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What is 'Window Dressing'

Window dressing is a strategy used by mutual fund and other portfolio managers near the year or quarter end 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. These securities are then reported as part of the fund's holdings.

BREAKING DOWN 'Window Dressing'

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 to sell stocks that have reported substantial losses, 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 have outperformed the total index but were underweight in the fund. 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.

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. 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.

While window dressing overall can help a fund’s returns in the short term, longer-term effects on a portfolio are typically negative. Investors should pay close attention to holdings that appear outside of a fund’s strategy. While these holdings may show higher short-term performance, over 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.

Window dressing also occurs across various other industries to improve a company's return. 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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