities or transfer the Fund's assets or income back
into the United States, or otherwise adversely affect the Fund's operations.
Other foreign market risks include foreign exchange controls, difficulties in
pricing securities, defaults on foreign government securities, difficulties in
enforcing favorable legal judgments in foreign courts, and political and social
instability. Legal remedies available to investors in certain foreign countries
may be less extensive than those available to investors in the United States or
other foreign countries.
Currency Risk and Exchange Risk. Securities in which a Fund invests may be
denominated or quoted in currencies other than the U.S. dollar. Changes in
foreign currency exchange rates will affect the value of the securities of the
Fund. Generally, when the U.S. dollar rises in value against a foreign currency,
your investment in a security denominated in that currency loses value because
the currency is worth fewer U.S. dollars. Similarly when the U.S. dollar
decreases in value against a foreign currency, your investment in a security
denominated in that currency gains value because the currency is worth more U.S.
dollars. This risk is generally known as "currency risk" which is the
B-21
possibility that a stronger U.S. dollar will reduce returns for U.S. investors
investing overseas and a weak U.S. dollar will increase returns for U.S.
investors investing overseas.
For a number of years, certain European countries have been seeking economic
unification that would, among other things, reduce barriers between countries,
increase competition among companies, reduce government subsidies in certain
industries, and reduce or eliminate currency fluctuations among these European
countries. The Treaty of European Union (the "Maastricht Treaty") seeks to set
out a framework for the European Economic and Monetary Union ("EMU") among the
countries that comprise the European Union ("EU"). Among other things, EMU
establishes a single common European currency (the "euro") that was introduced
on January 1, 1999 and is expected to replace the existing national currencies
of all EMU participants by July 1, 2002. Upon implementation of EMU, certain
securities issued in participating EU countries (beginning with government and
corporate bonds) were redenominated in the euro, and are now listed, traded,
declaring dividends and making other payments only in euros.
No assurance can be given that the changes planned for the EU can be
successfully implemented, or that these changes will result in the economic and
monetary unity and stability intended. There is a possibility that EMU will not
be completed, or will be completed but then partially or completely unwound.
Because any participating country may opt out of EMU within the first three
years, it is also possible that a significant participant could choose to
abandon EMU, which could diminish its credibility and influence. Any of these
occurrences could have adverse effects on the markets of both participating and
non-participating countries, including sharp appreciation or depreciation of
participants' national currencies and a significant increase in exchange rate
volatility, a resurgence in economic protectionism, an undermining of confidence
in the European markets, an undermining of European economic stability, the
collapse or slowdown of the drive toward European economic unity, and/or
reversion of the attempts to lower government debt and inflation rates that were
introduced in anticipation of EMU. Also, withdrawal from EMU at any time by an
initial participant could cause disruption of the financial markets as
securities redenominated in euros are transferred back into that country's
national currency, particularly if the withdrawing country is a major economic
power. Such developments could have an adverse impact on the Funds' investments
in Europe generally or in specific countries participating in EMU. Gains or
losses from euro conversion may be taxable to International VIP Portfolio
shareholders or shareholders of other Funds under foreign or, in certain limited
circumstances, U.S. tax laws.
Governmental Supervision and Regulation/Accounting Standards. Many foreign
governments supervise and regulate stock exchanges, brokers and the sale of
securities less than the United States does. Some countries may not have laws to
protect investors the way that the United States securities laws do. Accounting
standards in other countries are not necessarily the same as in the United
States. If the accounting standards in another country do not require as much
disclosure or detail as U.S. accounting standards, it may be harder for a Fund's
portfolio manager to completely and accurately determine a company's financial
condition.
Certain Risks of Holding Fund Assets Outside the United States. A Fund generally
holds the foreign securities in which it invests outside the United States in
foreign banks and securities depositories. These foreign banks and securities
depositories may be recently organized or new to the foreign custody business.
They may also have operations subject to limited or no regulatory oversight.
Also, the laws of certain countries may put limits on a Fund's ability to
recover its assets if a foreign bank or depository or issuer of a security or
any of their agents goes bankrupt. In addition, it can be expected that it will
be more expensive for a Fund to buy, sell and hold securities in certain foreign
markets than it is in the U.S. market due to higher brokerage, transaction,
custody and/or other costs. The increased expense of investing in foreign
markets reduces the amount a Fund can earn on its investments.
B-22
Settlement and clearance procedures in certain foreign markets differ
significantly from those in the United States. Foreign settlement and clearance
procedures and trade regulations also may involve certain risks (such as delays
in payment for or delivery of securities) not typically involved with the
settlement of U.S. investments. Communications between the United States and
emerging market countries may be unreliable, increasing the risk of delayed
settlements or losses of security certificates. Settlements in certain foreign
countries at times have not kept pace with the number of securities
transactions. These problems may make it difficult for a Fund to carry out
transactions. If a Fund cannot settle or is delayed in settling a purchase of
securities, it may miss attractive investment opportunities and certain of its
assets may be uninvested with no return earned thereon for some period. If a
Fund cannot settle or is delayed in settling a sale of securities, it may lose
money if the value of the security then declines or, if it has contracted to
sell the security to another party, the Fund could be liable to that party for
any losses incurred.
Dividends or interest on, or proceeds from the sale of, foreign securities may
be subject to foreign withholding taxes, and special U.S. tax considerations may
apply.
RISK FACTORS RELATING TO INVESTING IN HIGH YIELD SECURITIES
A description of security ratings is attached as an Appendix. Lower-rated or
unrated (that is, high yield) securities are more likely to react to
developments affecting market risk (such as interest rate sensitivity, market
perception of the creditworthiness of the issuer and general market liquidity)
and credit risk (such as the issuer's inability to meet its obligations) than
are more highly rated securities, which react primarily to movements in the
general level of interest rates. The Advisor considers both credit risk and
market risk in making investment decisions for the Funds.
The amount of high yield securities outstanding proliferated in the 1980's in
conjunction with the increase in merger and acquisition and leveraged buyout
activity. Under adverse economic conditions, there is a risk that highly
leveraged issuers may be unable to service their debt obligations upon maturity.
In addition, the secondary market for high yield securities, which is
concentrated in relatively few market makers, may not be as liquid as the
secondary market for more highly rated securities. Under adverse market or
economic conditions, the secondary market for high yield securities could
contract further, independent of any specific adverse changes in the condition
of a particular issuer. As a result, the Advisor could find it more difficult to
sell these securities or may be able to sell the securities only at prices lower
than if such securities were widely traded. Prices realized upon the sale of
such lower-rated or unrated securities, under these circumstances, may be less
than the prices used in calculating the Funds' net asset value prior to the
sale.
Lower-rated or unrated debt obligations also present risks based on payment
expectations. If an issuer calls the obligation for redemption, the Fund may
have to replace the security with a lower yielding security, resulting in a
decreased return for investors. If a Fund experiences unexpected net
redemptions, it may be forced to sell its higher-rated securities, resulting in
a decline in the overall credit quality of the Fund's portfolio and increasing
the exposure of the Fund to the risks of high yield securities.
ILLIQUID SECURITIES
A Fund may not hold more than 15% of its net assets in illiquid securities.
Illiquid securities generally include repurchase agreements which have a
maturity of longer than seven days, and securities that are illiquid by virtue
of the absence of a readily available market (either within or outside of the
United States) or because they have legal or contractual restrictions of resale.
Historically, illiquid securities have included securities subject to
contractual or legal restrictions on resale because they have not been
registered under the Securities Act, securities which are otherwise not readily
marketable and repurchase agreements that have a maturity of longer than seven
days. Securities which
B-23
have not been registered under the Securities Act are referred to as private
placements or restricted securities and are purchased directly from the issuer
or in the secondary market.
Illiquid securities are more difficult to sell and value than exchange-traded or
listed securities with similar characteristics. Limitations on resale may have
an adverse effect on the marketability of portfolio securities and a mutual fund
might be unable to dispose of restricted or other illiquid securities promptly
or at reasonable prices and might thereby experience difficulty satisfying
redemption within seven days. The absence of a trading market can make it
difficult to ascertain a market value for illiquid investments. Also market
quotations are less readily available. The judgment of the Advisor may at times
play a greater role in valuing these securities than in the case of unrestricted
securities. A mutual fund might also have to register such restricted securities
in order to dispose of them resulting in additional expense and delay. Adverse
market conditions could impede such a public offering of securities.
In recent years, however, a large institutional market has developed for certain
securities that are not registered under the Securities Act including repurchase
agreements, commercial paper, foreign securities, municipal securities,
convertible securities and corporate bonds and notes. Institutional investors
depend on an efficient institutional market in which the unregistered security
can be readily resold or on an issuer's ability to honor a demand for repayment.
The fact that there are contractual or legal restrictions on resale to the
general public or to certain institutions may not be indicative of the liquidity
of such investments.
Rule 144A under the Securities Act allows for a broader institutional trading
market for securities otherwise subject to restriction on resale to the general
public. Rule 144A established a "safe harbor" from the registration requirements
of the Securities Act for resales of certain securities to qualified
institutional buyers. The investment adviser anticipates that the market for
certain restricted securities such as institutional commercial paper and foreign
securities will expand further as a result of this regulation and the
development of automated systems for the trading, clearance and settlement of
unregistered securities of domestic and foreign issuers.
Restricted securities eligible for resale pursuant to Rule 144A under the
Securities Act and commercial paper for which there is a readily available
market will not be deemed to be illiquid. The Advisor will monitor the liquidity
of such restricted securities subject to the supervision of the Trustees. In
reaching liquidity decisions, the Advisor will consider, among others, the
following factors: (1) the frequency of trades and quotes for the security; (2)
the number of dealers wishing to purchase or sell the security and the number of
other potential purchasers; (3) dealer undertakings to make a market in the
security; and (4) the nature of the security and the nature of the marketplace
trades (for example, the time needed to dispose of the security, the method of
soliciting offers and the mechanics of the transfer). In addition, in order for
commercial paper that is issued in reliance on Section 4(2) of the Securities
Act to be considered liquid, (1) it must be rated in one of the two highest
rating categories by at least two nationally recognized statistical rating
organizations ("NRSRO"), or if only one NRSRO rates the securities, by that
NRSRO, or, if unrated, be of comparable quality in the view of the Advisor, and
(2) it must not be "traded flat" (that is, without accrued interest) or in
default as to principal or interest. Investing in Rule 144A securities could
have the effect of increasing the level of Fund illiquidity to the extent that
qualified institutional buyers become, for a time, uninterested in purchasing
these securities. Repurchase agreements subject to demand are deemed to have a
maturity equal to the notice period.
REVERSE REPURCHASE AGREEMENTS
The Bond Funds may enter into reverse repurchase agreements, whereby a Fund
sells securities concurrently with entering into an agreement to repurchase
those securities at a later date at a fixed price. During the reverse
B-24
repurchase agreement period, the Fund continues to receive principal and
interest payments on those securities. Reverse repurchase agreements are
speculative techniques involving leverage and are considered borrowings by these
Funds for purposes of the limit applicable to borrowings.
DOLLAR ROLLS
The Bond Funds may use dollar rolls as part of their investment strategy. In a
dollar roll, a Fund sells securities for delivery in the current month and
simultaneously contracts to repurchase substantially similar securities (same
type and coupon) on a specified future date from the same party. During the roll
period, the Fund forgoes principal and interest paid on the securities. The Fund
is compensated by the difference between the current sales price and the forward
price for the future purchase (often referred to as the "drop") as well as by
the interest earned on the cash proceeds of the initial sale. A "covered roll"
is a specific type of dollar roll for which there is an offsetting cash position
or cash equivalent security position that matures on or before the forward
settlement date of the dollar roll transaction.
The Bond Funds will mark as segregated cash, U.S. Government securities, equity
securities or other liquid, unencumbered assets, marked-to-market daily, equal
in value to their obligations with respect to dollar rolls. Dollar rolls involve
the risk that the market value of the securities retained by the Fund may
decline below the price of the securities the Fund has sold but is obligated to
repurchase under the agreement. If the buyer of the securities under a dollar
roll files for bankruptcy or becomes insolvent, the Fund's use of the proceeds
of the agreement may be restricted pending a determination by the other party,
or its trustee or receiver, whether to enforce the Fund's obligation to
repurchase the securities. Dollar rolls are speculative techniques involving
leverage and are considered borrowings by these Funds for purposes of the limit
applicable to borrowings.
BORROWING
As a fundamental policy, the Stock Funds may borrow money, but only from banks
for temporary or emergency purposes in amounts not exceeding 10% of each Fund's
total assets. The Bond Funds may borrow for temporary, emergency or investment
purposes. This borrowing may be unsecured. The 1940 Act requires a Fund to
maintain continuous asset coverage (that is, total assets including borrowings,
less liabilities exclusive of borrowings) of 300% of the amount borrowed.
Borrowing subjects a Fund to interest costs which may or may not be recovered by
appreciation of the securities purchased, and can exaggerate the effect on net
asset value of any increase or decrease in the market value of a Fund's
portfolio. This is the speculative factor known as leverage.
LOANS OF PORTFOLIO SECURITIES
For the purpose of achieving income, the Bond Funds may lend their portfolio
securities, provided: (1) the loan is secured continuously by collateral
consisting of short-term, high quality debt securities, including U.S.
Government securities, negotiable certificates of deposit, bankers' acceptances
or letters of credit, maintained on a daily marked-to-market basis in an amount
at least equal to the current market value of the securities loaned; (2) the
Fund may at any time call the loan and obtain the return of the securities
loaned; (3) the Fund will receive any interest or dividends paid on the loaned
securities; and (4) the aggregate market value of securities loaned will not at
any time exceed one-third of the total assets of the Fund.
B-25
WHEN-ISSUED SECURITIES
The International and Bond Funds may purchase securities on a when-issued or
delayed-delivery basis, generally in connection with an underwriting or other
offering. When-issued and delayed-delivery transactions occur when securities
are bought with payment for and delivery of the securities scheduled to take
place at a future time, beyond normal settlement dates, generally from 15 to 45
days after the transaction. The price that the Fund is obligated to pay on the
settlement date may be different from the market value on that date. While
securities may be sold prior to the settlement date, the Funds intend to
purchase such securities with the purpose of actually acquiring them, unless a
sale would be desirable for investment reasons. At the time the Fund makes a
commitment to purchase a security on a when-issued basis, it will record the
transaction and reflect the value of the security each day in determining the
Fund's net asset value. The Fund will also mark as segregated with its custodian
cash, U.S. Government securities, equity securities or other liquid,
unencumbered assets, marked-to-market daily, equal in value to its obligations
for when-issued securities.
REAL ESTATE INVESTMENT TRUSTS
Each Fund may invest in securities of real estate investment trusts or REITs.
Unlike corporations, REITs do not have to pay income taxes if they meet certain
Internal Revenue Code requirements. REITs offer investors greater liquidity and
diversification than direct ownership of properties, as well as greater income
potential than an investment in common stocks. Like any investment in real
estate, though, a REIT's performance depends on several factors, such as its
ability to find tenants for its properties, to renew leases and to finance
property purchases and renovations.
TEMPORARY DEFENSIVE POSITION
When adverse market or economic conditions indicate to the Advisor that a
temporary defensive strategy is appropriate, a Fund may invest all or part of
its assets in short-term investment grade debt obligations of the U.S.
Government, its agencies and instrumentalities, bank certificates of deposit,
bankers' acceptances, high quality commercial paper, demand notes and repurchase
agreements.
SHARES OF OTHER INVESTMENT COMPANIES
The Funds can invest in securities of other investment companies except to the
extent prohibited by law. Like all equity investments, these investments may go
up or down in value. They also may not perform in correlation with a Fund's
principal strategies. The Funds will pay additional fees through their
investments in other investment companies.
B-26
MANAGEMENT
The Trustees oversee the actions of the Funds' Advisor and other service
providers and decide upon matters of general policy. The Trustees also review
the actions of the Funds' officers, who conduct and supervise the daily business
operations of the Funds. The Trustees and officers of the Trust are:
Michael Baxter* (36) -- Trustee -- 725 South Figueroa Street, Suite 4000, Los
Angeles, CA 90017-5400. Co-Head of the Advisor (since 1999); Managing Director
of the Advisor (since 1996); Partner of the Advisor (1994 - 1996); Portfolio
Manager of the Advisor (since 1990).
Robert L. Burch III (66) -- Trustee -- One Rockefeller Plaza, New York, NY
10020. Managing Partner, A.W. Jones Co. (investments) (since 1984); Chairman,
Jonathan Mfg. Corp. (slide manufacturing) (since 1977).
John A. G. Gavin (69) -- Trustee -- 2100 Century Park West, Los Angeles, CA
90067. Partner and Managing Director, Hicks, Muse, Tate and Furst (Latin
America) (private equity investment firm) (since 1994); Chairman, Gamma Services
Corp. (venture capital) (since 1968); Principal, Gavin, Dailey & Partners
(consulting) (since 1993); U.S. Ambassador to Mexico (1981 - 1986); Director,
Apex Mortgage Capital, Inc., Atlantic Richfield Co., International Wire Corp.
and Krause's Furniture.
Joe Grills (65) -- Trustee -- P.O. Box 98, Rapidan, VA 22733. Member of the
Committee of Investment of Employee Benefit Assets of the Financial Executives
Institute ("CIEBA") (since 1986); member of CIEBA's Executive Committee (since
1988) and its Chairman (1991 - 1992); Assistant Treasurer of International
Business Machines Incorporated ("IBM") and Chief Investment Officer of IBM
Retirement Funds (1986 - 1993); Member of the Investment Advisory Committees of
the State of New York Common Retirement Fund and the Howard Hughes Medical
Institute (since 1997); Director (since 1992) and Vice Chairman (since 1998),
Duke Management Company; Director, KIMCO Realty Corporation (since 1997) and
LaSalle Street Fund (since 1995); Member of the Investment Advisory Committee of
the Virginia Retirement System (since 1998); Director, Montpelier Foundation
(since 1998); Trustee or Director of 24 registered investment companies
(consisting of 56 portfolios) for which Merrill Lynch Asset Management, L.P. or
its affiliate, Fund Asset Management, L.P., is the advisor.
Nigel Hurst-Brown* (48) -- Trustee -- 725 South Figueroa Street, Suite 4000, Los
Angeles, CA 90017-5400. Co-Head of the Advisor (since 1999); Managing Director
of Merrill Lynch Mercury Asset Management (since 1998); Director of Mercury
Asset Management Group Plc. (since 1990).
Madeleine A. Kleiner (48) -- Trustee -- 1900 Avenue of the Stars, Suite 1700,
Los Angeles, CA 90067. Senior Executive Vice President, Chief Administrative
Officer and General Counsel, H.F. Ahmanson & Company and Home Savings of
America, FSB (banking company) (1995 - 1998); Partner, Gibson, Dunn & Crutcher
(law firm) (1983 - 1995).
Richard R. West (62) -- Trustee -- Box 604, Genoa, NV 89411. Professor of
Finance (since 1984), Dean (1984 - 1993), and currently Dean Emeritus, New York
University Leonard N. Stern School of Business Administration; Director, Vornado
Realty Trust, Inc. (real estate holding company); Director, Bowne & Co., Inc.
(financial printers); Director, Alexander's, Inc. (real estate company); Trustee
or Director of 62 registered investment companies (consisting of 86 portfolios)
for which Merrill Lynch Asset Management, L.P. or its affiliate, Fund Asset
Management, L.P., is the advisor.
- ---------------
* "Interested" Trustee, as defined in the 1940 Act, due to the relationship
indicated with the Funds' Advisor.
B-27
Nancy D. Celick (48) -- President and Principal Executive Officer -- 725 South
Figueroa Street, Suite 4000, Los Angeles, CA 90017-5400. Chief Administrative
Officer of the Advisor (since 1998); Chief Financial Officer of the Advisor
(1993 - 1998); Chief Financial Officer of Kennedy-Wilson, Inc. (auction
marketing services) (1992 - 1993); Chief Financial Officer of First National
Corporation (bank holding company) (1984 - 1992).
Gail Bardin (53) -- Executive Vice President -- 725 South Figueroa Street, Suite
4000, Los Angeles, CA 90017-5400. Managing Director of the Advisor (since 1996);
Partner of the Advisor (1994 - 1996); Principal of the Advisor (1992 - 1994);
Portfolio Manager of the Advisor (1988 - 1992).
Mark D. Cone (32) -- Vice President -- 225 Liberty Street, 30th Floor, New York,
NY 10080-6130. Vice President of the Advisor; Retail Account Manager, Neuberger
& Berman (1991 - 1994).
Anna Marie S. Lopez (32) -- Treasurer, Principal Financial and Accounting
Officer and Assistant Secretary -- 725 South Figueroa Street, Suite 4000, Los
Angeles, CA 90017-5400. Compliance Officer of the Advisor (since 1999);
Compliance Associate of the Advisor (1997 - 1999); Manager, Price Waterhouse
(1991 - 1997).
Turner Swan (38) -- Secretary -- 725 S. Figueroa Street, Suite 4000, Los
Angeles, CA 90017-5400. Attorney with the Advisor (since 1997); Attorney,
Sheppard, Mullin, Richter & Hampton LLP (1995 - 1997); Attorney, Trout Trading
Management Company Ltd. (1993 - 1995).
Gracie Fermelia (38) -- Vice President, Assistant Secretary and Assistant
Treasurer -- 725 South Figueroa Street, Suite 4000, Los Angeles, CA 90017-5400.
Business Manager of the International Department of the Advisor (since 1998);
Compliance Officer of the Advisor (1994 - 1998); Senior Manager, Price
Waterhouse (1985 - 1994).
B-28
The Trust does not pay salaries to any of its officers or fees to any of its
Trustees affiliated with the Advisor. The following table sets forth the
aggregate compensation paid to the Trustees during the Trust's fiscal year ended
December 31, 1999 and the aggregate compensation paid to the Trustees for
service on the Trust's Board and that of any other fund for which the Advisor
serves as investment adviser or has an investment adviser that is an affiliated
person of the Advisor ("Fund Complex") for the calendar year ended December 31,
1999.
TOTAL 1999
COMPENSATION
AGGREGATE FROM TRUST AND
COMPENSATION FUND COMPLEX
NAME AND POSITION FROM TRUST PAID TO TRUSTEES*
----------------- ------------ -----------------
Michael Baxter,..................................... $ -- $ --
Trustee
Robert L. Burch III,................................ $13,000 $ 34,000
Trustee
John A. G. Gavin,................................... $10,000 $ 25,000
Trustee
Joe Grills,......................................... $13,000 $232,333
Trustee
Nigel Hurst-Brown,.................................. $ -- $ --
Trustee
Robert B. Hutchinson,............................... $13,000 $ 34,000
Former Trustee
Madeleine A. Kleiner,............................... $ 6,000 $ 18,000
Trustee
Merle T. Welshans,.................................. $13,000 $ 34,000
Former Trustee
Richard R. West,.................................... $13,000 $422,225
Trustee
- ---------------
* Each Trustee also serves as a Trustee of the Hotchkis and Wiley Funds. Messrs.
Grills and West also serve on the boards of other investment companies advised
by Merrill Lynch Asset Management, L.P. and its advisory affiliates.
For information as to ownership of shares, see "General Information About the
Trust's Shareholders."
THE ADVISOR
The Advisor provides the Funds with management and investment advisory services.
Hotchkis and Wiley, a division of Merrill Lynch Asset Management, L.P. ("MLAM"),
is located at 725 South Figueroa Street, Suite 4000, Los Angeles, California
90017-5400. MLAM is an indirect wholly-owned subsidiary of Merrill Lynch & Co.,
Inc., a financial services holding company incorporated in Delaware. MLAM and
its advisory affiliates act as the investment advisor for more than 140
registered investment companies and offer portfolio management and portfolio
analysis services to individual and institutional accounts.
The Equity Income and International VIP Portfolios pay the Advisor for the
services performed a fee at the annual rate of 0.75% of each Fund's average
daily net assets. The Total Return Bond VIP Portfolio pays the Advisor a fee at
the annual rate of 0.55% of its average daily net assets. The Low Duration VIP
Portfolio pays the Advisor a fee at the annual rate of 0.46% of its average
daily net assets. For the fiscal period ended December 31, 1998, the
International VIP Portfolio paid the Advisor $1,019,881 and for the fiscal year
ended December 31, 1999, the International VIP Portfolio paid the Advisor
$1,678,700. The Equity Income VIP Portfolio and the Low Duration VIP Portfolio
paid no
B-29
advisory fees and were reimbursed $44,455 and $51,340, respectively, by the
Advisor for the fiscal period ended December 31, 1998. For the fiscal year ended
December 31, 1999, the Equity Income VIP Portfolio and the Low Duration VIP
Portfolio paid no advisory fees and were reimbursed by the Advisor $40,647 and
$50,385, respectively. The Total Return Bond VIP Portfolio had not commenced
investment operations as of December 31, 1999.
In addition, the Advisor has agreed to limit the annual operating expenses of
the Equity Income VIP Portfolio to 1.15% of the Fund's average net assets. The
Advisor has agreed to limit the annual operating expenses of the International
VIP Portfolio to 1.35% of the Fund's average net assets. The Advisor has agreed
to limit the annual operating expenses of the Total Return Bond VIP Portfolio to
0.65% of the Fund's average net assets. The Advisor has agreed to limit the
annual operating expenses of the Low Duration VIP Portfolio to 0.58% of the
Fund's average net assets. The Advisor has agreed to these expense limits
through April 2001. For the fiscal period ended December 31, 1998, the Advisor
waived a portion of its fee as follows: Equity Income VIP Portfolio -- $5,646;
and Low Duration VIP Portfolio -- $5,111. For the fiscal year ended December 31,
1999, the Advisor waived a portion of its fees as follows: Equity Income VIP
Portfolio -- $7,896; and Low Duration VIP Portfolio -- $7,842.
Each of the four Investment Advisory Agreements provides that the Advisor shall
not be liable to the Trust for any error of judgment by the Advisor or for any
loss sustained by any of the Funds except in the case of a breach of fiduciary
duty with respect to the receipt of compensation for services (in which case any
award of damages will be limited as provided in the 1940 Act) or in the case of
willful misfeasance, bad faith, gross negligence or reckless disregard of duty.
SUBADVISORS
The Advisor has entered into subadvisory agreements with Mercury Asset
Management International Ltd. and Merrill Lynch Asset Management U.K. Limited,
affiliated investment advisors that are indirect subsidiaries of Merrill Lynch &
Co., Inc. The subadvisory arrangements are for investment research,
recommendations and other investment-related services to be provided to the
International VIP Portfolio at rates of compensation as may be agreed by the
parties. There is no increase in the aggregate fees paid by this Fund for such
services.
THE DISTRIBUTOR
Princeton Funds Distributor, Inc., 800 Scudders Mill Road, Plainsboro, New
Jersey 08536, is the Funds' distributor and makes a continuous offering of the
Funds' shares. It is not compensated by the Funds. The distributor is an
indirect subsidiary of Merrill Lynch & Co., Inc., and is an affiliate of the
Advisor.
CODE OF ETHICS
The Board of Trustees of the Trust has adopted a Code of Ethics under Rule 17j-1
of the 1940 Act which includes the Code of Ethics of the Advisor and distributor
(together, the "Code"). The Code significantly restricts the personal investing
activities of all employees of the Advisor and distributor and, as described
below, imposes additional, more onerous, restrictions on Fund investment
personnel.
The Code requires that all employees of the Advisor and principal underwriter
preclear any personal securities investment (with limited exceptions, such as
government securities). The preclearance requirement and associated procedures
are designed to identify any substantive prohibition or limitation applicable to
the proposed investment. The substantive restrictions applicable to all
employees of the Advisor and principal underwriter include a ban on acquiring
any securities in a "hot" initial public offering and a prohibition from
profiting on short-term trading in
B-30
securities. In addition, no employee may purchase or sell any security which at
the time is being purchased or sold (as the case may be), or to the knowledge of
the employee is being considered for purchase or sale, by any fund advised by
the Advisor. Furthermore, the Code provides for trading "blackout periods" which
prohibit trading by investment personnel of a Fund within 7 days of trading by
the Fund in the same (or equivalent) security. The Code is on public file with,
and is available from, the SEC.
OTHER SERVICE PROVIDERS
The Trust's custodian, Firstar Bank Milwaukee, N.A., 615 East Michigan Street,
Milwaukee, Wisconsin, is responsible for holding the Trust's domestic assets and
Firstar Mutual Fund Services, LLC ("FMFS"), located at the same address, acts as
the Trust's accounting services agent, transfer agent and dividend paying agent.
FMFS is responsible for the issuance, transfer and redemption of shares and the
opening and maintenance of shareholder accounts. For these services, FMFS
receives an annual fee of $14.00 per shareholder account. FMFS is also
reimbursed for its out-of-pocket expenses.
The Chase Manhattan Bank, Four Chase MetroTech Center, Brooklyn, New York 11245,
through its global custody network, provides custodial services for assets of
the Trust held outside the U.S.
The Trust's independent accountant, PricewaterhouseCoopers LLP, 100 East
Wisconsin Avenue, Milwaukee, Wisconsin 53202, examines the Trust's financial
statements and assists in the preparation of certain reports to the SEC.
PORTFOLIO TRANSACTIONS AND BROKERAGE
The Investment Advisory Agreements state that in connection with its duties to
arrange for the purchase and the sale of securities held in the portfolio of
each Fund by placing purchase and sale orders for that Fund, the Advisor shall
select such broker-dealers ("brokers") that will, in the Advisor's judgment,
implement the policy of the Trust to achieve "best execution", that is, prompt
and efficient execution at the most favorable securities price. In making such
selection, the Advisor is authorized in the Agreements to consider the
reliability, integrity and financial condition of the broker. The Advisor is
also authorized by the Agreements to consider whether the broker provides
brokerage and/or research services to the Fund and/or other accounts of the
Advisor. The Agreements state that the commissions paid to brokers may be higher
than another broker would have charged if a good faith determination is made by
the Advisor that the commission is reasonable in relation to the services
provided, viewed in terms of either that particular transaction or the Advisor's
overall responsibilities as to the accounts as to which it exercises investment
discretion. The Agreements also state that the Advisor shall use its judgment in
determining that the amount of commissions paid are reasonable in relation to
the value of brokerage and research services provided and need not place or
attempt to place a specific dollar value on such services or on the portion of
commission rates reflecting such services. The Agreements provide that to
demonstrate that such determinations were in good faith, and to show the overall
reasonableness of commissions paid, the Advisor shall be prepared to show that
commissions paid (1) were for purposes contemplated by the Agreements; (2) were
for products or services which provide lawful and appropriate assistance to the
Advisor's decision-making process; and (3) were within a reasonable range as
compared to the rates charged by brokers to other institutional investors as
such rates may become known from available information. The Advisor is also
authorized to consider sales of shares of each Fund and/or of any other
investment companies for which the Advisor acts as Advisor as a factor in the
selection of brokers to execute brokerage and principal transactions, subject to
the requirements of "best execution", as defined above, although the Advisor is
not currently doing so.
B-31
The research services discussed above may be in written form or through direct
contact with individuals and may include information as to particular companies
and securities as well as market, economic or institutional areas and
information assisting the Trust in the valuation of the Funds' investments. The
research which the Advisor receives for the Funds' brokerage commissions,
whether or not useful to a Fund, may be useful to the Advisor in managing the
accounts of the Advisor's other advisory clients. Similarly, the research
received for the commissions of such accounts may be useful to any Fund.
In the over-the-counter market, securities are generally traded on a "net" basis
with dealers acting as principal for their own accounts without a stated
commission although the price of the security usually includes a profit to the
dealer. Money market instruments usually trade on a "net" basis as well. On
occasion, certain money market instruments may be purchased by the Funds
directly from an issuer in which case no commissions or discounts are paid. In
underwritten offerings, securities are purchased at a fixed price which includes
an amount of compensation to the underwriter, generally referred to as the
underwriter's concession or discount.
The International VIP Portfolio anticipates that its brokerage transactions
involving securities of companies headquartered in countries other than the U.S.
will be conducted primarily on the principal exchanges of such countries.
Transactions on foreign exchanges are usually subject to fixed commissions which
are generally higher than negotiated commissions on U.S. transactions, although
the Trust will endeavor to achieve the best net results in effecting its
portfolio transactions. There is generally less government supervision and
regulation of exchanges and brokers in foreign countries than in the United
States.
The value of any Fund's aggregate holdings of the securities of its regular
brokers or dealers (as defined in Rule 10b-1 of the 1940 Act) as of December 31,
1999 is as follows:
REGULAR AGGREGATE
FUND BROKER-DEALER HOLDINGS
- ------------------------------------------------- --------------- ---------
Low Duration VIP Portfolio Lehman Brothers $24,773
During the fiscal year ended December 31, 1999, the following brokerage
commissions were paid by the Funds:
Equity Income VIP Portfolio................................. $ 502
International VIP Portfolio................................. $ 531,182
Low Duration VIP Portfolio.................................. $ 0
The Advisor is an affiliate of Merrill Lynch, Pierce, Fenner & Smith
Incorporated, a registered broker-dealer, and the other broker-dealer
subsidiaries of Merrill Lynch & Co., Inc. For the fiscal year ended December 31,
1999, transactions with affiliated broker-dealers were as follows:
PERCENTAGE OF AGGREGATE
DOLLAR AMOUNT OF
PERCENTAGE OF AGGREGATE TRANSACTIONS INVOLVING
BROKERAGE PAYMENT OF
COMMISSIONS PAID COMMISSIONS COMMISSIONS EFFECTED
TO AFFILIATED PAID TO AFFILIATED THROUGH AFFILIATED
FUND BROKER-DEALERS BROKER-DEALERS BROKER-DEALERS
---- ---------------- ----------------------- -----------------------
International VIP Portfolio............... $20,524 3.9% 2.4%
B-32
TRUST SHARES
The Declaration of Trust permits the Trustees to issue an unlimited number of
full and fractional shares of beneficial interest and to divide or combine the
shares into a greater or lesser number of shares without thereby changing the
proportionate beneficial interest in each Fund. Each share represents an
interest in a Fund proportionately equal to the interest of each other share.
Upon the Trust's liquidation, all shareholders would share pro rata in the net
assets of the Fund in question available for distribution to shareholders. If
they deem it advisable and in the best interest of shareholders, the Board of
Trustees may create classes of shares. The Board of Trustees has created four
series of shares, and may create additional series in the future, which have
separate assets and liabilities. Income and operating expenses not specifically
attributable to a particular Fund are allocated fairly among the Funds by the
Trustees, generally on the basis of the relative net assets of each Fund.
The Declaration of Trust provides that the Trustees will not be liable for
errors of judgment or mistakes of fact or law, but nothing in the Declaration of
Trust protects a Trustee against any liability to which he or she would
otherwise be subject by reason of willful misfeasance, bad faith, gross
negligence or reckless disregard of the duties involved in the conduct of his or
her office. The Declaration of Trust also provides that the Trust shall, upon
request, assume the defense of any claim made against any shareholder for any
act or obligation of the Trust and satisfy any judgment thereon.
Ten shareholders holding the lesser of $25,000 worth or one percent of a Fund's
shares may advise the Trustees in writing that they wish to communicate with
other shareholders for the purpose of requesting a meeting to remove a Trustee.
The Trustees will then, if requested by the applicants, mail at the applicants'
expense the applicants' communication to all other shareholders.
The Trust or any Fund may be terminated if approved by the vote of a majority of
the Trustees or by the approval of the holders of a majority of the Trust's
outstanding shares, as defined in the 1940 Act. If not so terminated, the Trust
will continue indefinitely.
Rule 18f-2 under the 1940 Act provides that as to any investment company which
has two or more series outstanding and as to any matter required to be submitted
to shareholder vote, such matter is not deemed to have been effectively acted
upon unless approved by the holders of a "majority" (as defined in the Rule) of
the voting securities of each series affected by the matter. Such separate
voting requirements do not apply to the election of Trustees or the ratification
of the selection of accountants. A change in investment policy may go into
effect as to one or more series whose holders so approve the change even though
the required vote is not obtained as to the holders of other affected series.
The rights accompanying Fund shares are legally vested in the separate accounts.
However, in accordance with current law and interpretations thereof,
Participating Insurance Companies will vote shares held in the separate accounts
in a manner consistent with timely voting instructions received from the holders
of variable annuity contracts and variable life insurance policies. Each
Participating Insurance Company will vote Fund shares held in separate accounts
for which no timely instructions are received from the holders of variable
annuity contracts and variable life insurance policies, as well as shares it
owns, in the same proportion as those shares for which voting instructions are
received. For a further discussion, please refer to the Participating Insurance
Company's separate account prospectus or private placement memorandum.
B-33
NET ASSET VALUE
As indicated in the Funds' prospectuses, the net asset value per share of each
Fund's shares will be determined on each day that the New York Stock Exchange is
open for trading. That Exchange annually announces the days on which it will not
be open for trading; the most recent announcement indicates that it will not be
open on the following days: New Year's Day, Martin Luther King, Jr. Holiday,
Presidents' Day, Good Friday, Memorial Day, Independence Day, Labor Day,
Thanksgiving Day and Christmas Day. However, that Exchange may close on days not
included in that announcement. Also, no Fund is required to compute its net
asset value on any day on which no order to purchase or redeem its shares is
received.
Securities are valued by an independent pricing agent to the extent possible. In
determining the net asset value of each Fund's shares, equity securities that
are listed on a securities exchange (whether domestic or foreign) or quoted by
The Nasdaq Stock Market ("NSM") are valued at the last sale price on that day as
of the close of regular trading on the New York Stock Exchange (which is
currently 4:00 p.m., New York time), or, in the absence of recorded sales, at
the average of readily available closing bid and asked prices on such exchange
or on NSM. Unlisted equity securities that are not included in NSM are valued at
the average of the quoted bid and asked prices in the over-the-counter market.
Fixed-income securities which are traded on a national securities exchange will
be valued at the last sale price or, if there was no sale on such day, at the
average of readily available closing bid and asked prices on such exchange.
However, securities with a demand feature exercisable within one to seven days
are valued at par. Prices for fixed-income securities may be based on quotations
received from one or more market-makers in the securities, or on evaluations
from pricing services. Fixed-income securities for which quotations or prices
are not readily available are valued at their fair value as determined by the
Advisor under guidelines established by the Board of Trustees, with reference to
fixed-income securities whose prices are more readily obtainable or to an
appropriate matrix utilizing similar factors. As a broader market does not
exist, the proceeds received upon the disposal of such securities may differ
from their recorded value. Debt securities which mature in less than 60 days are
valued at amortized cost (unless the Board of Trustees determines that this
method does not represent fair value), if their original maturity was 60 days or
less or by amortizing the value as of the 61st day prior to maturity, if their
original term to maturity exceeded 60 days.
Options, futures contracts and options thereon which are traded on exchanges are
valued at their last sale or settlement price as of the close of the exchanges
or, if no sales are reported, at the average of the quoted bid and asked prices
as of the close of the exchange.
Trading in securities listed on foreign securities exchanges or over-the-counter
markets is normally completed before the close of regular trading on the New
York Stock Exchange. In addition, foreign securities trading may not take place
on all business days in New York and may occur on days on which the New York
Stock Exchange is not open. In addition, foreign currency exchange rates are
generally determined prior to the close of trading on the New York Stock
Exchange. Events affecting the values of foreign securities and currencies will
not be reflected in the determination of net asset value unless the Board of
Trustees determines that the particular event would materially affect net asset
value, in which case an adjustment will be made. Investments quoted in foreign
currency are valued daily in U.S. dollars on the basis of the foreign currency
exchange rate prevailing at the time of valuation. Foreign currency exchange
transactions conducted on a spot basis are valued at the spot rate prevailing in
the foreign exchange market.
B-34
Securities and other assets for which market quotations are not readily
available are valued at their fair value as determined by the Advisor under
guidelines established by and under the general supervision and responsibility
of the Board of Trustees.
DIVIDENDS AND TAX STATUS
Each Fund (except the Total Return Bond VIP Portfolio, which had not commenced
investment operations as of December 31, 1999) has elected to qualify and each
Fund intends to remain qualified as a regulated investment company under
Subchapter M of the Internal Revenue Code (the "Code"). Qualification as a
regulated investment company requires, among other things, that (1) at least 90%
of each Fund's annual gross income, without offset for losses from the sale or
other disposition of securities, be derived from payments with respect to
securities loans, interest, dividends and gains from the sale or other
disposition of securities, foreign currencies or options (including forward
contracts) thereon; and (2) each Fund diversify its holdings so that, at the end
of each quarter of the taxable year, (i) at least 50% of the value of the Fund's
assets is represented by cash, U.S. Government securities and other securities
limited in respect of any one issuer to an amount not greater than 5% of the
Fund's assets and 10% of the outstanding voting securities of such issuer, and
(ii) not more than 25% of the value of its assets is invested in the securities
of any one issuer (other than U.S. Government securities). In addition, in order
not to be subject to federal taxation, each Fund must distribute to its
shareholders at least 90% of its net investment income, other than net capital
gains, earned in each year.
A separate account upon which a variable annuity contract or variable life
insurance contract is based must meet certain diversification requirements set
forth in the Code and U.S. Treasury regulations ("Regulations"). The Code
provides a safe harbor provision under which a separate account will be treated
as satisfying the diversification requirements if, as of the close of each
quarter, the assets in the account meet the diversification requirements for a
regulated investment company and no more than 55% of those assets consist of
cash, cash items, U.S. government securities and securities of other regulated
investment companies. The U.S. Treasury regulations provide an alternative to
the safe harbor provision of the Code. Under such regulations, a separate
account will satisfy the diversification requirements if, among other things,
the regulated investment company underlying such account invests no more than
(1) 55% of the value of its assets in one investment, (2) 70% of the value of
its assets in two investments, (3) 80% of the value of its assets in three
investments, and (4) 90% of the value of its assets in four investments. If, as
is intended, each Fund meets these requirements and complies with certain other
conditions, a separate account investing solely in shares of a Fund will also be
deemed to meet these diversification requirements. However, a failure of a Fund
to qualify as a regulated investment company or to meet such conditions and to
comply with such requirements could cause the owners of variable annuity
contracts and variable life insurance contracts based on such accounts to
recognize ordinary income each year in the amount of any net appreciation of
such contract during the year (including the annual costs of life insurance, if
any, provided under such contract).
A Fund is required to pay an excise tax to the extent it does not distribute to
its shareholders during such calendar year at least 98% of its ordinary income
for that calendar year, 98% of its capital gains over capital losses for the
one-year period ending October 31 in such calendar year, and all undistributed
ordinary income and capital gains for the preceding respective one-year period.
The Funds intend to meet these distribution requirements to avoid excise tax
liability.
Certain provisions of the Code and Regulations may require a Fund to recognize
income with respect to an investment before cash is received. In order to meet
the distribution requirements, the Fund may need to sell investments it
otherwise may wish to hold to insure that it has sufficient cash to meet these
requirements.
B-35
Dividends paid by a Fund from its ordinary income and distributions of the
Fund's net realized capital gains are includable in the respective Participating
Insurance Company's gross income. Distributions of a Fund's net realized
long-term capital gains retain their character as long-term capital gains in the
hands of the Participating Insurance Companies if certain requirements are met.
The tax treatment of such dividends and distributions depends on the respective
Participating Insurance Company's tax status. To the extent that income of a
Fund represents dividends on common or preferred stock, rather than interest
income, its distributions to the Participating Insurance Companies will be
eligible for the present 70% dividends received deduction applicable in the case
of a life insurance company as provided in the Code. See the prospectus or
private placement memorandum for the contracts issued by your Participating
Insurance Company for a description of the respective Insurance Company's tax
status, the taxation of an investment in your particular contract and the
charges which may be made to cover any taxes attributable to the separate
account.
Dividends and interest received by a Fund may be subject to withholding and
other taxes imposed by foreign countries. Tax conventions between certain
countries and the U.S. may reduce or eliminate these foreign taxes, and foreign
countries generally do not impose taxes on capital gains on investments by
foreign investors.
PERFORMANCE INFORMATION
Total Return. Average annual total return quotations used in the Funds'
advertising and promotional materials are calculated according to the following
formula:
P(1+T)(n) = ERV
where P equals a hypothetical initial payment of $1000; T equals average annual
total return; n equals the number of years; and ERV equals the ending redeemable
value at the end of the period of a hypothetical $1000 payment made at the
beginning of the period.
Under the foregoing formula, the time periods used in advertising will be based
on rolling calendar quarters, updated to the last day of the most recent quarter
prior to submission of the advertising for publication. Average annual total
return, or "T" in the above formula, is computed by finding the average annual
compounded rates of return over the period that would equate the initial amount
invested to the ending redeemable value. Average annual total return assumes the
reinvestment of all dividends and distributions.
Yield. Annualized yield quotations used in a Fund's advertising and promotional
materials are calculated by dividing the Fund's interest income for a specified
thirty-day period, net of expenses, by the average number of shares outstanding
during the period, and expressing the result as an annualized percentage
(assuming semi-annual compounding) of the net asset value per share at the end
of the period. Yield quotations are calculated according to the following
formula:
YIELD = 2 [(a - b + 1)(6) - 1]
-----
cd
where a equals dividends and interest earned during the period; b equals
expenses accrued for the period, net of reimbursements; c equals the average
daily number of shares outstanding during the period that are entitled to
receive dividends; and d equals the maximum offering price per share on the last
day of the period.
Except as noted below, in determining net investment income earned during the
period ("a" in the above formula), a Fund calculates interest earned on each
debt obligation held by it during the period by: (1) computing the obligation's
yield to maturity, based on the market value of the obligation (including actual
accrued interest) on the
B-36
last business day of the period or, if the obligation was purchased during the
period, the purchase price plus accrued interest; (2) dividing the yield to
maturity by 360 and multiplying the resulting quotient by the market value of
the obligation (including actual accrued interest). Once interest earned is
calculated in this fashion for each debt obligation held by the Fund, net
investment income is then determined by totaling all such interest earned.
For purposes of these calculations, the maturity of an obligation with one or
more call provisions is assumed to be the next date on which the obligation
reasonably can be expected to be called or, if none, the maturity date.
The 30-day yield for the Low Duration VIP Portfolio for the period ended
December 31, 1999 was 6.07%. (Unsubsidized 30-day yield for the Portfolio for
the period ended December 31, 1999 was 2.84%.)
Other information. Each Fund's performance data quoted in advertising and other
promotional materials represents past performance and is not intended to predict
or indicate future results. The return and principal value of an investment in a
Fund will fluctuate, and an investor's redemption proceeds may be more or less
than the original investment amount. Yields and total returns quoted for a Fund
include the effect of deducting the Fund's expenses, but may not include charges
and expenses attributable to a particular variable annuity contract or variable
life insurance policy. Including these charges in the quotations of a Fund's
yield and total return would have the effect of decreasing performance. Since
shares of the Funds can be purchased only through a variable annuity contract or
variable life insurance policy, a purchaser of such contract or policy should
carefully review the prospectus or private placement memorandum for the
applicable variable annuity contract or variable life insurance policy for
information on relevant charges and expenses. Performance information for the
Funds must always be accompanied by, and be reviewed with, performance
information for the insurance product which invests in the Funds.
In advertising and sales literature, a Fund may compare its performance to that
of various broad market indexes, including without limitation the Standard &
Poor's 500 Composite Stock Price Index, the Morgan Stanley Capital International
Europe, Australia, Far East Index, the Lehman Brothers Aggregate Bond Index, and
the Merrill Lynch 1-3 Year U.S. Treasury Note Index. When comparing its
performance to a market index, a Fund may refer to various statistical measures
derived from the historic performance of the Fund and the index, such as
standard deviation, beta and the like. In addition, a Fund may refer in
advertising or sales literature to (i) mutual fund performance ratings, rankings
and comparisons (including risk-adjusted ratings, rankings and comparisons),
(ii) other comparisons of mutual fund data including assets, expenses, fees and
other data, and (iii) other discussions reported in or assigned by Business
Week, CDA Investment Technologies, Inc., Financial World, Forbes Magazine,
Fortune Magazine, Lipper Inc., Money Magazine, Morningstar, Inc., U.S. News &
World Report, The Wall Street Journal, Barron's and other industry publications.
Performance comparisons should not be considered indicative of a Fund's relative
performance for any future period.
GENERAL INFORMATION ABOUT THE TRUST'S SHAREHOLDERS
As of March 31, 2000, the following shareholders owned of record, and to the
knowledge of the Trust, beneficially more than five percent of the outstanding
shares of the Equity Income VIP Portfolio:
Hotchkis and Wiley, 725 South Figueroa Street, Suite 4000, Los Angeles, CA
90017-5400 -- 93.98%.
American General Life Insurance Company, Separate Account D, P.O. Box
1591, Houston, TX 77251-1591 -- 6.02%.
B-37
As of March 31, 2000, the following shareholders owned of record, and to the
knowledge of the Trust, beneficially more than five percent of the outstanding
shares of the International VIP Portfolio:
Merrill Lynch Life Variable Annuity Separate Account A, Bldg 3, 4th Floor,
4804 Deer Lake Drive E, Jacksonville, FL 32246-6484 -- 90.74%
ML of New York Variable Life Separate Account, Bldg 3, 4th Floor, 4804 Deer
Lake Drive E, Jacksonville, FL 32246-6484 -- 6.95%
As of March 31, 2000, the following shareholders owned of record, and to the
knowledge of the Trust, beneficially more than five percent of the outstanding
shares of the Low Duration VIP Portfolio:
Hotchkis and Wiley, 725 South Figueroa Street, Suite 4000, Los Angeles, CA
90017-5400 -- 65.09%
American General Life Insurance Company Separate Account D, P.O. Box 1591,
Houston, TX 77251-1591 -- 29.07%
As of March 31, 2000, the following shareholders owned of record, and to the
knowledge of the Trust, beneficially more than five percent of the outstanding
shares of the Total Return Bond VIP Portfolio:
Hotchkis and Wiley, 725 South Figueroa Street, Suite 4000, Los Angeles, CA
90017-5400 -- 67.07%.
AIG Life Insurance Company, 1 Alico Plaza, Wilmington, DE
19801-3708 -- 32.93%.
B-38
APPENDIX -- DESCRIPTION OF RATINGS
MOODY'S INVESTORS SERVICE
BOND RATINGS:
"Aaa" -- Bonds which are rated Aaa are judged to be of the best quality. They
carry the smallest degree of investment risk and are generally referred to as
"gilt-edged." Interest payments are protected by a large or by an exceptionally
stable margin and principal is secure. While the various protective elements are
likely to change, such changes as can be visualized are most unlikely to impair
the fundamentally strong position of such issues.
"Aa" -- Bonds which are rated Aa are judged to be of high quality by all
standards. Together with the Aaa group they comprise what are generally known as
high-grade bonds. They are rated lower than the best bonds because margins of
protection may not be as large as in Aaa securities or fluctuation of protective
elements may be of greater amplitude or there may be other elements present
which make the long term risks appear somewhat larger than in Aaa securities.
Moody's applies numerical modifiers "1", "2" and "3" in each generic rating
classification from Aa through B. The modifier "1" indicates that the obligation
ranks in the higher end of its generic rating category; the modifier "2"
indicates a mid-range ranking; and the modifier "3" indicates that the company
ranks in the lower end of that generic rating category.
"A" -- Bonds which are rated A possess many favorable investment attributes and
are to be considered as upper-medium-grade obligations. Factors giving security
to principal and interest are considered adequate, but elements may be present
which suggest a susceptibility to impairment some time in the future.
"Baa" -- Bonds which are rated Baa are considered as medium-grade obligations
(that is, they are neither highly protected nor poorly secured). Interest
payments and principal security appear adequate for the present but certain
protective elements may be lacking or may be characteristically unreliable over
any great length of time. Such bonds lack outstanding investment characteristics
and in fact have speculative characteristics as well.
"Ba" -- Bonds which are rated Ba are judged to have speculative elements; their
future cannot be considered as well-assured. Often the protection of interest
and principal payments may be very moderate, and thereby not well safeguarded
during both good and bad times over the future. Uncertainty of position
characterizes bonds in this class.
"B" -- Bonds which are rated B generally lack characteristics of the desirable
investment. Assurance of interest and principal payments or of maintenance of
other terms of the contract over any long period of time may be small.
SHORT-TERM DEBT RATINGS:
Moody's short-term debt ratings are opinions of the ability of issuers to repay
punctually senior debt obligations. These obligations have an original maturity
not exceeding one year, unless explicitly noted.
"PRIME-1" -- Issuers rated "Prime-1" (or supporting institutions) have a
superior ability for repayment of senior short-term debt obligations. Prime-1
repayment ability will often be evidenced by many of these characteristics:
- - Leading market positions in well-established industries.
- - High rates of return on funds employed.
A-1
- - Conservative capitalization structure with moderate reliance on debt and ample
asset protection.
- - Broad margins in earnings coverage of fixed financial charges and high
internal cash generation.
- - Well-established access to a range of financial markets and assured sources of
alternate liquidity.
"PRIME-2" -- Issuers rated "Prime-2" (or supporting institutions) have a strong
ability for repayment of senior short-term debt obligations. This will normally
be evidenced by many of the characteristics cited above but to a lesser degree.
Earnings trends and coverage ratios, while sound, may be more subject to
variation. Capitalization characteristics, while still appropriate, may be more
affected by external conditions. Adequate alternate liquidity is maintained.
MUNICIPAL BOND RATINGS:
Moody's ratings for state and municipal short-term obligations are designated
Moody's Investment Grade or "MIG" with variable rate demand obligations being
designated as "VMIG." A VMIG rating may also be assigned to commercial paper
programs which are characterized as having variable short-term maturities, but
having neither a variable rate nor demand feature. Factors used in determining
ratings include liquidity of the borrower and short-term cyclical elements.
STANDARD & POOR'S RATINGS GROUP
BOND RATINGS:
"AAA" -- An obligation rated AAA has the highest rating assigned by S&P. The
obligor's capacity to meet its financial commitment on the obligation is
extremely strong.
"AA" -- An obligation rated AA differs from the highest-rated obligations only
in small degree. The obligor's capacity to meet its financial commitment on the
obligation is very strong.
"A" -- An obligation rated A is somewhat more susceptible to the adverse effects
of changes in circumstances and economic conditions than obligations in
higher-rated categories. However, the obligor's capacity to meet its financial
commitment on the obligation is still strong.
"BBB" -- An obligation rated BBB exhibits adequate protection parameters.
However, adverse economic conditions or changing circumstances are more likely
to lead to a weakened capacity of the obligor to meet its commitment on the
obligation.
Obligations rated BB and B are regarded as having significant speculative
characteristics. While such obligations will likely have some quality and
protective characteristics, these may be outweighed by large uncertainties or
major exposures to adverse conditions.
COMMERCIAL PAPER RATINGS:
An S&P commercial paper rating is a current assessment of the likelihood of
timely payment of debt considered short-term in the relevant market.
"A-1" -- This designation indicates that the degree of safety regarding timely
payment is strong. Those issues determined to possess extremely strong safety
characteristics are denoted with a plus sign (+) designation.
A-2
"A-2" -- Capacity for timely payment on issues with this designation is
satisfactory. However, the relative degree of safety is not as high as for
issues designated A-1.
MUNICIPAL BOND RATINGS:
S&P uses SP-1, SP-2 and SP-3 to rate short-term municipal obligations. A rating
of SP-1 denotes a strong capacity to pay principal and interest. An issue
determined to possess a very strong capacity to pay debt service is given a (+)
designation.
FITCH INVESTORS SERVICE, INC.
BOND RATINGS:
The following summarizes the ratings used by Fitch for corporate bonds:
"AAA" -- "AAA" ratings denote the lowest expectation of credit risk. They are
assigned only in case of exceptionally strong capacity for timely payment of
financial commitments. This capacity is highly unlikely to be adversely affected
by foreseeable events.
"AA" -- "AA" ratings denote a very low expectation of credit risk. They indicate
very strong capacity for timely payment of financial commitments. This capacity
is not significantly vulnerable to foreseeable events.
"A" -- "A" ratings denote a low expectation of credit risk. The capacity for
timely payment of financial commitments is considered strong. This capacity may,
nevertheless, be more vulnerable to changes in circumstances or in economic
conditions than is the case for higher ratings.
"BBB" -- "BBB" ratings indicate that there is currently a low expectation of
credit risk. The capacity for timely payment of financial commitments is
considered adequate, but adverse changes in circumstances and in economic
conditions are more likely to impair this capacity. This is the lowest
investment-grade category.
"BB" -- "BB" ratings indicate that there is a possibility of credit risk
developing, particularly as the result of adverse economic change over time;
however, business or financial alternatives may be available to allow financial
commitments to be met. Securities rated in this category are not investment
grade.
"B" -- "B" ratings indicate that significant credit risk is present, but a
limited margin of safety remains. Financial commitments are currently being met;
however, capacity for continued payment is contingent upon a sustained,
favorable business and economic environment.
PLUS (+) MINUS (-) -- Plus and minus signs may be appended to a rating to denote
relative status within major rating categories. Such suffixes are not added to
the "AAA" long-term rating category or to short-term ratings other than "F1."
SHORT-TERM DEBT RATINGS:
"F1" -- Highest credit quality. Indicates the strongest capacity for timely
payment of financial commitments; may have an added "+" to denote any
exceptionally strong credit feature.
"F2" -- Good credit quality. A satisfactory capacity for timely payment of
financial commitments, but the margin of safety is not as great as in the case
of the higher ratings.
A-3
"F3" -- Fair credit quality. The capacity for timely payment of financial
commitments is adequate; however, near-term adverse changes could result in a
reduction to non-investment grade.
DUFF & PHELPS CREDIT RATING CO.
BOND RATINGS:
The following summarizes the ratings used by Duff & Phelps for long-term debt:
"AAA" -- Highest credit quality. The risk factors are negligible, being only
slightly more than for risk-free U.S. Treasury debt.
"AA+," "AA," "AA-" -- High credit quality. Protection factors are strong. Risk
is modest but may vary slightly from time to time because of economic
conditions.
"A+," "A," "A-" -- Protection factors are average but adequate. However, risk
factors are more variable and greater in periods of economic stress.
"BBB+," "BBB," "BBB-" -- Below-average protection factors but still considered
sufficient for prudent investment. Considerable variability in risk during
economic cycles.
"BB+," "BB," "BB-" -- Below investment grade but deemed likely to meet
obligations when due. Present or prospective financial protection factors
fluctuate according to industry conditions or company fortunes. Overall quality
may move up or down frequently within this category.
"B+," "B," "B-" -- Below investment grade and possessing risk that obligations
will not be met when due. Financial protection factors will fluctuate widely
according to economic cycles, industry conditions and/or company fortunes.
Potential exists for frequent changes in the rating within this category or into
a higher or lower rating grade.
SHORT-TERM DEBT RATINGS:
"D-1+" -- Highest certainty of timely payment. Short-term liquidity, including
internal operating factors and/or access to alternative sources of funds, is
outstanding and safety is just below risk-free U.S. Treasury short-term
obligations.
"D-1" -- Very high certainty of timely payment. Liquidity factors are excellent
and supported by good fundamental protection factors. Risk factors are minor.
"D-1-" -- High certainty of timely payment. Liquidity factors are strong and
supported by good fundamental protection factors. Risk factors are very small.
"D-2" -- Good certainty of timely payment. Liquidity factors and company
fundamentals are sound. Although ongoing funding needs may enlarge total
financing requirements, access to capital markets is good. Risk factors are
small.
A-4
SCHEDULE OF INVESTMENTS -- DECEMBER 31, 1999
- --------------------------------------------------------------------------------
EQUITY INCOME VIP PORTFOLIO
COMMON STOCKS -- 98.2% Shares Value
- -------------------------------------------------------------
AEROSPACE -- 4.9%
.............................................................
Lockheed Martin Corporation 830 $ 18,156
.............................................................
Northrop Grumman Corporation 400 21,625
.............................................................
Rockwell International Corporation 160 7,660
........................ ........................ --------
47,441
- -------------------------------------------------------------
ALUMINUM -- 3.7%
.............................................................
Alcoa, Inc. 10 830
.............................................................
Reynolds Metals Company 460 35,248
........................ ........................ --------
36,078
- -------------------------------------------------------------
APPAREL & TEXTILES -- 0.7%
.............................................................
Russell Corporation 430 7,203
- -------------------------------------------------------------
APPLIANCE & HOUSEHOLD FURNITURE -- 1.3%
.............................................................
Whirlpool Corporation 200 13,013
- -------------------------------------------------------------
AUTO PARTS -- 5.0%
.............................................................
Dana Corporation 530 15,867
.............................................................
Delphi Automotive Systems Corporation 480 7,560
.............................................................
Meritor Automotive, Inc. 265 5,134
.............................................................
Tenneco, Inc. 226 2,105
.............................................................
TRW Inc. 350 18,178
........................ ........................ --------
48,844
- -------------------------------------------------------------
AUTOS & TRUCKS -- 5.2%
.............................................................
Ford Motor Company 500 26,719
.............................................................
General Motors Corporation 330 23,987
........................ ........................ --------
50,706
- -------------------------------------------------------------
BEVERAGES -- 1.2%
.............................................................
Anheuser-Busch Companies, Inc. 160 11,340
- -------------------------------------------------------------
CHEMICALS -- 3.4%
.............................................................
The Dow Chemical Company 150 20,044
.............................................................
Eastman Chemical Company 240 11,445
.............................................................
Millennium Chemicals Inc. 60 1,185
........................ ........................ --------
32,674
- -------------------------------------------------------------
CONTAINERS -- 1.2%
.............................................................
Pactiv Corporation# 1,130 12,006
- -------------------------------------------------------------
- -------------------------------------------------------------
Shares Value
ELECTRICAL: UTILITIES -- 10.6%
.............................................................
CMS Energy Corporation 400 $ 12,475
.............................................................
DTE Energy Company 200 6,275
.............................................................
Edison International 730 19,117
.............................................................
GPU, Inc. 120 3,592
.............................................................
Illinova Corporation 465 16,159
.............................................................
P P & L Resources, Inc. 493 11,277
.............................................................
Public Service Enterprises Group,
Inc. 295 10,270
.............................................................
SCANA Corporation 450 12,094
.............................................................
ScottishPower PLC 116 3,248
.............................................................
Texas Utilities Company 230 8,179
........................ ........................ --------
102,686
- -------------------------------------------------------------
ENGINEERING & CONSTRUCTION -- 0.9%
.............................................................
Harsco Corporation 260 8,255
- -------------------------------------------------------------
FOREST PRODUCTS -- 3.3%
.............................................................
Georgia-Pacific (Timber Group) 400 9,850
.............................................................
Weyerhaeuser Company 310 22,262
........................ ........................ --------
32,112
- -------------------------------------------------------------
INSURANCE: LIFE -- 3.1%
.............................................................
American General Corporation 200 15,175
.............................................................
Lincoln National Corporation 370 14,800
........................ ........................ --------
29,975
- -------------------------------------------------------------
INSURANCE: PROPERTY CASUALTY -- 5.3%
.............................................................
The Allstate Corporation 830 19,920
.............................................................
Safeco Corporation 500 12,438
.............................................................
St. Paul Companies, Inc. 560 18,865
........................ ........................ --------
51,223
- -------------------------------------------------------------
LEISURE/TOYS -- 0.9%
.............................................................
Fortune Brands, Inc. 270 8,927
- -------------------------------------------------------------
MACHINERY -- 1.7%
.............................................................
CNH Global N.V. 1,230 16,374
- -------------------------------------------------------------
METALS: MISC. -- 1.4%
.............................................................
Phelps Dodge Corporation 200 13,425
- -------------------------------------------------------------
OFFICE EQUIPMENT & SUPPLIES -- 1.6%
.............................................................
Xerox Corporation 690 15,654
- -------------------------------------------------------------
See Notes to the Financial Statements
1
SCHEDULE OF INVESTMENTS -- DECEMBER 31, 1999
- --------------------------------------------------------------------------------
EQUITY INCOME VIP PORTFOLIO
Shares Value
- -------------------------------------------------------------
OIL -- DOMESTIC -- 7.6%
.............................................................
Conoco Inc. -- Class B 330 $ 8,209
.............................................................
Occidental Petroleum Corporation 900 19,462
.............................................................
Phillips Petroleum Company 410 19,270
.............................................................
Sunoco, Inc. 100 2,350
.............................................................
USX-Marathon Group, Inc. 615 15,183
.............................................................
Ultramar Diamond Shamrock Corporation 400 9,075
........................ ........................ --------
73,549
- -------------------------------------------------------------
OIL -- INTERNATIONAL -- 0.4%
.............................................................
Texaco Inc. 80 4,345
- -------------------------------------------------------------
PAPER -- 4.7%
.............................................................
Georgia-Pacific Group 260 13,195
.............................................................
International Paper Company 577 32,564
........................ ........................ --------
45,759
- -------------------------------------------------------------
PHOTOGRAPHY/IMAGING -- 2.3%
.............................................................
Eastman Kodak Company 330 21,863
- -------------------------------------------------------------
POLLUTION CONTROL -- 0.3%
.............................................................
Waste Management, Inc. 175 3,008
- -------------------------------------------------------------
RAILROADS -- 2.0%
.............................................................
CSX Corporation 260 8,158
.............................................................
Norfolk Southern Corporation 570 11,685
........................ ........................ --------
19,843
- -------------------------------------------------------------
REGIONAL BANKS -- 4.5%
.............................................................
Bank One Corporation 424 13,594
.............................................................
First Security Corporation 300 7,659
.............................................................
First Union Corporation 320 10,500
.............................................................
KeyCorp 370 8,186
.............................................................
UnionBanCal Corporation 100 3,944
........................ ........................ --------
43,883
- -------------------------------------------------------------
RETAIL: DEPARTMENT STORES -- 1.2%
.............................................................
May Department Stores Company 350 11,287
- -------------------------------------------------------------
RETAIL: GENERAL MERCHANDISE -- 2.0%
.............................................................
J.C. Penney Company, Inc. 400 7,975
.............................................................
Sears, Roebuck & Company 390 11,871
........................ ........................ --------
19,846
- -------------------------------------------------------------
- -------------------------------------------------------------
Shares Value
SAVINGS & LOANS -- 1.8%
.............................................................
Washington Mutual, Inc. 680 $ 17,680
- -------------------------------------------------------------
SMALL LOANS & FINANCE -- 3.2%
.............................................................
Associates First Capital
Corporation -- Class A 142 3,896
.............................................................
Fannie Mae 270 16,858
.............................................................
Household International, Inc. 280 10,430
........................ ........................ --------
31,184
- -------------------------------------------------------------
STEEL -- 2.0%
.............................................................
USX-U.S. Steel Group, Inc. 600 19,800
- -------------------------------------------------------------
TOBACCO -- 2.7%
.............................................................
Philip Morris Companies, Inc. 1,120 25,970
- -------------------------------------------------------------
TELEPHONE -- 8.1%
.............................................................
AT&T Corporation 450 22,837
.............................................................
ALLTEL Corporation 240 19,845
.............................................................
Bell Atlantic Corporation 205 12,620
.............................................................
GTE Corporation 120 8,468
.............................................................
SBC Communications, Inc. 300 14,625
........................ ........................ --------
78,395
........................ ........................ --------
Total common stocks 954,348
(cost $1,111,583)
- -------------------------------------------------------------
VARIABLE RATE Principal
DEMAND NOTES* -- 2.2% Amount
- -------------------------------------------------------------
Pitney Bowes, Inc., 6.095%
(cost $21,702) $21,702 21,702
- -------------------------------------------------------------
Total investments -- 100.4%
(cost $1,133,285) 976,050
.............................................................
Liabilities in excess of other
assets -- (0.4%) (3,890)
........................ ........................ --------
Total net assets -- 100.0% $972,160
- -------------------------------------------------------------
# -- Non-income producing security.
* -- Variable rate demand notes are considered short-term obligations and are
payable on demand. Interest rates change periodically on specified dates.
The rate listed is as of December 31, 1999.
See Notes to the Financial Statements
2
STATEMENT OF ASSETS AND LIABILITIES
- --------------------------------------------------------------------------------
EQUITY INCOME VIP PORTFOLIO December 31, 1999
- -------------------------------------------------------------------------------
ASSETS:
Investments, at value*.................................... $ 976,050
Dividends and interest receivable......................... 2,835
Organizational expenses, net of accumulated
amortization............................................ 11,975
----------
Total assets.......................................... 990,860
----------
LIABILITIES:
Payable to Advisor........................................ 6,015
Accrued expenses and other liabilities.................... 12,685
----------
Total liabilities..................................... 18,700
----------
Net assets............................................ $ 972,160
==========
NET ASSETS CONSIST OF:
Paid in capital........................................... $1,096,351
Undistributed net investment income....................... 2,494
Undistributed net realized gain on securities............. 30,550
Net unrealized depreciation of securities................. (157,235)
----------
Net assets............................................ $ 972,160
==========
CALCULATION OF NET ASSET VALUE PER SHARE:
Shares outstanding (unlimited shares of no par value
authorized)............................................. 110,139
Net asset value per share (offering and redemption
price).................................................. $ 8.83
==========
*Cost of Investments....................................... $1,133,285
==========
See Notes to the Financial Statements
3
STATEMENT OF OPERATIONS
- --------------------------------------------------------------------------------
Year Ended
EQUITY INCOME VIP PORTFOLIO December 31, 1999
- -------------------------------------------------------------------------------
INVESTMENT INCOME:
Income*
Dividends............................................... $ 30,755
Interest................................................ 1,358
--------
Total income........................................ 32,113
--------
Expenses
Advisory fee............................................ 7,896
Legal and auditing fees................................. 359
Custodian fees and expenses............................. 5,390
Accounting and transfer agent fees and expenses......... 31,042
Administration fee...................................... 496
Trustees' fees and expenses............................. 360
Reports to shareholders................................. 10,841
Registration fees....................................... 22
Amortization of organizational expenses................. 4,208
Other expenses.......................................... 37
--------
Total expenses...................................... 60,651
Less, expense reimbursement............................. (48,543)
--------
Net expenses........................................ 12,108
--------
Net investment income................................... 20,005
--------
REALIZED AND UNREALIZED GAIN (LOSS) ON INVESTMENTS:
Net realized gain on securities......................... 34,115
Net change in unrealized depreciation of securities..... (86,565)
--------
Net loss on investments................................... (52,450)
--------
NET DECREASE IN NET ASSETS RESULTING FROM OPERATIONS........ $(32,445)
========
*Net of Foreign Taxes Withheld.............................. $ 101
========
See Notes to the Financial Statements
4
STATEMENT OF CHANGES IN NET ASSETS
- --------------------------------------------------------------------------------
March 18, 1998**
Year Ended through
EQUITY INCOME VIP PORTFOLIO December 31, 1999 December 31, 1998
- ---------------------------------------------------------------------------------------------------
OPERATIONS:
Net investment income................................... $ 20,005 $ 12,890
Net realized gain (loss) on securities.................. 34,115 (3,564)
Net change in unrealized depreciation of securities..... (86,565) (70,670)
-------- ----------
Net decrease in net assets resulting from
operations.......................................... (32,445) (61,344)
-------- ----------
DIVIDENDS AND DISTRIBUTIONS TO SHAREHOLDERS:
Net investment income................................... (21,583) (12,711)
-------- ----------
FUND SHARE TRANSACTIONS:
Net proceeds from shares sold........................... 75,069 1,070,974
Shares issued in connection with payment of dividends
and distributions...................................... 21,583 12,711
Cost of shares redeemed................................. (58,768) (21,326)
-------- ----------
Net increase in net assets from Fund share
transactions........................................ 37,884 1,062,359
-------- ----------
Total increase (decrease) in net assets..................... (16,144) 988,304
NET ASSETS:
Beginning of period..................................... 988,304 --
-------- ----------
End of period*.......................................... $972,160 $ 988,304
======== ==========
*Including undistributed net investment income of: $ 2,494 $ 1,547
======== ==========
CHANGES IN SHARES OUTSTANDING:
Shares sold............................................. 7,689 107,647
Shares issued in connection with payment of dividends
and distributions...................................... 2,335 1,390
Shares redeemed......................................... (6,520) (2,402)
-------- ----------
Net increase........................................ 3,504 106,635
======== ==========
**Commencement of operations.
See Notes to the Financial Statements
5
NOTES TO THE FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
DECEMBER 31, 1999
NOTE 1.
ACCOUNTING POLICIES. The Equity Income VIP Portfolio (the "Fund") is a series of
Hotchkis and Wiley Variable Trust (the "Trust"), an open-end, management
investment company organized as a Massachusetts business trust on February 4,
1997 and registered under the Investment Company Act of 1940. The Fund commenced
operations on March 18, 1998. The Fund seeks current income and long-term growth
of income, accompanied by growth of capital. Shares of the Fund are not offered
to the general public but may only be purchased by the separate accounts of
participating insurance companies for the purpose of funding variable annuity
contracts and/or variable life insurance contracts. In addition to the Fund, the
Trust offers the International VIP Portfolio, the Low Duration VIP Portfolio and
the Total Return Bond VIP Portfolio (collectively, the "Funds"). The assets of
each series are invested in separate, independently managed portfolios. The
following is a summary of significant accounting policies followed by the Fund
in the preparation of the financial statements.
ORGANIZATIONAL EXPENSES: Expenses incurred by the Trust in connection with the
organization, registration and the initial public offering of shares are being
deferred and amortized over the period of benefit, but not to exceed sixty
months from the Trust's commencement of operations. The proceeds of any
redemption of the initial shares by the original shareholder will be reduced by
a pro-rata portion of any then unamortized organization expenses in the same
proportion as the number of initial shares being redeemed bears to the number of
initial shares outstanding at the time of such redemption.
SECURITY VALUATION: Portfolio securities that are listed on a securities
exchange (whether domestic or foreign) or The Nasdaq Stock Market ("NSM") are
valued at the last sale price as of 4:00 p.m., Eastern Time, or, in the absence
of recorded sales, at the average of readily available closing bid and asked
prices on such exchange or NSM. Unlisted securities that are not included in NSM
are valued at the average of the quoted bid and asked price in the
over-the-counter market. Securities for which market quotations are not
otherwise available are valued at fair value as determined in good faith by
Hotchkis and Wiley (the "Advisor") under procedures established by the Board of
Trustees. Short-term investments which mature in less than 60 days are valued at
amortized cost (unless the Board of Trustees determines that this method does
not represent fair value), if their original maturity was 60 days or less, or by
amortizing the values as of the 61st day prior to maturity, if their original
term to maturity exceeded 60 days.
FEDERAL INCOME TAXES: It is the Fund's policy to meet the requirements of the
Internal Revenue Code applicable to regulated investment companies and the Fund
intends to distribute substantially all of its investment company net taxable
income and net capital gains to shareholders. Therefore, no federal income tax
provision is required.
EXPENSE ALLOCATION: Common expenses incurred by the Trust are allocated among
the Funds based upon (i) relative average net assets, (ii) as incurred on a
specific identification basis, or (iii) evenly among the Funds, depending on the
nature of the expenditure.
USE OF ESTIMATES: The preparation of financial statements in conformity with
generally accepted accounting principles requires management to make estimates
and assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ from those estimates.
6
DISTRIBUTIONS TO SHAREHOLDERS: Dividends from net investment income are declared
and paid quarterly. Distributions of net realized capital gains, if any, will be
declared and paid at least annually.
OTHER: Security and shareholder transactions are recorded on trade date.
Realized gains and losses on sales of investments are calculated on the
identified cost basis. Dividend income and dividends and distributions to
shareholders are recorded on the ex-dividend date. Interest income is recognized
on the accrual basis. Generally accepted accounting principles require that
permanent financial reporting and tax differences relating to shareholder
distributions be reclassified within the capital accounts.
NOTE 2.
INVESTMENT ADVISORY AGREEMENT. The Fund has an investment advisory agreement
with the Advisor, with whom certain officers and Trustees of the Trust are
affiliated. The Advisor is a division of Merrill Lynch Asset Management, L.P.,
an indirect wholly-owned subsidiary of Merrill Lynch & Co., Inc. The Advisor
receives a fee, computed daily and payable monthly, at the annual rate of 0.75%
as applied to the Fund's daily net assets. The Advisor has agreed to pay all
operating expenses in excess of 1.15% as applied to the Fund's daily net assets.
For the year ended December 31, 1999, the Advisor paid $48,543 of operating
expenses on behalf of the Fund.
As permitted under Rule 10f-3 of the Investment Company Act of 1940, the Board
of Trustees of the Trust has adopted procedures which allow the Fund, under
certain conditions described in the Rule, to acquire newly-issued securities
from a member of an underwriting group in which an affiliated underwriter
participates.
NOTE 3.
CREDIT FACILITY. Effective December 3, 1999, the Fund entered into a one year
Credit Agreement with a syndicate of bank lenders led by Bank of America
intended to provide the Fund with a source of cash to be used to meet redemption
requests from Fund shareholders. The Fund together with certain other open-end
investment companies advised by Merrill Lynch Asset Management, L.P. and/or its
affiliates may borrow in the aggregate up to $1,000,000,000, except that in no
event may the borrowing by the Fund or any participating fund be in excess of
that permitted by its prospectus and Statement of Additional Information or by
applicable law. The Fund had no borrowings under the Credit Agreement in 1999.
NOTE 4.
SECURITIES TRANSACTIONS. Purchases and sales of investment securities, other
than short-term investments, for the year ended December 31, 1999 were $287,042
and $241,692, respectively.
As of December 31, 1999, unrealized appreciation (depreciation) for federal
income tax purposes was as follows:
Net Appreciated Depreciated
Fund Depreciation Securities Securities
- ------------------------------------------------------------------------------------------------------
Equity Income VIP Portfolio................................. $(157,235) $84,372 $(241,607)
At December 31, 1999, the cost of investments for federal income tax purposes
was $1,133,285. Any differences between book and tax are due primarily to wash
sale losses.
The Fund utilized capital loss carryovers of $3,564 in 1999.
NOTE 5.
FEDERAL TAX DISCLOSURE (UNAUDITED). For the year ended December 31, 1999, 100%
of the ordinary distributions paid in the Fund qualify for the dividend received
deduction available for corporate shareholders.
NOTE 6.
SUBSEQUENT EVENT (UNAUDITED). As of February 16, 2000, the Fund's net assets and
net asset value per share were $843,238 and $7.66, respectively.
7
FINANCIAL HIGHLIGHTS
- --------------------------------------------------------------------------------
March 18, 1998*
Year Ended through
EQUITY INCOME VIP PORTFOLIO December 31, 1999 December 31, 1998
- ----------------------------------------------------------------------------------------------------
Net Asset Value, Beginning of Period........................ $ 9.27 $ 10.00
-------- --------
Income from Investment Operations:
Net investment income................................... 0.20 0.14
Net realized and unrealized gain (loss) on
investments............................................ (0.45) (0.75)
-------- --------
Total from investment operations........................ (0.25) (0.61)
-------- --------
Less Distributions:
Dividends (from net investment income).................. (0.19) (0.12)
-------- --------
Net Asset Value, End of Period.............................. $ 8.83 $ 9.27
======== ========
Total Return................................................ (2.73)% (6.04)%(1)
RATIOS/SUPPLEMENTAL DATA:
Net assets, end of period................................... $972,160 $988,304
Ratio of expenses to average net assets:
Before expense reimbursement............................ 5.76% 7.81%(2)
After expense reimbursement............................. 1.15% 1.15%(2)
Ratio of net investment income (loss) to average net assets:
Before expense reimbursement............................ (2.71)% (4.95)%(2)
After expense reimbursement............................. 1.90% 1.71%(2)
Portfolio turnover rate..................................... 24% 12%(1)
* Commencement of operations.
(1) Not annualized.
(2) Annualized.
See Notes to the Financial Statements
8
- --------------------------------------------------------------------------------
REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Trustees and Shareholders of Hotchkis and Wiley Variable Trust:
In our opinion, the accompanying statement of assets and liabilities, including
the schedule of investments, and the related statements of operations and of
changes in net assets and the financial highlights present fairly, in all
material respects, the financial position of the Equity Income VIP Portfolio
(one of the four portfolios of Hotchkis and Wiley Variable Trust, the "Fund") at
December 31, 1999, the results of its operations, the changes in its net assets
and the financial highlights for each of the periods indicated, in conformity
with accounting principles generally accepted in the United States. These
financial statements and financial highlights (hereafter referred to as
"financial statements") are the responsibility of the Fund's management; our
responsibility is to express an opinion on these financial statements based on
our audits. We conducted our audits of these financial statements in accordance
with auditing standards generally accepted in the United States, which require
that we plan and perform the audit to obtain reasonable assurance about whether
the financial statements are free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and disclosures in
the financial statements, assessing the accounting principles used and
significant estimates made by management, and evaluating the overall financial
statement presentation. We believe that our audits, which included confirmation
of securities at December 31, 1999 by correspondence with the custodian, provide
a reasonable basis for the opinion expressed above.
PRICEWATERHOUSECOOPERS
Milwaukee, WI
February 17, 2000
9
SCHEDULE OF INVESTMENTS -- DECEMBER 31, 1999
- --------------------------------------------------------------------------------
INTERNATIONAL VIP PORTFOLIO
COMMON STOCKS -- 94.6% Shares Value
- -----------------------------------------------------------
AUSTRALIA -- 3.6%
- -----------------------------------------------------------
INSURANCE: MULTI-LINE -- 1.1%
...........................................................
QBE Insurance Group, Ltd. 681,996 $ 3,177,675
- -----------------------------------------------------------
REGIONAL BANKS -- 1.4%
...........................................................
Australia and New Zealand
Banking Group, Ltd. 555,260 4,037,799
- -----------------------------------------------------------
TRANSPORTATION -- 1.1%
...........................................................
Qantas Airways Limited 1,267,155 3,159,968
..................... ...................... -----------
Total Australia 10,375,442
- -----------------------------------------------------------
AUSTRIA -- 0.5%
- -----------------------------------------------------------
STEEL -- 0.5%
...........................................................
Boehler -- Uddeholm AG 31,940 1,473,238
..................... ...................... -----------
Total Austria 1,473,238
- -----------------------------------------------------------
CANADA -- 3.3%
- -----------------------------------------------------------
INSURANCE: MULTI-LINES -- 2.2%
...........................................................
Clarica Life Insurance Co. 127,755 2,302,222
...........................................................
Manulife Financial Corporation # 306,177 3,915,298
..................... ...................... -----------
6,217,520
- -----------------------------------------------------------
METALS: MISC. -- 1.1%
...........................................................
Noranda, Inc. 225,320 3,029,684
..................... ...................... -----------
Total Canada 9,247,204
- -----------------------------------------------------------
FINLAND -- 1.6%
- -----------------------------------------------------------
PAPER -- 1.6%
...........................................................
UPM-Kymmene OYJ 114,170 4,599,224
..................... ...................... -----------
Total Finland 4,599,224
- -----------------------------------------------------------
FRANCE -- 8.3%
- -----------------------------------------------------------
BEVERAGES -- 1.2%
...........................................................
Pernod Ricard SA 58,375 3,339,242
- -----------------------------------------------------------
BUILDING MATERIALS -- 1.0%
...........................................................
Lafarge SA 24,390 2,839,502
- -----------------------------------------------------------
OFFICE EQUIPMENT & SUPPLIES -- 1.0%
...........................................................
BIC 61,039 2,777,322
- -----------------------------------------------------------
- -----------------------------------------------------------
Shares Value
OIL -- INTERNATIONAL -- 2.8%
...........................................................
Elf Aquitaine SA 5 $ 770
...........................................................
Total Fina SA -- Class B 60,027 8,010,048
..................... ...................... -----------
8,010,818
- -----------------------------------------------------------
REGIONAL BANKS -- 2.3%
...........................................................
Banque Nationale de Paris 72,616 6,698,852
...........................................................
Societe Generale 4 931
..................... ...................... -----------
6,699,783
..................... ...................... -----------
Total France 23,666,667
- -----------------------------------------------------------
GERMANY -- 6.3%
- -----------------------------------------------------------
CHEMICALS -- 2.7%
...........................................................
Aventis SA 89,483 5,181,811
...........................................................
SGL Carbon AG # 36,769 2,443,984
..................... ...................... -----------
7,625,795
- -----------------------------------------------------------
CONSUMER DURABLES -- MISCELLANEOUS -- 1.0%
...........................................................
Buderus AG 174,780 2,957,152
- -----------------------------------------------------------
REGIONAL BANKS -- 1.1%
...........................................................
Commerzbank AG 81,960 3,008,653
- -----------------------------------------------------------
UTILITIES: MISC. -- 1.5%
...........................................................
VEBA AG 85,782 4,168,368
..................... ...................... -----------
Total Germany 17,759,968
- -----------------------------------------------------------
HONG KONG -- 3.3%
- -----------------------------------------------------------
ELECTRICAL UTILITIES -- 1.6%
...........................................................
Shandong International Power
Development Company Limited 32,542,000 4,604,827
- -----------------------------------------------------------
REAL ESTATE -- 1.7%
...........................................................
Hang Lung Development Company 2,321,000 2,627,446
...........................................................
New World Development Co., Ltd. 1,047,000 2,357,006
..................... ...................... -----------
4,984,452
..................... ...................... -----------
Total Hong Kong 9,589,279
- -----------------------------------------------------------
IRELAND -- 4.1%
- -----------------------------------------------------------
FOODS -- 1.0%
...........................................................
Greencore Group PLC 919,300 2,823,772
- -----------------------------------------------------------
PAPER -- 1.6%
...........................................................
Jefferson Smurfit Group PLC 1,468,432 4,436,574
- -----------------------------------------------------------
See Notes to the Financial Statements
1
SCHEDULE OF INVESTMENTS -- DECEMBER 31, 1999
- --------------------------------------------------------------------------------
INTERNATIONAL VIP PORTFOLIO
Shares Value
- -----------------------------------------------------------
REGIONAL BANKS -- 1.5%
...........................................................
Allied Irish Banks PLC 371,358 $ 4,233,619
..................... ...................... -----------
Total Ireland 11,493,965
- -----------------------------------------------------------
ITALY -- 3.7%
- -----------------------------------------------------------
OIL -- INTERNATIONAL -- 1.2%
...........................................................
ENI SPA 644,400 3,543,405
- -----------------------------------------------------------
TELECOMMUNICATIONS -- 2.5%
...........................................................
Telecom Italia SPA 493,700 6,960,874
..................... ...................... -----------
Total Italy 10,504,279
- -----------------------------------------------------------
JAPAN -- 8.3%
- -----------------------------------------------------------
ELECTRONICS -- 3.4%
...........................................................
Nintendo Co., Ltd. 58,000 9,642,569
- -----------------------------------------------------------
OFFICE EQUIPMENT & SUPPLIES -- 1.3%
...........................................................
Canon, Inc. 92,000 3,657,134
- -----------------------------------------------------------
RETAIL: GENERAL MERCHANDISE -- 0.9%
...........................................................
Circle K Japan Company, Ltd. 63,000 2,584,530
- -----------------------------------------------------------
SMALL LOANS & FINANCE -- 1.8%
...........................................................
Promise Company, Ltd. 48,400 2,464,199
...........................................................
Sanyo Shinpan Finance Co., Ltd. 82,400 2,823,724
..................... ...................... -----------
5,287,923
- -----------------------------------------------------------
STEEL -- 0.9%
...........................................................
Yodogawa Steel Works, Ltd. 834,000 2,515,034
..................... ...................... -----------
Total Japan 23,687,190
- -----------------------------------------------------------
NETHERLANDS -- 9.1%
- -----------------------------------------------------------
CHEMICALS -- 1.6%
...........................................................
Akzo Nobel N.V. 90,955 4,561,719
- -----------------------------------------------------------
ELECTRONICS -- 2.1%
...........................................................
Philips Electronics N.V. 43,744 5,947,352
- -----------------------------------------------------------
INSURANCE -- MULTI-LINE -- 2.7%
...........................................................
Fortis (NL) N.V. 90,650 3,263,747
...........................................................
ING Groep N.V. 71,840 4,336,663
..................... ...................... -----------
7,600,410
- -----------------------------------------------------------
REGIONAL BANKS -- 0.9%
...........................................................
ABN AMRO Holding N.V. 101,050 2,523,833
- -----------------------------------------------------------
- -----------------------------------------------------------
Shares Value
TELECOMMUNICATIONS -- 1.8%
...........................................................
Koninklijke KPN N.V. 52,435 $ 5,117,026
..................... ...................... -----------
Total Netherlands 25,750,340
- -----------------------------------------------------------
NEW ZEALAND -- 2.1%
- -----------------------------------------------------------
TELECOMMUNICATIONS -- 2.1%
...........................................................
Telecom Corporation of New
Zealand 1,288,025 6,043,027
..................... ...................... -----------
Total New Zealand 6,043,027
- -----------------------------------------------------------
NORWAY -- 0.9%
- -----------------------------------------------------------
ENGINEERING & CONSTRUCTION -- 0.9%
...........................................................
Kvaerner ASA -- Class A# 120,606 2,530,681
..................... ...................... -----------
Total Norway 2,530,681
- -----------------------------------------------------------
PORTUGAL -- 1.9%
- -----------------------------------------------------------
TELEPHONE -- 1.9%
...........................................................
Portugal Telecom SA 499,364 5,476,684
..................... ...................... -----------
Total Portugal 5,476,684
- -----------------------------------------------------------
SINGAPORE -- 4.4%
- -----------------------------------------------------------
COMPUTER SOFTWARE & SERVICES -- 1.9%
...........................................................
Creative Technology, Ltd. 312,091 5,437,176
- -----------------------------------------------------------
DIVERSIFIED COMPANIES -- 0.7%
...........................................................
Jardine Matheson Holdings, Ltd. 466,400 1,837,616
- -----------------------------------------------------------
MONEY CENTER BANKS -- 1.8%
...........................................................
United Overseas Bank Ltd. 586,928 5,178,776
..................... ...................... -----------
Total Singapore 12,453,568
- -----------------------------------------------------------
SPAIN -- 2.1%
- -----------------------------------------------------------
TELECOMMUNICATIONS -- 2.1%
...........................................................
Telefonica S.A. 240,039 5,995,240
..................... ...................... -----------
Total Spain 5,995,240
- -----------------------------------------------------------
SWEDEN -- 1.4%
- -----------------------------------------------------------
ELECTRICAL EQUIPMENT -- 1.4%
...........................................................
Electrolux AB -- Class B 157,180 3,954,982
..................... ...................... -----------
Total Sweden 3,954,982
- -----------------------------------------------------------
SWITZERLAND -- 5.4%
- -----------------------------------------------------------
BUILDING MATERIALS -- 1.8%
...........................................................
Geberit International AG 14,960 5,118,497
- -----------------------------------------------------------
See Notes to the Financial Statements
2
SCHEDULE OF INVESTMENTS -- DECEMBER 31, 1999
- --------------------------------------------------------------------------------
INTERNATIONAL VIP PORTFOLIO
Shares Value
- -----------------------------------------------------------
MACHINERY -- 2.0%
...........................................................
Saurer AG "registered" # 6,059 $ 2,925,107
...........................................................
Sulzer AG "registered" # 4,382 2,847,260
..................... ...................... -----------
5,772,367
- -----------------------------------------------------------
MEDICAL PRODUCTS & SUPPLIES -- 1.6%
...........................................................
Novartis AG "registered" 3,160 4,638,163
..................... ...................... -----------
Total Switzerland 15,529,027
- -----------------------------------------------------------
UNITED KINGDOM -- 24.3%
- -----------------------------------------------------------
AIRLINES -- 1.4%
...........................................................
BAA PLC 563,720 3,961,010
- -----------------------------------------------------------
AUTO -- 0.1%
...........................................................
Lex Service PLC 68,090 409,147
- -----------------------------------------------------------
BEVERAGES -- 0.8%
...........................................................
Allied Domecq PLC 450,610 2,227,283
- -----------------------------------------------------------
BUILDING MATERIALS -- 1.4%
...........................................................
Hanson PLC 483,500 4,053,377
- -----------------------------------------------------------
DIVERSIFIED COMPANIES -- 5.5%
...........................................................
Cookson Group PLC 1,213,260 4,899,447
...........................................................
Invensys PLC 671,361 3,654,596
...........................................................
Tomkins PLC 1,095,040 3,537,636
...........................................................
Williams PLC 768,209 3,496,202
..................... ...................... -----------
15,587,881
- -----------------------------------------------------------
ENGINEERING & CONSTRUCTION -- 1.4%
...........................................................
TI Group PLC 510,690 3,918,358
- -----------------------------------------------------------
FOODS -- 0.8%
...........................................................
Unilever PLC 300,130 2,208,264
- -----------------------------------------------------------
HOUSEHOLD PRODUCTS -- 1.1%
...........................................................
Reckitt Benckiser PLC 351,219 3,293,316
- -----------------------------------------------------------
INSURANCE: MULTI-LINE -- 2.3%
...........................................................
Allied Zurich AG PLC 278,405 3,280,617
...........................................................
CGU PLC 196,980 3,173,863
..................... ...................... -----------
6,454,480
- -----------------------------------------------------------
- -----------------------------------------------------------
Shares Value
PUBLISHING -- 2.4%
...........................................................
Reed International PLC 377,100 $ 2,823,316
...........................................................
United News & Media PLC 321,358 4,095,617
..................... ...................... -----------
6,918,933
- -----------------------------------------------------------
REGIONAL BANKS -- 2.5%
...........................................................
Lloyds TSB Group PLC 276,070 3,453,773
...........................................................
National Westminster Bank PLC 178,910 3,843,611
..................... ...................... -----------
7,297,384
- -----------------------------------------------------------
RETAIL -- FOOD CHAINS -- 1.4%
...........................................................
Tesco PLC 1,301,850 3,958,669
- -----------------------------------------------------------
TELECOMMUNICATIONS -- 1.3%
...........................................................
British Telecommunications PLC 150,294 3,673,109
- -----------------------------------------------------------
TEXTILES -- 0.9%
...........................................................
Coats Viyella PLC 3,962,250 2,624,091
- -----------------------------------------------------------
TOBACCO -- 1.0%
...........................................................
B.A.T. Industries PLC 475,992 2,704,500
..................... ...................... -----------
Total United Kingdom 69,289,802
..................... ...................... -----------
Total common stocks (cost $242,990,611) 269,419,807
- -----------------------------------------------------------
PREFERRED STOCKS -- 0.5%
- -----------------------------------------------------------
GERMANY -- 0.5%
- -----------------------------------------------------------
BUILDING MATERIALS -- 0.5%
...........................................................
Dyckerhoff AG 48,190 1,475,377
..................... ...................... -----------
Total Germany 1,475,377
..................... ...................... -----------
Total preferred stocks (cost $1,745,673) 1,475,377
- -----------------------------------------------------------
VARIABLE RATE DEMAND Principal
NOTES* -- 4.7% Amount
- -----------------------------------------------------------
Chase Manhattan Bank, 3.9062%
(cost $13,407,489) $13,407,507 13,407,507
..................... ...................... -----------
Total investments -- 99.8% 284,302,691
(cost $258,143,773)
...........................................................
Other assets in excess of liabilities --0.2 %531,172
..................... ...................... -----------
Total net assets -- 100.0% $284,833,863
- -----------------------------------------------------------
#-Non-income producing security.
*-Variable rate demand notes are considered short-term obligations and are
payable on demand. Interest rates change periodically on specified dates. The
rate listed is as of December 31, 1999.
See Notes to the Financial Statements
3
STATEMENT OF ASSETS AND LIABILITIES
- --------------------------------------------------------------------------------
INTERNATIONAL VIP PORTFOLIO December 31, 1999
- -------------------------------------------------------------------------------
ASSETS:
Investments, at value*.................................... $284,302,691
Cash...................................................... 178,034
Dividends and interest receivable......................... 666,701
Organizational expenses, net of accumulated
amortization............................................ 12,709
Prepaid expenses.......................................... 497
------------
Total assets.......................................... 285,160,632
------------
LIABILITIES:
Payable to Advisor........................................ 175,783
Accrued expenses and other liabilities.................... 150,986
------------
Total liabilities..................................... 326,769
------------
Net assets............................................ $284,833,863
============
NET ASSETS CONSIST OF:
Paid in capital........................................... $255,830,197
Undistributed net investment income....................... 3,197,003
Undistributed net realized gain (loss) on securities and
foreign currency transactions........................... (355,851)
Net unrealized appreciation of securities and foreign
currency................................................ 26,162,514
------------
Net assets............................................ $284,833,863
============
CALCULATION OF NET ASSET VALUE PER SHARE:
Shares outstanding (unlimited shares of no par value
authorized)............................................. 24,734,480
Net asset value per share (offering and redemption
price).................................................. $ 11.52
============
*Cost of Investments........................................ $258,143,773
============
See Notes to the Financial Statements
4
STATEMENT OF OPERATIONS
- --------------------------------------------------------------------------------
Year Ended
INTERNATIONAL VIP PORTFOLIO December 31, 1999
- -------------------------------------------------------------------------------
INVESTMENT INCOME:
Income*
Dividends............................................... $ 5,462,950
Interest................................................ 451,144
-----------
Total income........................................ 5,914,094
-----------
Expenses
Advisory fee............................................ 1,678,700
Legal and auditing fees................................. 79,886
Custodian fees and expenses............................. 158,049
Accounting and transfer agent fees and expenses......... 78,278
Administration fee...................................... 104,159
Trustees' fees and expenses............................. 87,310
Reports to shareholders................................. 58,358
Registration fees....................................... 169
Amortization of organizational expenses................. 4,208
Other expenses.......................................... 8,452
-----------
Total expenses...................................... 2,257,569
-----------
Net investment income................................... 3,656,525
-----------
REALIZED AND UNREALIZED GAIN ON INVESTMENTS:
Net realized gain on securities and foreign currency
transactions........................................... 4,289,725
Net change in unrealized appreciation of securities and
foreign currency....................................... 28,388,537
-----------
Net gain on investments................................... 32,678,262
-----------
NET INCREASE IN NET ASSETS RESULTING FROM OPERATIONS........ $36,334,787
===========
*Net of Foreign Taxes Withheld.............................. $ 613,156
===========
See Notes to the Financial Statements
5
STATEMENT OF CHANGES IN NET ASSETS
- --------------------------------------------------------------------------------
June 10, 1998**
Year Ended through
INTERNATIONAL VIP PORTFOLIO December 31, 1999 December 31, 1998
- ---------------------------------------------------------------------------------------------------
OPERATIONS:
Net investment income................................... $ 3,656,525 $ 1,479,772
Net realized gain (loss) on securities and foreign
currency transactions.................................. 4,289,725 (3,884,261)
Net change in unrealized appreciation (depreciation) of
securities and foreign currency........................ 28,388,537 (2,226,023)
------------- ------------
Net increase (decrease) in net assets resulting from
operations.......................................... 36,334,787 (4,630,512)
------------- ------------
DIVIDENDS AND DISTRIBUTIONS TO SHAREHOLDERS:
Net investment income................................... (1,524,275) (1,179,786)
------------- ------------
FUND SHARE TRANSACTIONS:
Net proceeds from shares sold........................... 114,485,146 299,085,362
Shares issued in connection with payment of dividends
and distributions...................................... 1,524,275 1,179,786
Cost of shares redeemed................................. (155,121,028) (5,319,892)
------------- ------------
Net increase (decrease) in net assets from Fund
share transactions.................................. (39,111,607) 294,945,256
------------- ------------
Total increase (decrease) in net assets..................... (4,301,095) 289,134,958
NET ASSETS:
Beginning of period..................................... 289,134,958 --
------------- ------------
End of period*.......................................... $ 284,833,863 $289,134,958
============= ============
*Including undistributed net investment income of: $ 3,197,003 $ 62,996
============= ============
CHANGES IN SHARES OUTSTANDING:
Shares sold............................................. 10,476,787 30,816,414
Shares issued in connection with payment of dividends
and distributions...................................... 136,340 125,916
Shares redeemed......................................... (16,258,425) (562,552)
------------- ------------
Net increase (decrease)............................. (5,645,298) 30,379,778
============= ============
** Commencement of operations.
See Notes to the Financial Statements
6
NOTES TO THE FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
DECEMBER 31, 1999
NOTE 1.
ACCOUNTING POLICIES. The International VIP Portfolio (the "Fund") is a series of
Hotchkis and Wiley Variable Trust (the "Trust"), an open-end, management
investment company organized as a Massachusetts business trust on February 4,
1997 and registered under the Investment Company Act of 1940. The Fund commenced
operations on June 10, 1998. The Fund seeks current income and long-term growth
of income, accompanied by growth of capital. Shares of the Fund are not offered
to the general public but may only be purchased by the separate accounts of
participating insurance companies for the purpose of funding variable annuity
contracts and/or variable life insurance contracts. In addition to the Fund, the
Trust offers the Equity Income VIP Portfolio, the Low Duration VIP Portfolio and
the Total Return Bond VIP Portfolio (collectively, the "Funds"). The assets of
each series are invested in separate, independently managed portfolios. The
following is a summary of significant accounting policies followed by the Fund
in the preparation of the financial statements.
ORGANIZATIONAL EXPENSES: Expenses incurred by the Trust in connection with the
organization, registration and the initial public offering of shares are being
deferred and amortized over the period of benefit, but not to exceed sixty
months from the Trust's commencement of operations. The proceeds of any
redemption of the initial shares by the original shareholder will be reduced by
a pro-rata portion of any then unamortized organization expenses in the same
proportion as the number of initial shares being redeemed bears to the number of
initial shares outstanding at the time of such redemption.
SECURITY VALUATION: Portfolio securities that are listed on a securities
exchange (whether domestic or foreign) or The Nasdaq Stock Market ("NSM") are
valued at the last sale price as of 4:00 p.m., Eastern Time, or, in the absence
of recorded sales, at the average of readily available closing bid and asked
prices on such exchange or NSM. Unlisted securities that are not included in NSM
are valued at the average of the quoted bid and asked price in the
over-the-counter market. Securities for which market quotations are not
otherwise available are valued at fair value as determined in good faith by
Hotchkis and Wiley (the "Advisor") under procedures established by the Board of
Trustees. Short-term investments which mature in less than 60 days are valued at
amortized cost (unless the Board of Trustees determines that this method does
not represent fair value), if their original maturity was 60 days or less, or by
amortizing the values as of the 61st day prior to maturity, if their original
term to maturity exceeded 60 days. Investments quoted in foreign currency are
valued daily in U.S. dollars on the basis of the foreign currency exchange rate
prevailing at the time of valuation.
FOREIGN CURRENCY TRANSLATIONS: The books and records of the Fund are maintained
in U.S. dollars. Foreign currency transactions are translated into U.S. dollars
on the following basis: (i) market value of investment securities, assets and
liabilities at the daily rates of exchange, and (ii) purchases and sales of
investment securities, dividend and interest income and certain expenses at the
rates of exchange prevailing on the respective dates of such transactions. The
Fund does not isolate and treat as ordinary income that portion of the results
of operations arising as a result of changes in the exchange rate from the
fluctuations arising from changes in the market prices of securities held during
the period. However, for federal income tax purposes, the Fund does isolate and
treat as ordinary income the effect of changes in foreign exchange rates arising
from actual foreign currency transactions and the effect of changes in foreign
exchange rates arising from trade date and settlement date differences.
7
FORWARD CURRENCY EXCHANGE CONTRACTS: The Fund utilizes forward currency exchange
contracts for the purpose of hedging foreign currency risk. Under these
contracts, the Fund is obligated to exchange currencies at specific future
dates. Risks arise from the possible inability of counter-parties to meet the
terms of their contracts and from movements in currency values.
FEDERAL INCOME TAXES: It is the Fund's policy to meet the requirements of the
Internal Revenue Code applicable to regulated investment companies and the Fund
intends to distribute substantially all of its investment company net taxable
income and net capital gains to shareholders. Therefore, no federal income tax
provision is required.
EXPENSE ALLOCATION: Common expenses incurred by the Trust are allocated among
the Funds based upon (i) relative average net assets, (ii) as incurred on a
specific identification basis, or (iii) evenly among the Funds, depending on the
nature of the expenditure.
USE OF ESTIMATES: The preparation of financial statements in conformity with
generally accepted accounting principles requires management to make estimates
and assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ from those estimates.
DISTRIBUTIONS TO SHAREHOLDERS: Dividends from net investment income are declared
and paid annually. Distributions of net realized capital gains, if any, will be
declared and paid at least annually.
OTHER: Security and shareholder transactions are recorded on trade date.
Realized gains and losses on sales of investments are calculated on the
identified cost basis. Dividend income and dividends and distributions to
shareholders are recorded on the ex-dividend date. Interest income is recognized
on the accrual basis. Generally accepted accounting principles require that
permanent financial reporting and tax differences relating to shareholder
distributions be reclassified within the capital accounts.
NOTE 2.
INVESTMENT ADVISORY AGREEMENT. The Fund has an investment advisory agreement
with the Advisor, with whom certain officers and Trustees of the Trust are
affiliated. The Advisor is a division of Merrill Lynch Asset Management, L.P.,
an indirect wholly-owned subsidiary of Merrill Lynch & Co., Inc. The Advisor
receives a fee, computed daily and payable monthly, at the annual rate of 0.75%
as applied to the Fund's daily net assets. The Advisor has agreed to pay all
operating expenses in excess of 1.35% as applied to the Fund's daily net assets.
The Advisor has entered into subadvisory agreements with Mercury Asset
Management International Limited and Merrill Lynch Asset Management U.K.
Limited, affiliated investment advisors that are indirect subsidiaries of
Merrill Lynch & Co., Inc. The subadvisory arrangements are for investment
research, recommendations, and other investment-related services to be provided
to the Fund. There is no increase in the aggregate fees paid by the Fund for
these services.
The Fund paid $20,489 in commissions on Fund transactions to an affiliated
broker during the year ended December 31, 1999.
As permitted under Rule 10f-3 of the Investment Company Act of 1940, the Board
of Trustees of the Trust has adopted procedures which allow the Fund, under
certain conditions described in the Rule, to acquire newly-issued securities
from a member of an underwriting group in which an affiliated underwriter
participates.
8
NOTE 3.
CREDIT FACILITY. Effective December 3, 1999, the Fund entered into a one year
Credit Agreement with a syndicate of bank lenders led by Bank of America
intended to provide the Fund with a source of cash to be used to meet redemption
requests from Fund shareholders. The Fund together with certain other open-end
investment companies advised by Merrill Lynch Asset Management, L.P. and/or its
affiliates may borrow in the aggregate up to $1,000,000,000, except that in no
event may the borrowing by the Fund or any participating fund be in excess of
that permitted by its prospectus and Statement of Additional Information or by
applicable law. The Fund had no borrowings under the Credit Agreement in 1999.
NOTE 4.
SECURITIES TRANSACTIONS. Purchases and sales of investment securities, other
than short-term investments, for the year ended December 31, 1999 were
$150,846,867 and $182,928,700, respectively.
As of December 31, 1999, unrealized appreciation (depreciation) for federal
income tax purposes was as follows:
Appreciated Depreciated
Fund Net Appreciation Securities Securities
- -----------------------------------------------------------------------------------------------------------
International VIP Portfolio................................. $24,947,401 $43,005,529 $(18,058,128)
At December 31, 1999, the cost of investments for federal income tax purposes
was $259,355,290. Any differences between book and tax are due primarily to wash
sale losses and mark-to-market adjustments for passive foreign investment
companies.
At December 31, 1999, the Fund deferred, on a tax basis, post-October losses of
$1,291,782. The Fund utilized capital loss carryovers of $3,178,827 in 1999.
NOTE 5.
FEDERAL TAX DISCLOSURE (UNAUDITED). The Fund intends to make an election under
Internal Revenue Code Section 853 to pass through non-U.S. taxes paid by the
Fund to its shareholders. Non-U.S. taxes paid by the Fund for the year ended
December 31, 1999 were $625,356. Foreign source income earned by the Fund for
the year ended December 31, 1999 was $6,363,598.
9
FINANCIAL HIGHLIGHTS
- --------------------------------------------------------------------------------
June 10, 1998*
Year Ended through
INTERNATIONAL VIP PORTFOLIO December 31, 1999 December 31, 1998
- ---------------------------------------------------------------------------------------------------
Net Asset Value, Beginning of Period........................ $ 9.52 $ 10.00
------------ ------------
Income from Investment Operations:
Net investment income................................... 0.15 0.04
Net realized and unrealized gain (loss) on
investments............................................ 1.91 (0.48)
------------ ------------
Total from investment operations........................ 2.06 (0.44)
------------ ------------
Less Distributions:
Dividends (from net investment income).................. (0.06) (0.04)
------------ ------------
Net Asset Value, End of Period.............................. $ 11.52 $ 9.52
============ ============
Total Return................................................ 21.68% (4.38)%(1)
RATIOS/SUPPLEMENTAL DATA:
Net assets, end of period................................... $284,833,863 $289,134,958
Ratio of expenses to average net assets..................... 1.01% 1.05%(2)
Ratio of net investment income to average net assets........ 1.63% 1.09%(2)
Portfolio turnover rate..................................... 71% 24%(1)
* Commencement of operations.
(1) Not annualized.
(2) Annualized.
See Notes to the Financial Statements
10
- --------------------------------------------------------------------------------
REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Trustees and Shareholders of Hotchkis and Wiley Variable Trust:
In our opinion, the accompanying statement of assets and liabilities, including
the schedule of investments, and the related statements of operations and of
changes in net assets and the financial highlights present fairly, in all
material respects, the financial position of the International VIP Portfolio
(one of the four portfolios of Hotchkis and Wiley Variable Trust, the "Fund") at
December 31, 1999, the results of its operations, the changes in its net assets
and the financial highlights for each of the periods indicated, in conformity
with accounting principles generally accepted in the United States. These
financial statements and financial highlights (hereafter referred to as
"financial statements") are the responsibility of the Fund's management; our
responsibility is to express an opinion on these financial statements based on
our audits. We conducted our audits of these financial statements in accordance
with auditing standards generally accepted in the United States, which require
that we plan and perform the audit to obtain reasonable assurance about whether
the financial statements are free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and disclosures in
the financial statements, assessing the accounting principles used and
significant estimates made by management, and evaluating the overall financial
statement presentation. We believe that our audits, which included confirmation
of securities at December 31, 1999 by correspondence with the custodian, provide
a reasonable basis for the opinion expressed above.
PRICEWATERHOUSECOOPERS
Milwaukee, WI
February 17, 2000
11
SCHEDULE OF INVESTMENTS -- DECEMBER 31, 1999
- --------------------------------------------------------------------------------
LOW DURATION VIP PORTFOLIO
CORPORATE BONDS Principal
AND NOTES -- 27.4% Amount Value
- ------------------------------------------------------------
BANKS -- 2.9%
............................................................
Sovereign Bancorp, 6.625%,
3/15/2001 $ 50,000 $ 48,755
- ------------------------------------------------------------
EUROBANKS -- 10.2%
............................................................
National Westminster Bank P.L.C
6.62%, 9/16/2002 # 75,000 75,125
............................................................
Okobank, CLB 9/09/2002, 6.62%,
9/29/2049 # 50,000 49,252
............................................................
Svenska Hndls Banken, CLB
3/03/2002, 6.6212%, 3/29/2049 # 50,000 49,331
...................... ....................... ---------
173,708
- ------------------------------------------------------------
FINANCIAL SERVICES -- 4.4%
............................................................
Lehman Brothers Holdings, 7.000%,
10/01/2002 25,000 24,773
............................................................
U.S. West Capital Funding,
(Acquired 6/03/1999, cost
$50,000), 6.5712%, 6/15/2000 # r 50,000 49,990
...................... ....................... ---------
74,763
- ------------------------------------------------------------
OIL -- INTEGRATED -- 2.9%
............................................................
Occidental Petroleum Corp., 6.24%,
11/24/2000 50,000 49,661
- ------------------------------------------------------------
RETAIL -- 2.5%
............................................................
Rite Aid Corp., (Acquired
12/16/1998, cost $49,914),
5.500%, 12/15/2000 r 50,000 43,250
- ------------------------------------------------------------
TELECOMMUNICATIONS -- 1.6%
............................................................
Sprint Spectrum L.P., CLB
8/15/2001, 11.00%, 8/15/2006 25,000 27,641
- ------------------------------------------------------------
TRANSPORTATION -- 2.9%
............................................................
Bombardier Capital, Inc.,
(Acquired 1/22/1999, cost
$49,897), 6.00%, 1/15/2002 r 50,000 48,757
...................... ....................... ---------
Total corporate bonds and notes 466,535
(cost $476,538)
- ------------------------------------------------------------
GOVERNMENT AGENCY
MORTGAGE-BACKED Principal
SECURITIES -- 8.8% Amount Value
- ------------------------------------------------------------
COLLATERALIZED MORTGAGE OBLIGATIONS -- 8.7%
............................................................
Federal National Mortgage Association,
............................................................
1993-142 SA, 8.957%, 10/25/2022
# $ 7,329 $ 6,818
............................................................
1997-76 FT, 6.8687%, 9/17/2027 # 22,142 20,622
............................................................
Pool # 508757, 6.3610%,
8/01/2029 122,992 119,764
...................... ....................... ---------
147,204
- ------------------------------------------------------------
STRIPPED MORTGAGE-BACKED SECURITIES -- 0.1%
............................................................
Federal National Mortgage
Association,
1998-48 CI (IO), 6.50%,
8/25/2028 8,050 1,664
...................... ....................... ---------
Total government agency mortgage-
backed securities
148,868
(cost $152,007)
- ------------------------------------------------------------
NON-AGENCY MORTGAGE-BACKED SECURITIES -- 32.1%
- ------------------------------------------------------------
ASSET-BACKED SECURITIES -- 25.2%
............................................................
Asset Backed Funding Certificates,
CLB, 1999-1 A2F, 7.641%,
10/25/2030 24,940 24,885
............................................................
Associates Manufactured Housing
Pass Through Certificates, CLB,
1996-2 A4, 6.60%, 6/15/2027 75,000 74,172
............................................................
Champion Auto Grantor Trust,
(Acquired 3/18/1998, cost
$10,827) CLB, 1998-A A, 6.11%,
10/15/2002 r 10,827 10,814
............................................................
Chemical Master Credit Card Trust
1, CLB, 1995-2 A, 6.23%,
6/15/2003 25,000 24,948
............................................................
CIT Marine Trust, CLB, 1999-A A2,
5.80%, 4/15/2010 50,000 48,214
............................................................
DiTech Home Loan Owner Trust, CLB,
1997-1 A2, 6.59%, 4/15/2013 9,548 9,530
............................................................
Green Tree Recreational, Equipment
& Consumer Trust, CLB:
............................................................
1996-B CTFS, 7.70%, 7/15/2018 50,000 48,009
............................................................
1996-C A1, 6.7025%, 10/15/2017 # 45,016 45,043
............................................................
See Notes to the Financial Statements
1
SCHEDULE OF INVESTMENTS -- DECEMBER 31, 1999
- --------------------------------------------------------------------------------
LOW DURATION VIP PORTFOLIO
Principal
Amount Value
- ------------------------------------------------------------
Nationslink Funding Corporation,
CLB, 1999-SL A1V, 6.8187%,
4/10/2007 # $ 64,750 $ 64,772
............................................................
Navistar Financial Corporation
Owner Trust, CLB, 1996-B A3,
6.33%, 4/21/2003 38,999 39,006
............................................................
Nomura Asset Securities
Corporation, CLB, 1995-MD3 A1A,
8.17%, 3/04/2020 38,227 38,787
...................... ....................... ---------
428,180
- ------------------------------------------------------------
COLLATERALIZED MORTGAGE OBLIGATIONS -- 6.9%
............................................................
Citicorp Mortgage Securities,
Inc., CLB, 1997-3 A2, 6.92%,
8/25/2027 2,861 2,854
............................................................
First Union-Lehman Brothers
Commercial Mortgage Trust, CLB,
1997-C1 A1, 7.15%, 2/18/2004 23,157 23,017
............................................................
Nomura Depositor Trust, (Acquired
9/03/1999, cost $49,104),
1998-ST1A A3A, 7.0125%, 1/15/2003
# r 50,000 49,031
............................................................
Ocwen Residential MBS Corp.,
(Acquired 6/18/1998, cost
$29,431), CLB, 1998-R2
AP,6.4416%, 11/25/2034 # r 29,468 29,192
............................................................
Residential Funding Mortgage
Securities, Inc., CLB, 1998-S17
A6, 6.75%, 8/25/2028 12,856 12,815
...................... ....................... ---------
116,909
...................... ....................... ---------
Total non-agency mortgage-backed securities 545,089
(cost $553,828)
- ------------------------------------------------------------
U.S. TREASURY Principal
OBLIGATIONS -- 24.0% Amount Value
- ------------------------------------------------------------
U.S. TREASURY NOTES:
............................................................
5.50%, 2/29/2000 125,000 125,078
............................................................
6.25%, 6/30/2002 185,000 184,942
............................................................
5.75%, 10/31/2002 100,000 98,625
...................... ....................... ---------
Total U.S. Treasury obligations 408,645
(cost $413,402)
- ------------------------------------------------------------
- ------------------------------------------------------------
Principal
Amount Value
- ------------------------------------------------------------
VARIABLE RATE
DEMAND NOTES* -- 6.0%
- ------------------------------------------------------------
General Mills, Inc., 6.095% $ 60,723 $ 60,723
............................................................
Pitney Bowes, Inc., 6.095% 41,653 41,653
...................... ....................... ---------
Total variable rate demand notes
(cost $102,376) 102,376
- ------------------------------------------------------------
Total investments -- 98.3%
(cost $1,698,151) 1,671,513
............................................................
Other assets in excess of liabilities -- 1.7% 29,372
...................... ....................... ---------
Total net assets -- 100.0% $1,700,885
- ------------------------------------------------------------
# -- Variable rate security. The rate listed is as of December 31, 1999.
* -- Variable rate demand notes are considered short-term obligations and are
payable on demand. Interest rates change periodically on specified dates. The
rates listed are as of December 31, 1999.
IO -- Interest only.
CLB -- Callable.
r -- Restricted Security. Purchased in a private placement transaction; resale
to the public may require registration or may be limited to qualified
institutional buyers.
See Notes to the Financial Statements
2
STATEMENT OF ASSETS AND LIABILITIES
- --------------------------------------------------------------------------------
LOW DURATION VIP PORTFOLIO December 31, 1999
- -------------------------------------------------------------------------------
ASSETS:
Investments, at value*.................................... $1,671,513
Cash...................................................... 4,523
Receivable from Advisor................................... 22,855
Dividends and interest receivable......................... 14,404
Organizational expenses, net of accumulated
amortization............................................ 11,987
Prepaid expenses.......................................... 15
----------
Total assets.......................................... 1,725,297
----------
LIABILITIES:
Dividends payable......................................... 8,187
Accrued expenses and other liabilities.................... 16,225
----------
Total liabilities..................................... 24,412
----------
Net assets............................................ $1,700,885
==========
NET ASSETS CONSIST OF:
Paid in capital........................................... $1,744,882
Undistributed net investment income....................... 2,784
Accumulated net realized loss on securities............... (20,143)
Net unrealized depreciation of securities................. (26,638)
----------
Net assets............................................ $1,700,885
==========
CALCULATION OF NET ASSET VALUE PER SHARE:
Shares outstanding (unlimited shares of no par value
authorized)............................................. 174,932
Net asset value per share (offering and redemption
price).................................................. $ 9.72
==========
*Cost of Investments........................................ $1,698,151
==========
See Notes to the Financial Statements
3
STATEMENT OF OPERATIONS
- --------------------------------------------------------------------------------
Year Ended
LOW DURATION VIP PORTFOLIO December 31, 1999
- -------------------------------------------------------------------------------
INVESTMENT INCOME:
Income
Interest................................................ $100,600
--------
Total income........................................ 100,600
--------
Expenses
Advisory fee............................................ 7,842
Legal and auditing fees................................. 537
Custodian fees and expenses............................. 5,040
Accounting and transfer agent fees and expenses......... 36,501
Administration fee...................................... 773
Trustees' fees and expenses............................. 669
Reports to shareholders................................. 12,445
Registration fees....................................... 38
Amortization of organizational expenses................. 4,196
Other expenses.......................................... 74
--------
Total expenses...................................... 68,115
Less, expense reimbursement............................. (58,227)
--------
Net expenses........................................ 9,888
--------
Net investment income................................... 90,712
--------
REALIZED AND UNREALIZED LOSS ON INVESTMENTS:
Net realized loss on securities......................... (17,121)
Net change in unrealized depreciation of securities..... (25,481)
--------
Net loss on investments................................... (42,602)
--------
NET INCREASE IN NET ASSETS RESULTING FROM OPERATIONS........ $ 48,110
========
See Notes to the Financial Statements
4
STATEMENT OF CHANGES IN NET ASSETS
- --------------------------------------------------------------------------------
March 18, 1998**
Year Ended through
LOW DURATION VIP PORTFOLIO December 31, 1999 December 31, 1998
- ---------------------------------------------------------------------------------------------------
OPERATIONS:
Net investment income................................... $ 90,712 $ 61,726
Net realized loss on securities......................... (17,121) (143)
Net change in unrealized depreciation of securities..... (25,481) (1,157)
---------- ----------
Net increase in net assets resulting from
operations.......................................... 48,110 60,426
---------- ----------
DIVIDENDS AND DISTRIBUTIONS TO SHAREHOLDERS:
Net investment income................................... (91,719) (64,700)
---------- ----------
FUND SHARE TRANSACTIONS:
Net proceeds from shares sold........................... 227,553 1,713,346
Shares issued in connection with payment of dividends
and distributions...................................... 91,307 56,925
Cost of shares redeemed................................. (298,114) (42,249)
---------- ----------
Net increase in net assets from Fund share
transactions........................................ 20,746 1,728,022
---------- ----------
Total increase (decrease) in net assets..................... (22,863) 1,723,748
NET ASSETS:
Beginning of period..................................... 1,723,748 --
---------- ----------
End of period*.......................................... $1,700,885 $1,723,748
========== ==========
*Including undistributed net investment income of: $ 2,784 $ 1,612
========== ==========
CHANGES IN SHARES OUTSTANDING:
Shares sold............................................. 22,957 171,309
Shares issued in connection with payment of dividends
and distributions...................................... 9,271 5,683
Shares redeemed......................................... (30,071) (4,217)
---------- ----------
Net increase........................................ 2,157 172,775
========== ==========
** Commencement of operations.
See Notes to the Financial Statements
5
NOTES TO THE FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
DECEMBER 31, 1999
NOTE 1.
ACCOUNTING POLICIES. The Low Duration VIP Portfolio (the "Fund") is a series of
Hotchkis and Wiley Variable Trust (the "Trust"), an open-end, management
investment company organized as a Massachusetts business trust on February 4,
1997 and registered under the Investment Company Act of 1940. The Fund commenced
operations on March 18, 1998. The Fund seeks to maximize total return,
consistent with preservation of capital. Shares of the Fund are not offered to
the general public but may only be purchased by the separate accounts of
participating insurance companies for the purpose of funding variable annuity
contracts and/or variable life insurance contracts. In addition to the Fund, the
Trust offers the Equity Income VIP Portfolio, the International VIP Portfolio
and the Total Return Bond VIP Portfolio (collectively, the "Funds"). The assets
of each series are invested in separate, independently managed portfolios. The
following is a summary of significant accounting policies followed by the Fund
in the preparation of the financial statements.
ORGANIZATIONAL EXPENSES: Expenses incurred by the Trust in connection with the
organization, registration and the initial public offering of shares are being
deferred and amortized over the period of benefit, but not to exceed sixty
months from the Trust's commencement of operations. The proceeds of any
redemption of the initial shares by the original shareholder will be reduced by
a pro-rata portion of any then unamortized organization expenses in the same
proportion as the number of initial shares being redeemed bears to the number of
initial shares outstanding at the time of such redemption.
SECURITY VALUATION: Portfolio securities that are listed on a securities
exchange (whether domestic or foreign) or The Nasdaq Stock Market ("NSM") are
valued at the last sale price as of 4:00 p.m., Eastern Time, or, in the absence
of recorded sales, at the average of readily available closing bid and asked
prices on such exchange or NSM. Unlisted securities that are not included in NSM
are valued at the average of the quoted bid and asked price in the
over-the-counter market. Fixed-income securities are normally valued on the
basis of quotes obtained from broker-dealers or pricing services. Certain
fixed-income securities for which daily market quotations are not readily
available may be valued pursuant to guidelines established by the Board of
Trustees, with reference to fixed-income securities whose prices are more
readily obtainable or an appropriate matrix utilizing similar factors. As a
broader market does not exist, the proceeds received upon the disposition of
such securities may differ from values previously furnished by such methods.
Securities for which market quotations are not otherwise available are valued at
fair value as determined in good faith by Hotchkis and Wiley (the "Advisor")
under procedures established by the Board of Trustees. Short-term investments
which mature in less than 60 days are valued at amortized cost (unless the Board
of Trustees determines that this method does not represent fair value), if their
original maturity was 60 days or less, or by amortizing the values as of the
61st day prior to maturity, if their original term to maturity exceeded 60 days.
FEDERAL INCOME TAXES: It is the Fund's policy to meet the requirements of the
Internal Revenue Code applicable to regulated investment companies and the Fund
intends to distribute substantially all of its investment company net taxable
income and net capital gains to shareholders. Therefore, no federal income tax
provision is required.
EXPENSE ALLOCATION: Common expenses incurred by the Trust are allocated among
the Funds based upon (i) relative average net assets, (ii) as incurred on a
specific identification basis, or (iii) evenly among the Funds, depending on the
nature of the expenditure.
6
RESTRICTED SECURITIES: The Fund owns investment securities which are
unregistered and thus restricted as to resale. Resale to the public may require
registration or may be limited to qualified institutional buyers. At December
31, 1999, the Fund had restricted securities with an aggregate market value of
$231,034, representing 14% of the net assets of the Fund.
WHEN-ISSUED SECURITIES: The Fund may purchase securities on a when-issued or
delayed delivery basis. Although the payment and interest terms of these
securities are established at the time the purchaser enters into the agreement,
these securities may be delivered and paid for at a future date, generally
within 45 days. The Fund records purchases of when-issued securities and
reflects the values of such securities in determining net asset value in the
same manner as other portfolio securities. The Fund segregates and maintains at
all times cash or other liquid assets in an amount at least equal to the amount
of outstanding commitments for when-issued securities.
USE OF ESTIMATES: The preparation of financial statements in conformity with
generally accepted accounting principles requires management to make estimates
and assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ from those estimates.
DISTRIBUTIONS TO SHAREHOLDERS: Dividends from net investment income are declared
and paid monthly. Distributions of net realized capital gains, if any, will be
declared and paid at least annually.
OTHER: Security and shareholder transactions are recorded on trade date.
Realized gains and losses on sales of investments are calculated on the
identified cost basis. Dividend income and dividends and distributions to
shareholders are recorded on the ex-dividend date. Interest income is recognized
on the accrual basis. Generally accepted accounting principles require that
permanent financial reporting and tax differences relating to shareholder
distributions be reclassified within the capital accounts.
NOTE 2.
INVESTMENT ADVISORY AGREEMENT. The Fund has an investment advisory agreement
with the Advisor, with whom certain officers and Trustees of the Trust are
affiliated. The Advisor is a division of Merrill Lynch Asset Management, L.P.,
an indirect wholly-owned subsidiary of Merrill Lynch & Co., Inc. The Advisor
receives a fee, computed daily and payable monthly, at the annual rate of 0.46%
as applied to the Fund's daily net assets. The Advisor has agreed to pay all
operating expenses in excess of 0.58% as applied to the Fund's daily net assets.
For the year ended December 31, 1999, the Adviser paid $58,227 of operating
expenses on behalf of the Fund.
As permitted under Rule 10f-3 of the Investment Company Act of 1940, the Board
of Trustees of the Trust has adopted procedures which allow the Fund, under
certain conditions described in the Rule, to acquire newly-issued securities
from a member of an underwriting group in which an affiliated underwriter
participates.
7
NOTE 3.
CREDIT FACILITY. Effective December 3, 1999, the Fund entered into a one year
Credit Agreement with a syndicate of bank lenders led by Bank of America
intended to provide the Fund with a source of cash to be used to meet redemption
requests from Fund shareholders. The Fund together with certain other open-end
investment companies advised by Merrill Lynch Asset Management, L.P. and/or its
affiliates may borrow in the aggregate up to $1,000,000,000, except that in no
event may the borrowing by the Fund or any participating fund be in excess of
that permitted by its prospectus and Statement of Additional Information or by
applicable law. The Fund had no borrowings under the Credit Agreement in 1999.
NOTE 4.
SECURITIES TRANSACTIONS. Purchases and sales of investment securities, other
than short-term investments, for the year ended December 31, 1999, were as
follows:
Purchases Sales
-------------------------- --------------------------
Fund U.S. Government Other U.S. Government Other
- ---------------------------------------------------------------------------------------------------------------
Low Duration VIP Portfolio............................ $1,266,280 $968,247 $1,483,209 $712,763
As of December 31, 1999, unrealized appreciation (depreciation) for federal
income tax purposes was as follows:
Net Appreciated Depreciated
Fund Depreciation Securities Securities
- ------------------------------------------------------------------------------------------------------
Low Duration VIP Portfolio.................................. $(26,638) $410 $(27,048)
At December 31, 1999, the cost of investments for federal income tax purposes
was $1,698,151. Any differences between book and tax are due primarily to wash
sale losses.
At December 31, 1999, the Fund had accumulated net realized capital loss
carryovers of $3,361 expiring in 2006 and $16,782 expiring in 2007. To the
extent that the Fund realizes future net capital gains, those gains will be
offset by any unused capital loss carryover.
NOTE 5.
FEDERAL TAX DISCLOSURE (UNAUDITED). For the year ended December 31, 1999, 23% of
dividends distributed were derived from interest on U.S. government securities
which is generally exempt from state income tax.
8
FINANCIAL HIGHLIGHTS
- --------------------------------------------------------------------------------
March 18, 1998*
Year Ended through
LOW DURATION VIP PORTFOLIO December 31, 1999 December 31, 1998
- ---------------------------------------------------------------------------------------------------
Net Asset Value, Beginning of Period........................ $ 9.98 $ 10.00
---------- ----------
Income from Investment Operations:
Net investment income................................... 0.54 0.46
Net realized and unrealized loss on investments......... (0.27) (0.03)
---------- ----------
Total from investment operations........................ 0.27 0.43
---------- ----------
Less Distributions:
Dividends (from net investment income).................. (0.53) (0.45)
---------- ----------
Net Asset Value, End of Period.............................. $ 9.72 $ 9.98
========== ==========
Total Return................................................ 2.80% 4.40%(1)
RATIOS/SUPPLEMENTAL DATA:
Net assets, end of period................................... $1,700,885 $1,723,748
Ratio of expenses to average net assets
Before expense reimbursement............................ 4.00% 5.56%(2)
After expense reimbursement............................. 0.58% 0.58%(2)
Ratio of net investment income to average net assets
Before expense reimbursement............................ 1.90% 0.47%(2)
After expense reimbursement............................. 5.32% 5.45%(2)
Portfolio turnover rate..................................... 137% 296%(1)
* Commencement of operations.
(1) Not annualized.
(2) Annualized.
See Notes to the Financial Statements
9
- --------------------------------------------------------------------------------
REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Trustees and Shareholders of Hotchkis and Wiley Variable Trust:
In our opinion, the accompanying statement of assets and liabilities, including
the schedule of investments, and the related statements of operations and of
changes in net assets and the financial highlights present fairly, in all
material respects, the financial position of the Low Duration VIP Portfolio (one
of the four portfolios of Hotchkis and Wiley Variable Trust, the "Fund") at
December 31, 1999, the results of its operations, the changes in its net assets
and the financial highlights for each of the periods indicated, in conformity
with accounting principles generally accepted in the United States. These
financial statements and financial highlights (hereafter referred to as
"financial statements") are the responsibility of the Fund's management; our
responsibility is to express an opinion on these financial statements based on
our audits. We conducted our audits of these financial statements in accordance
with auditing standards generally accepted in the United States, which require
that we plan and perform the audit to obtain reasonable assurance about whether
the financial statements are free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and disclosures in
the financial statements, assessing the accounting principles used and
significant estimates made by management, and evaluating the overall financial
statement presentation. We believe that our audits, which included confirmation
of securities at December 31, 1999 by correspondence with the custodian, provide
a reasonable basis for the opinion expressed above.
PRICEWATERHOUSECOOPERS LLP
Milwaukee, WI
February 17, 2000
10