Transparency is a fundamental tenet of modern financial market efficiency and fairness. Investors should have full disclosure of material information to assist with investment decisions. The Securities and Exchange Commission (SEC) was created to do just that for public companies and publicly available securities. Current law requires mutual funds to disclose their holdings quarterly1. Quarterly holding disclosures are an improvement to semiannual schedules from a couple of decades ago, yet mutual funds still partake in window dressing.
Pooled investments (such as mutual funds, annuity sub-accounts, etc.) strive to fulfill regulatory requirements while not revealing too much about their securities selection process, intellectual property, competitive advantage, or upsetting their existing/prospective investors. As the quarter-end approaches, pooled investments may choose to temporarily insert better known names in lieu of questionable companies. This is referred to Window Dressing. The performance drivers may not be what they seem.
Combating Window Dressing is a task for due diligence analysts. Due diligence analysts employ a variety of techniques to circumvent the mutual fund opacity. The first is to gain a good gasp of the investment process. A good understanding of how portfolio managers select securities goes a long way to confirm the disclosed securities. This is often accompanied by due diligence questionnaires, site visits and personal interactions.
The second is insisting on more frequent holdings’ disclosures. Some fund families have chosen more frequent disclosures, such as monthly. Though Window Dressing could still occur, the increased trading activity would drive up costs and be disruptive to the fund’s operations making the fund less competitive against its peers.
A third is to deploy more advanced analytical techniques to see through window dressing. Specifically, due diligence analysts often employ regression analysis to determine the fund’s behavior. This is akin to, “if it walks like a duck and quacks like a duck, it must be a duck.” Regression analysis, when performed correctly, ignores the underlying holdings by statistically comparing the fund’s returns to a set of indices. The statistical conclusion evaluates the fund’s return behavior, which can be more telling than holdings disclosures.
To many, fund/manager due diligence can be quite boring. To financial advisors and investment strategists, due diligence is vital to develop and manage client portfolios. As the fourth quarter is set to begin, holiday window dressing will commence; first with Halloween, then with Thanksgiving followed by year-end holidays. Unlike financial due diligence, those window dressings are meant to be enjoyed.
1SEC Rule 33-8393