Front-Running by Mutual Fund Managers: A Mixed Bag

Jean-Pierre Danthine and Serge Moresi

Review of Finance, 1998, vol. 2, issue 1, 29-56

Abstract: 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 her front-running activity reduces the liquidity costs of her customers, 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, however, for those investors who are not subject to front-running. In aggregate, front-running has either no or positive consequences for welfare. JEL Classification. G14, G23.

Date: 1998
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