What Is Window Dressing in Finance?

Window dressing is a concept in finance that involves manipulating financial statements or investment portfolios to make them appear more attractive to investors during reporting periods. While we have no direct evidence that window dressing in finance is common practice, it is well documented, and there are plenty of corporate accountants tasked with creating financial statements that tell a ‘good’ story.

I would say perception drives investment, and therefore creating a good perception would make window dressing in finance extremely common. While this may happen at a corporate level, we are more interested in trying to create a window dressing trading strategy, so therefore we are interested in mutual fund window dressing rather than accounting window dressing.

Window Dressing in Mutual Funds

In the context of mutual funds, window dressing refers to adjusting the portfolio holdings in the days leading up to the end of an accounting or reporting period. Fund managers (supposedly) do this to by purchasing strong-performing stocks and disposing of underperforming ones to create the illusion of a well-performing portfolio for investors and marketing purposes.

This act of mutual funds window dressing portfolio holdings can have a real impact on the market. By driving up the prices of hot stocks even further and driving down the price of poor performers as fund managers scramble to reposition themselves… that is the theory anyway.

What we really need to know as individual traders and investors is whether this is real, and can we profit from it.

What Window Dressing in Finance Means for Individual Investors

As individual traders and investors, we constantly seek trading strategies that can provide a stable edge and generate profits for our portfolios. If the window dressing effect is real and has a measurable impact on the price of the hottest stocks (and on the worst performing stocks) then maybe we can create a profitable trading strategy around it.

This would be a very attractive trading strategy because it is based on a real and regularly occurring market anomaly. So let’s dig in and see if there is a profitable window dressing trading strategy we could use. By identifying stocks that are likely to be subject to window dressing, hopefully we can capitalize on the temporary boost in price towards the end of the reporting period (and also on the temporary drop in prices in the poorest performing stocks too).

Window Dressing Trading Strategy

To determine whether the window dressing effect is real and whether we can create a profitable trading strategy around it, we will design a simple strategy and backtest it in Amibroker.

The rules of our trading strategy are straightforward:

1. Identify the top 5 strongest (weakest) stocks in the S&P500 based on their relative strength against the S&P500 Index
2. Buy (short) the top (bottom) 5 performing stocks 5 days before the end of the month (I have simplified this to be 5 calendar days before the end of the month)
3. Hold these stocks for 5 days, then sell (cover)
4. The positions should be equally weighted, allocating 20% of the equity into each stock.
5. Allow 0.25% per trade for slippage and commissions in backtesting

By backtesting this trading strategy, we can evaluate whether window dressing has a real impact on the performance of these stocks.

Backtesting this trading strategy provides a systematic way to explore whether the window dressing affect is real and whether it gives us a tradeable edge as an individual investor.

Window Dressing Backtest Results

We will backtest these trading strategy rules using Amibroker on data from 1 January 1990 to 1 January 2018. This will leave us some out of sample data to validate the strategy on (2018 – 2023 at the time of writing this article) just in case we find something useful.

When we backtest our Window Dressing Trading Strategy on the long side, we get the following equity curve:

While this backtest is profitable, performance compared to the S&P 500 index is not great:

• Annual Return: 1%
• Exposure: 5%
• Risk Adjusted Return: 26.0%
• Max Drawdown: 47.8%
• CAR/MDD: 0.11
• Average Profit Per Trade: 0.71%

Looking at the short side in isolation we see no evidence at all that the weakest stocks fall further in price at the end of the month due to window dressing:

Let’s ignore the short side from now on and focus on the long side to see if we can improve it to something tradeable.
The first idea is rather than trading this strategy every month, let’s look at whether the end of the quarter provides a more significant window dressing effect which might be tradeable. Here we only take trades towards the end of the quarter (March, June, September, December). All other months are ignored.

Backtesting the quarterly window dressing effect trading strategy, we get the following results:

The performance statistics are certainly no better – all of the main trading system performance metrics have degraded:

• Annual Return: 1.1%
• Exposure: 6.6%
• Risk Adjusted Return: 17.1%
• Max Drawdown: 29.8%
• CAR/MDD: 0.04
• Average Profit Per Trade: 0.49%

At this point there is not much reason to believe that we will be able to generate a profitable trading strategy out of the window dressing effect. At this point in the trading system development process we like to see a much more promising edge before adding additional rules to refine the strategy.

We are going to suspend further analysis here, because one of the things I have learned about trading system development is that if an edge is not obvious and material in it’s raw form, any trading strategy developed from that edge will most likely be curve fit. However if you would like to take this analysis further, here are some ideas for you to test:

• Test different lookback periods for the stock rate of change calculation used in ranking (we used ROC(C,60) in this article)
• Test alternative measures of stock strength like Relative Strength, RSI, Linear Regression Slope
• Test entering earlier of later in the month
• Test holding positions for longer or shorter periods

Conclusion on Window Dressing Trading Strategy

While there may be a lot of discussion about fund manager window dressing online, based on our backtesting of the window dressing trading strategy, we don’t see a lot of evidence to warrant further investigation. Other trading strategies like our Turnaround Tuesday Trading Strategy show a lot more potential.

This of course does not mean that no trading strategy based on the window dressing effect will be profitable, It simply means that what we have investigated in this article so far has not given us enough cause for continued investigation.

If you have other ideas relating to the window dressing effect that we could test and include in the article, please leave a comment below and we will take a look.

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