NEW YORK (CNN/Money) - The stock market is cued up for its best quarterly performance since 1998, but not everybody is pumping their fists.
Wringing their hands is more like it for all the mutual fund managers who haven't participated in the rally. It is perhaps forgivable if they haven't beaten the S&P 500's 15.1 percent move -- there's a long tradition of underperforming the benchmark -- but if their returns have lagged below their peers', that is a different story.
But underperforming funds have tools, which they will never admit to using, at their disposal to help soften the sting. Welcome to the wonderful world of window dressing and marking up.
Window dressing -- the scuttling of poorly performing stocks and the buying up of gainers -- doesn't do a thing to improve returns, but it does gussy up the portfolio and make it more presentable. When funds send out their quarterly update to investors, they don't want their top-ten list of stocks to look particularly heinous. It's okay to have one clunker in there, but two badly-performing stocks is pushing it and three is right out. And if your number 11 stock is, say, The Gap, which has risen 28.6 percent this quarter, why not bump that baby up to the 10 spot?
As a result of such window dressing, there is a tendency at the end of the quarter for stocks that have been performing well to see outsized gains against the market, while stocks that have been underperforming suffer.
When funds engage in marking up, they are trying to boost returns. The way it works, a fund company will buy heavily stocks it already has big positions in, which sends these stocks higher. The gains can be fairly large, because funds pick the more volatile names, where they can get the most bang for their buck.
The problem with window dressing and marking up -- besides the obvious point that it's a two-faced move -- is that such buying and selling is entirely artificial. Because the stocks aren't moving for fundamental reasons, the moves reverse themselves.
Out of balance
Window dressing and marking up aren't the only funny business going on at the end of the second quarter. Monday also brings the annual rebalancing of the Russell 2000 index.
The Russell 2000, which represents the bottom 2000 of the top 3000 stocks in the U.S. market, is the most widely cited small-cap index. Each year Frank Russell Co. rejiggers the index, making room for stocks that have gained ground, or entered the market through initial public offerings, and pulling out stocks that have languised.
When the Russell is rebalanced, index funds that track the index must buy the stocks that are getting added, and sell the ones that are getting deleted. Because these are small-cap stocks we're talking about, the moves up in the adds, and down in the deletes, can be quite large.
Naturally, many traders take advantage of this. Beginning in April, lists of likely adds and deletes start getting passed around, and traders start buying and selling the stocks. In the month before the rebalancing, the adds have outsized gains against the market, while the deletes fall behind. On July 1, the moves tend to reverse themselves.
But the Russell game may be coming to an end. For index funds the annual rebalancing is major headache, and many have begun considering tracking alternative small-cap indexes. In May, in fact, Vanguard switched it's $4.4 billion small-cap index fund to the Morgan Stanley Capital International U.S. Small Cap 1750 index. Others may follow.
|