Mutual Funds and Frontrunning: What You Need to Know

Have you heard about front running? Do you know that recently many fund managers have been punished for this? Read this article to know more

Mutual Funds and Frontrunning

Recently, allegations of malpractice have been made against mutual funds. These malpractices, known as "front-running," involve the use of insider information and misuse of information to gain an unfair advantage in the market. This article analyses the approach of these perpetrators and explores whether these malpractices hurt investors. Despite the shock of these charges, it should be noted that insider trading, front-running, and misusing information are not uncommon in the investment world. Over the past year, several instances of these practices have been brought to light.

What is front running?

Front-running is an illegal activity in which brokers make use of advanced information given to them by mutual fund staff. This advanced knowledge (stock information) of impending purchases gives these traders an undue advantage over others and can lead to high profits. By leveraging buying power, even bigger gains can be made. However, this is not as straightforward as it may seem.

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Can front running be stopped completely?

The trading rooms of brokerages and mutual funds are highly secure environments with stringent confidentiality protocols in place. Traders are prohibited from bringing personal phones into the area and must use recorded phone lines for communication. However, with the shift to work-from-home over the past two years, these rules have become less rigid. Additionally, even the most stringent rules cannot prevent an individual from sharing confidential information outside of office hours. Therefore, while mutual funds and market regulator SEBI maintain close surveillance, the unpredictable nature of human behaviour means that front-running cannot be entirely eradicated.

Which kind of stocks can get impacted by front running?

Front-running is not as profitable for large-cap stocks as it is for mid-cap and small-cap stocks, due to the size of the purchase order required to make a significant impact. For instance, a purchase order of Rs.20-30 crore may be enough to move the price of a stock with a market cap of Rs.2,000-3,000 crore, but it would not create a significant shift in the price of a stock with a market cap of Rs.50,000-60,000 crore. However, the merger announcement of HDFC Bank and HDFC caused a dramatic increase in the price of even large-cap stocks, which allowed derivative buyers to make substantial profits on the same day. This highlights the corporate governance standards of the HDFC group, as they managed to keep the news a closely guarded secret.

Does front running impact normal investors?

Although it is both unethical and illegal, front-running does not really have an impact on the average investor in stocks and mutual funds. There have been instances where brokers have made huge amounts of money by utilizing this illicit market practice (of passing secret stock information), with two entities paying a sum of Rs.10 crore in 2019 to resolve a front-running instance.

Despite the illegal nature of front-running, the impact of these purchases on stock prices is typically minimal. Mutual fund investors do not bear the burden of this activity, despite the fact that front-runners may greatly benefit from it. The only parties that may suffer losses as a result of front-running are the sellers, who may not be aware that a large purchase order will drive up the stock price the following day. 

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Examples of illegal activities such as front-running, insider trading and stock price manipulation are not uncommon in the realm of investments. Here are some examples of this misconduct that have recently occurred:

In May 2022, Viresh Joshi and Deepak Agarwal, fund managers of Axis Mutual Fund, were suspended following a probe conducted by the fund house. It is believed that they divulged information regarding investment choices to brokers in Gujarat in exchange for bribes. Additionally, their possessions were more than what their declared income allowed. Sebi also investigated the matter.

In December 2021, Akash Singhania (Fund manager of Deutsche Mutual Fund), and his parents, Ashok Kumar Singhania & Premlata Singhania, paid Rs. 5 crores to resolve a case involving accusations of front-running. As the manager of the fund, Singhania had access to knowledge of upcoming orders from the fund house. He created four trading accounts in his parents' names, which were used to buy shares before the fund house placed its orders, and then sold the shares when the prices increased. The Securities and Exchange Board of India (SEBI) states that they made over Rs.1.4 crore in profits through this activity.

In May 2021, the Securities and Exchange Board of India (SEBI) issued a ruling that banned three individuals from participating in the capital market due to their involvement in a front-running scheme. The individuals were Rakesh Shah ( dealer with Reliance Capital Mutual Fund), Sanjay Parekh (dealer at Anugrah Stock & Broking) and Anita Shyam Mhatre (trading account holder). Shah, who had information on upcoming large trades, used to inform Parekh, and Parekh would then use Mhatre's trading account to purchase securities. As a result, the group was able to profit by approximately Rs.8.87 lakh.

Source: Economic Times 

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Overall, while front-running is an illegal activity, it does not have a significant impact on the average investor in stocks and mutual funds. Examples of this illegal activity abound and punishments have been imposed, but it is important to remember that the primary victims are the sellers of the assets, rather than the mutual fund investors. 

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