Like displaying more than 10 inflatable lawn ornaments, the practice should be banned
To many of us, this time of year means stringing holiday lights outside, bringing out the inflatable candy canes and decorating windows with frosty snowflakes highlighted by fake candlelight. To financial advisors, this time of year brings another type of behavior: “window dressing” of mutual funds by portfolio managers. Let’s examine what mutual fund window dressing is, how you can spot it and what you should do.
As you probably know, all mutual funds must list their actual holdings four times a year at the end of every quarter and many fund companies send investors copies of these reports (or they can be found online too). But what you might not know is that the list of fund holdings is only a snapshot on one particular day – not all the actual holdings that were owned throughout the quarter.
Knowing this fact, some portfolio managers will sell certain stocks and buy others right before the time that their holdings will be reported – thereby presenting a better picture – the window dressing – to shareholders. And while this practice can occur at the end of every quarter, it is much more common at the end of the year, when investors are more apt to pay attention to their mutual fund holdings.
In an interview with the Wall Street Journal, Russ Kinnel, from mutual fund researcher Morningstar, had this to say about mutual fund window dressing:
“The basic concept is that managers are either hiding their mistakes or adding winners to make themselves look a little smarter.”
Example of Window Dressing
Let’s say you own the Big City Large Cap Stock Fund and it returned 12% for the year vs. the S&P 500, which returned 18%. The Big City LCS Fund also bought stocks A, B and C at the beginning of the year and unfortunately, they each had negative returns for the year, thereby dragging down the overall performance of the Big City LCS Fund.
On the other hand, the Big City LCS Fund does not own stocks D, E and F, which is too bad because each of them enjoyed widely publicized, double-digit returns for the year. So, in an effort to fool investors and make it appear as if the Big City LCS Fund had invested in stocks D, E and F the whole time, the portfolio manager sells stocks A, B and C and replaces them with stocks D, E and F two days before the year is over.
Shareholders get their Annual Report and only see that their beloved Fund “owns” stocks D, E and F – they don’t see that they really owned stocks A, B and C for most of the year. The Big City LCS Fund was window-dressed. ‘Tis the Season…
Does Mutual Fund Window Dressing Really Happen?
Sadly, the answer is yes. In a research-paper written by Iwan Meiera of HEC Montreal and Ernst Schaumburg of the Kellogg School of Management, the following was said:
“It is not uncommon for mutual fund managers to make significant adjustments to their allocations before closing out their portfolios at the end of the quarter. We analyzed the semi-annual holdings and daily net asset values of 4,025 U.S. domestic equity mutual funds over the period from 1997 to 2002 and find strong evidence of increased turnover during the last days of the quarter, consistent with window dressing.
In particular, we show that growth funds and funds with poor recent performance are more likely to report misleading holding. Furthermore, the end of quarter trading activity is not easily accounted for by momentum/relative strength strategies and is not associated with strategies that on average provide any added value to investors, even before accounting for expenses.”
How Can Shareholders Spot Window Dressing?
So, what should mutual fund investors look for to determine whether their mutual funds were subjected to window dressing? Here are 3 things to keep in mind:
1.) Performance Matters
The first (and probably the most important) thing investors should pay attention to is the fund’s overall performance, net of fees, compared to an appropriate benchmark. So in the above example, how did the Big City LCS Fund compare to the S&P 500? Because a portfolio manager can move holdings around until they are blue in the face – but you can’t hide bad performance numbers.
2.) Out-Of-Place Holdings
Second, review the holdings in your mutual funds and see if something seems out of place. For example, based on its name, you can surmise that the Big City Large Cap Stock Fund will own large cap stocks. If you see a bunch of small cap stocks in its Top 10 Holdings, then something is amiss and you should ask questions.
3.) High Portfolio Turnover
Mutual funds publish their annual portfolio turnover percentages and it is a good idea for you to review. In simple terms, portfolio turnover is exactly what it sounds like – how often your portfolio manager is buying and selling stocks within your mutual fund. If a portfolio manager owns 100 stocks and sells 10 of them during the year, then the fund’s portfolio turnover is 10%. If 75 get sold, then the portfolio turnover is 75%.
Now, higher portfolio turnover is not necessarily bad (although it will increase trading costs and expenses), but historically higher turnover does point to more buying and selling and you should understand why – especially if your fund has underperformed its benchmark index.
Finally, Be Careful When Making Conclusions
Often times we can reach the right conclusion, but arrive there based on incorrect assumptions. For example, you might have a fund that underperforms with very high turnover and conclude that the high turnover is the reason for underperformance. While it might be a contributing factor, it could be that the portfolio manager just picked some underperforming sectors or stocks.
Or maybe you have a fund with great relative performance with low turnover and a huge percentage of its holdings in cash. Again, those are contributing factors, but may not be the main drivers of outperformance.
The point is that you need examine your mutual funds periodically to be sure you understand 1) how they performed and 2) why they performed. But before you draw conclusions, talk to your financial advisor and see if he/she agrees with you. Because there are usually multiple reasons why mutual funds underperform or outperform.
But always remember this: mutual fund window dressing is just what it sounds like and it is designed to fool you. Don’t be fooled.