Window Dressing – A Technique Used by Mutual Funds to Enhance Performance Perceptions
Window dressing is the name given to a widespread practice of institutional investors, and particularly of mutual fund managers, that is regularly adopted to ensure that their quarterly reports to investors present an artificially positive aspect regarding the investments they have brought into their portfolio.
This window dressing is achieved through the culling at quarter end of particularly poorly performing stocks. Such stocks, generally regarded as “losers” owing to their recent price performance, are replaced with stocks that have been among the top performers of recent times. This practice is designed to support marketing efforts that seek to encourage new investors to invest in the fund. Window dressing has the effect of making it appear that the fund manager has been smart enough to invest largely or exclusively in the winners he/she now lists as making up the portfolio.
As a marketing tactic the practice makes perfect sense. Potential investors will check out the fund’s current positions and will in their mind register that the fund manager appears to have been consistently successful in selecting stronger-performing stocks.
However from the point of view of maximizing investment returns, window dressing is counter-productive as it brings the fund manager into a classic “buy high, sell low” scenario, especially as the investments made for window dressing purposes are mostly reversed after the quarter end reporting period has passed. The practice is so widespread, however, that at each quarter end there is a resulting clear tendency for losing stocks to be pushed further downwards as big institutions exit their positions en masse.
Meanwhile, those stocks that have already been on a tear will find themselves pushed even higher as fund managers engaged in window dressing seek to include these success stories in their portfolio. For the contrarian investor/trader as a result, each quarter end offers a great opportunity to buy some already beaten down stocks at an even cheaper price and then watch them recover as the window dressing pressure subsides and reverses.