Front-running in mutual funds: Meaning and how it works

Brokers have access to data on investor orders placed in advance. It is referred to as front-running if they exploit this information to trade stocks for personal gain without authorisation. Brokers and traders may use this private information to make investments that will profit them personally. Front-running is an unethical practice and can have a negative effect on fund investors by driving up the prices at which they can purchase stocks or driving down the prices at which they can sell them.

How does front-running work?

Usually, a front-running operation involves two partners. An information carrier receives early notice of a major order by an investor because they work for the company as a dealer, trader, or employee, and the front-runner, typically a friend, acquaintance, or family member, executes the trades.

Although they are different, front-running and insider trading sometimes are confused to be the same. In insider trading, it’s a company insider or employee who trades based on extensive knowledge of corporate activity. One example would be using insider knowledge to buy or sell shares before a significant announcement.

When it comes to front-running in mutual funds, it is the broker or trader that uses insider knowledge of a future transaction that can materially change the price of a security. For instance, a client asks a broker to help them buy 50,000 shares of Company A. Such a transaction will substantially increase the price. So, in case of front running, the broker will first execute an order for his personal account for the same stock and keep the client’s order on hold. Then, when he fulfils the customer’s request and the stock price rises due to the size of the order, he will sell the shares he bought. 

The broker benefits right away from the price increase. Similar to insider trading, front-running rewards the broker with secret information that will influence the asset’s price with inflated profits.

Facts about front-running 

  • Mass securities transactions are aided by front-running without major institutional bull traders impacting price movement.
  • If the brokers give this guidance to other clients, they are paid a commission.
  • Since it displays a typical trading process and is not under the exchange commission’s monitoring, it is challenging to trace.
  • Such trading activity can benefit small investors as they can make enormous profits quickly and without spending extra money. However, it is not recommended as it is against the law. 
  • Purchasing or selling before the client’s transaction is not regarded as prohibited after the larger transaction is made public.

How to prevent front-running?

Some brokers can exploit crucial information for their advantage in trading because they are aware of important transactions even before they happen. The only way to stop such an unethical practice is to closely monitor all business operations and uphold the highest ethical standards. 

The actual reason for investor losses is a lack of strong internal control. A person who handles other people’s money has a certain amount of trust placed in them; once it is gone, it is difficult to regain. Therefore, carefully verifying the credentials and experience of the broker or platform through which you invest in mutual funds is essential. 

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