The trading activities of large investors can alter stock prices, even when they are not based on private information about the fundamental values of assets. This is because such trades may be indistinguishable from those made by informed insiders. This renders information about the activities of liquidity traders valuable. Managers of large investment funds have the opportunity to make personal profits from information about future fund trades – a strategy known as front-running – but whether such activity should be permitted remains controversial. In Discussion Paper No. 1528, Jean Pierre Danthine and Serge Moresi model the trade of a front-running fund manager against an informed insider. They endogenize noise trading – trading by small investors through mutual funds to hedge illiquid assets.

Previous studies suggest that front-running by insiders with information about trades reduces potential profits for insiders with information on fundamentals. Danthine and Moresi instead show that modelling market interaction of the two types of information, within a framework which takes into account the motives that bring liquidity traders to the market and incorporates the effect of front-running, drastically alters the welfare implications of front-running. The authors find no case where front-running is socially bad. Its effect on the profits of insiders with information on fundamentals can be viewed favourably on fairness grounds – but front-running fund managers may find themselves in a conflict of interest with their investors.

Front-running by Mutual Fund Managers: It Ain’t That Bad.
Jean-Pierre Danthine and Serge Moresi