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Window dressing is defined as the act partaken by a portfolio manager to strategically manage his funds' holdings to better serve capital acquisition efforts. It's a superficial manipulation of the appearance of a fund's past activity in order to garner new capital, and you need to be aware of it, and maybe even profit from it.

Last week brought the close of the third quarter for most corporations. However, about half of the institutional mutual funds in existence close their fiscal year and quarter at the end of October. Still, "window dressing" should be factoring into the movement of stocks today. Window dressing is defined as the acts partaken by portfolio managers to strategically manage their funds' holdings to better serve capital acquisition efforts. Indeed, those investment pools with October year-ends will be engaging in such action through the month ahead, and may be already doing so in order to pre-empt their peers and to gain better exit and entry points for specific trades.

What this means is that portfolio managers are, and will be, actively shuffling out of the fiscal year's losers, or stocks that have lost significant value this year, and into winners, or capital gainers. This dresses their prospectuses up in order to attract investors that might act on perception. It's like Andre Agassi's memorable advertising campaign, where he utters the unforgettable phrase, "Image is everything." Image indeed plays an important role in the distribution of capital.

The theory behind window dresses is based on investment company observation that prospective investors will place their money in funds that hold names they know have increased in value in recent times, and not in the funds that hold the shares of recent losers. When one sees a fund holds a stock that has had a dramatic loss of value, one might be less inclined to send a check out to that particular fund manager. The same goes for the year's big winners held in portfolios.

A critical investor might act in a contrary fashion though, because value stocks typically represent the shares of companies that have decreased from a historical mean line valuation. So the stock of an established company, whose business is unthreatened, might represent a value after a bad year. The whole "Dogs of the Dow" investment methodology is based on this thesis. Generally speaking, you buy last year’s losers from the Dow Industrials Index, and do well over the following year. This is a value chasing strategy.

I brushed on the fact that even the October end funds may already be engaging in these actions. There are several reasons for this. Funds tend to liquidate or establish positions in stocks over time, because large funds must take a large position in a stock in order for it to become a significant holding that makes a difference in performance. Big funds, therefore, tend to move stocks if they liquidate positions all at once or too quickly. Even small funds can move microcap stocks. In order to detach themselves from association with last year's losers by fiscal year end then, the fund must begin selling well ahead of October 30th.

For a fund to include a new name as a holding, it need not take a large stake. However, this can make window dressing for winners easily identifiable in a prospectus. All you have to note is the size of the interest held in the particular past year’s winner. However, in all likelihood, an intelligent portfolio manager will seek winners that he views still worth purchasing in order to save himself from a near immediate need to reverse the trade. In efforts to identify window dressing, you might also compare holdings from prior report, but this might not produce information that is free of noise, and it may mis-categorize sincere trading.

Window dressing is something investors should be aware of, and even seek to benefit from. As the large investment pools make changes to their holdings, they create anomaly and profit opportunity for all. Be a beneficiary of window dressing, rather than the bearer of collateral damage.

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Disclosure: No positions

Source: Window Dressing Tricks and Treats