TCS Daily

Late Trading and The Horse Race Fallacy

By John E. Tamny - January 28, 2004 12:00 AM

USA Today recently featured an Eliot Spitzer interview in which he made it known that his office "continue(s) to see platforms for late trading that are out there," and that these violations make more charges against mutual fund companies "'almost inevitable.'"

Late trading gets special attention here not just because it is an SEC violation, but because Spitzer has singled out the act as a particularly bad one; at one point telling the Wall Street Journal that late trading is the equivalent of "betting on a horse after the horses have crossed the finish line."

Briefly, mutual fund share prices are set once a day at the 4 PM close. Spitzer's "horses" analogy has to do with investors buying at the 4 PM price after the close, usually after major news has come out that would possibly move the price of the fund shares higher. If so, the late traders' gains would dilute those of long-term fund investors.

Most media accounts of late trading have swallowed the Spitzer analogy whole. Indeed, Tuesday's USA Today said that if "big news breaks after the close of trading, late traders are virtually assured of a quick profit or of avoiding a loss."

Rather than take USA Today and Spitzer at their word, I chose to test their assumptions against arguably the biggest news story of the year: Saddam Hussein's December 14th capture by U.S. troops. For the purposes of this test, news about Hussein's capture luckily broke on a Sunday morning during non-trading hours.

By the Spitzer/major media definition of late trading, the above news would clearly be an example of the kind of late trading opportunities that existed for preferred investors. Newspaper headlines the following morning included, "Investment strategists expect a rally in the U.S. based on the news (Los Angeles Times),"Markets set for strong rally following Saddam's capture (Irish Independent)," "Investors likely to capture some quick gains (New York Post)," and "Saddam's capture expected to give stock market, dollar a short-term boost (AP)."

A late trading opportunity if there ever was one, right? Not so fast. The horses crossed the finish line on December 15th, and instead of rallying as was universally expected, the Dow Jones Industrial Average fell 19 points, and the NASDAQ plummeted nearly 31 points.

To even the most casual observer of CNBC or CNNFN, the market's reaction to the great news about Saddam Hussein would not necessarily have been surprising. The answer for why involves market futures trading that occurs before and after the 9:30 AM and 4:00 PM closes of the U.S. stock markets. A longtime watcher of CNBC myself, I don't have enough hands or fingers to count how many times market futures predicted a bloodbath that turned into a rally, and conversely a major rally that turned into a rout.

Going back to the Saddam example, if even his capture could not ignite a sustained rally, can't we then deduce that Spitzer and his friends in the media are wrong, that late trading is not as easy they portray it to be, and that in fact it's a very risky strategy that often leads to losses for those engage in it, and gains for the long-term fund investor?

Money manager Kenneth Fisher confirmed as much in his December 8 Forbes column when he wrote that, "after talking with a handful of securities lawyers who represent most of the mutual funds that the fund timers used, I know that as a group fund timers lost money."

This is important because by Eliot Spitzer's definition, if fund timers were making money on timed and late trades, then long-term shareholders were losing money. But what if Fisher's information is better than that possessed by Spitzer?

If long-term shareholders in the end actually benefited in total from timed and late trades (per Fisher's assertion) does not mean those who violated SEC rules against the latter should not be punished. It does, however, call into question the credibility of a man who has sold a willing to be duped media on the notion that the small investor was the big loser in this whole fiasco.

Time will surely tell, but it increasingly looks like timed and late trading were the unwitting beneficiaries of the small investor, and that the actual losers in this scandal were those entering into these kinds of risky trades.

If nothing else, hopefully more in the media will cast a more critical light on the assumptions of the man who would be Governor of New York. Speaking of, absent the horrific market downturn of recent years, would anyone outside of New York have ever heard of Eliot Spitzer? Talk about picking a horse after the horses have crossed the finish line.

John Tamny lives in Washington, DC, and can be reached at


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