The sleight-of-hand does actually little to improve the fund's performance, but it does keep a fund manager's biggest mistakes of the year out of the annual reports sent to investors. For that reason, most fund managers do some window dressing every December. And in years that the overall stock market has struggled - as it has this year - they're busier than usual.
Indeed, managed funds have actually fared worse than market averages this year. The Merrill Lynch composite index of hedge funds is down more than 7% on the year, and many mutual funds are hovering below such benchmarks at the Standard & Poor's 500 Index. The S&P 500 itself is down more than 1% on the year and more than 2% over the past six months.
In fact, this year's third quarter was the fourth-worst performance in hedge fund industry history.
Playing the ReboundEven though the types of stocks fund managers sell in December tend to be major dogs, the extent of the selling is so severe that many of them rebound come January.
"Ideally, you're buying these stocks now when the selling pressure is still there and selling them in the middle of January," Pankaj Patel, an analyst at Credit Suisse Group AG (NYSE: CS), told Reuters.
Patel has found that large-cap stocks with prices close to their 52-week lows in November outperform the S&P 500 through the following January. Last year Patel developed a list of downtrodden stocks that beat the S&P 500 by 5.8% over that time frame.
It's a pattern other investing experts have noticed as well. George Putnam, editor of The Turnaround Letter, has for 24 years published a list of downtrodden stocks he believes fund managers have punished disproportionately.
Last year Putnam's picks gained more than 15% on average just from mid-December to mid-January, while the Dow Jones Industrial Average gained only 2.7% and the S&P 500 4.26%.
Fund managers were plagued by external forces in 2011 - primarily political gridlock in the United States and the deepening Eurozone debt crisis - that wreaked havoc on stocks.
The carnage left fund managers selling heavily out of some of the worst-hit sectors. Bank of America Corp.-Merrill Lynch (NYSE: BAC) strategist Mary Ann Bartels told the Chicago Tribune that hedge fund managers have dumped 50% of their holdings in financial stocks and 49% of their holdings in industrial stocks.
But the best way for investors to use the annual window dressing dance to their advantage is to peruse the list of abused stocks.