Most mutual fund managers and many money managers only have to report their holdings on a quarterly basis. This practice has led to a fund management phenomenon known as a “window dressing.”
In basic terms, managers want to make their portfolios look as desirable as possible in these reports. “Desirable” holdings in the portfolio keep current investors interested and help attract new investors. To accomplish this, managers sell off under performing stocks before the reporting date and replace them with the hottest, most desirable names. Then when the portfolio contents are reported, the fund looks like it’s doing a bang-up job.
Since many investors make investment decisions for the coming year based on what they see from the previous year end, some traders try to take advantage of the quarterly and year-end window dressing process.
This practice of selling the lower performing stocks should have the effect of driving the prices of these under performers even lower, at least for a short time. Well, there is research that supports that series of events.
A Unique Way to Profit from Window Dressing
Jeffery and Yale Hirsh at Stock Trader’s Almanac have studied this window dressing occurrence and have come up with an interesting way to play the year-end version.
Looking back to 1974, they have calculated the returns that would have accrued if one bought all of the stocks trading at their 52-week lows on the 15th of December and sold them on the 15th of February.
The numbers are eye-opening. In the 35 years of the study (the last 11 of which are from actual newsletter picks), there have only been 7 down years. That’s an 80% win rate to start with.
Beyond that high winning percentage, only one of those losses was a double-digit loss in percentage terms. In contrast, out of the 28 winning years, an amazing 17 years produced double-digit gains.
As a control or baseline to measure overall performance, buying the NYSE composite index on the same day in December and selling it in February resulted in a net gain of 113% over the 35 years for an average gain of 3.2%. (Keep in mind that this is a seasonally strong time in the markets.)
Buying only the bargain stocks during the same time frame resulted in an impressive 453% total gain or an average of 12.9% for the three months of investing.
The Caveats and an Idea
The portfolio of stocks hitting new lows in mid-December can be too large for the average retail investor. The most stocks ever required for the “bargain stock” portfolio was 112 and the average number of stocks bought and sold per year was 28.
Regardless, the concept is simple, interesting and—based on the Hirschs’ data—quite robust. One thought seems ripe for further research: we could narrow the portfolio to a limit of 10 per year and then test performance. For example, which would prove the better filter: picking the 10 under performers with the worst 52-week performance or the ones with the strongest (worst of the worst vs. best of the worst)? Or picking the 10 most volatile based on a long term average true range?
A Parting Note
One of the implications of this data is that portfolio managers who practice “window dressing” at the end of the year are most likely hurting their fund’s performance. Perhaps that’s a little payback for a shady practice?