Writing covered calls sounds like such an innocuous strategy. You own shares in a company that you like for the long term. Its performance has been modestly positive but fairly unexciting. You don’t want to sell but want to make a little more money out of the investment. So you sell call options to generate some income. Covered call writing is widely used. As benign as it sounds, it’s generally not a great way to approach investing.  Most obviously, this is because your underappreciated investment can unexpectedly rise, when the sold calls will deny you the full return you had sought just as it reaches the valuation you expected. It also impedes your flexibility should you decide to sell the stock, since the sold call option will also need to be bought back.

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.

We certainly make our share of mistakes, so don’t misread the absence of any gold mining exposure in our client portfolios as bragging. Regular readers of this blog will be aware of the occasional wrong turn. One of the most insightful lessons of Behavioral Finance is the overconfidence many people have in their forecasts of all kinds of things, from jellybeans in a jar to quarterly earnings. A recognition of how little short term certainty there is creates some humility around position sizing, and hopefully makes the inevitable mistakes small.

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.

My friend Josh Friedlander, Editor at Absolute Return, has written a very good essay in the Hedge Fund Intelligence Global Review 2013. Unlike most journalists covering the sector who offer uncritical praise of their subjects, Josh asks some very pertinent questions about the future of the hedge fund industry. He’s asking the right questions. Hedge fund investors would benefit from more critical thinking like this.

Here’s a piece AR Magazine invited me to write.

This is the title of a “mini-book” by William Bernstein. I just came across a review of it by Larry Swedroe. I haven’t yet read Mr. Bernstein’s book (I just ordered it this morning) but Swedroe’s review caught my attention. It looks as if a three factor analysis of hedge fund returns has arrived at the same conclusion I did in my book – that hedge funds used to be great, that early investors did well, and that the industry today is overcapitalized.

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.

Canada’s Business News Network picked up on my recent blog on Agrium (AGU) and the company’s plan to pay Canadian financial advisers who vote their clients’ shares in favor of management’s slate of Board nominees. Here’s a brief spot I did earlier today.

Who thought that Canadian equity markets operated with shareholder protections that would bring even a developing country’s regulator to shame? Here’s the story: Agrium (AGU), a poorly managed producer and distributor of agricultural products in Calgary, is engaged in a proxy fight with Jana Partners, an activist investor with some very good ideas on how AGU could improve its performance. Jana has proposed its own slate of five nominees for the Board of Directors, people who it believes will improve the Board’s ability to run its retail business. AGU hasn’t welcomed Jana’s interest, and in the upcoming vote it transpires that AGU will be paying Canadian financial advisers who vote their clients’ shares in favor of AGU’s nominees.

It’d be bad enough to pay individual shareholders to vote a certain way, but paying their advisers? Are the Canadian managers of client assets really up for sale? Are they really the world’s oldest profession?

It’s a quite extraordinary set of circumstances, surely not a way of doing business that Canadian regulators can defend. We are invested in AGU. Jana’s interest piqued ours. AGU’s vote-buying makes it a more attractive investment, since it confirms the poor judgment of current management. Their continued tenure is surely now more tenuous.

My thanks to Joshua Rogers, a contributor to Forbes, for wading in to the debate on hedge funds. You can read his post here, and scroll down to see my comment in response.

Here’s a brief spot I did earlier today.

The EU has come up with a novel way of trampling over depositors’ rights in Cyprus with their proposed “tax” on depositors of Cypriot banks. So far through the Eurozone crisis depositors have been left whole, but the news on Saturday suggests they’ll be unwilling participants in the latest bailout. One might expect senior and subordinated debtholders to be taking a loss as well before depositors. That would be the more appropriate treatment of their capital structure. However, their €19BN economy supports a banking system with €68BN in customer deposits, and this highly leveraged system has hardly any senior debt outstanding. So finding the €5.8BN needed requires going after the depositors.

Even more amazing is the reporting that the tiered haircut (latest proposal of 3.3% on deposits below €100,000, 9.9% from €100,000-500,000 and 15% above) is designed to grab a significant amount of Russian investors’ money. The Cypriot President Nicos Anastasiades is a brave man.

One would think that a logical consequence of this move would be for Greek depositors to pull their cash from the Greek banking system. It’s probably a stretch to assume a run on Italian and Spanish banks,  but it must be a good bet now that the next Greek bailout will place their depositors at risk. This particular genie is out of the bottle. It’s frankly amazing that anybody ever held more than €100,000 in Cypriot deposits to begin with, but it must be that the days of large, unsecured deposits being held in southern European banks are numbered.

We haven’t changed any positions on the back of this news. The US$ should benefit but we’re not yet short the Euro. We still like being long US$ versus the Yen. America’s respect for property rights rests on a more solid foundation than in some other countries. The biggest positions we own (CXW, BRK, MSFT) are not overly exposed to such turmoil. But this news does potentially complicate the investment outlook.