In recent years, the financial sector has undergone a significant ethical revolution that has transformed the industry. Measures promoting market integrity and respect for ethical principles are repeatedly mentioned in the media, with a particular emphasis on the fight against money laundering and terrorist financing. This growing movement has highlighted the important for effective internal compliance.

The compliance function is an independent unit within a given firm that identifies, evaluates, and controls the firm’s risk of financial loss, reputational damage and judicial reprimand. In several countries it has become a mandatory function in financial institutions. Why is there an increased demand for compliance now? It can be explained by three reasons.

First, many financial and corporate scandals (such as Hollinger Int’l, Enron, Barings Bank, BRE-X and Madoff Investment Securities) have been widely reported in the media. The events we have experienced in recent years have led legislators to toughen the requirements for internal control. This is one reason why compliance has become increasingly important.

Second, in the midst of recent economic turmoil, the need for transparency has been underscored—whether in connection with CDS (Credit Default Swap), MBS (Mortgage Back-Securities), ABCP (Asset-Backed Commercial Paper) or other complex, structured financial products. The dangers of uncontrolled leverage and under or non-capitalized positions in terms of systemic risk are now evident. The complexity and risks of these complex products are not fully understood. Statistical computer modeling is an important tool but needs to be coupled with human intervention and sound judgment, thereby explains another reason why organizations are focused on compliance.

Third, the general regulatory environment continues to grow more complex as offenders are being pursued more aggressively than ever. Self-regulation, backed by industry and trade associations, has played a vital role in regulation in Canada and the United States. Compliance professionals are working today in an environment of rapidly evolving marketplaces and sophisticated and innovative products. The next years will involve a lot of challenges. The current system needs transparency and timely information. Thus, there is increased demand for compliance within the financial industry.

It is only logical, therefore, that self-regulatory organizations (SRO) are growing at an exponential rate. However, despite the generally held view that there is never enough regulation, some regulatory organizations are becoming too big and risk going out of control. Some agencies may exaggerate the need for their presence and create unneeded regulations in order to “feel” useful. Rather than be costly, ineffective, and distorting, regulation should encourage proper behaviour without imposing an unnecessary burden on participants through high compliance costs.

I’m not saying anything innovative when I say that finance is very very competitive and that is one of the reasons why every competitive edge is used when selling products. And for investments, that is obviously return. But in a world where returns can vary from +20% to a year like 2008 where even getting -20% can be considered “good”, it is difficult to compare returns and for that reason, investors have been comparing their returns to the returns of the market for about a century now. Of course, since there is no perfect “market”, many dozens of indexes exist depending on what you are comparing with.

Generally speaking, returns have been compared with stock indexes such as the S&P 500, a broad US stock market index that covers the 500 largest US corporations traded on stock exchanges (more or less). And so for decades, investors have been trying to outperform these indexes through a multitude of ways. Then hedge funds came along, saying they were unique and that they could deliver absolute returns. An absolute return in theory would mean that no matter how good the year, your investment would generate a positive return and thus not really apply to a given index.

That became a major selling point and of course over the past couple of years, many investors have discovered the tough way that absolute return is maybe not as easy to obtain as it looks. Many funds have performed poorly in 2008 and in fact the average hedge fund track by Credit Suisse Tremond returned about -20%! Better than the market? Yes, but surely not what they were selling.

So now, hedge fund managers are selling the fact that their returns performed better than the overall market. Might be true. But I’m having a hard time applying this to my personal situation. As you know by now, the picks on IntelligentSpeculator are generally long/short. The advantage of course is that I’m not as affected by huge market moves since I do not have much of net market exposure, I’m long and short. So on a major down day like we had last week, I will outperform the market generally (if the spread between my picks remains the same), and the opposite will happen on good days.

That has made me think about the validity of comparing my picks to the S&P500 when in fact they are really absolute picks. I’m tending to convert back to simply getting an absolute return and comparing that return to similar fund returns instead. And so this draws me to a question: While not hedge funds are in this situation (especially short bias funds or other funds that do have a general market direction), would you agree that hedge funds that are long-short should be evaluated using an absolute return. It might not be over 0%, but if that is the case, either it is a bad year, or a bad manager. But comparing to a broad market index simply seems like a misrepresentation of results….

I wrote briefly last week about shorting stocks, how it is done, the strategy behind how I short stocks, etc. Of course, there is a lot of stigma that surrounds shorting stocks, and just how risky it is. We are often told that shorting a stock should not be done because you have an unlimited loss. Let’s examine that statement carefully.

Take a stock on Microsoft (MSFT). If you short the stock at 20$, your main risk is basically that MSFT will shoot up and become very expensive when you close your trade. Let’s say the stock goes up to 30$, a 50% increase, well, I am sorry to say you have lost 50% on your trade. Just to put this into context, I think quite a few investors have lost 50% on a trade in 2009. And since I am shorting using long/short strategies, this 50% increase would have to happen without the other stock going up for me to actually suffer this loss. Unlikely I’d say. Possible sure, but unlikely. And what about the unlimited loss? Well, yes of course, if the prices moves to 100$, then you have lost 400%, a much bigger amount than you could ever lose by simply owning a stock. But as I wrote, I will generally set a 20% loss limit on my trades, so again, not very likely is it?

In my opinion, shorting a stock is like any investment, it must be done with caution and with careful planning. The same people who say you should not use shorting as a strategy are often trading things like mining stocks or technology stocks, that are also very volatile.

One risk of course is that even with a limit you might not be able to close out your trade at your limit. For example, if you had a 25$ stop loss order to “limit” your loss to 25% on your short trade, you would lose more if MSFT announced major news and the stock instantly jumped to 27$. But again, what are the odds that MSFT will jump 50% overnight? Very very unlikely. And the two main periods when it could happen is basically during earnings announcements as well as because of takeover offers. For the first one, I’ve sometimes opted to close a short trade before earnings are released (even if I were to re-enter the trade after), simply because there is a lot more volatility and risk involved during these announcements (just to be clear, the same is true if you own the stock). As for takeover offers, there is no way to be 100% certain but some companies are better targets. Of course, I had said a while ago I would not short VCLK because it could potentially be purchased by another company.

I beleive that like any investment strategy, it is important to know what you are doing and what your objectives are and be discplined, nothing different from any other investment. We will soon be writing about why the mainstream media is not discussing this strategy more.

“I read your post on Million Dollar Journey today and checked out your site.  I liked some of the ideas, and while I won’t invest based only on your trades, they are some interesting thoughts to add to the mix.

But, after reviewing your site a little I didn’t find a basic primer section.  I’m not a beginner investor, but I don’t normally short stocks.  I do like the idea of hedging that you’re doing.  But, do you have advise as to how to best do it?  Is it a 50/50% thing?  50% long 50% short (per dollar?).

Thanks.  I look forward to reviewing your site.”

Thanks a lot for the email. Actually, the idea behind shorting stocks is one I’ve been experiencing with for a while now. My day job is close to the hedge fund industry and you technically have 2 types of funds:

-Market neutral: Generally maintain a $ exposure of 50/50

-Long/Short: More what I’m doing which is get some flexibility, and yes on most picks I would be 50/50 but I could be outright long or short.

I like the long/short mainly because you are trying to get a sense of the discrepancy between 2 stocks rather than on the overall market.

When shorting a stock, you will generally have to specify that you are doing so because your broker will have to borrow it. Because you are 50/50, no money is needed up front (except for commissions). But generally brokers will require a margin because of your short position. It will depend on stocks and so on but as a general rule I use 70% of the short value. So you will be paying for the borrow but getting interest on your cash, which should offset each other (or close).

Here is an example of my last trade:

LONG PCLN:                150 X 66.28$=9942$

SHORT AMZN:              -170X 58.51$=9947$

Overall, the trade cost had a cost of -5$. However, given the risk in a short position, the broker will ask me to have about 70% or close to 7000$ in my account.

Then the broker will charge me a cost for borrowing the AMZN shares but will give me interest on the 7000$ in my account. The two will be close to offsetting each other.

When closing the trade, I will do the opposite, so sell PCLN and buy AMZN. So I’m looking to have PCLN have a better performance to AMZN, it’s the only thing that matters to me.

The start of February is always an interesting month for the advertising world as the biggest yearly event in the world takes place, the American Football championship, known better as the Super Bowl. How many shots do advertisers have at reaching 90 million American viewers at once? Not many. And so it is a rare opportunity to get a new message across or simply work on branding. Even more important is that the ads are actually a major part of the show with many viewers looking forward to seeing the ads, discussing them, and seeing them more and more.

Of course, this puts a lot of pressure on advertisers looking to generate buzz and get the press and viewers talking about their ads. But it does not come cheap obviously, as NBC this year was charging about $3 millions US for a 30 second spot. And while it is always a lot of money, that is even more true in this current very challenging environment. And some of the biggest sponsors decided to skip their turn. The most notable one was GM, usually one of the 2-3 biggest sponsors of the event that was not part of the show this year.

The major goal in such ads that target a broad audience is generally branding. Either you are looking to get viewers to discover who you are, or you want to reinforce it. Look at ads such as the much buzzed “CareerBuilder” ad. With about 1,5 million views on Yahoo videos, countless others on Hulu.com, Youtube, etc. Add to that the viewers that saw it on tv, all those that have been discussing it and you can easily manage how they now have a lot more internet users that will think of careerbuilder the next time they look for a job. Of course, the product still needs to be of great quality. And that is always the risk isn’t it?

See the CareerBuilder advertisement here:

When you think about it, $3 millions is indeed a lot of money, and if it was only the tv viewers that saw it, I might agree that it is just too expensive. But given everything around these ads and the potential for a huge hit, I think it can be worth its pot of gold. Of course, competing against so many other great ads makes it critical to have success:

1-Be on the edge: The ads that were most discussed were either very funny or on the edge of what was acceptable. For more established ads it was not as crucial, but especially if you are trying to make a name for yourself, it is critical.

2-Ideally, lead to action. I’m surprised that not many did this, but I thought that GoDaddy’s ad was brilliant in that it gave an incentivefor users (especially male ones) to go see the end of their ad on their website, giving them a lot more potential of converting their users and getting even more brand recognition.

GoDaddy:

3-Create hype: Knowing that these ads will be more discussed than anything else in your marketing, be sure to give users something to talk about so that your investment is one for a few weeks, not 30 seconds!!!