What Is Window Dressing?
Window dressing in finance involves altering financial reports or portfolios to create a misleading impression of a fund or company’s performance. This deceptive practice can obscure real results and impact investment decisions. Fund managers may buy or sell securities at strategic times, while companies may adjust accounting methods to present more favorable financial outcomes. This article delves into how these strategies work and offers guidance on identifying them.
Key Takeaways
- Window dressing is a strategy to make funds or companies look better financially by altering their holdings or accounting practices.
- Portfolio managers might sell losing stocks and buy high-performing ones, misleadingly boosting fund performance.
- Companies may change accounting methods to enhance financial reports, potentially deceiving investors or lenders.
- Window dressing is illegal in accounting but is unethical in investment management, aiming to mislead stakeholders.
- Investors can detect window dressing by analyzing changes in a fund’s holdings and ensuring consistency with the fund’s objectives.
Understanding the Mechanics of Window Dressing
Window dressing is a deceptive practice no matter what industry it is used in or what purpose it serves. It paints a false financial picture because information is changed to make a company seem to perform better than it did.
Mutual funds buy stocks and sell shares to investors. Managers may replace poor-performing stocks at the end of a reporting period to make the fund appear stronger.
Companies can alter reportable financial information through their accounting procedures. This changes the data that is reported on their quarterly and annual reports or letters to shareholders.
Altering accounting practices to change report appearances is illegal. However, replacing a fund’s holdings at certain times isn’t illegal unless it violates securities laws. That said, it is an unethical practice because it attempts to deceive investors and regulators.
The Role of Window Dressing in Mutual Funds
Fund managers are paid to make sure investments perform well. If they don’t, investors might seek better returns elsewhere. To prevent this from happening, managers might replace holdings near the end of the reporting period to keep investors from moving money to other investments.
Common Techniques for Window Dressing in Investment Funds
A hedge fund manager might sell stocks that have experienced significant losses and purchase high-flying stocks near the end of the quarter or year. These securities are then reported as part of the fund’s holdings, making it seem like they had been there the entire time.
When performance has been lagging, fund managers may sell stocks that have reported substantial losses and replace them with stocks expected to produce short-term gains to improve the fund’s overall performance for the reporting period.
Tip
Investors should pay close attention to holdings that appear outside of a fund’s strategy and the assets that have been replaced.
For example, imagine that a fund investing in stocks exclusively from the S&P 500 has underperformed the index. Stocks A and B outperformed the total index but were underweight in the fund, while stocks C and D were overweight in the fund but lagged the index.
To make it look like the fund was investing in stocks A and B all along, the portfolio manager could sell out of stocks C and D, replacing them with A and B. This would also give an overweight to stocks A and B.
Managers may also buy stocks that don’t match the mutual fund’s style. For example, a precious metals fund might invest in unrelated high-performing stocks. This gives the fund the appearance of a short-term performance boost that is not aligned with the market or indexes it might mirror.
Detecting Signs of Window Dressing in Fund Portfolios
Though disclosure rules are intended to aid in increasing transparency for investors, window dressing can still obscure the practices of the fund manager. There are some techniques you can use to identify window dressing:
First, ensure holdings match the index that the fund tracks if it is an index fund. If it isn’t an index fund, make sure they meet the fund’s published intent. Most funds have a description of what they are designed to invest in, usually called the fund’s objective. For example, the Fidelity Value Fund’s (FDVLX) objective is to seek capital appreciation, using a strategy of valuating companies with valuable fixed assets and purchasing the stocks of the ones it believes are undervalued.
Fast Fact
If you found holdings in this fund you believed didn’t fit the objective and strategy, it might be window dressing. But then, it might not because the fund’s valuation methodology might allow it to change holdings.
Second, look over the fund’s holdings and compare the returns of each one. For instance, FDVLX had more than 200 holdings on Jan. 31, 2023, with the top 10 stocks making up slightly more than 10% of the fund. If you look at the fund’s monthly holding report, you can find each stock’s ticker and evaluate it. By comparing holdings from month to month, you might also see them changing and be able to investigate performance differences between the old and new ones.
Third, use these reports to identify past and current turnover and determine when it occurs. There might be a pattern of turnover, such as a majority of stocks remaining in the fund’s holdings with several nonperformers turning over at intervals that don’t make sense. This could be regular fund management, but it pays to take a look.
Finally, look at the fund’s management. Fund managers lacking trading acumen or who have experienced poor performance in the past are more likely to window dress. Good funds have experienced, ethical managers who do not need to window dress.
Understanding Window Dressing in Financial Accounting
Public companies must follow accounting rules that ensure transparency for investors and regulators. Many hire accounting firms to keep accurate books and reports.
Management may not like the financial report results and could alter accounts or methods to appear more successful.
The most significant reason a business would window-dress its financial reports is to ensure they don’t lose investor interest. Investors and lenders make up a large portion of a company’s fundraising efforts. Lenders use these reports to make lending decisions, and investors use them for investing decisions. Therefore, lower financial performance can mean less funding.
Accounting Tactics for Window Dressing
Not all accounting window dressing is as evident as changing some numbers. Here are a few examples of changes in accounting methods:
- Cash window dressing: Paying suppliers after the period ends to boost cash balances
- Capitalization window dressing: Increasing profits by capitalizing small expenses instead of charging them as an expense
- Fixed asset window dressing: Selling fixed assets with accumulated depreciation, so the fixed assets still owned appear to have less depreciation
- Expenses window dressing: Recording supplier invoices in the next period to reduce liabilities on the balance sheet
Important
It’s important to understand that many businesses are honest and trying to do the right thing. Looking out for window dressing should be part of your tool kit when you’re evaluating investment opportunities, just in case you come across a company that is trying to cook the books or deceive you.
Uncovering Window Dressing Practices in Accounting
While difficult to determine, you can identify window dressing by studying past financial reports and reading about a company’s activities via their news releases and investor reports. You may be able to identify discrepancies between them. For instance, examine the cash flow statement to see where cash is coming from and where it is going, then compare it to cash flows from the last few periods.
Significant changes should be explained in the reports. If not, it’s worth investigating further. Look for a change in accounting procedures—a company should publish that they began accounting differently for something recently (in fact, publicly traded companies are required to report accounting procedure changes).
Look for increases in valuation, a dramatic increase in sales that doesn’t correspond to past seasonal or cyclical sales, or another issue that might raise an eyebrow.
What Does It Mean If Something Is Window Dressing?
You may have heard that a stock is window dressing for a fund or that a business’s reports are window dressed. This means that a stock has been replaced close to the end of a reporting period to boost performance falsely, or the reports are altered to be more financially attractive to investors and lenders.
Is Window Dressing Illegal in Accounting?
Window dressing in accounting is unethical and illegal. The Financial Industry Regulatory Authority (FINRA) has fined companies for window dressing.
How Do You Window Dress Financial Statements?
Financial statements are an aggregation of the results of the accounting process for an accounting period. There are several ways to window dress these statements. Some examples are recording certain expenses differently or capitalizing expenses rather than accounting for them as expenses.
The Bottom Line
Window dressing in finance is a deceptive practice used by investment managers and executives to make investments or businesses appear more successful than they truly are. While altering accounting procedures to mislead stakeholders is illegal, strategically swapping investment holdings to falsely enhance fund performance breaches ethical guidelines. This misleading tactic can skew investor decisions, potentially leading them to choices they might otherwise avoid. Recognizing and identifying these practices is crucial for making informed investment decisions.
