Enhanced S&P 500 Index Contracts

Several enterprising money managers have begun aggressively marketing a product with the above name. The gist of their pitch is that, if your organization will lock up money for three years, they will promise an annualized return equal to the return on the S&P 500 plus (typically) 0.25%. The promise is backed by an insurance company. Too good to be true? Not necessarily, although organizations can deploy their money in a manner that will achieve essentially the same result, but without the middleman's fee. In practice, the managers in question will invest funds committed to them in a portfolio of relatively short-term corporate obligations "overlaid" with S&P 500 futures. Since the debt instruments will, on average, have a lower quality and hence higher yield than the cash equivalents reflected in the pricing of such futures (specifically, instruments pegged to the London Interbank Offered Rate or LIBOR), the portfolio should have a decent chance of outperforming the S&P 500 by a modest margin over each contract's life. Foundations seeking to replicate this strategy can overlay a bond portfolio (or bond mutual fund) with futures, i.e., long positions in S&P 500 futures, coupled with short positions as needed in bond futures to trim the portfolio's interest rate risk to the desired level. The bottom line is that the contracts discussed here are not necessarily too good to be true, but � due to the credit risk they entail (including the insurance company's potential default) � they are anything but a free lunch.