When analyzing mutual funds, reviewing fund holdings is useful to ensure adequate diversification within a fund, as well as between different funds.
But you need to be certain that the holdings you review accurately reflect the fund’s investment strategy. If they do not, it may be due to the presence of window dressing.
Historically, the term “window dressing” refers to shop windows you pass while walking down the street. Stores present attractive display cases in the hope that you will be interested in their wares, enter the store, and make a purchase.
With mutual funds, I would describe window dressing in two ways.
The Common View of Window Dressing
Just before a reporting period (i.e., quarter or year end), fund managers will try to make their fund holdings appear more attractive to shareholders. Investments that either have significant unrealized losses or are considered poor investments will be sold and replaced with more appealing assets. These may include investments that are currently performing well or assets that are receiving positive publicity in the business news.
At period end, shareholders receive statements that show the fund made up of popular and appreciating investments, rather than dogs and assets that have fallen in value.
While this is the common view of mutual fund window dressing, I think it is a little simplistic. It also assumes fund shareholders are idiots.
Yes, I like to review my funds’ holdings. And I like to see what I think are appealing investments within the portfolio.
But I am more focussed on fund performance (and ensuring I am adequately diversified).
If the managers are choosing poorly and dumping losers just before period end, their actions will be reflected in fund under-performance. It should not take long for investors to see through this type of fund manager manipulation.
My View of Window Dressing
I am more concerned about window dressing for two other reasons.
Index Huggers
First, window dressing can hide the index huggers.
That is, active fund managers that simply replicate their benchmark index in a passive management approach, yet charge shareholders for full active management.
By slightly altering fund holdings prior to reporting periods, fund managers can appear to show variances between their portfolio holdings and the benchmark. Yet once the new period commences, they revert back to the benchmark holdings.
As I hate to pay for services that I do not actually get, I like to watch for this in funds.
Style Departures
Second, window dressing can hide departures from a fund’s stated investment style.
A fund’s style is crucial to enable individuals to properly allocate their investment assets. Investors need to be certain that the investment style they believe they are investing in is truly the style.
A change in a fund’s investment style is known as style drift.
We will look at that next.
