Assuming you’re not the type of investor whose mood is synchronized with the daily gyrations of the stock market, October has been an interesting month. Although it’s not over yet so of course anything can happen, to this point October looks like a big, short-lived margin call. Leveraged investors and those who like to hedge their downside have had a torrid time and many must regard their recent activity wondering how so much frenetic portfolio adjusting could have been so harmful.

It will be especially interesting to see how hedge funds finish the month. Industry apologists long ago perfected shifting the goalposts of performance. What was once the Absolute Return industry moved to generating attractive relative returns, later supplanted by uncorrelated returns as each description of the performance objective was found to be at odds with the empirical results. Nowadays sophisticated hedge fund consultants promote downside protection as the raison d’etre of a hedge fund allocation.

So what to make of the way October is shaping up? Through yesterday, the S&P500 was down 1.6% for the month, an innocuous result that scarcely describes the wealth adjustment that was inflicted earlier. MLPs, in which we have more than a passing interest, were at one point down 14% before the V-shaped market move thankfully began its ascent.

Hedge funds, as defined by the HFRX Global Hedge Fund Index, are currently estimated to be down 2.5%. Many hedge funds, particularly those focused on equities,  have done far worse. Stocks may of course spend the rest of the month falling, but assuming they don’t one imagines there will be some uncomfortable conversations as investors contemplate the value destruction that’s possible when hedged strategies test the market timing skills of their practitioners beyond the level of their ability.

It’s a fair question to ask that, in a market environment characterized by a sharp trip down followed by an equally fast return, what exactly should a hedged strategy return? Presumably, if a hedge fund maintains constant exposure, the round trip ought not to be much different than for the long only investor. But it’s looking very much as if the risk management being practiced is of the “dynamic” variety, which is to say highly responsive to market moves, or perhaps less generously, prone to sell low and buy high.

It reminded me a little of the crash of October 1987, whose 27th anniversary of course just passed on Monday. Not nearly as traumatic of course, and spread over a longer period of days, but what both events have in common is the use of hedging strategies that rely on risk reduction in response to falling prices. In 1987 it was called Portfolio Insurance. Its 2014 version has more complexity and variety of implementation, but thematically is another version of taking more risk when prices are rising and less when they’re not. There are other ways to grow your savings.

We’re in one of those periods of time in the market where participants are simply talking past one another. The fundamentally-driven bull case acknowledges that sharply lower oil prices are bad for E&P companies but notes that for the rest of the economy it’s like a tax cut. Power consumption just got cheaper. And yes, growth overseas is slowing, notably in the EU but also in China and Brazil. But the U.S. economy is doing fine. And finally, Ebola is in every conversation but the media hype and fear are magnitudes out of proportion to the actual incidence of infections.

Meanwhile, the sellers don’t engage in the debate on these issues at all, but simply keep selling. Not because they want to, but because they have to. In fact, it’s quite extraordinary that after all the losses and capital destruction that went on during the financial crisis in 2008, that there is still so much money invested on a seeming hair trigger. So many participants evidently  operate under a psychological margin call that induces them to sell when prices fall a certain amount, or indeed an actual one. Investing with leverage is generally not a smart way to grow your savings, but a lot of people obviously still do it in one form or another. Perhaps one of the most bearish items over the near term is that the bearish case is so rarely articulated. Most of what you can read or watch on TV seems to be another fundamentally driven bullish analysis.

Meanwhile, Kinder Morgan (KMI) reported after the close yesterday and reaffirmed their $2 dividend for 2015, 10% annual dividend growth and a backlog of projects up from $17 billion to $17.9 billion (even after dropping $1.1 billion into production, so $2 billion of projects were added). We think at $35 it’s a good investment. We also think Burger King (BKW) apparently a widely-owned hedge fund stock is starting to look attractive as its price is now retreating back towards its level prior to the merger announcement with Tim Horton (THI).

It ought to be a great opportunity for hedge funds to demonstrate their added value as uncorrelated investments that can dampen downside volatility, as opposed to showing that they are in fact over-capitalized. So far this year, the simple 60/40 S&P500 and Dow Jones Corporate Bond combination has returned +4.6% (through Tuesday) compared with the HFRX Global Hedge Fund Index (HFRX) of -1.6%, closing in on an incredible 12th straight year of underperforming the 60/40 alternative.

Some market strategists had been warning of a market reversal, and had been telling us that low levels of volatility couldn’t continue. If you keep forecasting a market drop long enough you’ll be right. Even for those of us who don’t focus much attention on market timing and therefore ought not to care, it’s never pleasant watching the investments you like drop like a fridge hurled from a tenth story apartment.

So there’s no insight here on market direction, simply an update on what we’ve been doing; which is mostly re-examining what we own and not selling. The collapse in crude oil resembles what you’d find in a full-blown recession, and markets are evidently pricing in such at least for the Eurozone with slower growth in China and Brazil among others. Lower oil reflects recently revised forecasts of slower demand growth from the EIA as well as increasing U.S. output. MLPs reacted fully like energy stocks this week even though their energy infrastructure businesses have limited direct sensitivity to oil and gas prices and are more driven by volumes and growth prospects, both of which appear good and unchanged.

Nonetheless, the seeming one-way train that has been MLP prices abruptly changed. The sharp correction allowed us to make minor portfolio upgrades in certain strategies.  In recent days for our MLP Strategy we acquired a little more Plains GP Holdings (PAGP) which we like as the GP of Plains All America, and Markwest Energy Partners (MWE) an MLP with no GP to siphon away cashflows. We may add a little more PAGP on further weakness.

In our High Dividend Low Beta Strategy we added modestly to Spectra Energy (SE), a large pipeline operator whose stock price had dropped 15% from its recent high along with many other energy sector names. In our Low Beta Long Short (Best Ideas) for similar reasons, we bought Enbridge, selling Coke (KO) following its recent strength (surprisingly, some stocks have been rising) after Pepsi’s earnings report.

In Deep Value we added a small position in Monsanto (MON).

All of which is to say we are holding about 99% of the same positions we did at the beginning of the month, albeit at lower prices. Friday’s midday bounce in MLPs almost felt like a market recovery even though stocks overall had another poor day. Kinder Morgan (KMI), Berkshire Hathaway (BRK), Williams Companies (WMB), IBM and Hertz (HTZ) remain among our biggest holdings across strategies.

Interest rates remain low and look set to stay that way a good while longer. We have further minor portfolio upgrades in mind if the market continues its correction. Unlike most prognosticators, we won’t try and forecast it, but will simply be prepared.

This weekend the Striking Price column in Barron’s referred to the Options Industry Council’s educational series of videos. I have to say I have mixed feelings on the topic. On the positive side of course educating investors is a good thing. The videos currently available are extremely basic, offering definitions on terms such as “strike price” or “in the money”, but presumably there will be additional offerings that will explain how options can be used in various strategies.

The negative element is that the vast majority of individual investors really ought not to be using options at all. At their most basic, options introduce leverage and leverage makes the timing of an investment return far more important than it ought to be. Buying call options on a stock you think will rise will never be as profitable as buying the stock, if the stock rises. Buying put options to protect against a market fall is not as good as limiting your overall exposure to that which you can sustain through a market fall.

Options turn investors into traders, and while this is good for the options industry and for firms that make markets in options, transactions costs, taxes and missed opportunities will render long term returns lower than they would be otherwise. In short, for the majority it’s fair to say that the less time you spend on options the richer you’ll be. FINRA’s Investor Alerts page offers a lot of sensible advice, but including advice to focus on the long term term is probably a step too far.

For many years I ran an interest rate options trading business. Broadly speaking, market makers are more often sellers than buyers of options. It’s too much of a simplification to justify this bias by saying most options settle worthless, but the demand is heavier from those seeking protection (i.e. paying the option premium) than the reverse.

Warren Buffett made an interesting options investment some years ago (it was in long dated options with ten or more years to expiry; exceptionally far out and therefore an exception to the notion that options are usually for traders). In effect he bet that the Black-Scholes (B-S) formula  so often used to price options is flawed. B-S takes today’s security price and extends it out into the future at the risk free rate to estimate its future value. The volatility of the stock reflects the model’s confidence that the stock in question will be at that projected level when the option expires.

By selling long dated options priced this way, Buffett was acting on his conviction that projecting out today’s value for the S&P500 at the yield on the ten year treasury note (i.e. the risk free rate) understates the likely level of the S&P500 in ten years time. The B-S assumption allows for an elegant algebraic solution to the price, but in Buffett’s view the solution was wrong. So Berkshire sold put options on the S&P500 to B-S reliant options market makers, based on his insight that their models were assuming the future price of the S&P500 to be too low and therefore overvaluing the put options they were buying.

Berkshire had to stop adding such trades because of the possibility they’d have to post margin if the trades moved against them, which in an extreme case (i.e. very weak equity market) might have tied up more liquidity than was prudent to support their insurance business. The settlement dates extend into the next decade, so it’ll be many years before the result of those decisions is known. Berkshire’s 2013 10-K noted $2.8 billion in gains from equity index put option contracts whose fair value (i.e. what Berkshire owes at current prices) has dropped to $4.8 billion (excluding premium taken in).

However, I doubt the Options Industry Council will publish videos on how to trade options like Warren Buffett. Like alcohol, best used in moderation.

The California Public Employee Retirement System (CalPERS) recently announced they were closing down their $4.1 billion hedge fund program. I don’t know if they read The Hedge Fund Mirage. It might have saved them some time.

The New York Times has an interesting perspective.

CalPERS’ $4 billion hedge fund portfolio will cause barely a ripple in the $2.5 trillion hedge fund industry as it’s redeemed over the next several quarters. Some speculate that their decision will cause other public pension funds to re-examine their commitment to hedge funds, although you’re unlikely to find a public pension trustee who will admit to being a follower.

What struck me most about this news though was the fees CalPERS paid. They disclosed a 7.1% net return on their $4 billion portfolio during their last fiscal year, as well as $135 million in fees. In recent years there’s been some anecdotal evidence that the ubiquitous “2 & 20” (2% management fee and 20% profit share) was coming down. That may be so, but you wouldn’t know it from CalPERS’ experience.

They don’t disclose their actual fee structure, but an educated guess is possible. Given the information provided (investment size, net return and fee expense) 1.9 and 19 (i.e. a 1.9% management fee and 19% incentive fee) would make the numbers add up. 2 and 18.5 also works. Given that CalPERS has a reputation as one of the most aggressive negotiators of investment terms, it’s surprising that their realized fees during their last fiscal year were so close to the traditional 2 & 20.

Now, it’s possible that some of their funds lost money, which doesn’t alter their effective fee but could mean that they’d negotiated lower incentive fees but had failed to benefit. There are no negative incentive fees. And CalPERS does include funds of hedge funds in their portfolio so that again may understate the fee savings they negotiated with individual managers.

Nonetheless, it still adds up to $1 of fees for every $2 in investment return. Nice business for some.

The Economist is my favorite magazine. Since I joined the 21st century and started downloading it on my Samsung tablet, I can now read it on Thursday nights when it’s published instead of waiting for my physical copy to arrive by mail, on Saturday (if I’m lucky). The writing is invariably high quality and typically well researched. I don’t always agree with their opinions though. They recently suggested that the resignation for personal reasons of Mark Frissora, former CEO of Hertz (HTZ), somehow reflected his prescient forecast that the car rental business is in for hard times. The article relies heavily on Morgan Stanley who are bearish on HTZ.

Of course it’s possible Frissora could be so farsighted. But there are a few problems with this theory. First, the car rental business is great right now. Avis (CAR), HTZ’s main competitor, is enjoying record business. Its stock recently made an all-time high. HTZ business and stock have both been struggling. They still haven’t reported 2013 financials, and in their most recent quarter attributed weak revenues to unexpectedly strong demand from business clients whose advance booking left insufficient cars to meet short term, more profitable leisure customers. Neither one of these issues sound like industry-specific as much as the result of poor management at HTZ.

My guess is that the increasing role of activist investors looked likely to make Frissora’s life miserable. The company is relocating to Estero, in SW Florida and no doubt the Naples golf courses looked increasingly appealing compared with battling Mark Tannenbaum of Fir Tree Partners, a HTZ investor who recently said Frissora, “has completely lost credibility.” Yesterday Carl Icahn reached an agreement with HTZ to replace three existing board members with his own slate. 

We thought Frissora would soon be leaving. His departure is good for HTZ investors. We remain one of them.

For individual investors seeking advice, the world they enter can be a confusing place. I’m thinking here of the different types of financial advisors that offer to help investors deploy their capital.  Non-finance people shouldn’t need to bother themselves with subtle elements of the investing regulatory landscape, but there are some things they’re better off knowing. Financial advisors don’t all operate with the same set of objectives. Some, who work for investment advisory firms and are Registered Investment Advisors (RIAs) are bound by the 1940 Investment Advisors Act to conduct themselves as a fiduciary, meaning they’re legally obliged to put their clients’ interests first. It seems like a sensible standard, but it’s not the only standard. There’s another class of financial advisor who work for broker-dealers rather than investment advisory firms. Their activities are bound by a lower standard of suitability and disclosure.

A financial advisor who is an RIA and works for an investment advisory firm has to put the client’s interests first. A financial advisor working for a broker-dealer may not be so constrained. It’s as if the RIA is sitting next to you, the client, at the table working with you to identify and implement an appropriate investment strategy, while the broker-dealer version of a financial advisor is sitting across the table from you trying to sell you something.

Neither model on the face of it is necessarily better than the other. In our business at SL Advisors we are fiduciaries and we believe that is best for clients. But the non-fiduciary type of advisor may be more appropriate for some people. When you buy legal or medical services you’re dealing with somebody who has to put your interests first. When you buy an automobile or a house, you’re not. Many people wouldn’t want to make those purchases through fiduciary relationship. It’s well understood that in buying a car you need to do your homework and that the car salesman is obviously promoting the positive aspects of the car. There’s no need to employ your own agent to negotiate with a car salesman on your behalf.

The interesting question is whether the typical investor, when buying financial advice,  can recognize the difference between a financial advisor with a fiduciary obligation and one without. The term “financial advisor” is confusing because it sounds a lot like someone whose unequivocally on your side. You need to understand the difference, and in particular whether or not they work for an investment advisory firm (fiduciary obligation) or a broker-dealer (probably, though not always, no fiduciary obligation). So next time you’re talking to your advisor, ask whether they’re the fiduciary type or the car salesman type.

The 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act directed the SEC to evaluate whether a uniform fiduciary standard should apply to all financial advisors, not just those employed by investment advisory firms. The SEC duly did this and concluded that it would be a good idea. The brokerage industry successfully lobbied against this. They argued that it would be adverse for certain types of clients for whom coverage would no longer be commercially attractive. But there’s also little doubt that it would impede the ability of broker-dealers to market some fee-laden products such as non-traded REITs (with as much as 15% of upfront fees), many varieties of structured notes and other illiquid yet expensive products. It would create enormous challenges for municipal bond dealers whose profitability hinges on the mark-up they can add to a bond before selling it to the client. Being a fiduciary is inconsistent with profiting from any of these transactions when they’re sold to clients. The car-salesman type of financial advisor is far more likely to have their client invest in a non-traded REIT than the fiduciary type of advisor, because the car-salesman receives some of the upfront fees whereas the fiduciary type does not.

So two types of financial advisor will remain for the foreseeable future. But there’s still plenty that can be done to ensure that investors are better informed about the relationships they have and the investment products they’re offered. FINRA (The Financial Industry Regulatory Authority) publishes an “Investor Alert” section of its website. Its existence is not widely known, and yet it contains a great deal of basic, sound advice for self-directed investors interested to learn more. It also includes warnings on certain products (such as non-traded REITs, structured notes and the potential mark-up on municipal bonds). You’d think that the existence of such warnings from a government regulatory agency would give pause to any financial advisor (fiduciary or otherwise) selling such instruments. Maybe many do steer clear, mindful of the problems FINRA highlights, but clearly they don’t all do so.

It would seem to me a fairly obvious thing for a certain class of Investor Alert to be provided to any client prior to making a purchase. Given all the problems with non-traded REITs, why not require that any buyer be directed to the website before buying? Smokers still buy cigarettes with their government warnings. Let people make their own decision, but at least make sure they’ve been provided relevant information. If FINRA feels it necessary to issue a warning about a certain security, that ought to be known to every potential buyer. The CFA could take the lead on this issue by advocating for such communication to investors prior to a trade involving the security subject of such a warning. It would be a logical extension of the CFA Institute’s support for a uniform fiduciary standard across all financial advisors.

Even if that fairly simple step doesn’t happen, there’s nothing to stop financial advisors from conducting their business in a way that’s consistent with such investor alerts being widely known. In fact, you’d think that any reputable financial professional or firm would feel queasy at the least in profiting from securities highlighted in this way by FINRA. The financial services industry has been the subject of withering reputational attacks, some of them justified and due to self-destructive behavior. The resulting populist outrage at Wall Street and ever greater regulatory burden are the political result. Investors deserve better, and many financial professionals don’t deserve the opprobrium heaped on the industry. It’s time for us to start regaining trust by behaving in ways that reflect common sense regardless of whether the law requires it. Individual financial advisors need to conduct their business with the client’s interests first  whether or not they have a fidiuciary obligation to do so. If advisors swore off selling products that are targets of FINRA’s Investor Alert website that would be one step towards taking back the industry’s reputation.

Sometimes being invested in a stock can feel like being trapped while the enemy takes shots at you from all sides. You were expecting reinforcements to arrive at this exact spot, and while you know you can hang on it sure would be nice to not be fighting this battle alone.

Then, out of nowhere arrives the U.S. Cavalry and although the fight’s not over, you finally believe that victory might be at hand. The stock in question is Hertz (HTZ), which we own, and right now Carl Icahn looks a lot like the U.S. Cavalry.

When an industry has two big publicly traded competitors, comparing their performance is an obvious element of researching their investment potential. HTZ and Avis (CAR), along with privately held Enterprise, dominate the North American car rental market. Consolidation has dramatically improved the prospects for the surviving firms, by reducing competition and thereby allowing price hikes. Rental firms are also making better use of their biggest asset, which is cars. HTZ for example owns Dollar Thrifty and can recycle cars from the Hertz brand whose customers expect a newer car downstream to a lower price point, thereby getting more use out of their cars before selling them. HTZ and Avis are also experimenting with hourly rentals which turn out to be complimentary to their traditional business (business travelers rent for days during the week while hourly renters are typically on weekends). In short, the fundamentals for the business are great.

To examine the periodic public comments from HTZ and Avis you would think they operate in completely different environments. Avis introduced their 2Q results with the following summary, “Our strong second quarter results were driven by our continued growth in both volume and pricing in North America and our relentless focus on accelerating growth in our most profitable channels,” said Ronald L. Nelson, Avis Budget Group Chairman and Chief Executive Officer. “Summer volume and pricing have continued the trends we saw in the first half of the year, and we expect to post record results in our third quarter.”

Meanwhile HTZ, which hasn’t filed a comprehensive financial report this year due to accounting software issues, recently said, “The Company now expects to be well below the low end of its 2014 guidance due to operational challenges in the rental car and equipment segments…”

The operational challenges in the rental market are self-inflicted. The company has been wrong-footed by higher than expected demand combined with recalls on some of their models, with the odd result that, as noted in their recent 8-K filing “Fulfilling advance reservations and contracted business consumed the majority of available fleet. This left the company without inventory to capture more of the higher-rate leisure close-in rentals, which typically generate greater ancillary sales.”

HTZ is a company begging for new leadership. They’re shooting themselves in the foot when their biggest competitor is growing its EBITDA by 19% and expecting a record 3Q. As well as performing poorly, HTZ keeps requesting more time to produce restated financials for 2011-13. It increasingly looks to be just a matter of time before some adult supervision gets involved.

That’s the beauty of investing in public companies. You’re not alone. Carl Icahn has a wonderful quote on his blog from comments he made at a 1988 Texaco annual meeting: “A lot of people died fighting tyranny. The least I can do is vote against it.”

Icahn doesn’t appear to have lost any appetite for a fight during the subsequent 26 years. In the 13D disclosing his 8.7% holding in HTZ, “… lack of confidence in management” was listed as one of the reasons. We share that view. Other notable investors include Glenview (run by Larry Robbins) and Fir Tree (run by Jeffrey Tannenbaum). They’re also fed up with the ongoing mistakes. Tannenbaum recently said that HTZ CEO Mark Frissora, “has completely lost credibility.” We look forward to some fireworks, and to Mark Frissora devoting more time to his golf game.

It’s an odd phenomenon that, although capitalism as a philosophy is built around the meritocracy of free markets, in the area of corporate governance the power of profit maximization has often failed to dump ineffective boards of directors and/or management in favor of more competent people.

Boards are usually made up of invited friends, and sometimes their supervision of senior management resembles that of golf partners where it’s good manners to ignore others’ poor shots while offering congratulations on the good ones. The pressure to avoid rocking the boat is felt by everyone.

Hence the Economist this weekend noted an innovative solution to the issue of weak, sometimes unqualified board members. Why not outsource the function to companies whose business it is to provide such services? This currently happens with audit and legal work. Board members are hardly engaged full-time by any one corporation. Why not develop specialists who are truly independent and full-time?

It struck me as quite a clever suggestion. It ought not to be necessary, but the many failings we see week after week highlight that capitalism is often coming up woefully short in this important area of corporate governance, or how the very stewards of capital are managed and evaluated. Even Warren Buffett punted when a few months ago he was asked about the egregious compensation plan recommended by Coke’s (KO) management.

Although Berkshire (BRK) is KO’s biggest shareholder and Buffett about as vocal on investor rights as anybody, the great man meekly abstained rather than vote against a plan he freely admitted was needlessly generous.  “If you keep belching at the dinner table, you’ll be eating in the kitchen,” was his typically folksy and non-combative explanation. He understands as well as anybody the duty of board members to be only occasionally critical and then in the nicest possible way.

Other examples include ADT, which as I’ve written before is busy demonstrating the ham sandwich test (invest in a company that could be run by a ham sandwich, because one day it will), as shown by their buyback of Corvex’s position in ADT stock last year at $44 just before disappointing earnings took its price eventually below $30. Activists are often a force for good as they seek to expose management failings, but Keith Meister’s Corvex is a negative since he’ll readily throw other investors under the bus for a quick profit. We own ADT in spite of its leadership since we think anybody could run it as badly as current management and many could do better. It’s an option on executive suite change.

Currently the role of using capital to improve management is taken by activists such as Carl Icahn. He just provided a stark reminder of how shareholders often need activists to correct some of their self-seeking behavior. Family Dollar (FDO) just the other day agreed to sell itself to Dollar Tree (DLTR), an unlikely partnership since they operate different business models and would continue to do so afterwards.

FDO CEO Howard Levine noted that no discussions had taken place with the more obvious and bigger merger partner Dollar General (DG), to whose steadily improving operating metrics FDO eternally aspired but never reached. DG’s CEO Rick Dreiling flatly contradicted this by noting that DG had expressed interest in a combination multiple times in recent years. Carl Icahn backed this up, recounting a dinner with Levine at which the subject of a combination with DG was discussed. With DG, Howard Levine will lose his job to the superior operator, whereas with DLTR he’d keep it. As Icahn memorably noted, Levine thinks that because his father founded the company the son owns it. But he doesn’t. FDO’s stock has consistently underperformed DG’s in recent years as has its business. As close competitors it’s been helpful for investors as well as the companies themselves to compare their relative operating performance which has invariably favored the larger, better run DG (we are currently invested in DG, and were until very recently invested in FDO).

DLTR was a better merger partner for a CEO putting his own job ahead of his fiduciary obligation to his shareholders, and the FDO board passively acquiesced. Levine even agreed to a $300 million break-up fee in the DLTR transaction, a final slap in the face to those stockholders who thought he had their interests at heart.

Investors though should be far more assertive. If well-run boards with good corporate governance were more highly valued, they’d arrive more quickly. The more a poorly run company’s stock is shunned the quicker activists or competitors can buy a stake and fix it. The best solution to poor corporate governance is to invest with competent management and avoid the poorly run, at least until they’re cheap enough to draw in an activist. FDO had at least met this test in the last couple of years. Even institutional investors don’t have to own every publicly listed large cap company. Until investors become even more discriminating in their allocation of capital, activists will continue to correct perhaps the biggest weakness in contemporary capitalism – the management of the executive suite.