# Understanding Window Dressing in Finance: Impact, Strategies, and Detection

## What Is Window Dressing?

Window dressing in finance involves altering financial reports or portfolios to create a misleading impression of a fund or company's performance. The tactics are sometimes used in mutual funds and accounting. This deceptive practice can obscure real results and impact investment decisions. Detection them is crucial for making informed financial decisions.

Fund managers may buy or sell securities at strategic times, while companies may adjust accounting methods to present more favorable financial outcomes. This article delves into how these strategies work and offers guidance on identifying them.

### Key Takeaways

*   Window dressing in finance involves manipulating financial reports or portfolios to create a misleading impression of performance.
*   Fund managers may buy or sell securities at strategic times to improve fund performance deceptively.
*   Changing accounting practices to enhance financial reports is illegal, but altering holdings in funds is unethical rather than illegal.
*   Detecting window dressing involves analyzing fund holdings for consistency, reviewing turnover patterns, and assessing management's past performance.
*   In accounting, window dressing tactics include delaying supplier payments and altering expense reporting to falsely boost financial results.

## How Window Dressing Manipulates Financial Appearances

Window dressing is a [deceptive practice](https://www.investopedia.com/articles/economics/12/legal-business-practices-of-dubious-ethics.asp) no matter what industry it is used in or what purpose it serves. It paints a false financial picture because information is changed to make a company seem to perform better than it did.

Mutual funds buy stocks and sell shares to investors. Managers may replace poor-performing stocks at the end of a reporting period to make the fund appear stronger.

Companies can alter reportable financial information through their accounting procedures. This changes the data that is reported on their quarterly and annual reports or letters to shareholders.

Altering accounting practices to change report appearances is illegal. However, replacing a fund's holdings at certain times isn't illegal unless it violates securities laws. That said, it is an unethical practice because it attempts to deceive investors and regulators.

## Impact of Window Dressing on Mutual Fund Performance

Fund managers are paid to make sure investments perform well. If they don't, investors might seek better returns elsewhere. To prevent this from happening, managers might replace holdings near the end of the reporting period to keep investors from moving money to other investments.

## Techniques Fund Managers Use for Window Dressing

A hedge fund manager might sell stocks that have experienced significant losses and purchase high-flying stocks near the end of the quarter or year. These securities are then reported as part of the fund’s holdings, making it seem like they had been there the entire time.

When performance has been lagging, fund managers may sell stocks that have reported substantial losses and replace them with stocks expected to produce [short-term gains](https://www.investopedia.com/terms/s/short-term-gain.asp) to improve the fund’s overall performance for the reporting period.

> **Tip**
>
> Investors should pay close attention to holdings that appear outside of a fund’s strategy and the assets that have been replaced.

For example, imagine that a fund investing in stocks exclusively from the [S&P 500](https://www.investopedia.com/terms/s/sp500.asp) has underperformed the index. Stocks A and B outperformed the total index but were [underweight](https://www.investopedia.com/terms/u/underweight.asp) in the fund, while stocks C and D were overweight in the fund but lagged the index.

To make it look like the fund was investing in stocks A and B all along, the portfolio manager could sell out of stocks C and D, replacing them with A and B. This would also give an [overweight](https://www.investopedia.com/terms/o/overweight.asp) to stocks A and B.

Managers may also buy stocks that don't match the mutual fund's style. For example, a [precious metals](https://www.investopedia.com/terms/p/preciousmetal.asp) fund might invest in unrelated high-performing stocks. This gives the fund the appearance of a short-term performance boost that is not aligned with the market or indexes it might mirror.

## How to Identify Window Dressing in Investment Portfolios

Though disclosure rules are intended to aid in increasing transparency for investors, window dressing can still obscure the practices of the fund manager. There are some techniques you can use to identify window dressing:

First, ensure holdings match the index that the fund tracks if it is an index fund. If it isn’t an index fund, make sure they meet the fund’s published intent. Most funds have a description of what they are designed to invest in, usually called the fund’s objective. For example, the Fidelity Value Fund’s (FDVLX) objective is to seek capital appreciation, using a strategy of valuating companies with valuable fixed assets and purchasing the stocks of the ones it believes are undervalued.

> **Fast Fact**
>
> If you found holdings in this fund you believed didn’t fit the objective and strategy, it might be window dressing. But then, it might not because the fund’s valuation methodology might allow it to change holdings.

Second, look over the fund’s holdings and compare the returns of each one. For instance, FDVLX had more than 200 holdings on Jan. 31, 2023, with the top 10 stocks making up slightly more than 10% of the fund. If you look at the fund’s monthly holding report, you can find each stock’s ticker and evaluate it. By comparing holdings from month to month, you might also see them changing and be able to investigate performance differences between the old and new ones.

Third, use these reports to identify past and current turnover and determine when it occurs. There might be a pattern of turnover, such as a majority of stocks remaining in the fund’s holdings with several nonperformers turning over at intervals that don’t make sense. This could be regular fund management, but it pays to take a look.

Finally, look at the fund’s management. Fund managers lacking trading acumen or who have experienced poor performance in the past are more likely to window dress. Good funds have experienced, ethical managers who do not need to window dress.

## Exploring Window Dressing Techniques in Financial Reporting

Public companies must follow accounting rules that ensure transparency for investors and regulators. Many hire accounting firms to keep accurate books and reports.

Management may not like the financial report results and could alter accounts or methods to appear more successful.

The most significant reason a business would window-dress its financial reports is to ensure they don’t lose investor interest. Investors and lenders make up a large portion of a company’s fundraising efforts. Lenders use these reports to make lending decisions, and investors use them for investing decisions. Therefore, lower financial performance can mean less funding.

## Common Window Dressing Tactics in Company Accounting

Not all accounting window dressing is as evident as changing some numbers. Here are a few examples of changes in accounting methods:

*   **Cash window dressing**: Paying suppliers after the period ends to boost cash balances
*   **Capitalization window dressing**: Increasing profits by capitalizing small expenses instead of charging them as an expense
*   **Fixed asset window dressing**: Selling fixed assets with accumulated depreciation, so the fixed assets still owned appear to have less depreciation
*   **Expenses window dressing**: Recording supplier invoices in the next period to reduce liabilities on the balance sheet

> **Important**
>
> It’s important to understand that many businesses are honest and trying to do the right thing. Looking out for window dressing should be part of your tool kit when you’re evaluating investment opportunities, just in case you come across a company that is trying to cook the books or deceive you.

## Uncovering Window Dressing Practices in Accounting

While difficult to determine, you can identify window dressing by studying past financial reports and reading about a company’s activities via their news releases and investor reports. You may be able to identify discrepancies between them. For instance, examine the cash flow statement to see where cash is coming from and where it is going, then compare it to cash flows from the last few periods.

Significant changes should be explained in the reports. If not, it's worth investigating further. Look for a change in accounting procedures—a company should publish that they began accounting differently for something recently (in fact, publicly traded companies are required to report accounting procedure changes).

Look for increases in valuation, a dramatic increase in sales that doesn’t correspond to past seasonal or cyclical sales, or another issue that might raise an eyebrow.  

## What Does It Mean If Something Is Window Dressing?

A stock identified as window dressing for a fund or window dressed business reports means they've been altered to falsely boost appearances. This involves replacing stocks at the end of a reporting period to falsely boost performance or altering reports to appear more financially attractive.

## Is Window Dressing Illegal in Accounting?

Window dressing in accounting is unethical and illegal. The Financial Industry Regulatory Authority (FINRA) has fined companies for window dressing.

## How Do You Window Dress Financial Statements?

Financial statements are an aggregation of the results of the accounting process for an accounting period. There are several ways to window dress these statements. Some examples are recording certain expenses differently or capitalizing expenses rather than accounting for them as expenses.

## The Bottom Line

Window dressing involves manipulating financial statements or portfolios to present a misleading impression of performance to investors. While it's illegal in accounting, window dressing remains unethical in investment management, aiming to deceive stakeholders. It can have a significant impact on investor decisions, potentially distorting investment decisions by painting a false financial picture, leading investors toward potentially disadvantageous choices.

Monitoring changes in fund holdings or accounting practices and ensuring alignment with fund objectives can help detect the practice. The practice commonly appears in areas of mutual funds and corporate accounting.

> **Article Sources**
>
> 1.  Fidelity. “[FDVLX: Fidelity® Value Fund](https://fundresearch.fidelity.com/mutual-funds/summary/316464106).”
>     
> 2.  Fidelity. “[Portfolio Holdings Listing Fidelity Value Fund](https://institutional.fidelity.com/app/funds-and-products/39/fidelity-value-fund-fdvlx.html).” Scroll down to Prospectus, Reports, & Related Literature. Click on Monthly Holdings Report.
>     
> 3.  AccountingTools. “[Window Dressing in Accounting](https://www.accountingtools.com/articles/what-is-window-dressing-in-accounting.html).”
>     
> 4.  Financial Industry Regulatory Authority. “[Financial Industry Regulatory Authority Letter of Acceptance, Waiver and Consent No. 2015048047101](https://www.finra.org/sites/default/files/fda_documents/2015048047101%20MTG%20LLC%20dba%20Betterment%20Securities%20BD%2047788%20AWC%20jm.pdf),” Page 2.