Window Dressing: What It Is, Who Does It, and Why

What Is Window Dressing?

Window dressing is a strategy used by mutual fund and other portfolio managers to improve the appearance of a fund’s performance before presenting it to clients or shareholders. To window dress, the fund manager sells stocks with large losses and purchases high-flying stocks near the end of the quarter or year. These securities are then reported as part of the fund's holdings.

The term can also refer to actions taken by companies to improve their forthcoming financial statement, such as by postponing payments or finding ways to book revenues earlier.

Key Takeaways

  • Window dressing occurs when portfolio managers try to boost a fund’s investment performance prior to investor or shareholder presentations.
  • It can be identified by carefully evaluating a firm or fund's financial statements and looking for suspicious trades coinciding with the end of a quarter or fiscal year.
  • Window dressing can give the appearance of better returns, but these strategies often simply defer losses that will materialize later on.

Window Dressing

How Window Dressing Works

Performance reports and a list of the holdings in a mutual fund are usually sent to clients every quarter, and clients use these reports to monitor the fund's investment returns. When performance has been lagging, mutual fund managers may use window dressing, selling stocks that have reported substantial losses and replacing them with stocks expected to produce short-term gains to improve the overall performance of the fund for the reporting period.

Another variation of window dressing is investing in stocks that do not meet the style of the mutual fund. For example, a precious metals fund might invest in stocks in a hot sector at the time, disguising the fund's holdings and investing outside the scope of the fund’s investment strategy.

Example of Window Dressing

A fund investing in stocks exclusively from the S&P 500 has underperformed the index. Stocks A and B outperformed the total index but were underweight in the fund, while stocks C and D were overweight in the fund but lagged the index.

To make it look like the fund was investing in stocks A and B all along, the portfolio manager sells out of stocks C and D, replacing them with, and giving an overweight to, stocks A and B.

The act of window dressing is under close watch by investment researchers and regulators with potentially forthcoming rules that could require more immediate and greater transparency of holdings at the end of a reporting period.

Monitor Your Fund Performance

For investors, window dressing provides another good reason to monitor your fund performance reports closely. Some fund managers might try to improve returns through window dressing, which means investors should be cautious of holdings that seem out of line with the fund’s overall strategy.

Investors should pay close attention to holdings that appear outside of a fund’s strategy.

Window dressing can boost a fund’s returns in the short term, although longer-term effects on a portfolio are typically negative. While these holdings may show higher short-term performance, in the long run these types of investments drag on the portfolio’s returns, and a portfolio manager cannot often hide poor performance for long. Investors will certainly identify these types of investments, and the result is often lower confidence in the fund manager and increased fund outflows.

Who Engages in Window Dressing

Though disclosure rules are intended to aid in increasing transparency for investors, window dressing can still obscure the practices of the fund manager. A study by Iwan Meier and Ernst Schaumburg of Northwestern University found that certain characteristics of a fund can signal that the manager may be engaging in window dressing. Specifically, growth funds with high turnover and a manager who has recently posted poor returns are more often the ones who will window dress. 

Window dressing also occurs across various other industries. For instance, companies can offer products at discounted prices or promote special deals that enhance sales for the end of the period. These promotional efforts seek to increase the return in the final days of a reporting period.

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