International Finance
Finance Wealth Management

Understating Riskiness Through Window Dressing

Window Dressing may make a fund appear more attractive, but the stock will tend to decline after a certain period. 5th September 2013 Consider this scenario, share prices on Philippine Stock Exchange opened higher last Friday (August 3oth), extending Thursday’s rebound as positive sentiment over higher than expected gross domestic product (GDP) output in the second quarter. The PSE was up 36.80 points or 0.62...

Window Dressing may make a fund appear more attractive, but the stock will tend to decline after a certain period.

5th September 2013

Consider this scenario, share prices on Philippine Stock Exchange opened higher last Friday (August 3oth), extending Thursday’s rebound as positive sentiment over higher than expected gross domestic product (GDP) output in the second quarter. The PSE was up 36.80 points or 0.62 percent to 5,981.01. The surge in the prices of stocks was due to end of the month “window dressing”.

An analyst in the PSE said “We see a continued rally today due to a combined better than expected GDP growth in the second quarter and month end window dressing”.

Why is the term window dressing used and what does it imply? What are the possible repercussions of window dressing? and is it ethical for companies to window dress their holdings? – International Finance Magazine with data and factual inputs from the Wall Street Journal explains the concept of Window Dressing, the different strategies employed in Window Dressing, how does it benefit hedge fund managers, movement of a particular stock which employs the window dressing strategy and the SEC crack down on banks for understating their risk and avoiding a replica of the sub prime crisis.

What is Window Dressing?

Investopedia defines Window Dressing as “a strategy used by mutual fund managers near the year or quarter end to improve the appearance of the portfolio/fund performance before presenting to clients or shareholders. In a case of window dressing, the fund manager will sell stocks with large losses and purchase high flying stocks near the end of the quarter. These securities are then reported as part of the fund’s holdings”.

Theoretically, window dressing may make a fund appear more attractive, but the stock will tend to decline after a certain period.

For Example: Let us assume that Lucky and Co wants its balance sheet to look attractive to potential acquirers. It might do some window dressing by announcing higher sales projections in the quarter ended, double the cash in hand position and sell certain losing positions so as to display only positions that have gained in value. Financial institutions also employ another strategy of window dressing wherein they dispose off the debt from their balance sheet near the end of the quarter in a temporary manner. This will make the bank/financial institution appear to have less leverage than it actually did.

While the former is considered legal the latter is illegal.

Quoting another example that appeared in The Wall Street Journal, the stock of Iridex Corp., a maker of lasers used to treat visual ailments had been hovering around $ 3.43 all day on June 29th., but five minutes before the market could call it a day, it took off, moving from $ 3.65  to $ 3.80. Less than half a second before the trading day and the calendar quarter ended, Iridex jumped 4 percent to $ 4.17, an unprecedented increase of 22 percent for the day. The next trading day, July 2nd, Iridex dropped by 10 percent and did not reach $ 4 until late October.

Wall Street Journal Analysis

The unusual rise and fall of Iridex is not unusual, a Wall Street Journal analysis of daily trading in roughly 10,000 stocks since 2004 found that on the final trading day of each quarter, there was a sharp increase in the number of stocks that beat the market by at least five percentage points, then trailed it by three points or more the next day.

“Marking the Close or Portfolio Pumping”

Marking the Close or Portfolio Pumping is a form of window dressing wherein a variety of techniques are employed by asset managers wait until the waning  moments of the quarter to bid aggressively for more shares of a stock they already own, which drives up the value of their entire position in the stock. This activity boosts their performance at the very moment when they report results, making their funds look more appealing to potential investors. Even if the jump in stock price is only temporary, the managers can attract new money and earn higher fees. The Journal’s analysis compared the performance of those 10,000 stocks to the one day return of the S&P 500 index, the results were baffling, on days that didn’t end the quarter, an average of 217 stocks beat the index by 5 percentage points then trailed by at least 3 the next day. But on the final trading days of the quarters, an average of 280 stocks did.

Window dressing occurs more frequently in small, thinly traded stocks, whose shares tend to swing rigorously, according to trading and securities-law experts. With reference to the example quoted from The Wall Street Journal, Iridex has a market value of $ 36 million, making it  about 1/20th the size of the average U.S. “micro map” small stock. The day before Iridex’s sudden rise in value on June 29th the stock had been down 22 percent for the quarter, its last minute surge helped it close the quarter down at 5.4 percent. The company’s market value rose to more than $ 37 million, from less than $ 31 million the day before the window dressing.  The firm got richer by $ 7 million in the last five minutes of June 29th.

Who are the Gainers?

Hedge funds make millions of dollars through window dressing; a stock jump in the closing hours of can benefit a hedge fund manager‘s fees.  Hedge funds typically collect annual fees equivalent to 2 percent of total assets and pocket 20 percent of profits. Regulators and industry experts say a fund that already has a substantial holding in a small stock can drive up the value of its entire position by purchasing as few as 100 additional shares at a premium to their market price in the final moments of trading at the end of a measurement period.

Richard Sinise, a portfolio manager at Kennedy Capital says that for hedge funds whose fees are linked to performance, “there can be that urge on the last day to put all your cash into your stocks and get them to the price you think they should be at”

SEC cracks down on banks for Window Dressing

The SEC in 2010, proposed rules designed to stop banks and other companies evading information to investors on their short term borrowings. The proposed disclosure rules would require companies to report their average and maximum short term borrowings, as well as the debt outstanding at the end of each reporting period, Directors would be held liable to explain for any significant discrepancies between the debt levels.

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