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Tuesday, January 22, 2008

Front Running and Institutional Investors

A few years ago there was a Long Island restaurant that served the most deliciously yummy foods and desserts, all of which were labeled as being ridiculously low in calories and fat. The lines extended out the door. But one night a local television station reported that its testing revealed the restaurant's food was in fact incredibly high in calories and fat. The restaurant issued an apology and reverted to a healthy menu focused primarily on salads, but barely anyone would frequent the place. The trust was gone and the restaurant closed.

You would think that institutional money managers, who have a fiduciary responsibility to their clients, would also avoid doing business with any firms that engaged in organized wrongdoing and ripped them off. But that certainly doesn't appear to be the case. There have been repeated incidents where major Wall Street firms reportedly have traded in advance of major trades they were asked to execute for their institutional clients. This practice, known as front running, gives brokerage firms an unfair advantage because they have insider knowledge that a pending block order will likely cause a significant price swing.

The SEC reportedly is investigating whether Merrill Lynch was front running orders placed by Fidelity Investments, the massive mutual fund operator. If the allegations prove true, it won't be the first time Merrill Lynch has been nailed for this infraction. In 1995 the firm was fined $10,000 and censured by the American Stock Exchange for "the practice of profiting on advanced knowledge of a planned transaction." The piddling fine didn't even cover the losses incurred by Merrill's client and could hardly be considered a major deterrent. Whoever coined the phrase "crime doesn't pay," never worked on Wall Street.

But let's not just pick on Merrill. Front running has long been suspected as a widespread practice at all the big brokerage firms. Yet institutional money managers continue to route the bulk of their trades through them, rather than support the various independent boutiques that have sprung up in recent years offering very sophisticated algorithmic trading capabilities. One of the reasons is that the big brokerage firms offer their institutional clients equity research, but we know that most of that research is hardly worth the paper it's printed on. Another major reason is simply fear: In the words of one institutional money manager, "no one is going to get second guessed for routing an order through Goldman Sachs."

Rest assured, even if the SEC finds that Merrill was front running Fidelity's orders, nothing much will come of it. The matter will be settled by Merrill agreeing to pay a relatively insignificant penalty without admitting any wrongdoing. It will, of course, get to keep most of its ill-gotten gains. The SEC neither has the resolve, or the resources, to take on a big Wall Street firm.

It's about time mutual fund boards acted responsibly and begin questioning how trading in the equities they oversee are executed. Customers betrayed by the Long Island restaurant weren't willing to grant a second chance, and I'm confident that mutual investors would be similarly unforgiving about having their holdings routed through institutions engaged in pervasive wrongdoing.

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