Photo credit: Wikipedia Creative Commons
By Jason Zweig
Dec. 8, 2014
With the final three weeks of the year upon us, investors should be alert for signs of window-dressing – the practice through which professional money managers pump up the value of their holdings by buying a few shares at ridiculously high prices at year-end.
Increasingly, the traditional term “window-dressing” has been replaced by “portfolio-pumping.” Window-dressing is more often used now to refer to the practice of selling money-losing stock positions that would look bad on a fund’s year-end statement of portfolio holdings. Portfolio-pumping (or “marking the close”) describes a technique in which a fund manager who already owns a substantial position in a stock aggressively buys a small number of additional shares in the waning hours of the last trading day of the year. Driving up the price on that relative handful of shares revalues the entire position at the new, inflated price. A manager can do the same thing with bonds.
Imagine that you run a $100 million fund that has 3% of its total net assets in Aeromatic, a company trying (and, thus far, failing) to develop scratch-‘n’-sniff apps for mobile phones. You own 3 million shares of Aeromatic; you paid $1.10 apiece for them in early October and now, as December draws to a close, they have sunk to $0.99 per share. You’ve lost 10% on Aeromatic in less than three months. It’s one of your larger holdings, and it’s hurting your returns. But, because the last statement of your portfolio positions that went out to your investors showed what you owned as of Sept. 30, most people don’t even know you own the stock. So you have three obvious choices:
* Be honest, patient, and take your lumps.
* Sanitize your portfolio by selling out of Aeromatic completely. So long as you do it before the close of the trading day on Dec. 31, when you next have to report your positions, no one will be the wiser. The market closes at 4 p.m. If you sell all the shares at any time before that, you won’t have to include them in your statement of year-end holdings.
* Wait until the last possible moment — say, 3:59:59 p.m. on Dec. 31 — and buy 100 shares at a crazy price. The most recent trade in the stock was at 99 cents. You bid $1.25 and, sure enough, someone sells you 100 shares at $1.25. A second earlier, your shares of Aeromatic were worth $2,970,000 (3 million shares times $0.99). But now you own 3,000,100 shares, each valued at $1.25, the closing price for the stock. Your Aeromatic position is now worth $3,750,125. You spent $125 and added $750,125 to the reported value of the fund. Your portfolio’s net assets now total $100,750,125 — an increase of more than 0.75% with a single tiny trade.
Of course, on the first day of trading in the following year, Aeromatic will almost certainly drop right back to $0.99, because there was no fundamental reason for it to go up to $1.25. But maybe that 0.75% goosing was all you needed to push your portfolio into the top quarter of all similar funds. Investors will throw money at you, and once they give you their money they probably won’t ask for it back. You’ll get to charge management fees on that enlarged base of assets. Your firm could end up earning millions of dollars more. That $125 you put up was money well-spent.
Trying to stamp out this kind of behavior is a nightmare for securities regulators, since (unless you were so stupid as to write anything down about why you did the trade) it’s almost impossible to prove that you deliberately manipulated the price or sought to defraud investors. You can always say you just like the stock, want to own more, bought only because you had a little leftover cash, meant to buy it earlier in the afternoon but had to go to the bathroom, and so on. These cases are fiendishly difficult to prove, and often the dollar amounts involved are piddling.
So the practice goes on — and probably always will, although it appears to be somewhat less common among mutual funds nowadays. Whenever I ask portfolio managers if they think the prices of thinly traded stocks are manipulated at year-end, they respond with a resounding yes. When I ask whether they do it themselves, they say no. When I ask if they know who is doing it, they say no.
“Not me,” says…well, everybody.
Here’s some of what I’ve written about this over the years.
This PDF, of a story from 1997 that was one of the first ever to explore the topic, is a large file and may take a while to load; you might need to right-click, Ctrl+click, or hold down your cursor. This article has often been cited by academic researchers studying the topic. In the many years since I wrote it, I’m not sure much — if anything — has changed.
This “Intelligent Investor” column from December 2011 explains the incentives that may lead some money managers to engage in the practice.
This article from December 2012, for Page One of The Wall Street Journal, which I co-wrote with Tom McGinty, documented several cases of apparently suspicious trading in which every large holder of the stocks agreed that the trading was suspicious and said that somebody else was causing it.
In short, if you’ve been thinking of buying a small stock and you see it making a big move at year-end, stay away. Watch it carefully: You might be able to buy it much more cheaply on the first trading day of January. And you should be extremely wary of investing in any fund of any kind that has a bigger-than-average pop in the final days of December.
Finally, here are outside resources on the topic for readers who want to delve deeper:
A pioneering article in the Journal of Finance in 2002 found that funds “lean for the tape” as measurement periods end, pumping up the returns of their portfolios by up to two percentage points on the last day of the year.
At least in Australia, underperforming funds tend to engage even more in portfolio pumping, apparently in an attempt to play catch-up.
Funds tend to be most active in pumping the stocks in which they already have sizable positions.
Portfolio managers who improve their returns by window-dressing attract much more money from investors.
Although the practice seems still to be common among hedge funds, it appears to be declining among mutual funds.
This search on Google Scholar and this one should capture the latest research as it emerges.