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Investors should watch out for 'window dressing' in managed funds

Investors should watch out for 'window dressing' in managed funds

As you enjoy a few easy days at the end of the year, think about your mutual fund managers. Lots of people who oversee actively managed funds put in long days just before New Year.
The final week of every quarter is known as "window dressing week." It's when portfolio managers sell stocks that have done poorly during the quarter and replace them with ones that did well.
The idea is to make themselves look good: Reports to investors include snapshots of major fund holdings at the end of the quarter. So packing the big winners into the fund makes the manager look like a great stock picker.
But if those winners were added to the fund at only the last minute, it was too late. Most of the gains came earlier - so your fund didn't benefit. Moreover, the winners are often sold soon after the reporting period ends.
Dumping the fund's losers helps make the picture even prettier, since investors won't know the manager rode these dogs down.
Hoodwinking investors is bad enough, but window dressing also racks up trading commissions and other costs. Since these are paid out of the funds' holdings, they come from shareholders pockets, eroding investment returns in a way that's invisible to shareholders.
How common is window dressing? Many experts believe it to be very widespread, though no one admits doing it.
A study by Thomson Financial, an information provider to the financial industry, found evidence that window dressing is common. As managers scrambled to buy the best-performing stocks in the Standard & Poor's 500, the extra demand drove those stocks' prices up, Thomson found.
In fact, that caused temporary gains in the funds' prices as well. But those were soon reversed as managers unloaded the recently hot stocks to buy others that looked more promising.
In a 2001 study, Edward S. O'Neal, a finance professor at Wake Forest University, found abundant circumstantial evidence or window dressing. He compared returns of hot stocks with those of stock-owning mutual funds. The two groups tended to march in a kind of lock step at the end of the year but not the rest of the time. That suggested the fund managers had pumped the hot stocks into their portfolios.
The small fluctuations in fund prices caused by window dressing are not terribly important - not as important as the unnecessary costs it incurs.
Even more important, though, is the dishonesty. A window-dressing fund manager is like a job applicant who fakes his college transcript.
Many investors look closely at funds' biggest holdings when choosing one fund over another. They take these lists as accurate reflections of the manager's stock-picking prowess. The data is also used by fund-analysis firms like Morningstar Inc., which many small investors rely on.
The deception involved in window dressing is just one of many examples of fund companies putting their interests ahead of investors'. Management fees have remained high, even though the mushrooming size of the industry should have produced efficiencies to drive fees down. Fund-industry ads tend to cherry-pick performance data to make funds look better than they are.
What is to be done?
Regulators could require that funds report all holdings on a daily or weekly basis so that window dressing could be detected - and thus deterred. (A reasonable reporting delay could be allowed so funds would not have to reveal their stock-picking strategies to competitors.)
Or you could take matters into your own hands by avoiding actively managed funds in favor of index funds.
Indexers have no incentive to engage in window dressing because their holdings must match those of the underlying index, such as the S&P 500. An indexer's biggest holding at the end of the year will be the biggest stock in the index, even if that stock didn't do very well.
Lots of evidence shows that indexers tend to provide bigger returns over time than managed funds. It's largely because indexers don't rack up big costs in a fruitless hunt for hot stocks.
The lack of window dressing is just another reason to look at indexers first.
Jeff Brown is a business columnist for The Philadelphia Inquirer.


Updated : 2021-07-29 02:15 GMT+08:00