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Front Running & Excess Returns

News Background. The Securities and Exchange Commission (SEC) is investigating allegations that Jeffery Vink, head of the $56 billion Fidelity Magellan Fund, and other Fidelity executives have engaged in "front running," according to the Washington Post, April 12 1996.

 Issues. I will use this event to:

a) Define Front Running

b) Analyze its implications for excess returns on professionally managed equity funds.

Front Running refers to situations when a manager who has private information about the direction of movement of an asset takes a private position in the asset before purchasing it for the fund.

Let’s look at an example. Suppose you work for the research company of a mutual fund. You would know what companies your research department intends to buy. If you use that information to purchase these stocks for your own account before you buy them for the fund, then you are "front running" the fund.

When Wall Street traders learn that a major fund is buying a particular company, the stock’s price usually rises. Obviously if you buy before the increase in price then you can make a handsome profit. The profit is referred as "excess profit" in that it exceeds the profits that you would have obtained from the stock without such private information.

Implications on Excess Return. Front running has the potential of increasing the actual price that the fund has to pay for these stocks This would lower the returns to the investors in the fund.

Thus, even if a fund manager can find undervalued stocks, "front running" would eat up some of the profits that otherwise would have been realized without front running. Put differently, for a fund manager to obtain returns higher than a passive strategy, such as holding an index fund, she has to find stocks that are significantly undervalued so that front running would not eat up all the excess returns.

It is very difficult to control front running in large corporations, and this makes the task of beating the market by money managers even harder.