All the factors that affect stock prices don't neatly fit into regular time windows, but reporting obligations do. Funds have to report on the status of the portfolio at particular times of the year. Exactly what needs to be reported and how varies depending on the regulatory regime. In some cases, funds are only required to report a subset of the portfolio holdings, such as the top 10 or the top contributors and detractors.
Two risks may emerge: conscious short-term portfolio manipulation to make the report look better, and unconscious overtrading around reporting dates.
Short-term manipulation with the intention of misleading investors is a form of market abuse that can lead to significant fines. One tactic is window dressing, which misleads investors about the portfolio holdings. Another is portfolio pumping, which misleads investors about the valuation of the portfolio at the time of reporting. They're similar, but there's a subtle difference between them.
Consider this scenario. Recent market events are affecting a segment of a manager's portfolio. Those stocks comprise a significant percentage of the total holdings, so the overall performance has been negative. A short time before the report is issued, the manager buys some high-flying stocks and sells the underperformers to produce short-term gains. Alternatively, he buys the high-flying stocks in sufficient size so they replace the underperformers on the top 10 holdings list. Regulators and compliance experts view short-term reversals to the original positions after the reporting period as highly suspicious, and they may class it as potential window dressing.
Let's say the underperformers are small or illiquid stocks. The manager might place numerous orders on these existing holdings, which increases the price of the stocks as well as the portfolio value. That's portfolio pumping.
So how do you know that a fund manager might be manipulating results? For starters, window dressing typically isn't done by purchasing a single security: multiple securities need to be bought to affect the entire portfolio. Holdings that appear outside of a fund's strategy could be another indicator. In window dressing and portfolio pumping, the timing of the purchases matters: transactions close to the end of the month, quarter or year should raise a red flag.
Nasdaq Buy-Side Compliance solution uses a holistic approach to detect window dressing and portfolio pumping. It produces a profile of the fund based on factors such as performance over time, the weight of each holding in the portfolio and the timing of purchases and sales. Moreover, the solution learns from the data, so it knows what industry sectors individual fund managers trade in, their typical holding periods and their attitude toward risk. The solution detects any deviation from the norm and builds context around changes to help understand the intent behind the trading. The quality of detection is extremely important. For example, a large inflow of money just before the month end may trigger a significant amount of trading and increase the size of the portfolio. These kinds of false positives are filtered out automatically.
Revealing short-term trading around reporting periods enables firms to tackle the risk of misconduct in their organization head-on. The best asset managers also use the same behavioral profiles to prove their long-term management capabilities, maintain client trust and thrive in a competitive landscape.