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Appearance Is Everything at Quarter's End

Despite the fund crackdowns, window-dressing is alive and well.

Despite the crackdown on mutual fund chicanery, some deceptive practices continue to go unchallenged by regulators.

While no mutual fund will admit to "window-dressing" or "portfolio pumping" before the end of a quarter, academic studies have shown that these abuses are widespread in the industry. Wall Street traders and analysts readily concede that they affect trading.

In his missive on the

Web site Monday, trader James De Porre said window-dressing is "the main thing to keep in mind for the next couple days."

"Fund managers will want to make sure they finish on a high note and have some performance statistics that they can brag about in the months ahead," he said. (



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Window-dressing generally occurs at the end of a quarter, when portfolio managers buy stocks that have performed well during the previous three months and sell stocks that have underperformed, purely to enhance the appearance of the fund.

When mutual funds release their holdings to the public, they're required to mention only the stocks that they currently hold, not stocks that they bought and sold during the quarter. For example, this allows them to boast about an 18% jump in


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, even if they bought it one day before the end of the quarter, while omitting a 14% decline in



, which they owned for almost the entire period.

Because money managers do report how much the overall fund rose or fell during the quarter, investors aren't totally in the dark. Still, securities lawyers say window-dressing can be misleading.

"To the extent that the portfolio holdings are not really representative of the holdings during the period of time covered, that could raise questions about how much investors really know," said Henry Hu, securities law professor at the University of Texas.

Critics also note that window-dressing can send share prices artificially higher or lower at the end of the quarter.

Hu said he is even more troubled by portfolio pumping or marking up, in which fund managers buy large chunks of stock that they already own so that the price of those shares go up. This usually happens with small, illiquid stocks.

"The very fact that there's manipulation could be enough to generate a securities violation," he said. "That's a serious issue but it's hard to prove."

In August, the

Securities and Exchange Commission


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launched investigations into Durus Capital Management, which spent about $260 million to acquire huge stakes in





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. The hedge fund then sold millions of shares of both stocks, after they had posted triple-digit percentage gains. The SEC also has filed a complaint against hedge adviser Lancer Management for manipulating the month-end closing prices of certain stocks held in the portfolio.

While these may be extreme cases, portfolio pumping is actually fairly common. In a 2002 study, a group of academics found that quarter-end and year-end mutual fund prices were abnormally high because fund managers were marking up stocks.

Wharton finance professor David Musto, who helped write the report, said the top-performing funds recorded their best gains on the last trading day of the quarter, and their worst returns on the first day of the new quarter. Stocks that had performed well during the three-month time frame spiked in the last trading day of the quarter and declined the following day.

Regulators recently launched an investigation into several mutual funds, alleging they allowed hedge funds to trade illegally in mutual fund shares.

Juanita Scarlett, a spokeswoman for the New York state attorney general, said Eliot Spitzer has not launched a special probe into window-dressing or marking up, although it is something that could come under scrutiny over the course of the investigation.

"We look at all the practices of a fund, so if something is apparent to our investigation, then we would consider it in our approach to reviewing

the mutual funds" she said.

For its part, the SEC has said that it is constantly monitoring any kind of stock-price manipulation, which includes window-dressing and marking up.

The bad news is that prosecuting mutual funds for these abuses is "virtually impossible" because regulators must prove that there was some fraudulent intent, according to Mercer Bullard, founder and president of Fund Democracy and a former SEC attorney.

That's why Bullard favors greater disclosure from mutual funds. Earlier this year, he sent a letter to the SEC saying fund managers should be required to disclose their holdings on a monthly basis.

"The only effective way to deter window-dressing and portfolio pumping is disclosure," he wrote. "More frequent disclosure will enable the market to identify and punish managers who engage in these practices."