Investors Beware: Some Mutual Fund Managers Inflate Year-end Returns

During the typical year-end holiday season, not all the window dressing is in the department stores. A great deal of it ends up in mutual funds, according to a study co-authored by Wharton finance professor David K. Musto and doctoral candidate Adam V. Reed.

Musto and Reed, along with Mark M. Carhart from Goldman Sachs Asset Management and Ron Kaniel from the University of Texas at Austin, examined stock mutual funds from 1985 to 1997, paying special attention to quarter- and year-end share-closing prices. Their results disclosed an interesting pattern: Mutual funds tended to outperform the widely-followed Standard & Poors 500 (S&P) Index on the last trading day of the year and the quarter, but on the very next trading day the funds proceeded to under-perform the S&P.

Musto and Reed see more than random occurrence at work here. Instead, they say, evidence suggests that fund managers engineer these higher closings to increase one period’s return at the expense of the next, a technique known formally as "marking the close," and defined by the SEC as "the practice of attempting to influence the closing price of a stock by executing purchase or sale orders at or near the close of the market." (A fund manager’s purchases have the general effect of increasing closing prices because more of these prices are at the ask.)

The practice, sometimes referred to incorrectly as "window dressing," is prohibited, although it’s difficult to prove because the trading itself is not illegal. What’s illegal is trading with the intention of overvaluation.

The researchers used data from four sources: Standard & Poors’ Micropal, CDA Investment Technologies, the New York Stock Exchange’s Trade and Quote (TAQ) Database, and the Center for Research in Security Prices (CRSP). Their report, entitled "Leaning for the Tape: Evidence of Gaming Behavior in Equity Mutual Funds," follows a previous study by Money magazine columnist Jason Zweig that first documented this phenomenon.

The underpinnings of marking the close lie in the policy of most equity funds to value each holding at the last reported trade price on its primary exchange. For example, if IBM last trades on the NYSE at 172½ at say year-end, then 1,000 shares will be valued at $172,500, even if IBM soon trades at 172. Portfolio managers can therefore boost their funds’ valuations on a given day – and by implication their total returns over any period ending on that day – with this strategy.

The downside is the opposite effect on the next trading day’s return, when the prices are lower. Instead of being generally at the ask level, as they were at the end of the quarter, they are equally distributed between bids and asks.

On the face of it, marking the close seems like an exercise in futility. Why go to the bother of artificially pumping up a stock if it will just give back the gains on the next trading day?

The answer is compensation. Mutual-fund performances from one calendar year to the next (and, to a lesser degree, from quarter to quarter) are spotlighted in such publications as the general and financial press, mutual-fund ratings and databases, and academic literature. Fund managers, in turn, are commensurately compensated for high annual numbers, either directly with performance bonuses, or indirectly with new investment.

In addition, by helping to draw new investors, the positive coverage can help increase the fund’s leverage and management fees, which are often computed as a percentage of dollars under management (or mismanagement, as the case may be).

The Wharton researchers note that finance literature has already uncovered and analyzed many peculiarities of year-end price shifts. Most attention has focused on small-cap stocks, whose year-end shifts apparently defy risk-based explanations. Further, although alternate explanations include tax-loss selling and institutional demand, neither one explains why the shift starts a day before the year-end. Instead, Musto and his colleagues contend that some subset of fund managers deliberately causes the pattern by manipulating year-end valuations.

In fact it isn’t necessary for all funds to mark the close for funds in general to show the pattern. Previous studies suggest that if funds concentrate in certain equities, and a few determined fund managers increase their valuations by marking up some of these securities, then other funds will join in the marking effect of these managers. Those responsible may not even manage mutual funds, since calendar-year returns are also important in such other institutional-investor categories as pension and hedge funds. Pension and hedge fund managers, for example, may herd with mutual funds when picking stocks, and then mark the close.

The Wharton study also notes that quarter-ends are influential in mutual-fund analysis, though less so than year-ends. Using such sources as the Wall Street Journal, which analyzes each calendar-quarter’s relative fund returns; Morningstar, which updates ratings as of calendar quarters; and the quarterly returns and prices that are reported to pension-plan participants, Musto notes these quarterly results show similar window-dressing movement, while other month-ends show nothing, despite many more observations. He says these results rule out month-end explanations for the effect, such as transfers from paychecks to fund accounts.

Summarizing his findings, Musto observes that:

  • Equity funds earn much more than the S&P 500 on the last day of the year, and much less on the first day of the next year. This applies on a smaller scale to quarter-ends, but not month-ends that aren’t quarter-ends.
  • Aggressive-growth funds show the strongest effect.
  • Across funds, better end-of-period returns precede worse beginning-of-period returns.
  • The year’s best-performing funds do the best on the last day of the year, and the worst on the following day.
  • Winner stocks are relatively higher at their year-end close than they are an hour before, or 30 minutes into the next trading day.
  • Stocks in the disclosed portfolios of winner funds are especially overvalued at the year-end, compared to other stocks with similar size and recent performance.

Knowing this, what steps can an investor take to protect himself or herself?

Keeping in mind the fact that funds outperform the S&P by half a percent on average, not over a year, but in just one day (since year-ends plus quarter-ends add up to 1% per year above the S&P, while the first days of the year and quarters add up to minus 0.6%), Musto says the way to beat the S&P is to hold an S&P index fund every day except at ends of calendar quarters, when the best-performing open-end funds are held instead. "Obviously it may not be feasible to invest in a mutual fund for just one day … The more practical prescription is simply not to invest in a mutual fund at the end of a quarter."

Musto also advises investors to review a fund’s performance over a multi-year period, using fund-trackers like Morningstar. "If your pension money is invested in mutual funds at the ends of months, then you are paying inflated prices whenever the end of the month is the end of a quarter, and especially when it is the end of the year."

The market’s recent spectacular performance, he adds, doesn’t change his findings. "With the market’s rise, we haven’t noticed any increase or decrease in the practice of marking the close," he says. "Regardless of the level of the market, or the type of stocks in the fund, the primary motive among fund managers is to get into the top-performing group."

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