RSJ Enhanced Equity Funds1

RSJ is a boutique investment advisory founded by three college friends Jerrad Joseph, Sam
Hyder and Ram Subra. As of March 31, 1992 RSJ managed $15.4 billion representing over
164 institutional clients. Its separate accounts client were principally corporate public, and
multiemployer pension funds, foundations and endowments. RSJ managed several mutual and
commingled funds, and a number of closed-end country funds. The firm employed 7
investment professionals (including the promoters) – most of whom had 10 years or more of
experience – and 16 support staff. RSJ consisted of three portfolio managers who were the
founders, two traders, and two portfolio assistants. Investment decisions were made by each
portfolio manager individually, but only after discussion with the traders the other portfolio
managers. No new form of trade could be carried out without the collective decision.

RSJ offered a variety of specialised 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). The firm boasted strong performance records in each of
these product areas. The company also offered clients investment consulting services in the
area of hedging and asset/liability management, pension funding, asset allocation, and
transactions cost measurement - all fields in which the firm considered itself to be an innovator
and industry leader.

RSJ’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 client a high degree of product customization and made extensive
use of derivatives.

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.
Derivatives-based products consisted primarily of enhanced equity index funds (1.6 billion,)
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.

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Adopted from HBSP

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A typical hedge program would be aimed at limiting the portfolio’s downside exposure while
retaining much of the upside exposure.

Enhanced equity index funds

According to the promoters enhanced equity index fund management means:

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 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 earn interest on the cash.

If the futures are correctly priced, 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 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 (to the term of contract). If you can earn returns
on your cash in excess 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
unfavourably priced at the time of a rollover.

Till date RSJ had been highly successful in implementing the synthetic approach consistently
earning returns in excess of the index averaging 80 basis points per annum. This
outperformance stemmed mainly from historically favourable 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.

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The enhanced cash strategies involved buying certain securities and selling short related
securities. RSJ 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 categorised by degree of
risk tolerance, and matched with enhanced cash strategized of appropriate riskiness.

Recently, the bulk of RSJ’s cash enhancement trades involved positions designed to take
advantage of the mean reverting pattern in the volatility of markets. In these trades, RSJ 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 US 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. RSJ was considering trying to benefit from this discrepancy by purchasing ‘straddles’
on these markets and dynamically hedging out the exposure of the position to directional moves
in the markets. RSJ 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. Unlike derivatives traded on organised exchanges, over the counter
derivatives involved bilateral negotiations between parties. 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.

While the interest rate swap market initially grew out the needs of debt issuers, the equity
linked swap and related derivatives market was primarily investor driven. Variants in 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. Index linked
notes and swaps were not always accorded the same tax treatment.

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The client

RSJ’s new enhanced index client was a Luxembourg subsidiary of 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. The insurer had approached RSJ after hearing a presentation from a
Wall Street firm on index linked notes. The firm had offered to issue the insurer a three year
note with a 2.65% coupon paid semi-annually, 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&P500
currently. The all in price of the note was par, equal to $100 million. The issuer’s publicly
traded medium – term notes were A rated. The insurer had invited a comparison of RSJ’s
enhanced equity product with this note offering and had decided to invest instead with RSJ.

Under the terms of the investment advisory agreement, the client permitted RSJ 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.

The client had also asked RSJ 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.

The Key question

In deciding how to invest the money Ram and Sam 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 Boris had supplied them with pricing and other information
pertinent to the September and December contracts. 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 and the bid-ask spread for $100 million of exposure was
currently 0.10 “S&P points” or 2.4 basis points. The position would require initial margin of
$ 10,000 per contract (4.8%) which RSJ would post in the form of US Treasury bill maturing

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within six months. Mr. Boris 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, RSJ could enter into an S&P
500 index swap. In conversations with various dealers earlier in the day, the best Ram could
find in the required size was a three year swap at LIBOR minus 10 basis points, and the dealer
would make quarterly payments to RSJ of the total quarterly return on the S&P 500, both
payments based on a notional amount that would being 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 RSJ if the difference was positive, or paid by RSJ to the dealer if the
difference was negative. The dealer was prominent A and A1/P1 rated New York investment
bank.

Enhanced cash alternative

Sam and Jerrad 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
RSJ 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 US
institutions.

During the morning, Sam had tried to negotiate favourable 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 being 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 Sam 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. Sam felt he could probably do still
better if he bided his time and waited for a special opportunity.

There were a variety of factors to be taken into account in analysing this alternative. First, RSJ
traders had estimated that the round trip transaction cost to purchase, and eventually sell the
EAFE stock would be about 200 basis points inclusive of all transfer taxes, commissions and
bid ask spreads.

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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.

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 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 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 Sam 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”. Sam 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. RSJ had been
approached by a major US financial institution wanting to move part of its inventory of
Japanese stocks off balance sheet. The institution would sell RSJ 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. 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 RSJ and would involve no additional transactions costs either at the outset or at
the time of exercise of the put option. Sam 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 the 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 a publicly traded debt outstanding, it was unrated. However, the subsidiary was

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capitalised and managed in such a way so as to be about AAA. RSJ would be able to inspect
its balance sheet and hedging operations on a confidential basis prior to entering into the
transaction.

RSJ’s Product line

Equity management Fixed Income Derivatives

US Equity management
Convertible security
management
Futures and Options
integrated equity
Balanced portfolio
Global equity management
Portfolio hedging
International equity
management
International equity
Global equity
Emerging markets equity
Structured active bond Portfolio hedging
portfolios
Investment grade bond Enhanced index funds
management
Enhanced bond indexing Market neutral arbitrage
Immunization / dedication Currency hedging
Intermediate bond Portfolio liquidation/pension
management plan restructuring
Fixed income hedging Immunization / structured
fixed income
High yield bond Futures and options
management integrated asset management
Cash management
Municipal bond
management

RSJ enhanced equity index composite (annualised returns for periods ending 3/31/92)

Years RSJ S&P 500

1 11.5% 11.1%
2 13.1% 12.7%
3 15.3% 14.8%
4 16.4% 15.6%
5 11.2% 10.4%
Before management fees and custodial costs

Miscellaneous information on July 13, 1992

a) S&P 500 index futures contracts

Expiration Price Days until Dividends LIBOR
expiration
September 1992 $ 414.65 66 $ 2.43 3.49%

December 1992 $ 415.15 100 $ 5.52 3.56%

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 b) Level of S & P 500 index: 414.87
c) Interest rates (LIBOR)
Term Rate (%)
(months)
1 3 3/8
2 3 7/16
3 3½
6 3 5/8
9 3¾
12 3 7/8

US Treasury and corporate notes

Corporate spread over Treasury’s (bp)
Term (years) U S Treasury AAA AA A
1 3.51 10 15 20
2 4.28 20 35 45
3 4.77 20 35 45

Morgan Stanley EAFE index (June 30, 1992)

Country Capitalisation weight as Dividend yield
percentage of index (%)
Austria 0.6 1.8
Belgium 1.3 5.2
Denmark 0.8 1.8
Finland 0.3 2.1
France 7.0 3.4
Germany 7.8 3.5
Italy 2.3 3.3
Netherlands 3.4 4.3
Norway 0.5 1.9
Spain 2.5 5.1
Sweden 1.7 3.2
Switzerland 4.1 2.2
UK 21.2 5.1
Europe 53.6 4.1
Australia 3.0 3.7
Hong Kong 3.1 3.4
Japan 38.5 1.1
New Zealand 0.4 5.6

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 Singapore/ 1.4 1.8
Malaysia
Pacific 46.4 1.5
Total EAFE 100 2.9

Estimate costs associated with Direct equity ownership

Stamp tax
and Dealer Portfolio
commissions spread rebalancing Custody
Australia- All ordinaries 1.60% 1.60% 0.32% 0.15%
France CAC - 40 0.9 1.5 0.23 0.15
German - DAX 0.5 1.4 0.19 0.15
UK - FTSE 100 0.9 1.2 0.21 0.15
Japan TOPIX 0.8 0.9 0.17 0.15
Netherlands EOE 0.75 1.5 0.23 0.15
Switzerland SMI 0.8 1.5 0.23 0.15
US S&P 500 0.25 0.7 0.1 0.05

Dividend Taxation
Shareholder's Hong Luxemb Switzerla
domicile France Germany Kong Italy Japan ourg nd UK US
France 15 0 15 15 15 5 15 15
Germany 0 0 32.4 15 15 15 0 15
Hong Kong 25 26.9 32.4 20 15 35 0 30
Italy 15 26.9 0 15 15 15 15 15
Japan 15 15 0 15 15 15 15 15
Luxembourg 25 26.9 0 32.4 20 35 0 30
Switzerland 15 15 0 15 15 15 15 15
UK 15 15 0 15 15 15 15 15
US 15 10 0 15 15 7.5 15 15

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Key Questions

1. How does RSJ’s enhanced equity index fund approach work?

2. Evaluate the attractiveness of the strategy involving S&P500 futures. How will it
perform relative to the S&P 500 all – in?
3. Evaluate the attractiveness of the strategy involving the S&P 500 swap. How will it
perform relative to the S&P 500 all in?
4. Evaluate the attractiveness of the index-linked note. How will this investment perform
relative to the S&P 500 all in?
5. Which is the most attractive enhanced cash alternative?
6. How should RSJ think about counterparty risk in its use of index-linked notes, swaps,
and futures contracts?
7. What course of action would you recommend to RSJ?
8. How might the proliferation of derivatives like those in the case change the money
management business?

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