Front-Running in Mutual Funds

The recent unearthing of front-running in the Quant Mutual Fund has suddenly brought this term to the forefront with investors getting a bit panicky and wondering if they should exit the fund. The article explains how front-running takes place and whether any such illegal activity impacts the investors’ money 

India’s mutual fund industry, a haven for retail investors seeking long-term wealth creation, finds itself battling a persistent demon – front-running. This unethical practice, where fund managers or insiders exploit their privileged knowledge of upcoming large trades to make personal profits ahead of their clients, is not just a regulatory headache, but a dangerous threat to the very core of investor trust. While we boast of a well-regulated market with the Securities and Exchange Board of India (SEBI) at the helm, several high-profile cases have dented investor confidence. 

India’s mutual fund industry has been rocked again quite recently by allegations of front-running, this time involving the high-flying Quant Mutual Fund. Known for its impressive returns and a meteoric rise in assets over the last few years, Quant MF now faces a regulatory probe, casting a shadow over its past performance. Quant MF, which is in the thick of a controversy, is one of India’s fastest growing asset managers and has seen its assets under management (AUM) grow by 251 per cent over the last one year versus industry growth of 53 per cent, which means it has grown by five times the industry average. 

Quant MF’s total assets under management from all equitydedicated schemes at the end of May 2024 stood at ₹84,028 crore, up from ₹23,956 crore as on May 31, 2023. It was at just ₹225 crore in May 2019. This is a staggering 37,246 per cent jump in five years. Meanwhile, the net AUM of equity-oriented schemes as on May 31, 2024 for the industry stood at ₹25.39 lakh crore this May versus ₹16.56 lakh crore in the same month of the previous year. It was at ₹7.24 lakh crore as on May 31, 2019. The industry AUM growth has been 250 per cent in the aforementioned period. 

The reason for such a huge rise in the fund’s AUM is that the schemes of this fund house have not just outperformed their benchmarks but have also given superior returns over their peers in different categories. Our analysis of different equity schemes managed by the fund house shows that most of the funds have returns that fall in the first quartile of their category returns in the last one year. For example, Quant Large and Mid-Cap Fund and Quant BFSI Fund are the top performing funds among their categories. So are the Quant Mid-Cap Fund and Quant Flexi-Cap Funds, which remain in the top five of their respective categories. These superior returns have helped the fund house to attract investors to invest towards their funds. 

History of Front-Running
This is not an isolated case and we have a history of frontrunning in India. As of now, we know of the Quant MF only because it has come to light but there may be many cases where it might not have been discovered or unearthed. Following are some of the important and prominent front-running cases in the Indian mutual fund industry: 

May 2021: Nippon India Mutual Fund
Formerly known as the Reliance Mutual Fund, allegations against it surfaced regarding front-running activities by some employees. SEBI, in its investigation, found that an employee, while working with the fund house as a dealer and having knowledge of the impending large trades to be executed on behalf of the fund house, passed on information pertaining to the trades to a dealer in a stock broking firm to execute trades on this behalf. 

Following this the regulator barred these individuals from the capital markets for six months for front-running the trades and asked them to disgorge the unlawful gains, along with simple interest at the rate of 4 per cent. Post this event there was not much of an impact seen in the overall asset under management of the AMC. Between July 2021 and September 2021, the AUM of the fund house increased by 10.37 per cent, highest among the top five AMCs. If we take the period between April 2021 and June 2021, their AUM increased by 5.16 per cent. 

May 2022: Axis Mutual Fund
In May 2022, SEBI cracked down on Axis MF after uncovering front-running by a former chief dealer and associates. SEBI’s surveillance system alerted them on suspected trading activities conducted from September 1, 2021 to March 31, 2022 on the trades of Axis Mutual Fund that were in violation of provisions of the Securities and Exchange Board of India Act, 1992 and other regulations. Based on alerts, SEBI conducted a detailed investigation to unearth the fraud and issued an interim order against the chief dealer and his accomplice. 

The parties in this case followed the buy-buy-sell or sell-sellbuy strategy to execute the trades. For example, Axis Mutual Fund proposed to sell 32.30 lakhs shares of Hindalco Industries Limited. Before placing the order, the Axis MF dealer leaked this information to his accomplice who sold 3.97 lakh shares of Hindalco Industries at ₹419.72 - ₹422.28 a minute prior to the order of Axis Mutual Fund. Subsequently, the shares were sold by Axis Mutual Fund, which led to a decrease in the share price of Hindalco Industries’ scrip to an average price of ₹417.78. 

After that, the dealer’s accomplice squared off their position by buying similar shares at a lower price and registered profits on their trade. Once again, we found that there was no statistically significant outflow from the fund house. Yes, between April 2022 and June 2022, Axis MF saw its AUM falling by 5.45 per cent but then other major fund houses too saw their AUM dropping in the same period. For example, HDFC AMC saw its AUM declining by around 4 per cent in the same period. One of the reasons for such a fall may be the drop in equity indices in the same period. In the next three months we saw the AUM of Axis AMC improving by 1.16 per cent. 

No Great Repercussions
In addition to the above, there are other cases of front-running in the Indian MF industry. However, we observe that there hardly has ever been any impact on a fund’s performance or inflows of the fund towards AMCs where such cases have happened. Even in the current case, it has almost been more than a week since the news was leaked and yet there has not been any negative knock or slide in the net asset value (NAV) of the equity-dedicated funds of Quant MF. They are generating returns as per the industry average in their categories. Out of the 14 categories that they are present in, their funds are underperforming only in two categories while outperforming in the rest. This is after ₹1,400 crore worth of investments was redeemed from the funds managed by Quant MF within the first three days of this news. 

Action Plan for Investors
Considering everything and taking experience from the past such cases of front-running, there is little justification for investors to rush to exit funds based on such information. While the situation could further deteriorate from the existing level, history shows that adopting a wait-and-watch approach might be the most prudent policy at such a stage. Before taking any action, investors should closely monitor developments and official communications from both SEBI and fund houses on this matter, given that there are periods in a mutual fund industry when performance charts are dominated by a given fund house. 

Hence, there might be cases that many investors gravitate towards it. Therefore, this is also an opportune moment for investors to reassess their portfolio diversification in terms of fund houses. Although Quant MFs have been strong performers, this incident highlights the importance of not putting all the eggs in a single basket, regardless of how reputed a fund house may be. 

In a broader context, this investigation serves as a wake-up call for the entire mutual fund industry. It underscores the need for robust internal controls, stringent ethical guidelines, and a culture of transparency. As the investigation unfolds, it will be crucial for all stakeholders—regulators, fund houses, and investors—to learn from this incident. If the industry has to grow, the trust of investors is of paramount importance and it’s not only the responsibility of the regulator but of everyone in the ecosystem to refrain from such unlawful practices.