Investor’s guide to surviving the front-running storm

I’ve always observed these incidents with a mix of concern and professional interest. Because front-running isn’t a new phenomenon, nor is it unique to any single fund house. This practice, where insiders use advance knowledge of pending orders to trade for their own benefit, has reared its ugly head multiple times in the Indian mutual fund industry.

In 2007, for instance, HDFC Mutual Fund found itself under scrutiny when its then equity fund manager was alleged to have engaged in front-running activities. The case involved accusations that the manager used his wife’s and father’s accounts to trade ahead of the fund’s transactions, potentially benefiting from price movements caused by the fund’s larger orders. This incident led to regulatory investigations and highlighted the need for stricter internal controls within fund houses.

More recently, in 2022, we saw Axis Mutual Fund embroiled in a front-running scandal that led to the barring of its fund manager, and 20 other entities, from the securities market. The Securities and Exchange Board of India (Sebi) took decisive action, imposing trading restrictions and financial penalties on those involved.

But front-running isn’t limited to mutual funds. In May 2023, Sebi issued an interim order regarding a front-running case at the Life Insurance Corp. of India (LIC). This case is particularly noteworthy as it involves an insurer handling ₹41 trillion of public money. The alleged offender, a bond dealer turned equity dealer at LIC, reportedly used accounts of close relatives, including his mother, mother-in-law, and even his deceased father, to conduct these illicit trades.

These incidents underscore a sobering reality: where there’s opportunity for financial gain, there will always be those willing to bend or break the rules.

However, what’s particularly intriguing about the recent Quant Mutual Fund case is the market’s response. Unlike previous incidents where fund houses faced significant redemption pressures, Quant MF has seen redemptions not exceeding 1.1% of its assets under management (AUM). This muted reaction raises questions about investor behaviour and market resilience in the face of controversy.

And I’m not here to defend or condemn any asset management company (AMC). My aim is to provide a balanced perspective and equip investors with the tools to make informed decisions.

So, what should investors look for when faced with allegations of front-running or other ethical breaches at their chosen fund houses? Here are some key considerations:

Liquidity and portfolio composition: Assess the fund’s liquidity position and any shifts in portfolio composition. For instance, Quant MF’s increased holdings in large-cap stocks could be seen as a step to manage potential redemption pressures.

Investor concentration: Examine the holdings of top investors. A well-diversified investor base, with top investors holding small percentages, 2-3% each, suggests a lower risk of large-scale disruptions.

Fund performance and redemption trends: Monitor the fund’s performance post-allegations and any available information on redemption trends. These can indicate overall investor sentiment and the fund’s resilience.

Regulatory response and AMC transparency: Keep an eye on Sebi’s actions and the fund house’s communication. Clear, timely responses from the AMC can be crucial in maintaining investor confidence.

Independent analysis: Consider views from independent financial analysts for unbiased assessments of the situation.

While these considerations are important, it’s also important to remember that front-running allegations, though serious, don’t necessarily spell doom for your investments. If you’re invested in a fund facing such scrutiny, resist the urge to make hasty decisions. 

For long-term investors with well-diversified portfolios, holding your position and allowing the situation to unfold might be the prudent approach. Short-term investors or those with higher risk tolerance may want to reassess their positions, but even then, panic selling is rarely the answer. 

As a risk mitigation measure, investor should also keep their AMC level exposures in check. Moreover, the Indian mutual fund industry has shown resilience in past. Besides, regulatory bodies are continually working to safeguard and increase transparency in the system.

As investors, our best defense against such uncertainties is knowledge and diversification. Don’t put all your eggs in one basket, regardless of how attractive a particular fund’s performance might be. 

Regularly review your portfolio, stay informed about the funds you’re invested in. After all, it’s not about avoiding all risks, but about understanding, managing and making informed decisions.

Arihant Bardia, founder and chief information officer, Valtrust.