What is Window Dressing?

Window dressing refers to manipulation by portfolio managers near the end of a financial period to make the fund appear more successful when reporting results to investors.

In this post, we’re going to look at why portfolio managers use window dressing, how they do it, and how you can spot it. We’ll also touch on another area of finance where window dressing is common.

How Window Dressing Works

Let’s start with the basics of how all window dressing works. Every quarter, funds provide a report that includes the performance and holdings of that fund. This report is a snapshot of the portfolio at the end of a reporting period. The report does not contain a list of all the holdings the fund has had throughout the reporting period.

Right before reporting performance, portfolio managers may adjust the holdings to make the fund look better. Since these reports include the assets in a fund but are not required to disclose when those holdings were bought or sold, investors may draw incorrect conclusions about the fund.

How Window Dressing Makes a Portfolio Manager Look Better

Portfolio managers engage in window dressing because, at least in the short-term, it makes them look better. But how and why does window dressing make a fund look good? Window dressing is often described as buying well-performing stocks and selling weak performing stocks. While this is sometimes the case, there are also other ways portfolio managers may engage in window dressing. Let’s look at each of the main forms of window dressing, since understanding each of them can make them easier to spot.

Top Holdings

A fund often reports its top 10 or 25 holdings (the holdings with the most weight). These top holdings are often a key component in reviewing a fund, even if their total percentage of the fund is relatively low. Let’s say a portfolio manager has a few holdings in the portfolio that have done quite well, but the fund does not have a high enough percentage of these holdings for them to make the top holdings list. As the reporting period comes to a close, the portfolio manager could purchase more of these holdings, so they end up in the top holdings list, making it appear that the portfolio manager had included a high percentage of stocks that performed well.

Poor Performers

Just as the inclusion of high performing stocks makes a portfolio manager look better, so does the exclusion of low performing stocks. Therefore, a portfolio manager may try to sell some or all of a holding that has performed poorly.

Missed Opportunities

A portfolio manager may also want to avoid appearing like he or she missed out on a holding that turned out to be a fantastic opportunity. While this can happen in any fund, it’s especially common in more specialized funds. Specialized portfolio managers may feel that missing out on a great opportunity in an area in which they’re supposed to be knowledgeable could hurt their reputation and will, therefore, purchase the holding before the end of the reporting period.

Investing Outside the Fund Universe

A portfolio manager may choose to invest in a way that is not in line with the fund’s objectives and then change the holdings right before the reporting period, so they’re back in line with the fund’s objectives. For example, during a time when the market is down, a portfolio manager may choose to have a large cash holding in an equity portfolio. This could theoretically help limit some of the negative impacts of the market but is not in line with the fund’s objectives. Therefore, the fund manager would move the holdings back to equities before the end of the reporting period.

Improving the Sharpe Ratio

The Sharpe Ratio is a tool investors can use that measures the risk of an investment in relation to its return. A portfolio manager that wants to make a portfolio to appear less risky can change the positions of the fund before the reporting period by investing in lower-risk securities. This strategy can be especially detrimental to investors because it may lead them to invest in a fund that exceeds their risk tolerance without their knowledge.

The Problems with Window Dressing

Window dressing is legal, but that doesn’t mean it’s okay. Window dressing is all about creating an appearance of more success than there truly is. The most obvious issue is that this practice may mislead investors and cause them to make investments they would not otherwise make.

The other problem with window dressing is that portfolio managers with poor portfolio management more often implement it. This is not surprising, since the worse the performance of a portfolio manager, the more he or she stands to benefit from window dressing. Not only is window dressing associated with worse performance, but it can also cause it. Window dressing can cause worse long-term performance, in part due to the high rate of turnover in the portfolio, which often leads to higher trade costs.

How to Spot Window Dressing

While window dressing is not illegal, that still doesn’t mean you want it occurring in your account. The SEC may issue stricter rules regarding window dressing in the future, but for the time being, it’s up to you to monitor your accounts for window dressing. Thankfully, there are a few simple red flags to watch out for.

The best way to avoid being misled by window dressing is to review performance. Holdings may lie, but performance is a far more reliable metric. You’ll also want to look out for investments in a fund that isn’t in line with the strategy. Finally, you should review portfolio turnover percentages, which is how often the portfolio manager buys and sells investments. High portfolio turnover is not necessarily a bad thing, but it can be a red flag. Not all funds with a high turnover percentage are window dressing, but almost all funds that use window dressing will have a high turnover percentage.

While window dressing can occur quarterly, it is more often used at the end of the year, since this is usually when more investors review reports. This means you may want to spend extra time studying reports highlighting year-end performance and holdings.

If you spot any window dressing red flags, the best thing to do is ask questions. There may be a perfectly harmless explanation for what’s happening, but often the only way to find out for sure is to ask.

Window Dressing Outside of Mutual Funds

Window dressing is not limited to portfolio managers and mutual funds. Companies may also use window dressing to make financial statements look better than they are.

There are two main reasons companies use window dressing. The first is to raise the share price of the company by making the company look better to shareholders and investors. The second reason is to convince a lender to allow the company to borrow money under more favorable circumstances.

Window dressing at a company is similar to the window dressing of a portfolio, but it is slightly different. Near the end of an accounting period, a company may use several different strategies to improve the appearance of financial statements. These strategies may include accounting practices that impact accounts receivable, revenue, fixed assets, cash, depreciation, expenses, etc. For example, a company may wait to pay suppliers so that it looks like there’s more cash than there is.

Like window dressing with funds, window dressing the financial statements of a company is legal but misleads shareholders, investors, and lenders. It may also be a slippery slope. Companies that encourage window dressing may continue using more and more manipulative accounting practices that eventually constitute fraud.

The Takeaway

Window dressing is a way of legally manipulating the reports of a portfolio manager or company to improve appearances. While there’s nothing technically wrong with this practice, it can often mislead investors. Thankfully, once you know what to look for, it becomes relatively easy to spot.


Leo Smigel

Based in Pittsburgh, Analyzing Alpha is a blog by Leo Smigel exploring what works in the markets.