Front-Running Threatens to Widen Fund Scandal

Will front-running be the next focus of the fund industry’s market-timing scandal? The Spitzer complaint said that Canary Capital was able to obtain daily portfolios  from Bank of America’s Nations Funds. If other hedge funds had similar arrangements, it’s certainly possible that one of them was front-running the portfolio.

Front-running means trading individual stock positions ahead of a big mutual fund. Indeed, a big fund might need days or weeks to accumulate or divest itself of a sizable position. Thus, if others knew the fund was making such a trade, they could buy or sell ahead of the fund, anticipating that the fund's trades would likely move the stock. Presumably this could be a far more lucrative opportunity than simply doing stale pricing arbitrage.

According toBusinessWeek, the SEC is considering insider trading charges related to front-running. If it was widespread, this would certainly raise the dollar amount of damages in the scandal.

Time for Reg FD for Mutual Funds
I don’t know where this investigation will lead, but it does highlight the need for a fair disclosure rule for fund investors. There is such a rule for stocks and it requires that market-moving information be disseminated to all investors rather than a chosen few. So, why not disclose fund portfolios to all investors at the same time?

While some fund companies have argued that more frequent disclosure would lead to front-running, they themselves turn around and provide additional portfolios to consultants and others. The SEC appears likely to require that portfolios be provided quarterly with a set lag time. That’s a big win for investors. For fund companies that want to provide more frequent portfolios to certain customers, why not require that they post top 25 holdings and sector weights on their Web site, so that all shareholders are given equal access to portfolio data?

Now for Some Good News
I doubt they’re actually working together, but Fidelity and Vanguard founder Jack Bogle have both called for an end to trading by NYSE specialists in their own accounts. (If you subscribe to WSJ.com,click herefor the whole story.) The reason is simple: The specialists are reaping hefty profits at the expense of the investing public. Bogle cited a study that showed the firms enjoy profit margins between 35% and 60%. The specialists are supposed to ensure smooth trading but they have consistently earned big returns by trading for their own accounts.

"We need not worry about the specialist abusing his privileged position, we are assured, because the NYSE's cardinal principle is that the investor's interest is always served first,"wroteBogle in The Wall Street Journal. "But it's easy to get around this tenet. Even though there is no imbalance between supply and demand, the specialist simply trumps the price of investor orders. If a specialist is holding investor orders to buy IBM for $10.00, he cannot buy at $10 until all investor orders at $10.00 are executed. But he can buy at $10.01. With his informational advantage over everybody else concerning the likely direction of a stock's price, the specialist will outbid investors only at the most advantageous moments."

No one is in a better position to judge the situation than Fidelity because it trades more stocks on the Big Board than anyone else. Fidelity says the answer is to completely do away with the specialists and move to an all-electronic trading system similar to Nasdaq. American Century has also said specialists need to be curbed, though the company hasn’t called for as dramatic a change as Fidelity has.

This is the sort of thing I expect from fund companies. They should speak out for the average investor particularly in cases where the fund companies are in a much better position to see how the system works than the rest of us.