DP1528 Front-running by Mutual Fund Managers: It ain't that Bad

Author(s): Jean-Pierre Danthine, Serge X Moresi
Publication Date: December 1996
Keyword(s): Front-running, Insider Trading, Noise Trading
JEL(s): G14, G23
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=1528

This paper evaluates the welfare implications of front-running by mutual fund managers. It extends the model of Kyle (1985) to a situation in which the insider with fundamentals-information competes against an insider with trade-information and in which noise trading is endogenized. Noise traders are small investors trading through mutual funds to hedge non-tradable or illiquid assets. The insider with trade-information is one of the fund managers. We find that front-running activity reduces their customers? liquidity costs, but it also reduces their hedging benefits. As a result, the customers of the front-running manager may be worse off and place smaller orders. The opposite is true, for those investors who are not subject to front-running, however. In aggregate, front-running will either have no effect, or have a positive effect on welfare.