A TRS is a financial contract which transfers both the credit risk and market risk of an underlying asset. (It can be categorized as a type of credit derivative).
The protection seller (i.e. the investor) pays the fixed rate (i.e. LIBOR + 40 bps) to receive the return (& risk) of the underlying asset.
The protection buyer (i.e. the broker/dealer) receives the fixed rate & pays the return of the underlying asset (as well as transfers the risk of the underlying asset) to the seller.
Essentially, the protection buyer has "bought protection" by swapping the risky underlying for a fixed rate.
An advantage of a TRS is that one party (i.e. the seller) can derive the economic benefit of owning an asset without actually carrying the asset on its balance sheet while the other party, who does carry the asset on its balance sheet, is protected from loss in the asset's value.
(It is not unlike the scenario where the dealer gives the investor a loan to purchase assets, that are held with the dealer as collateral.)
Hedge funds may use TRS's to obtain leverage on the reference assets (i.e. they can post a smaller amount of collateral upfront than the size of the reference asset.)
The cost of the derivative is determined by the cost to the dealer (i.e. the buyer) of carrying the underlying position (which is made up of the financing charge for acquiring the underlying index position in the cash market, compensation for counterparty risk, dealer profit, & any adjustment for tax related expenses).
So if the cost to the investor (i.e. the seller) is "LIBOR - 40" bps to get long the return of the S&P 500...
We can view it as... The investor is borrowing money at the cost of LIBOR to buy underlying stocks. However, the actual cost is 40 bps less. This "made" 40 bps can be considered "out-performance" offered by the broker/dealer. Perhaps the broker/dealer is able to offer this out-performance due to its actual way of implementing the return (i.e. futures that roll cheap, lending stock inventory, etc.)
