What Is Window Dressing in Finance?

What Is Window Dressing?

Window dressing is the term for a strategy used by retailers—dressing up a window display—to draw in customers. The financial industry adopted it to refer to the practice of altering financial data to appear more attract investors.

Businesses can time adjustments in their accounting procedures, and investment holdings can be changed at specific times to seem as if they are more profitable, have higher returns, or have been performing well the entire period.

Specific to investments, it is used to refer to how a fund or portfolio manager might buy or sell securities at a particular time to appear to be performing better.

How Window Dressing Works

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 are companies that purchase stocks and sell portions of those stocks to investors. Fund managers might replace non-performing stocks near the end of a reporting period to make it seem as if a fund is performing better than it is.

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.

It is illegal for businesses to alter their accounting practices to change how their reports look. But unless there is a clear violation of securities laws or if the fund alters its accounting methods to window dress, investment managers are not doing anything illegal by replacing a fund's holdings at specific times. That said, it is an unethical practice because it attempts to deceive investors and regulators.

Window Dressing in Mutual Funds

Fund and portfolio managers get paid to ensure investing instruments are performing. If they don't perform, investors may become interested in other products or services that appear to be offering better returns. 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.

Methods for Window Dressing in 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.

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.

Another way is for a manager to purchase stocks that do not meet the style or strategy of the mutual fund. For example, a precious metals fund might invest in stocks that were performing well and disguise them. This gives the fund the appearance of a short-term performance boost that is not aligned with the market or indexes it might mirror.

How to Identify Window Dressing in Funds

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 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.

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 ten 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 non-performers 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 that do not need to window dress.

Window Dressing in Accounting

Publicly-owned companies must follow specific accounting guidelines that ensure investors and regulators have a transparent view of financial performance. Some hire accounting firms to ensure their books are kept up-to-date and that reports are generated.

There is always the chance that management or leadership will not like the results seen on these financial reports, so they may try to make changes to accounts or accounting methods to make it look like they performed better than they did.

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 fund-raising efforts. Lenders use these reports to make lending decisions, and investors use them for investing decisions. Therefore, lower financial performance can mean less funding.

Methods for Window Dressing in Accounting

Not all accounting window dressing is so 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

How to Identify Window Dressing 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.

If there are significant changes, you should be able to find a summary in the investor or financial reports with a description of why it has changed. If you don't see it, you may want to investigate 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.

The Bottom Line

Window dressing is used by some investment managers, financial departments, or executives to give the appearance that a particular investment or business is doing better than it is. It is an illegal practice regarding accounting procedures and financial reporting.

But when investment managers window dress by replacing holdings at the end of a period to make an investment instrument appear to perform better, it's more of a violation of ethical fund management practices. It is an attempt to fool you into investing in something you might not invest in otherwise. That's why it's essential to know what it is and how to identify it.