The mutual fund industry is once again in the limelight after two fund managers at Axis Mutual Fund were suspended pending an investigation. So, in today’s Finshots, we explain what the allegations are and why everyone seems to be talking about them.

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The Story

Imagine you’re a fund manager in a popular mutual fund company. You manage hundreds of crores in people’s wealth. News media companies want to know about your hot take on the market. And regular people want to know what you think about specific stocks.

If you do your job well, you could turn these people into crorepatis. And your employers pay you rather handsomely when you outperform expectations.

But maybe this isn’t enough for you. Maybe you want to make more.

Well, in that case, you could use the great powers conferred on you to make money using illegitimate means.

Let me explain.

As a fund manager, you’re buying a whole bunch of stocks to make up a portfolio that can help your customers make enormous wealth. And you probably have a very good idea about the kind of stocks that will help you get there. However, the Indian markets aren’t particularly liquid. That is, you don’t always have enough buyers and sellers dabbling in every stock imaginable. So if you were expecting to buy a few crores of a medium-size listed company, you’ll notice that you’ll have a hard time doing this. In fact, every time you try and accumulate this stock, the buying action alone will push the prices of these stocks higher. And you’ll have to keep buying them at even higher prices. This makes the whole endeavour more expensive and in common parlance, they call this the “impact cost.”

But if you knew this singular detail, you could also try and use it to your advantage. For instance, if you knew you had to accumulate a certain stock in large quantities, you could slip this information to somebody else. These people in turn could start buying the stock even before you begin your move. And when you’re done with your bit, the share price would have rallied considerably. At which point, your friends/agents could dump their holding for a neat profit. You could even share a part of the spoils and buy yourself a cool Lamborghini.

This illicit game is called front running and needless to say, it’s illegal to participate in such an enterprise.

However, reports allege that a couple of fund managers in Axis Mutual Fund house have been dabbling in such a thing. And they also go on to claim that both individuals have made quite a bit of money in the process. Also, it seems SEBI is already investigating the matter, despite no official confirmation from the regulator. But the all-important question is — Will these people be found guilty?

Well, it’s hard to say. People do get away with financial crimes without leaving behind a paper trail. They use intermediaries to conduct illegitimate transactions and deal with cash to escape scrutiny. However, under the current law, SEBI doesn’t need to find a smoking gun. They just need to establish circumstantial evidence that the fund managers likely did front run trades, based on a preponderance of probability. Patterns of trades, suspect conversations, and disproportionate assets all help SEBI to build its case. In the event they are found guilty, SEBI could impose penalties of up to 25 crores and also initiate criminal proceedings if they so desire.

But what about the retail investors? Doesn’t it shake their confidence in the ecosystem? After all, this isn’t a one-off. It has happened at HDFC Mutual Fund. It’s happened at Deutsche Mutual Fund. And it has happened at Reliance Securities.

How do they deal with such things?

Well, you can’t do much, can you? Sure, you could immediately run for the woods — Redeem all your investments from your mutual fund schemes and park them elsewhere. And you would be well within your rights to do it. But here’s the thing — instances of front running at HDFC, Reliance and Deutsche haven’t precipitated system-wide failures. They’ve largely been localised and the effects haven’t had a massive bearing on retail investors. Having said that, if you’re uncomfortable with some of the developments that have made it to the forefront recently, maybe you should prioritize peace of mind above all else.

Finally, it’s also important to know what Axis Mutual Fund has had to say about all this. In a statement released yesterday, they noted that the errant individuals have been suspended pending an investigation. An investigation that apparently began in February after the company was made privy to certain irregularities. And while it’s entirely possible that the top brass at Axis had nothing to do with any of this, it’s also important to note that they only publicly admitted as much, after news outlets started reporting on the matter.

So you have to ask — “Is Axis Mutual fund entirely blameless here?”

Well, we will let you decide that one.

Until then...

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