The term window dressing, applied in the retail industry, is a strategy used by retailers to attract customers — retailers place items of sale in front of store windows and display products to passers-by to grab the attention of potential consumers.

To attract the attention of customers, it makes sense for retailers, so why is there a “window dressing effect” in the financial industry?

In fact, just as retailers think, some fund managers of public funds will want their products to perform well enough. As a result, every time a company publishes a quarterly report, some “strategies” are adopted to beautify their portfolios. The purpose of doing this is not only to satisfy existing investors, but also to attract a wave of new investors, which is to say the opposite. Therefore, when many institutional investors powder their products, the “window trim effect” often appears on the market.

How exactly do these investment managers powder their doors?

Having just said that, in general, this window dressing effect usually occurs at the end of a quarter, at which time these investment managers are less than a day away from disclosing results. How to make your portfolio more profitable in a short period of time is a priority for investment managers.

For investment managers, the quickest approach takes just two steps — that is to sell stocks that have suffered significant losses while buying stocks that perform strongly.

The adjusted individual shares will replace the original positions that appear on the fund's paper, periodic reports or marketing materials, and most investors will assume this is a list that the institution has held. This strategy masked weak performance, making the fund appear to have improved short-term performance, creating the illusion of visible returns.

For example, a fund may have performed poorly in the past few months. From the perspective of a fund manager, he is certainly not willing to reveal that he holds a lot of positions in poorly performing companies. In order to powder their portfolio, managers may choose to sell these heavily loss-making stocks and buy the latest market pets — A, B, and C companies. When investors are surprised to discover that companies A, B and C appear on the disclosure list, they think they are following people, but only the fund manager himself knows that this is not the case.

In addition, there are some style funds that “still need to be restored after powder coating”, so some investment managers will choose to repurchase previously sold stocks in the next quarter. Due to the high cost of round-trip transactions, this practice of powdering the doors actually hurts the returns of the entire portfolio.

Therefore, this practice is a form of deception regardless of which industry or service is used for what purpose. The way investors can deal with such funds is only by keeping a close eye on the performance of the fund strategy and whether there were any changes at the end of the quarter.

If investors find that the underlying assets held by the fund do not meet the objectives and strategies originally established, the performance may be “tarnished”.

So in what aspects of the stock market does the “window effect” manifest itself?

Near the end of the year, the behavior of investment managers “powder the door” may affect stocks that have performed particularly well or especially poorly this year. FOR WIN-WIN STAR STOCKS, SUCH TRADING BY INVESTMENT MANAGERS WILL FURTHER DRIVE THE STOCK PRICE HIGHER. In the case of stocks that are not performing as well as they are, selling will put downward pressure on the share price. Loss-battered stocks from the previous year are likely to bounce back in January when the selling behavior of institutional investors stops.

A 2007 study by the Journal of Financial Analysts found that in the U.S. stock market, the “window dressing effect” and “tax loss selling” contributed to stock return momentum. The average monthly return for the momentum strategy was 59 basis points at the end of the quarter and 310 basis points at the end of the quarter. This pattern is more pronounced in stocks traded by high-level institutions, especially in December.

According to Benzinga's analysis, from a technical perspective, the S&P 500 index will rebound into the resistance zone at the end of June 2023, and analysts believe that two different Wall Street machines are at play this week: the end-of-season window effect and the end-of-season rebalancing, both of which are dragging the market in the opposite direction.

Analysts expect the “window trim effect” trend to continue, according to a report from Zacks Investment Ideas on December 12, 2023: With the Nasdaq 100 ETF up nearly 50% in early 2023 to date, this tech-share-dominated index should benefit from the power of the “window dressing effect” and the power of the performance chase.

The window effect is also likely to be present in the stock markets of other countries around the world. For example, Germany's DAX is currently affected by the window trim effect. Zalando, Bayer and Siemens Energy may not unexpectedly extend losses in the DAX index, analysts said in a December 15 forecast; while Heidelberg materials companies, Rhine-Metals and Adidas are vying for the role of the year's biggest winners. In addition, Malaysian stock market analysts said that the window dressing effect does not seem to have visited horse stocks this year, and the underlying stock market performed poorly this year.

Is it possible for individual investors to apply the “window trim effect” as a strategy?

Some investors may be wondering, since there is such a rule in the market, can individual investors profit from the “window effect” produced by institutional investors?

Analysts at Enlightened Stock Trading once created a set of trading strategies to answer this question.

This trading strategy rule is:

1. Identify the 5 strongest and weakest stocks in the index based on the “relative strength” of the S&P 500

2. Buy the 5 best performing stocks on the 5 calendar days before the end of each month and sell the 5 stocks below the low performing pad

3. Hold these stocks for 5 days and then close the position

4. 20% weightings allocated to each share

5. In retrospect, 0.25% slippage and commission should be considered per trade

If this trading strategy runs out of more excess gains than the S&P 500, then this would be a very attractive combination. However, the results are not as good as we would like.

Source: Enlightened Stock Trading | Note: Using Amibroker to look back on data from 1990 to 2017.

Simply put, the total earnings of this combination are still falling short of those of the S&P 500, which is because there is no evidence that the “window dressing effect” will cause the worst 5 stocks to fall further at the end of the month. Therefore, the 5 worst performing stocks are not profitable. If you change the rules, change the monthly trade to every quarter, and don't sell short to buy only, the result is not good either. As such, analysts at Enlightened Stock Trading believe that trading using the “window trim effect” may require more conditions.

At the moment, if individual investors want to make a decent income using the “window dressing effect” at the end of the season, there is still a greater risk.

Overall, the “window trim effect” is not a strategy, but a phenomenon that may exist in the market. For some stock transactions, such as abnormal spikes or oversold situations, investors also need rational analysis and caution.