Quant's mutual funds might have some front-running

Who's the sucker for whom Quant's magic powder wasn't enough?

Horses are good at running in front.

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(I’m going to have a very high bar on quality.)

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Let’s revisit how front-running works:

1. You figure out that a large investor is going to buy a particular stock.

2. You buy that stock before the large investor.

3. You turn around and sell the stock to the large investor.

4. Profit? Maybe, assuming you’re able to buy low, sell high.

The profitability of this trade depends on the liquidity of the stock (or the lack of it). If there are a lot of people buying and selling the stock that you’re trying to front-run, the large investor might get all the stock they want without moving its price a lot. But if there aren’t too many traders in the stock, the large investor buying will push the price up.

With this in mind, here’s a report from Moneycontrol last week:

The market regulator Sebi has conducted search and seizure operations on Sandeep Tandon-owned Quant Mutual Fund suspecting front-running as part of a probe into suspected front-running, three people familiar with the development said. The search and seizure operation was conducted across two locations – Mumbai and Hyderabad.

…

Although two of the people cited confirmed that the case relates to front-running, the exact nature of the allegations could not be ascertained. One person said that the alleged profits from the transactions being probed by Sebi are close to Rs 20 crore. However, it is not clear if the management is under investigation in this case, or whether the probe relate only to external parties.

SEBI is investigating asset manager Quant Mutual Fund because apparently someone at the fund is front-running its trades.¹ SEBI probably found a pattern of shady buying/selling on its monitoring systems and is now looking for concrete evidence. Still early stuff. But people are worried! Quant’s mutual funds have been beating pretty much every other fund in the market in most categories. It’s almost been as if Quant has some magic powder that it sprinkles on its mutual funds and they end up topping the charts.

Magic powder aside, one thing Quant does do is buy a lot of small company stock.² Stock that is usually less liquid than large company stock. That’s what adds to people’s worries—Quant invests in small companies with less floating stock and there’s a fair bit of front-running potential here.

If someone at Quant is indeed front-running its trades, the main losers are the mutual fund’s investors. The front-runner skims away some of the potential profits of the fund and investors consequently make a little bit less than they would otherwise. But… Quant’s funds have been doing great! Better than everyone else! Does it matter that there is a bit of skimming happening?

Well, sort of. It depends on who is doing the skimming. If the front-running is being done by a fund manager, that’s bad! Sure, the fund is performing well, but if a fund manager—who makes investment decisions—is making money front-running, he no longer wants Quant’s funds to buy the stock that he expects to do well, but instead wants the fund to buy the stock that he expects to be able to front-run. And of course these would be small companies with less liquid stock.

But the front-runner need not be a fund manager! Last year, SEBI had similarly investigated Axis Mutual Fund for some front-running. The main culprit there was Viren Joshi, who used to be the “chief dealer” at Axis. The chief dealer and his team execute the trades that are decided by the fund manager. The fund manager might decide that he wants to buy $1 billion of a particular company’s stock, but he isn’t going to spend time figuring out at what times of the day(s) to execute the order to get the best price, or which brokers to send the order to. This is operational stuff that the chief dealer and the dealing team handle.

The chief dealer sits between the investment team (which includes the fund manager) and the brokers with whom the orders are placed. There couldn’t be a more convenient position for a front-runner.

I don’t know who at Quant is front-running its trades but if it ends up being someone from the dealing team, it might not be too bad. Minus the front-running, the fund will get better prices for the stocks it buys and its performance will get even better. If it turns out to be a fund manager though it could mean the fund is filled with illiquid stocks which cannot be sold.³

Cover Photo by Helena Lopes/Pexels

1. Disclosure: A portion of my investments is in one of Quant’s funds.

2. For context, HDFC’s Flexi Cap fund has 74% of its assets in large companies at the moment, while the corresponding figure for Quant’s Flexi Cap fund is just about 56%.

3. Without massively crashing the prices of those stocks, that is.