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What Mutual Funds Don't Tell You

Imagine if your boss came to work only four times a year. As long as you could get everything looking good for that one day every three months, you could get away with a lot in between visits.

As crazy as that sounds, something very much like that happens all the time on Wall Street. Mutual fund managers may have to report share prices every day, but they don't have to show what stocks they own anywhere near as frequently. While some funds report their holdings every month, many others only reveal their investments on a quarterly basis. As you might imagine, the lack of more frequent disclosure gives investors incomplete information that's potentially subject to manipulation.

The doggie in the window
Because so many mutual funds disclose their holdings only a few times each year, fund managers can time new purchases and sales of stocks they own in a way that masks their actual impact on portfolio returns. To convince shareholders that their money is invested in stocks that have done well, fund managers can add winning stocks to portfolios near the end of the quarter, while selling shares of companies that have done poorly.

Although this practice, known as window dressing, is far from the only factor that affects share prices, its effects are often visible. This quarter, for instance, the downtrodden financial sector dropped nearly 9% in just the last six trading sessions, with companies like JPMorgan Chase (NYSE: JPM  ) and Bank of America (NYSE: BAC  ) leading the way down. Meanwhile, soaring energy stocks like ExxonMobil (NYSE: XOM  ) and Chevron (NYSE: CVX  ) led the sector up over 3% in a dropping overall market.

Look past the window
Because it's so easy for fund managers to use window dressing tactics to fill their portfolios with attractive-looking stocks after they've already gone up, investors have to work harder and look beneath the surface of quarterly reports. Here are two relatively simple things you can do:

  • Compare fund holdings from quarter to quarter. By tracking which stocks appear and disappear from lists of holdings over time, you can piece together your fund manager's investment strategy -- or lack thereof. Although you may not be able to tell exactly when during the quarter a particular buy or sell occurred, you can get a general sense of whether your manager is making good decisions.
  • Look at the actual fund returns. For instance, if you see strong performers like Apple (Nasdaq: AAPL  ) in your portfolio, but your fund shares haven't performed well lately, odds are good that your manager hasn't owned those hot stocks very long. Similarly, even if your fund got rid of a losing stock like Motorola (NYSE: MOT  ) or UnitedHealth Group (NYSE: UNH  ) sometime during the quarter, you may have suffered from its losses up until a few days before the quarter ended.

One way to avoid the worst effects of window dressing is to look for funds with low turnover. If fund managers don't trade very much, any extensive window dressing will show up as a blip of unusually high trading activity.

Perhaps the best way to address window dressing, though, is by simply focusing on long-term returns. For instance, when fellow Fool Tim Beyers looks for investment ideas among the stocks that the funds are buying, he looks for funds with proven track records of making smart stock buys for the long haul.

Nevertheless, whenever you're looking at a fund's list of stock holdings, bear in mind that it represents a snapshot in the past. If your fund takes advantage of reporting requirements to obscure its actual investments, your quarterly reports may well be out of date before you even see them.

For more fund investing, read about:

At Motley Fool Champion Funds, our goal is to help you find funds that won't play tricks on you. With solid returns and strong long-term track records, our fund recommendations won't treat you wrong. Curious? Take a free look for 30 days with no obligation.

Fool contributor Dan Caplinger wants to assure his bosses that, even if he only makes it down to HQ a few times a year, he's getting all his work done. Really. He doesn't own shares of the companies mentioned in this article. JPMorgan Chase and Bank of America are Motley Fool Income Investor recommendations. UnitedHealth Group is a Motley Fool Inside Value selection. UnitedHealth Group and Apple are Motley Fool Stock Advisor recommendations. The Fool's disclosure policy doesn't hide a thing.

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