What is Front-Running
Front-running is when a broker enters into an equity trade with foreknowledge of a block transaction that will influence the price of the equity, resulting in an economic gain for the broker. It also occurs when a broker buys shares for their account ahead of a firm's strong buy recommendation to clients. Front-running is also known as tailgating. Front-running is a prohibited practice for brokers.
BREAKING DOWN Front-Running
Front-running is the practice of a broker or trader stepping in front of large orders to gain an economic advantage. For example, a broker receives a request from a client to buy 500,000 shares of XYZ Company. He holds the client's order until after personally executing an order for the same stock for his account. Later when he places the client's request, there is a rise in share price, due to the size of the order. This rise creates an instant profit for the broker.
This form of front-running is not only unethical; it is illegal, as it gives an unfair advantage to the broker. Front-running, much like insider trading, provides unfair advantages to the broker who has nonpublic information about a company.
Index funds, which have enjoyed many years of outperformance at the expense of active traders, have become targets for another type of front-running. Index funds track an index by mirroring the index's portfolio. Because the index changes its composition of stocks periodically, traders anticipate when an index fund will also update its portfolio. As a result, traders step in front of the trade by buying or selling shares to gain a profit or prevent a loss.
For example, in 2015, the Standard & Poor’s 500 index (S&P 500) added American Airlines Group Inc. to its holdings. Immediately after the announcement, HFT traders bought shares in advance of the rest of the market. This advance buying benefited the traders with an 11% gain before the addition of the American Airlines Group Inc. stock to the index.
In contrast to the broker front-running example, this form of index front-running is legal. The information used by investors is public and is seen as offering them no unfair advantage.