What the Front-Running Investigation Means for Fund Investors

Before the investigation into market-timing became public, fund companies were under siege from market-timers looking for a back door that would let them do market-timing, time-zone arbitrage, and even late trading. However, once Eliot Spitzer held his press conference back in September 2003, timing dried up quickly.

Suddenly, timing wasn't just something that hurt fund investors. It was a threat to fund company executives' careers and even freedom, and it was also a threat for the hedge funds and others who had been offering bribes to get away with timing and late trading. The net result was a big benefit for fundholders, as they are now pretty well-protected from timing, which reduces fund returns for long-term shareholders.

Now, the SEC is apparently launching a new probe, and it's my hope that it will benefit fundholders just as much as the timing probe did. According to The New York Times, the SEC is investigating whether brokers are tipping off hedge funds and others about big mutual fund trades so that they can profit from those trades.

Once again, this is a practice that hurts the average fund investor. When big fund companies make big trades, billions of dollars' worth of stock change hands. Naturally it can take days--even weeks--to move that much money, so if someone were tipped early on, they could dive into the trade themselves because they know the trade will move the price of the stock. By causing the fund to get a worse price on the trade, front-running sucks money from fund investors' bottom lines.

That's why mutual fund traders go to great lengths to cover their tracks. They spread trades out through many brokers in order to mask the size of their trades. They use electronic networks for trading because the trades are anonymous. In addition, they keep close tabs on how the market reacts to their trades and who knows about the trades so that they can cut out brokers they suspect of leaking information.

Even with all those tactics, big trades still move stock prices. It doesn't require illegal front-running for that to happen either. The old laws of supply and demand mean that a surge in supply (that is, a big fund sale) drives down the price and a surge in demand (that is, a big fund purchase) drives it up. In addition, lots of traders and hedge-fund managers watch trading closely for signs of big moves and trade accordingly without getting any illegal tips.

Front-running would naturally make the price movement even worse and therefore hurt fundholders, but proving it won't be easy. The SEC will need to find not simply price movement but evidence that someone who knew about a trade was tipping someone who, in turn, bought or sold stocks before or during the trade. The Times reports the SEC is looking into allegations that traders would tip favored hedge funds who would then place a trade with a different firm so that it wouldn't be obvious they were acting on inside information.

In recent years hedge funds have supplanted mutual funds as brokerages' biggest clients because they've grown in size and trade much more rapidly than mutual funds. Thus, it's certainly plausible that some front-running has occurred. However, mutual funds are still valuable customers of brokerages. While it might be in the interests of a few brokers to bend the rules, it would be dopey from a business standpoint for a firm to actually choose to give some of its best customers a raw deal.

I've talked with lots of people who work at mutual fund trading desks who were certain that the information on trades did leak out on occasion. However, we'll have to see what the investigation unearths to know if it really happened and to what extent. Even in the timing scandal, some of the investigations of individual companies found nothing wrong.

Unlike the market-timing probe, the fund industry is apt to be 100% behind the SEC investigation into front-running. After all, in this case they and fundholders are the victims and the probe is focused on giant Wall Street firms. Moreover, mutual fund companies have faced increasing pressure from hedge funds in recent years, as hedge funds have purported to deliver superior risk-adjusted performance.

For fund investors, the important thing is not who did what but that the extra attention should increase safeguards against front-running. With regulators focusing on it, you can be sure that Wall Street's internal compliance efforts will be beefed up and that brokers will be much more wary of giving anyone a peek at their orders. Thus, fund investors may well benefit from this investigation.