The Quant saga: What is front-running, and its recent history

In the movie 'Too Big to Fail', William Hurt plays the role of Henry Paulson (an American investment banker turned United States Secretary of the Treasury). At the height of the 2008 global financial crisis, Hurt summarised how the banking system works in two lines: "There is not a bank in the world that has enough money in its vault to pay its depositors. It's all built on trust."

To an extent, the same applies to the larger financial system. Trust binds the financial system together. Without it, you might as well keep your money under the carpet.

As the news of SEBI's investigation of Quant Mutual Fund broke out yesterday evening (June 23, 2024), many have taken to social media to voice their concerns and opinions. But don't succumb to the chaos. We are here to help you understand what front running means and walk you through a few previous instances.

What is front running?

Mutual fund houses buy and sell stocks through brokers, known as dealers. If the dealer knows that a fund house is about to place a purchase/sell order and buys/sells the company's shares beforehand, they can make money unfairly.

Here is the modus operandi.

The dealer learns that a fund house is set to buy shares of Company A. He/she will buy Company A shares at (say) Rs 100 in their personal account or affiliate's account(s). At a later date, the dealer will buy the shares of Company A on behalf of the fund house. As the share price rises and goes up to (let's say) Rs 110, the dealer will make a cool and easy 10 per cent profit.

If the said dealer drives up the share price before investing on the fund house's behalf, then you stand to lose as an investor in the mutual fund.

You can see why this is an illegal activity and why SEBI is keen to tighten the screw on entities undertaking such practices.

Here are a few instances of front-running in the Indian mutual fund industry.

Axis Mutual Fund (2022)

Perhaps the biggest front-running scandal was uncovered at Axis Mutual Fund. SEBI's surveillance systems generated alerts regarding certain trades between September 1, 2021, and March 31, 2022, which were suspected to be front-running the trades of Axis Mutual Fund.

During its investigation, SEBI found that various individuals connected to Viresh Joshi (the former chief dealer of Axis Mutual Fund) had traded in different securities ahead of the impending orders placed on behalf of the fund house. These individuals collectively earned an aggregate sum of wrongful gains amounting to Rs 30.56 crore. However, SEBI's order did not indicate any wrongdoing on the part of fund managers or the AMC.

HDFC Mutual Fund (2020)

SEBI imposed a penalty of Rs 2 crore on four entities in 2020 for front-running the trades of HDFC Mutual Fund. Nilesh Kapadia (equity dealer for HDFC Mutual Fund between 2000 and 2010) tipped Dharmesh Shah regarding impending trades.

Our take

There have been many such instances in the past. The dealing function of a fund house is particularly vulnerable to such mischief. However, that doesn't mean that a fund house is deliberately trying to deceive you.

For the time being, the best thing to do is to do NOTHING. Wait for SEBI's investigation process to cook and then make a decision.

Also read: Interview with Sandeep Tandon, CEO of Quant Mutual Fund

This article was originally published on June 24, 2024.