RIGHT TRADE, WRONG TIME.(Canary Capital's market timing scheme)(The Talk of the Town)

Speculators get a bad rap. In the popular imagination they're greedy, heedless, and amoral, adept at price manipulations and dirty tricks. In reality, they often play a key role in making markets run smoothly. Their frequent trades make it easier for the rest of us to find someone to trade with, and their perpetual hunt for market inefficiencies can make prices more accurate. But sometimes speculators really are just greedy and amoral. Certainly that's true of the hedge funds that are at the heart of Wall Street's latest scandal, which surfaced last month when New York State Attorney General Eliot Spitzer brought civil charges against a New Jersey hedge fund called Canary Capital, which is run by Edward Stern, a son of the former Village Voice owner Leonard Stern. Canary, Spitzer alleges, engaged in an elaborate bunco straight out of David Maurer's classic "The Big Con," effectively betting on horse races (in this case, mutual-fund prices) after they'd already been run. Canary operated the scheme with the help of mutual funds owned by some of the country's biggest financial institutions, including Bank of America, Bank One, and Janus Capital. In the weeks since, it's become clear that Canary (which quickly settled the charges) was not alone, and a host of mutual funds and brokerage houses have been implicated.

The offending strategies are called "late trading" and "market timing." Late trading is illegal; market timing isn't, though most funds say they actively discourage it. Both take advantage of the fact that mutual-fund prices don't change during the day, the way stock prices do. Instead, they're set once, at 4 p.m. This establishes a level playing field for all investors: if you buy before four o'clock, you get that day's price, and if you buy after four o'clock you get the next day's price. Canary, though, conspired to buy funds after four o'clock while still paying that day's price. So when important news broke after four--news that was likely to boost the market or a particular fund the next day--Canary could buy the fund's shares and then flip them for a quick and easy profit. That's late trading.

Market timers play similar games with, among other things, mutual funds that have a lot of international stocks. Markets overseas close long before 4 p.m. New York time. The Tokyo Stock Exchange, for instance, closes at 2 a.m. So international mutual-fund prices, based on closing stock prices that are hours old, are "stale." If something important happens in the U.S. market that will probably boost overseas markets the next day--say, a big tech rally--market timers buy the international mutual fund at its current cheap, stale price and then sell it the next day at a tidy profit.

The victims are ordinary investors; the profits come right out of their pockets. Hedge funds like Canary are the fluke worms of Wall Street, feeding on the strength of ...