MC Explains | Quant MF under scrutiny: What is front-running and how does it hurt investors?

Front-running negatively impacts investors in several significant ways.

Quant Mutual Fund, which has assets under management (AUM) of Rs 93,000 crore, has been suspected of front-running by the capital markets regulator.

Moneycontrol reported that the Securities and Exchange Board of India (Sebi) has conducted search and seizure operations on Sandeep Tandon-owned Quant MF. The operation was conducted across two locations – Mumbai and Hyderabad.

Front-running in mutual funds is an illegal practice where an intermediary, such as a broker or dealer, uses advance knowledge of a large pending mutual fund transaction to make personal trades. Moneycontrol takes a look inside the concept for a better understanding of the issue.

How does front-running work?

Mutual funds execute large orders such as buying and selling in stock markets through intermediaries such as dealers.

Front-running is a practice where these intermediaries exploit their position for profit. The intermediary trades stocks just minutes before a large institutional investor, like a mutual fund, is expected to enter the market. If the intermediary anticipates a mutual fund's buy order, they start accumulating the stock beforehand. When the mutual fund's order pushes up the stock price, the intermediary sells at a profit.

Conversely, if a mutual fund is expected to sell, the intermediary short-sells the stock just before the mutual fund's order. These trades are not made in the intermediary's own account but through the accounts of associates.

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This practice is illegal because it exploits insider information and undermines market fairness, harming the interests of the mutual fund and its investors.

How is it different from insider trading?

Front-running and insider trading are both illegal practices in the financial markets. They differ in their nature and the type of information used.

Insider trading involves trading based on material, non-public information about a company. This confidential information, often obtained from within the company, can significantly affect the company's stock price once it becomes public. Examples include earnings reports, mergers and acquisitions, major business developments, or other significant corporate events.

Individuals with access to this non-public information trade the company's stock to profit from the price movement that will occur once the information is disclosed to public.

How does front-running impact the investor?

Front-running negatively impacts investors in several ways. When intermediaries front-run large orders, it causes the stock price to move against the interests of the investor.

If a mutual fund, for example, plans to buy a large number of shares and the intermediary front-runs by purchasing the shares first, the price of the stock increases before the mutual fund can complete its purchase. This results in the mutual fund paying a higher price for the shares, reducing its potential returns. Conversely, for sell orders, the mutual fund receives a lower price for the shares, again reducing its potential returns.

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For mutual funds involved, any association with front-running can lead to significant legal consequences, including fines and sanctions. Additionally, the reputational damage can result in loss of investors and redemptions, further impacting the financial health of the fund house.

If we look at the past instances of front-running, the mutual fund houses have witnessed a slowdown in fund inflows as well as underperformance in the schemes.

How significant is the Quant MF issue?

Quant Mutual Fund has been among the best-performing mutual fund houses over the past three years. Its AUM has grown from Rs 258 crore in January 2020 to Rs more than Rs 90,000 crore by June 2024.

“Quant MF funds have enough largecap investments in even small and midcap funds of theirs. Both the funds have almost 10 percent each in Reliance alone. Liquidity is not a problem at all from the redemption perspective if at all,” Kirtan Shah, founder of Credence Wealth Advisors LLP, wrote on X on the immediate impact of Quant Mutual Fund’s scrutiny.

“There might be selling in mid and small stocks that Quant holds and expect some underperformance by the funds in the near term,” Shah added.

How Sebi is dealing with front-running cases?

Whenever Sebi finds violations, it imposes monetary penalties. Typically, the penalties are directed at dealers, fund managers, and the outside brokers with whom they have colluded.

The regulator last year barred Viresh Joshi and 20 more listed in the Axis mutual Fund front-running case from buying, selling or dealing in the securities market or associating themselves with the securities markets.

Further, Rs 30.55 crore was impounded from these entities according to the wrongful gains they have made through their front-running activities.

In the recent times, the markets regulator has taken steps after noticing a rise in the number of front-running activities. Today, it is mandatory to record all communications by dealers and fund managers.

Sebi in April asked fund houses or asset management companies (AMCs) to have an institutional mechanism for deterrence of potential market abuse, including front-running.

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The new structured institutional mechanism involves enhanced surveillance systems, internal control procedures and escalation processes to identify, monitor and address specific types of misconduct including front-running, insider trading, and misuse of sensitive information.

The regulation also asked the industry body Association of Mutual Funds in India (AMFI) to come up with detailed standards for such an institutional mechanism.