Quant Mutual Fund Episode: A crucial wake-up call

SEBI’s investigation into the around Rs 93,000 crore Quant Mutual Fund has raised concerns among millions of investors about the safety of their investments. If the allegation of front-running turns out to be true, it could severely undermine the confidence of investors who are moving from traditional assets like fixed deposits and savings accounts to modern investments such as mutual funds. It is not the first time a fund has faced allegations of front-running. Prominent fund houses like HDFC Mutual Fund, Axis Mutual Fund, and more recently, Life Insurance Corporation of India, have previously been involved in similar controversies.

Several months ago, Quant Mutual Fund attracted significant attention for its exceptional performance, despite being a relatively new entrant in the market. However, this success, driven by concentrated portfolios and unconventional holdings, led many analysts to caution against expecting this level of performance to continue in the future.

In the last week of June, Quant Mutual Fund made headlines for a negative reason. The Securities and Exchange Board of India (SEBI) launched a crackdown on the fund over allegations of front-running, significantly shaking investor confidence in the rapidly growing mutual fund industry. SEBI’s investigation into the around Rs 93,000 crore Quant Mutual Fund has raised concerns among millions of investors about the safety of their investments. The regulator’s probe into front-running allegations is worrisome. While there hasn’t been a run on the fund’s schemes so far, front-running continues to be a serious issue in the over Rs 50 trillion industry. If the allegation of front-running turns out to be true, it could severely undermine the confidence of investors who are moving from traditional assets like fixed deposits and savings accounts to modern investments such as mutual funds.

Founded by Sandeep Tandon, Quant MF has become one of the fastest-growing fund houses. Its average assets under management skyrocketed to over Rs 90,000 crore, up from Rs 200 crore in FY19. During raids on Quant’s Mumbai headquarters and the Hyderabad premises of suspected beneficiaries, SEBI seized mobile phones, computers, and other digital devices to uncover who might have been leaking confidential information from the asset management company for illicit profit. The investigation suspects that either a dealer from a Quant entity or a broking firm through which the asset management company places orders could be involved. Concerns highlighted by audit firms and discrepancies identified by SEBI’s surveillance systems have raised sufficient red flags to justify the investigation.

What is Front Running?

Front running is a practice where a trader or broker executes orders for their account based on advanced knowledge of pending orders from their clients. It typically occurs in financial markets and is considered unethical and illegal in many jurisdictions. The idea is that insider knowledge allows the front-runner to make a profit by placing trades before the client’s orders are executed, thus potentially benefiting from the price movements that occur as a result of the client’s orders. For example, if a broker knows a large buy order is about to be placed by a client, they might buy the stock themselves beforehand. Once the client’s buy order is executed, it could drive up the price, allowing the broker to sell at a profit. The practice is not only unethical but also illegal and banned under SEBI regulations. Front-running is an unlawful tactic where fund managers, dealers, or brokers use privileged knowledge about impending large transactions to execute their trades in advance.

It is not the first time a fund has faced allegations of front-running. Prominent fund houses like HDFC Mutual Fund, Axis Mutual Fund, and more recently, Life Insurance Corporation of India, have previously been involved in similar controversies. Since Axis Mutual Fund’s front-running scandal surfaced in 2022, the fund has struggled to recover. If Quant’s fund managers are found responsible for the alleged front-running, or if the fund pre-emptively replaces them, it could significantly impact the fund’s future performance. A change in fund managers typically means that past performance is no longer a reliable indicator of future results.

A Lethal Cocktail

Many quantitative investment strategies are primarily driven by Momentum, which involves holding stocks that have recently risen and expecting them to continue their upward trajectory. Since 2020, the Momentum factor has been particularly influential, with rallying stocks drawing increasing investor interest and experiencing further gains. This trend aligns with the significant performance improvement observed in Quant funds since 2020, suggesting that Momentum plays a key role in the algorithms of Quant funds.

Momentum-based strategies are susceptible to significant drawdowns, making the investment approach of Quant funds quite risky. Triggers that unsettle investors could abruptly end the rally in these stocks, leading to a panic-driven correction. This risk is particularly pronounced for small-cap stocks, where low liquidity and float can magnify the impact of fleeing investors. If these small-cap stocks were involved in alleged front-running, the situation could become even more perilous. Corrections in these stocks, driven by redemption pressures in Quant fund schemes, might alarm investors and create a vicious cycle of escalating corrections.

It would be wise to reduce exposure to Quant Mutual Fund, especially their mid- and small-cap schemes, and avoid making new investments in these funds. This recommendation is particularly relevant given the concentration and unconventional nature of Quant Fund’s portfolios, which increases their risk. Additionally, for small-cap stocks exclusively held in Quant Fund portfolios, it is advisable to trim these positions, particularly if they lack sufficient research into their business fundamentals.

SEBI Needs More Cautious Approach

The market regulator has acted swiftly, imposing strict guidelines on fund houses and conducting surprise audits. Despite these efforts, problems persist, necessitating a deeper investigation into whether the issue is systemic or driven by individual greed. A systemic problem is particularly concerning, as it indicates that internal controls within the fund houses are inadequate. Additionally, if SEBI’s audits fail to identify these issues, it suggests a need for improved auditing practices. On the other hand, if the problem arises from individual greed, both the fund house and SEBI may be limited in their capacity to address it. In such cases, imposing severe fines, barring individuals from the stock market, and involving other agencies like the Income Tax Department, Central Bureau of Investigation, or Enforcement Directorate are essential steps.

With the Indian stock market expanding rapidly and attracting millions of new retail investors each year, it’s crucial to address financial crimes with greater urgency. A notable example of swift and severe action is Bernie Madoff, the former Nasdaq chairman. His Ponzi scheme, reported by his sons in December 2008, led to his arrest within a day and a 150-year prison sentence by March 2009—an outcome achieved in less than 150 days. To protect investors and ensure fairness, market regulators in India should expedite their decisions, minimizing delays for both fund houses and investors.

A fund house such as Quant MF, which manages around Rs 93,000 crore and has over eight million investors, requires a swift resolution to prevent disruptions in its operations. Clear guidelines and enhanced measures are crucial, potentially involving stricter monitoring, auditing, and compliance requirements. If investors have been harmed by front-running, any fines collected should be reinvested into the affected schemes to compensate for their losses.

However, a significant challenge remains in substantiating these allegations with concrete evidence. Front-running undermines investor trust in the fund house, potentially leading to redemptions and impacting the fund’s Net Asset Value (NAV). The investigation process can also generate uncertainty, causing investors to pause additional investments or redeem existing holdings until the matter is resolved.

A consultation paper from SEBI last year on “Prohibition of Unexplained Suspicious Trading Activities” highlighted several cases where the regulator identified unnatural trades leading to unusual profits but struggled to establish proof of guilt. The paper reported that in 2022 alone, SEBI generated around 5,000 suspicious trading alerts involving 3,588 unique entities. Among these, 97 entities were flagged more than five times for suspicious activities. Despite these alerts, SEBI has not been able to secure conclusive evidence of communication between entities. This marks the third instance of front-running uncovered by SEBI in the past three years, serving as a crucial wake-up call for the mutual fund industry.