Harvard Business School

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BEA Associates: Enhanced Equity Index Funds
On the afternoon of July 13, 1992, Messrs. Jeffrey Geller and David DeRosa, derivatives portfolio managers at BEA Associates, were considering alternative ways of investing the assets of a new $100 million enhanced index account. They wanted to find the most attractive combination of derivative and cash market positions to achieve the client's objective which was to outperform the S&P 500 stock index by 50 basis points in a low risk manner. The alternatives included the use of over-the-counter equity swaps, a relatively new financial instrument that had proliferated in recent years.

BEA Associates
BEA Associates was an investment advisory firm founded as Basic Economic Appraisals in 1934. As of March 31, 1992, the firm managed $15.4 billion representing over 164 institutional clients. Its separate accounts clients were principally corporate, public, and multiemployer pension funds, and foundations and endowments. BEA also managed several mutual and commingled funds, and a number of closed-end country funds. The firm employed 33 investment professionals—most of whom had 10 years or more of experience—and 76 support staff. BEA offered a variety of specialized investment management services grouped under equities ($3.4 billion), fixed income ($5.6 billion), derivative-based strategies ($5 billion), and international equities ($1.6 billion). (See Exhibit 1). The firm boasted strong performance records in each of these product areas. BEA also offered clients investment consulting services in the areas of hedging and asset/liability management, pension funding and asset allocation, and transactions cost measurement, all fields in which the firm considered itself to be an innovator and industry leader.

Derivatives Management
BEA's investment philosophy was to emphasize return enhancement as well as risk control, the objective being to seek maximum return per unit of risk, or minimum risk per unit of return. The firm also aimed to offer clients a high degree of product customization. In pursuit of these aims, BEA made extensive use of derivative instruments such as options, futures, and swaps.

This case was written by Professor André F. Perold as the basis for class discussion rather than to illustrate either effective or ineffective handling of an administrative situation. Copyright © 1992 by the President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call 1-800-545-7685, write Harvard Business School Publishing, Boston, MA 02163, or go to http://www.hbsp.harvard.edu. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means—electronic, mechanical, photocopying, recording, or otherwise—without the permission of Harvard Business School.

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In its more traditional equity and fixed-income portfolios, where outperformance was sought principally by investing in attractively valued stocks, bonds, and other physical securities, derivatives were used mainly as a low-cost way of controlling market risk and currency risk. In its derivativesbased portfolios, derivative instruments were used much more extensively both to manage desired portfolio risk exposures and, through various arbitrage-like strategies, to generate incremental returns. Derivatives-based products consisted primarily of enhanced equity index funds ($1.6 billion, described more fully below) and portfolio hedging ($3.2 billion). Portfolio hedging involved overlaying on top of an already existing portfolio a series of derivative hedge positions designed to tailor the portfolio's exposure to broad market risks such as currency risk, interest rate risk, or equity market risk. A typical hedge program would be aimed at limiting the portfolio's downside exposure while retaining much of the upside exposure to the risk in question. BEA's derivatives group was formed in 1982. Currently, the group consisted of three portfolio managers, two traders, and two portfolio assistants. The portfolio managers were Jeffrey Geller, Managing Director, head and founder of the group, David DeRosa, and Vincent Bailey; the traders were Mark Barres and Mario Montoya. Each member of the group had a particular area of specialization and a strong background in the area of derivatives.1 Investment decisions were made by each portfolio manager individually, but only after discussion with the traders and other portfolio managers. No "new" kinds of trades could be implemented without Jeffrey Geller's approval. The complexity and ongoing maintenance requirements of derivative strategies made such group consultation a critical part of quality and risk control.

Enhanced Equity Index Funds
David DeRosa explained the basis of BEA's approach to enhanced equity index fund management: Compare investing in an S&P 500 index fund with the synthetic alternative of investing in money market securities and buying S&P 500 futures. In the case of the index fund, your cash goes to purchase the stocks in the index, and your return comes in the form of dividend income plus capital gains or losses on the stocks. You forego interest on the cash. In the synthetic alternative, you do not pay anything for your futures position, and you earn capital gains or losses on the futures contract which will closely mirror the gains or losses in the index. You forego the dividends on the stocks, but you earn interest on the cash. If the futures are correctly priced,2 these two strategies should produce virtually identical results—regardless of the subsequent direction taken by the market. The two methods will thus be economically equivalent. The futures approach has several actual and potential advantages: First, index futures have much lower transaction costs than stocks (roughly a 15:1 advantage), and much lower custodial and administrative costs. Second, implicit in the futures price is an interest rate, usually above the Treasury bill rate and slightly below LIBOR (applicable to the term of the contract). If you can earn returns on your cash in excess

1Mr. Geller and Mr. DeRosa, for example, each had 14 years of experience investing with derivatives, and had

authored books (in the case of Mr. DeRosa) and articles on the use of derivatives. Both had graduated from the University of Chicago Graduate School of Business, Mr. Geller with an MBA, Mr. DeRosa with a Ph.D. 2That is, according to the cost-of-carry model in which the futures price equals the price of the underlying stocks plus the interest that can be earned on the cash minus the dividends foregone by not owning the stocks. 2
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of this "implied repo" rate, say by 40 basis points, the futures strategy will outperform the index fund strategy by the 40 basis point spread. Third, futures contracts need to be rolled over on or before their maturity date. This "calendar roll" can be accomplished at a profit whenever the further out contract is attractively priced. The principal disadvantages of the derivatives approach stem from the loss of potential stock loan fees (quite small in the case of the S&P 500), and from the risk that the far contract will be unfavorably priced at the time of a rollover. To date, BEA had been highly successful in implementing the synthetic approach (see Exhibit 2), consistently earning returns in excess of the index averaging 80 basis points per annum. This outperformance stemmed mainly from historically favorable mispricing of the futures calendar roll— from which the firm had devised ways to profit by as much as 30 basis points per annum—and also from various arbitrage techniques that the firm employed to obtain enhanced cash returns. The enhanced cash strategies involved buying certain securities and selling short related securities. BEA had done arbitrage trades involving a broad range of fixed income securities, convertible bonds, stock index baskets, stock index options, currency options, and other derivative instruments. The riskiness of these strategies varied from almost no risk to moderate risk, and the returns tended to vary commensurately. Accounts were categorized by degree of risk tolerance, and matched with enhanced cash strategies of appropriate riskiness. Recently, the bulk of BEA's cash enhancement trades involved positions designed to take advantage of the mean-reverting pattern in the volatility of markets. In these trades, BEA would usually be a "buyer of cheap volatility," but occasionally a "seller of expensive volatility" after a large informational shock to a market as in October, 1987. For example, the actual volatility of U.S. stocks and the $/DM and $/Yen exchange rates currently appeared far higher than the volatility assumptions implicit in the prices of options on the S&P 500, the $/DM, and the $/Yen. BEA was considering trying to benefit from this discrepancy by purchasing "straddles" (combinations of puts and calls) on these markets, and dynamically hedging out the exposure of the position to directional moves in the markets. BEA was also contemplating doing the exact opposite—selling puts and calls— in the Japanese stock market which, after its recent tumultuous plunge, appeared far less volatile than what was implied by the prices of Japanese stock index options.

Over-the-Counter Derivatives
Gaining exposure to the S&P 500 through index futures was but one way to obtain the index return synthetically. Over-the-counter derivative securities like index-linked swaps represented another alternative. (The exact mechanics of some of these securities is described later in the case.) Unlike derivatives traded on organized exchanges, over-the-counter derivatives involved bilateral negotiations between parties (usually between dealers and their customers). Standardization of terms was less important in this market, permitting a greater degree of customization. There was also no central clearing house to monitor collateral and enforce the performance of counterparty obligations. Accordingly, participation in this market required close attention to the management of counterparty risk. Over-the-counter derivative contracts have existed at least since the seventeenth century.3 However, the volume in over-the-counter derivatives only began to mushroom in the mid 1980s, first

3A 1688 treatise by Joseph de la Vega reveals that options and other derivative contracts were actively traded on

the Amsterdam stock exchange at that time. In Capital Ideas (The Free Press, 1992), Peter Bernstein reports that in Book I of Politics, Aristotle tells an anecdote about Thales that makes mention of a financial option. 3
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with the proliferation of interest rate swaps, caps, and floors, then foreign currency swaps and options and, quite recently, equity-linked swaps and related securities. The notional amount of all swap contracts outstanding in 1992 was estimated at in excess of $3 trillion. While the interest rate swap market initially grew out the needs of debt issuers, the equitylinked swap and related derivatives market was primarily investor-driven. Financial institutions would write these contracts to create custom products for investors. Examples of some of the more esoteric contracts included currency-hedged equity index swaps, which would allow the investor to contractually receive the return on a foreign stock market hedged into dollars without the investor having to own any foreign stocks or engage someone to perform the currency hedging; and asset allocation swaps which, for example, could allow the investor to maintain a constant 60/40 stock/bond allocation without having to rebalance as market movements drove the existing allocation away from its target ratio. Any of these swaps could be tailored to have additional features such as a minimum downside risk or early termination under certain market conditions, for example, after a market index had appreciated 20%. Variants of these swap contracts came in the form of over-the-counter index-linked notes. These were medium-term notes whose final redemption value floated with the return on the index of choice (for example, the currency-hedged return on a foreign stock market; or the return on the S&P 500 with downside protection). Index-linked notes and swaps were not always accorded the same tax treatment. For example, until recently, swaps had not been granted safe harbor from the unrelated business income tax (UBIT) that could be assessed on U.S. tax-exempt investors like pension funds. On the other hand, index-linked notes were exempt from UBIT because they qualified as debt securities. Index-linked notes had increasingly been issued to meet demand from U.S. tax-exempt investors. A long-awaited July 1992 Internal Revenue Service ruling stating that U.S. tax-exempt institutions could not be taxed on income earned on swap contracts was expected to give a strong boost the over-the-counter derivatives market.

The Client
BEA's new enhanced index client was an Luxembourg subsidiary of a Japanese life insurance company. The $100 million was part of the insurer's global equity portfolio, and was to be invested with the goal of outperforming the S&P 500 by 50 basis points per annum without taking substantial risk.4 he insurer had approached BEA after hearing a presentation from a Wall Street firm on indexlinked notes. The firm had offered to issue the insurer a three-year note with a 2.65% coupon paid semiannually, and final principal equal to par value multiplied by the ratio of the S&P 500 index level at the end of year three to the level of the S&P 500 currently. The all-in price of the note was par, here equal to $100 million. The issuer's publicly traded medium-term notes were A-rated. The insurer had invited a comparison of BEA's enhanced equity product with this note offering and had decided to invest instead with BEA. Under the terms of the investment advisory agreement, the client permitted BEA to create the portfolio's S&P 500 exposure with the use of futures, options, swaps, or index-linked notes, and to seek enhanced cash returns by taking offsetting positions in cash market and derivative securities. Counterparties had to have A1/P1 commercial paper ratings and be rated A or better for longer-term debt. Swap agreements had to conform to the standards set by the International Swap Dealers Association (ISDA).

4Performance would be measured in U.S. dollars.

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The client had also asked BEA to be cognizant of withholding taxes in performing its calculations. Most countries imposed substantial withholding taxes on dividends declared by publicly-held corporations, of which about half usually could be recovered under tax treaties, if applicable. Ironically, investors domiciled in countries normally regarded as "tax havens," like Luxembourg, usually were unable to recover withholding taxes. Exhibit 6 contains information on withholding taxes for specific countries.

The Decision at Hand
In deciding how to invest the money, Mr. Geller and Mr. DeRosa first wanted to evaluate how to best create the portfolio's exposure to the S&P 500. They started by evaluating the current pricing of the S&P 500 index futures contracts. Trader Mark Barres had supplied them with pricing and other information pertinent to the September and December contracts. (See Exhibit 3.) With the S&P 500 index futures market being one of the most liquid in the world, transaction costs would be small. Commissions were $20 per contract on a round-trip basis (about one basis point per dollar of exposure), and the bid-ask spread for $100 million of exposure was currently .10 "S&P points" or 2.4 basis points. The position would require initial margin of $10,000 per contract (4.8%) which BEA would post in the form of U.S. Treasury bills maturing within six months. Mr. Barres opined that the futures contracts seemed better priced than in recent days, as did the calendar roll. Instead of using index futures to obtain its stock market exposure, BEA could enter into an S&P 500 index swap. In conversations with various dealers earlier in the day, the best Mr. DeRosa could find in the required size was a three-year swap at LIBOR minus 10 basis points. That is, BEA would make quarterly payments to the dealer of three-month LIBOR minus 10 basis points, and the dealer would make quarterly payments to BEA of the total quarterly return on the S&P 500, both payments based on a notional amount that would begin at $100 million and be increased or decreased at the end of each quarter in proportion to the total return on the S&P 500. Payments would be netted so that only the difference between the index return and LIBOR minus 10 basis points would be paid to BEA if the difference was positive, or paid by BEA to the dealer if the difference was negative. The dealer was a prominent A and A1/P1-rated New York investment bank.

Enhanced Cash Alternatives
Mr. Geller and Mr. DeRosa currently were considering two enhanced cash alternatives. The first involved purchasing the basket of stocks in the Morgan Stanley Europe Australia Far East (EAFE) index and entering into a swap agreement much like the S&P 500 swap described above, except that BEA would pay the EAFE return on the basket and receive LIBOR plus or minus a spread. EAFE swaps were being done fairly regularly, reflecting increased investing abroad by U.S. institutions. Summary information on the EAFE index is provided in Exhibit 4. During the morning, Mr. DeRosa had tried to negotiate favorable terms on a three-year swap with a AAA-rated bank. As in the previously mentioned swap, payments would be netted and made quarterly; the notional amount would begin at $100 million and be increased or decreased at the end of each quarter in proportion to the total return on the EAFE index. The index return—calculated by Morgan Stanley—assumed withholding taxes on dividends from the perspective of a Luxembourg investor. Initially, the bank had offered to pay Mr. DeRosa three-month LIBOR minus 80 basis points in return for receiving the total return on the EAFE index. After considerable haggling, the bank had agreed to do it for LIBOR even. Mr. DeRosa felt he could probably do still better (perhaps by five basis points or so) if he bided his time and waited for a special opportunity.

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There were a variety of factors to be taken into account in analyzing this alternative. First, BEA's traders had estimated that the round-trip transaction cost to purchase, and eventually sell, the EAFE stocks would be about 200 basis points inclusive of all transfer taxes, commissions, and bid-ask spreads. (See Exhibit 5 for further information on the costs of trading and holding index baskets.) Second, he thought the client could negotiate a custody fee of 7 basis points per annum, a little higher than the custody costs for a typical S&P 500 basket.5 Third, there would be potentially large stock loan fees that could be earned on the portfolio of stocks. In many countries, especially Japan and Germany (which constituted a large fraction of the EAFE index), large amounts of shares were held by institutions that, for reasons of relations with the underlying companies or for regulatory reasons, were unwilling lenders of stock. Short sellers thus found it difficult to borrow shares of stock and had to pay premium loan fees. How these fees were to be divided between custodian and client had to be negotiated. The custodian's willingness to share the fees generally depended on the account size, the portfolio turnover, and the ongoing nature of the client relationship. Based on previous experience, Mr. DeRosa estimated that an EAFE portfolio would, on average, generate about 40 basis points per annum in lending fees, occasionally going as high as 1% on an overnight basis. In contrast, lending fees that could be earned on stocks in the S&P 500 could range as high as 30 basis points per annum on an overnight basis, averaging more like 10 basis points per annum. Negotiations on lending fees were usually a "long and arduous affair." Mr. DeRosa thought the client could probably get its custodian to agree to a 50/50 share of these fees. The second enhanced-cash alternative was an inventory financing trade. BEA had been approached by a major U.S. financial institution wanting to move part of its inventory of Japanese stocks off balance sheet. The institution would sell BEA a $50 million portfolio of these stocks and, for an additional $50 million, a European put option to sell the identical basket of stocks back to it in one year at a price of $100 million plus one-year LIBOR plus 40 basis points (calculated on $100 million). The portfolio contained about 200 names and closely resembled the portfolio comprising the Nikkei stock average. The transaction would be directly between the institution and BEA (acting on the client's behalf) and would involve no additional transactions costs (including savings of Japanese stamp tax of 30 basis points), both at the outset or at the time of exercise of the put option. Mr. DeRosa had received indications that the custody fees for this portfolio would be 10 basis points per annum plus "ticket" costs of $40 each way, and that stock loan fees averaging 60 basis points per annum could be earned, with the split between client and custodian again to be negotiated. The institution in question had an A rating. However, the put option would be written by one of its off-shore subsidiaries created expressly for the purpose of this kind of transaction. The subsidiary had no operations other than a balance sheet of financial assets and liabilities. Having no publicly traded debt outstanding, it was unrated. However, the subsidiary was capitalized and managed in such a way so as to be "about AAA." BEA would be able to inspect its balance sheet and hedging operations on a confidential basis prior to entering into the transaction.

5Custody fees usually had a fixed per annum charge plus a "per ticket" amount (i.e., per company in the

portfolio). Typical charges for an S&P 500 basket were 3 basis points per annum plus $18 per ticket, or $36 on a round-trip basis. On $100 million, the round-trip ticket charges would amount to 500 x $36 ÷ $100 million = 1.8 basis points. Total charges would thus be around 5 basis points for a one-year holding period. 6
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Exhibit 1 BEA Associates Product Line

Equity Management
U.S. Equity Management Convertible Security Management Futures and Options Integrated Equity Balanced Portfolio Global Equity Management Portfolio Hedging

Fixed Income Management
Structured Active Bond Portfolios Investment Grade Bond Management Enhanced Bond Indexing Immunization/Dedication Intermediate Bond Management Fixed Income Hedging High Yield Bond Management Cash Management Municipal Bond Management

Derivatives Management
Portfolio Hedging Enhanced Index Funds Market Neutral Arbitrage Currency Hedging Portfolio liquidation/pension plan restructuring Immunization/structured fixed income Futures and options integrated asset management

International Equity Management
International equity Global equity Emerging markets equity

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Exhibit 2 BEA Enhanced Equity Index Composite (Annualized returns for periods ending 3/31/92a)

Years 1 2 3 4 5

BEA 11.5% 13.1% 15.3% 16.4% 11.2%

S&P 500 11.1% 12.7% 14.8% 15.6% 10.4%

a Before management fees and custodial costs.

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Exhibit 3 Miscellaneous Pricing Information on July 13, 1992

a) S&P 500 index futures contracts
Days until expiration 66 160

Expiration September 1992 December 1992

Price $414.65 $415.15

Dividendsa $2.43 $5.52

LIBORb 3.49% 3.56%

b) Level of S&P 500 index:

$414.87

c) Interest rates

LIBOR
Term (months) 1 2 3 6 9 12 Rate (%)c 3 3/8 3 7/16 3 1/2 3 5/8 3 3/4 3 7/8

U.S. Treasury and Corporate Notes
Corporate spread over Treasurys (bp) Term (years) 1 2 3 U.S. Treasuryd 3.51 4.28 4.77 AAA 10 20 20 AA 15 35 35 A 20 45 45

a Estimated dividends to be received on one unit of the S&P 500. b Applicable LIBOR rate for the term of the contract (expressed as a 365-day bond equivalent yield). c 360 day money-market yield. d Bond-equivalent yield-to-maturity.

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Exhibit 4 Morgan Stanley EAFE Indexa (June 30, 1992)

Country Austria Belgium Denmark Finland France Germany Italy Netherlands Norway Spain Sweden Switzerland United Kingdom Europe Australia Hong Kong Japan New Zealand Singapore/Malaysia Pacific Total EAFE

Capitalization weight as a percentage of index 0.6 1.3 0.8 0.3 7.0 7.8 2.3 3.4 0.5 2.5 1.7 4.1 21.2 53.6 3.0 3.1 38.5 0.4 1.4 46.4 100.0

Dividend yield (%) 1.8 5.2 1.8 2.1 3.4 3.5 3.3 4.3 1.9 5.1 3.2 2.2 5.1 4.1 3.7 3.4 1.1 5.6 1.8 1.5 2.9

a Source: Morgan Stanley & Co.

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Exhibit 5 Estimated Costs Associated with Direct Equity Ownershipa

Stamp taxes and commissions Australia - All-Ordinaries France - CAC-40 Germany - DAX UK - FTSE-100 Japan - TOPIX Netherlands - EOE Switzerland - SMI U.S. - S&P 500 1.60% 0.90 0.50 0.90 0.80 0.75 0.80 0.25

Dealer Spread 1.60% 1.50 1.40 1.20 0.90 1.50 1.50 0.70

Portfolio rebalancingb 0.32% 0.23 0.19 0.21 0.17 0.23 0.23 0.10

Custodyc 0.15% 0.15 0.15 0.15 0.15 0.15 0.15 0.05

a Source:

J.A. Allen and J.L. Showers, "Equity-Index-Linked Derivatives - An Investor's Guide," Salomon Brothers, April, 1991. b Assumes 10% portfolio turnover c Estimates of annual safekeeping, dividend collection, reporting, and other miscellaneous expenses. 11
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Exhibit 6 Dividend Taxationa

Company's Domicile Shareholder's domicile France Germany Hong Kong Italy Japan Luxembourg Switzerland U.K. U.S. 0 25 15 15 25 15 15 15 26.9 26.9 15 26.9 15 15 10 0 0 0 0 0 0 15 32.4 15 15 15 20 15 15 15 15 15 7.5 15 15 15 Germany 15 Hong Kong 0 0 Luxembourg 15 15 15 15 15 Switzer -land 5 15 35 15 15 35

France

Italy 15 32.4 32.4

Japan 15 15 20 15

U.K 15 0 0 15 15 0 15

U.S. 15 15 30 15 15 30 15 15

a Effective rate of dividend withholding tax (%) after deductions and tax credits under tax treaties. Source:

Morgan Stanley & Co. 12
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