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There are certain widespread practices that have existed in the financial industry for many years that seem to have no purpose but to defraud the retail investor. I've often wondered how these can still be legal. Window dressing is one such practice and as we approach the end of the second quarter 2009, now is an apropos time to broach a discussion about this controversial practice. If you are not familiar with the term “window dressing” it is the practice whereby fund managers, at the very end of each quarter,

(1) Dump many of the worst performing stocks in their portfolios; and/or

(2) Add some stocks that had the highest returns of that quarter to their portfolios.

Why do fund managers engage in this practice? Because investment firms are required to disclose their funds’ holdings to their clients and shareholders, and the holdings at the end of each quarter is the list of stocks disclosed to clients and future prospects. Thus, a good number of fund managers attempt to make themselves appear much smarter than they really are to clients and to prospects by “window dressing” their portfolios.

Is this an honorable practice? No. Is it a truthful practice? No. Is it a deceitful practice that helps investment firms sell more investment funds to their clients and new prospects? Yes. In fact, Investopedia even defines one example of window dressing as “investing in stocks that don’t meet the style of the mutual fund. For example, a precious metals fund might invest in stocks that are in a hot sector at the time, disguising the fund’s holdings, so clients really have no idea what they are paying for.”

Thus, window dressing theoretically allows a fund manager to simply dump all the stocks that fall outside the fund’s stated objective before each quarter-end to deceive shareholders into believing that the fund is remaining true to its stated objective even if it is not. If this occurs, an investor in such a fund would never know that the fund manager is engaging in considerable style drift.

So why isn’t this practice illegal? Since window dressing serves absolutely no purpose that is beneficial to the client or prospect and fund managers engage in it solely to deceive clients, almost all rational people would agree that it is unethical. The Securities and Exchange Commission [SEC] states on its very own website that its mission is “to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation”. Yet the practice of window dressing violates every single aspect of the SEC’s stated mission.

Window dressing contributes to inefficient markets since a number of high-profile losers get pounded on at the end of each quarter for no reason other than the fact that fund managers want to conceal from investors the fact that they had purchased said losing stocks. In addition, a number of high-profile winners will see an appreciation in share price due to buying that is spurred only by a desire to paint a false picture to current and future shareholders.

Since every insider of the investment industry, including the SEC, has known about window dressing for decades, why has the SEC done nothing about it? (this is a rhetorical question as we have all learned that the SEC is as much interested in protecting fraud as prosecuting it, depending upon the offending party.) As I explained in my earlier article, “How the Financial Elites Enronized America”, legislation increasingly rarely has anything to do with ethics. These two concepts, in the financial world, are often exclusive of one another. Clearly, window dressing is unethical. Yet it has been legal for many years with little real debate to end it.

If the SEC wants to know how to prevent the fraudulent practice of window dressing, I’ll solve this problem for them right here in this article in less than ten minutes' time. At the end of each quarter, require all fund managers to disclose in all marketing materials handed to existing and prospective clients the following two pieces of information:

(1) the exact date that they bought the most material positions of the stocks that presently constitute the top fifteen most heavily weighted stocks in their portfolio; and

(2) the exact date that they sold the most material positions of the stocks that constituted the fifteen most heavily weighted stocks that were sold that particular quarter.

If the SEC simply passed these two disclosures into law, a deceitful fund manager would no doubt be embarrassed into halting his practice of window dressing if he was a manager that repeatedly engaged in window dressing to add winners to his portfolio in the weeks or days before each quarter end. Secondly, a fund manager prone to window dressing would also likely stop dumping all his top losers right before the quarter-end if clients knew the only reason he dumped those losing stocks was so that they would not know that he held these stocks for 86 out of the 90 days of that quarter. The two above disclosures would not only halt the deceitful intent of window dressing practices, but it would also halt huge inefficient anomalies from occurring in stock markets at the end of each quarter.

Those in the industry that wish to continue the deceitful practice of window dressing will argue that increased disclosure, per my above proposals, is problematic because it reveals firms’ trade secrets that can then be leeched by other fund managers at competing firms. This is a bunch of nonsense for the following reasons. If you were to disclose the top 15 most heavily weighted sells in a portfolio, if they were sold to lock in profits, then even if a manager plans on re-buying some of these stocks, no one will know the exact date of when the manager re-buys these stocks in the next quarter, or even if he does re-buy these stocks, they will not know this information until the end of the next quarter. And if a manager dumped the stock because it performed horribly, then providing the exact dates these stocks were sold would hardly be disclosing any information of value to a competitor.

But what about stock purchases? Wouldn’t that provide valuable trade secrets to competing firms? To begin, every investment firm already lists the top 10-15 holdings of each portfolio in freely distributed material. After all, it’s required by law (depending on the size of the fund) and it would be immensely difficult to sell a fund without disclosing its top holdings to prospective investors. However, there is great irony in this statement, for the practice of window dressing allows an investor to purchase a fund whose current top holdings at the end of each quarter as presented in marketing materials may be materially different than the fund’s holdings during the remainder of the following quarter. Thus, if a manager had to disclose that 5 of his top 15 holdings were purchased in the last week of the quarter, an obvious attempt to “window dress” a fund’s holding, no investor would trust such a fund manager with their hard-earned cash. Thus, the practice of “window dressing” on the buy side would also cease.

For those interested in helping restore honesty and integrity to our financial world, please write your local Congressman or Congresswoman and lobby for a law to make the practice of window dressing illegal or contact the SEC directly here to voice a complaint. With enough pressure, new legislation can increase transparency and end deceit in the financial world. It is time for all of us to collectively take action now. If we do not, we have no right to complain about continuing fraudulent financial industry practices.

The last great contribution to society was the Industrial Revolution. Before the Industrial Revolution, 61 hours of labor were required to produce an acre of wheat. By 1900, thanks to the advances of the Industrial Revolution, only 3 hours, 19 minutes were required to produce an acre of wheat. Our current monetary system and the rampant fraud in the financial industry have reversed a great deal of the benefits of the Industrial Revolution to humanity. Before the year 2000, if 2,000 hours of labor earned a person USD $50,000 with which he or she bought a basket of goods, in just 8 years, by 2008, at the same pay scale, that same person had to work twice as many hours, 4,000 hours, just to buy the same basket of goods that 2,000 hours of labor would have purchased him or her 8 years prior!

The next great revolution that will improve the life of every citizen in the world is a Monetary Revolution in which we end fraudulent financial practices and the unsound monetary system that supports them. Learn more about how you can permanently end financial fraud through participation in a worldwide initiative here.

Source: The Deceitful Practice of Window Dressing: Why Has the SEC Done Nothing About It?