This must have been the expectation of the shorts who sold 44% of the outstanding shares in Tesla (TSLA); that the company was over-hyped, relied on unproven technology and was doomed to fail taking its Hollywood investors with it. So imagine the wide-eyed horror of the unwitting passengers on TSLA’s current moon shot as they assess a company now worth over $10BN, trading at roughly 11 X trailing sales and 350 times trailing Gross Profit (there are no earnings). TSLA may be many things, but out of favor is not one of them.

As if a tripling of its price in six months isn’t bad enough, the shorts also have to deal with a CEO with a sense of humor. For Elon Musk, evidently not one you’d want to join at a poker table, has shown his exquisite understanding of markets by committing to invest $100MM of his own cash in the upcoming secondary offering of shares just as the shorts are enduring their own particular tail event. How often do you see that?

So TSLA’s price has moved beyond what must have been plausible for most short sellers, who like all shorts are further dealing with the consequences of a steadily growing position as it loses money. We have no position in TSLA and have no intention of taking one. But watching its stock price in recent days has been entertaining to say the least.

This perverse accounting treatment got me thinking about why pension funds continue to invest in hedge funds seeking 8% returns, even though it’s been many years since hedge funds made 8% and it’s not likely they will in the near future either. Certainly not with over $2 trillion competing for opportunities. Based on the accounting, including an asset with an 8% return target helps reduce the value of their liabilities even if the 8% return expectation is an unreasonable one. So the motivation for a pension fund trustee could be to include hedge funds because of their helpful impact on the discount rate on their liabilities even while their continued failure to achieve that target doesn’t cause huge immediate problems. Far better than lowering the discount rate to a more appropriate level and revealing the true shortfall with all its political consequences.

This is how the $3 trillion underfunded position is growing. Sometimes accountants can cause a lot of damage.

We’re sympathetic to the argument. Bonds are a horrible investment. But if investors choose a bond fund and the manager buys equities, whatever asset allocation decision made by the client is being distorted. What the Loomis Sayles managers are saying is that their clients should hold less in bonds, and they’re going to help you with that asset allocation shift by doing it themselves. It’s not that stocks are necessarily a poor choice – far from it. But in the next bear market Loomis Sales clients may find they have more equity exposure than they expected to have based on their asset allocation.

It’s really not as conservative as it sounds. Put-call parity is a Mathematical identity that determines the price of a put option if you know the price of the identical call option and the underlying security. In the jargon of option Math, a long put option can be created by a short position in the stock combined with a long call option. P = C – S. It’s as rigid as 2+2=4. Options market makers routinely make prices based on “conversions” as they’re called. If call options are well bid, traders offset the calls they’ve sold by going long the underlying stock and buying put options. In this case, C = S + P. You can rearrange the symbols following the rules of algebra.

What this means is that if you are long a stock and you sell a call option against it, you have created for yourself a short put option (last bit of algebra: S – C = – P). The returns on a short put option and the equivalent covered call position are identical. They are economically equivalent. You retain the risk of a complete loss of your investment, but the short call means you now have only limited upside. Most obviously, if your risk appetite runs to shorting put options on individual stocks, why not just do that instead of going to all the trouble of owning the stock and selling a call? The transaction costs are lower and it’s simpler to execute. More important though, shorting put options can be bad for your financial health. For some, there is a certain appeal to getting paid an option premium in return to agreeing to buy a stock you like if it becomes cheaper. Put option sellers are happy to commit to buy at that lower price and to be paid in return. Others like to retain flexibility around their price targets – after all, maybe the stock has  fallen 10% for good reason and no longer looks so attractive. You might be happy to be able to change your mind based on new information. The difference is a philosophical one. However, not all writers of covered calls recognize that they are in fact writers of puts.

I once met a hedge fund manager whose strategy was substantially one of selling covered call options. I asked him why he didn’t simply write put options and save himself some trouble and commissions. His honesty exceeded his marketing ability, for he quickly pointed out that few clients would consider investing in a hedge fund that sold put options. That is economically what he was doing, but he was sensibly customizing his message for the audience. I can’t say I followed his subsequent progress, but I imagine that the 2008-09 market collapse and subsequent recovery was a memorable experience for his investors. We were not one of them.

For the client whose financial adviser sells covered calls, there exists an additional problem. As skilled as the adviser may be in selectively selling call options that will expire worthless, it’s hard to evaluate the results. Selling out of the money call options may earn you a small premium most of the time, but markets are full of surprises and occasionally the covered call position will deny the investor a substantial return on a long stock position that suddenly appreciates. To say that most of the time selling call options generates a small profit isn’t the same as saying that selling call options is a profitable strategy.

Importantly, you can no longer simply compare the performance of your account with a benchmark such as the S&P500, because in a strong market your account will underperform as your longs get called away. The premium income may compensate at other times, but you’ll never really be able to evaluate your results with numbers. Performance may be reported to you as “quite good”, or “acceptable under the circumstances” as opposed to “2% better (or worse) than the market”.

Investing results that defy quantitative assessment but instead rely on adjectives are to the advantage of the advisor and the detriment of the client. As much as one wants to retain a positive view of the financial advisory business, as new clients open accounts and transfer over the investments that their former adviser had made on their behalf, one’s faith in the judgment of other investment professionals can be challenged. Recently, a new client’s portfolio was transferred and included therein were short call options doing what they’re not supposed to, which is moving into the money and causing the underlying long positions to be called away, thereby limiting the return on the stocks that would otherwise have been retained.

So next time you or your financial adviser contemplate selling calls on a stock you own, consider whether you would just as readily be simply short the put options. Because that’s the position you’ll have.

Writing about gold when it’s just had its biggest drop in 30 years is only for those who weren’t involved. The all-too-obvious problem with gold is that you can’t figure out its NPV, because it generates no cash. Instead it consumes a lot to dig it up, move it and store it. So we don’t avoid it because we’re bearish, we just can’t figure out its value. From time to time I’ll run in to people who own some gold as their, “when all else is lost at least I’ll have some” investment. The game’s not over, and they may turn out to be smarter than we are. But I always respond that if inflation is your fear, wouldn’t you rather own shares in companies that sell products everybody wants and have pricing power? Like Coke (KO), which reported earnings this morning ahead of analysts’ expectations.

There are some scenarios involving civil strife and a complete breakdown of civilization in which shares in KO or any other financial investment might be useless, and a stash of gold plus an armory a more appropriate position. You can’t be certain of very much, so even that has a probability > 0%. But 5%+ inflation and the discrediting of fiat money is a higher probability (albeit not yet the most likely outcome in our view). A portfolio of investments in companies that look like KO will probably offer a better prospect of holding its value than a lump of yellow metal. Businesses that can sell a little more product annually to the growing consumer base in emerging economies, and can be relied upon to pass through the cost increases that higher inflation might impose, can remind you why you own them each quarter

Gold will not have many days like yesterday, maybe not for at least another 30 years. But if you prefer the Coke Standard to the Gold Standard at least you have some future cashflows to estimate and present value back to today.

David Hsieh, Professor of Finance at Duke’s Fuqua School of Business suggested that alpha is finite, and that’s why today’s hedge fund investors will continue to be disappointed. Makes perfect sense to me. So now we have some real academics weighing in on the debate, as opposed to the pseudo-variety hired and paid for by AIMA in London.  Mediocre returns delivered at great expense continue, providing additional support for the critics.