We window dress in our lives all the time. When people post pictures on Facebook, they post the happy moments, they are displaying their best smile. We don’t see how they look in between each one of those photos.
Mutual funds companies are supposed to report their holdings at the end of each quarter. This is when they show us their best picture, However, This report does not reflect the holding the fund held during the previous 89 days. By the time a client reads the prospectus, the fund could have a totally different portfolio. In short, as a mutual fund investor, you will never know for sure which equities you have in your portfolio.
What is Window Dressing
In order to show the best face for the public, many funds engage in the practice of window dressing, this means that right before the quarterly report they get rid of losing stocks and buy the best-performing stocks in the market.
Imagine a fund that trades in the technology sector. Imagine that Google went up 20% while Apple went down 15%. What the fund would do is to buy Google and sell Apple. That way, when the investors get the report, they will believe that the fund manager was able to choose the rising stars and drop the dogs. But it’s not true, it’s all make-believe.
Since there is a lack of transparency in the mutual fund industry, managers also get away with buying stocks that are outside of their mandate. For example. Imagine a mutual which claims to invest exclusively in big companies. Well, this mutual fund has an 89-day window to buy stocks in small companies and then get rid of them before the next report.
What are the problems with Window Dressing
The biggest problem is a lack of transparency. The investor deserves to know which stocks he owns at all times. What if he doesn’t like to have stocks that deal with arms, tobacco or alcohol? Doesn’t he deserve to know?
The next problem is worse, I call it buying high and selling low. This is totally the inverse of what an investor should do, but if a portfolio manager buys a stock after it has gone up, to showcase it in his portfolio, he’s buying high. And if he’s getting rid of poor performers because they are an embarrassment for the portfolio, he’s selling low.
The last problem that I see, it the excessive transaction cost. When the fund manager buys and sells stocks simply to showcase them in the portfolio, he is engaging in a lot of transactions. These transactions are expensive and they drive down the performance of the portfolio.
What can you do as an investor
The best thing to do is not to have actively managed funds in your portfolio. Instead, opt for index funds or ETFs. With index funds, you know exactly what you own at all times and in which proportion. For example, when I buy the XIU (iShares S&P/TSX 60 Index Fund) I know that I own the 60 biggest Canadian companies on the Toronto Stock Exchange. There is no mystery to that. I know 365 days a year what I own, I don’t have to wait once a quarter to find out.
I don’t have to worry about excessive transactions and about buying stocks when they are high and selling them when they are low.
Overall, index fund investing has proven to be an investment strategy that is totally transparent, has little or no transaction costs, is 10 times less expensive than actively managed funds and has proven, with time, to outperform 90% of the actively managed funds.
Action steps
Next time you see your financial adviser, ask him about index funds and ETFs.
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