Front-Running in Mutual Funds: Here’s How SEBI Plans to Keep Check

Want to know more about Axis Mutual Fund's front-running case? Watch this video:

Not just Axis Mutual Fund, but even HDFC Mutual Fund, Deutsche Mutual Fund, and LIC, among others, have been involved in front-running.

[Read: Front-running Cases in Mutual Funds: All You Need to Know]

For starters, front-running refers to a practice of performing trades based on confidential information about future trades that may vastly affect stock prices. The vital information that isn't available in the public domain about planned but unexecuted trades is leaked in close nexus of people involving brokers and other traders/investors, even fund managers and other employees, who then accumulate the stock in advance for their own vested, thus inflating the stock price, which primarily benefits the tight circle than the investors at large. So, front-running is regarded as a market manipulation activity.

The capital market regulator weighs two key aspects when evaluating if there has been an instance of front-running: 1) Whether beforehand knowledge of unpublished information about a large pending trade in a particular security was used, and 2) Whether the orders are executed, directly or indirectly, by the front-runner ahead of a sizeable orders placed in a particular security before the other investors uninvolved in front-running.

What Are the Changes Made by SEBI to Keep Front Running In Check?

This time around in its board meeting, SEBI has made major changes to enhance the existing framework by requiring AMCs to put in place a 'structured institutional mechanism' for...

1) Identification and deterrence of potential market abuse, including front-running, and

2) Fraudulent transactions in securities

Structured institutional mechanisms, according to the regulator, should consist of enhanced surveillance systems, internal control procedures, and escalation processes to identify, monitor and address specific types of misconduct, including front running, insider trading, misuse of sensitive information, etc.

The broad framework of the institutional mechanism will be specified by SEBI in the time to come. Moreover, in consultation with SEBI, the Association of Mutual Funds in India (AMFI), shall specify detailed standards for such an institutional mechanism.

The SEBI Board has made further amendments to the regulations, putting the onus on the AMCs to do the following:

1) Enhance responsibility and accountability of the management of AMCs for such an institutional mechanism; and

2) Foster transparency by requiring AMCs to have a whistle-blower mechanism

SEBI's new front-running norms are effective after the implementation of the institutional mechanism for AMCs.

However, the possible gap or loophole in the regulations to keep watch on the front-running activity is that the SEBI Board has approved an exemption from the requirement of recording face-to-face communication, including out-of-office interactions, during market hours. Most of the front-running activity also happens through offline interactions. It is possible that there may be many more such skeletons in the closet at the fund houses that have gone unnoticed, or no one has bothered to show the courage to whistle blow.

Therefore, the worry is that most of the front-running may still happen in the absence of necessary recordings of such communications.

I expect that in the coming days, to curb instances of front-running or any other misdoing, fund houses strengthen their compliance and governance norms in the interest of investors. Fund houses or AMCs cannot shrug off responsibility citing 'increasing burden'.

It remains to be seen how diligently and with high fiduciary standards, mutual fund houses handle the hard-earned money of investors.

What Should Investors Do?

It is recommended that investors consider fund houses that follow robust investment processes and systems and not give weightage to star fund managers when selecting mutual fund schemes for their portfolio.

To make a suitable choice of a plethora of schemes available, consider your age, risk profile, investment objective, the financial goals you are addressing, and the time in hand to achieve those goals envisioned financial goals. This need-based analysis shall help you own befitting mutual fund schemes (or any other investment product for that matter) in the portfolio.

Further, to make the best choice among mutual funds, evaluate a host of quantitative (viz. returns across time periods, risk taken to clock returns, risk-adjusted returns, performance across market cycles) and qualitative parameters (viz. portfolio characteristics, the percentage of AUM of the fund house actually performing - to judge whether a fund house is a prudent asset manager or mere asset gatherer - also the credentials of the fund manager, etc.) when selecting schemes under consideration. Don't just look at past returns of mutual funds, as they are not an indicator of future returns.

Be thoughtful in your approach. And when in doubt, don't hesitate to reach out to a SEBI Registered Investment Advisor.

Happy Investing!

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Disclaimer: Investment in securities market are subject to market risks, read all the related documents carefully before investing.
This article is for information purposes only and is not meant to influence your investment decisions. It should not be treated as a mutual fund recommendation or advice to make an investment decision in the above-mentioned schemes.