When I was a registered representative for a large mutual fund management company, the term “window dressing” came up often near the end of each year.

What is window dressing?

In short, window dressing describes the action some investment managers take to help improve the “appearance” of their fund(s).

Imagine you’re a fund manager and the money you manage performs worse than the benchmark or peer group. If your statement of investments reveals you didn’t own shares of a great performing stock, it may spotlight a weakness in your capabilities. Or maybe you own shares of the stock, but not enough to make a difference in the overall fund performance.

Since many investors – and advisors – look closely at year-end reports when making decisions about where to invest money, some portfolio managers shift money into high returning stocks in the month of December. While they’re at it, they sell the dogs. This is known as window dressing.

How can window dressing affect stocks?

Assume there are thousands of fund managers trying to make their funds look good as the year winds down. The result can be millions of dollars flowing into some of the year’s top performing stocks for no other reason than to help make the funds look better on paper. Momentum of this sort can create artificial demand for good performing stocks and drive their prices up temporarily. At the same time, poor performing stocks can get punished unfairly.

How to avoid window dressed funds

It’s nearly impossible to know which managed funds employ window dressing tactics. That’s because funds are not required to disclosed why they added securities to or removed them from the fund. Most funds disclose their holdings, but generally those reports are 90 days or more old by the time they’re made public. And even then, no motive is provided as to why certain holdings were traded. All that said, the best way to avoid funds that use window dressing tactics is to invest in either wholly-indexed mutual funds or exchange-traded funds (ETFs).

Hint: Look for funds with the word “index” in the name. Look closely at the fund objectives to make sure there is no “active management” by fund managers. Some beneficial byproducts of index funds and ETFs include generally lower fees and lower turnover of holdings.

Window dressing is not new a new phenomenon. Fund managers have been doing it for decades. While it does happen to some extent around the end of each quarter, the practice tends to be more common near the end of the year. Since index funds are mostly managed with computers to mimic specific benchmark indices, they tend to be a good way to avoid funds that employ window dressing approaches.

This post is intended to be educational only. It should not be construed as investment advice or instructions on what to do with your money.