How front-running in MFs affects you

Mint 28/6/10

India’s second largest mutual fund house with assets under management of Rs1.01 trillion, HDFC Asset Management Co. Ltd is in a bit of trouble. On 18 June, mutual fund (MF) investors and the industry woke up to a rude shock when the capital market regulator, the Securities and Exchange Board of India (Sebi), accused the fund house of front-running—a corrupt stock market practice.

In a 12-page order, it specifically named an employee of the fund house, Nilesh Kapadia, as accused and three other stock market brokers who operated in collusion. According to Sebi, HDFC MF unit holders suffered a loss of Rs2.38 crore. So if you are an investor of HDFC MF, should you be worried?

What is front-running?

It is an activity by which a person who is privy to the trading information of a large institution places its trades minutes before the large entity is to benefit in terms of price. For instance, a mutual fund dealer (who is going to execute the buy and sell orders for a mutual fund) could enter with his own personal order for the shares of a company just before the fund does and gets a lower price. When the fund begins to buy, the price will usually rise since it is a large order.

Front-running at HDFC MF

According to the Sebi order, there were four parties in this scam. On one side of the fence were Rajiv Sanghvi, a small broker working out of a broker’s office premises, an investor named Chandrakant Mehta and his daughter-in-law Dipti Mehta. Sanghvi and Chandrakant Mehta used to trade on their own and Chandrakant traded on his daughter-in-law’s behalf as well. Sebi found during investigation that Dipti did not know equity trading. On the other side of the fence was Nikhil Kapadia, assistant vice-president (equities), HDFC AMC.

Sebi found out that Kapadia would tip-off Sanghvi about what HDFC MF was going to buy on a particular day. Sanghvi and Chandrakant would then buy a substantial amount of scrips a few minutes before the fund was supposed to and wait. As the fund’s dealer, Kapadia would then buy the same equity scrips on behalf of HDFC MF. Since most of these scrips were small- and mid-sized companies, and are low on liquidity, their stock prices would show sharp rises when bought. Once these scrips’ market prices rose, Sanghvi and Chandrakant would sell their personal quantities and make money.

Sebi found out that this was done 38 times over 24 days between April and July 2007.

Kapadia was an equities dealer with the fund house since 2000. He was with the fund house till 17 June 2010. Market sources say he stopped coming to office only after Sebi’s order came out. He gave tips to Sanghvi through, what appears to be, his office’s landline telephone, though he knew that telephone lines in the dealing rooms of mutual fund offices are tapped. We assume that HDFC MF’s telephone lines are recorded, in keeping with industry standards. Mint could not independently confirm this though as an email sent to HDFC MF went unanswered.

Sebi got wind of this when the two stock exchanges, the Bombay Stock Exchange and National Stock Exchange, reported suspicious activities in the market. After digging deeper, Sebi realized that these two cases were related to one another and the trail led to Kapadia at HDFC MF.

Keeping a close eye

Though very few instances of front-running have come to light, market experts privately admit it’s a common practice. However, fund houses claim that they do their best to prevent this evil from creeping in their dealing rooms. For starters, dealing rooms are sanitized and have restricted access. Most fund houses ban mobile phones inside.

All conversations mandatorily take place on landline phones from within the dealing room and are recorded. “We keep phone records for 10 years,” said a fund manager on condition of anonymity owing to the sensitivity of the case.

Spotting behavioural changes, claim fund officials, is the best way to keep a check on dealers. “Since mobile phones aren’t allowed inside the dealing rooms, frequent stepping out or excessive use of mobile phones or too much texting is viewed suspiciously,” said a head of a compliance. All fund officials that Mint spoke to refused to be quoted as the issue involves the regulator.

Lifestyle changes can give precious clues if money is being made on the sidelines. “Last week when it rained heavily in Mumbai, all my dealers came late. It showed that all of them used public transport,” said a senior fund official. He added that it took him about eight years to buy a home in Mumbai, but if a dealer outruns him in, say, two to three years, that could give a clue. It’s a subtle art that can have devastating effects.

Some fund houses, occasionally, listen to live phone conversations of calls made from within the dealing rooms. A compliance head told us that he regularly “barges in a live conversation” through a sophisticated computer software that enables him to listen to dealing room phone lines from his own workstation. Too many conversations in regional languages are also viewed suspiciously by some. Random checks on mobile phone bills are conducted to see if calls were made regularly during market hours.

Investment committee review

As frequent as front-running may be, quite a few fund managers claim it can also be caught if fund houses are vigilant. For instance, if trades are consistently executed at a price higher than what fund managers desire, the pattern can give vital clues. Investment committees of fund houses that, typically, meet every morning to review the previous day’s transactions can catch this.

Stock exchanges are also built to spot trading irregularities. For instance, their surveillance systems can spot large trades in illiquid scrips that resemble similar trades made within a few minutes to a few hours, by a large institution, if this is a pattern. That is how it appears that Kapadia’s misdemeanours were initially spotted.

That HDFC MF did not catch this despite boasting of high internal risk quality controls and processes (rating agency Crisil Ltd had rated the HDFC AMC “Fund House Level 1” in 2005, citing “highest governance levels and process quality in fund management practices”) shows a “little bit of lethargy”, says the senior fund official we spoke to.

What should you do

While it’s unthinkable that a prominent fund house like HDFC MF is involved in malpractices, the act wasn’t perpetrated by the fund house. Black sheep can be present in any organization and so far as corrective action takes place in time, your money is safe.

However, it’s strange that Kapadia was invariably allowed to stay on until Sebi itself got him sacked. The loss may not be huge, but it’s a matter of good governance if tainted officials are shown the door, pending completion of investigation.

The days ahead will tell us what HDFC MF will do. Sebi has given it a month’s time to submit a plan to overhaul its internal control systems. While you may stay invested in the fund house purely on account of its historical pedigree (that one takes a massive hit), past performances and good fund management, choosing a fund house with a good pedigree has become more important now than ever before.

One thought on “How front-running in MFs affects you

  1. After reading this article i am verymuch affraid.How safe we are in STOCK MARKETS.Please inform the various safeguard measures an investor has to take before investing in mkts

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