Hooray for the SEC

The SEC has recently announced that it will be looking into the practices of Hedge Funds that seem to be consistently beating the market. The financial sector has begun to scream its collective head off at the “…effrontery of the SEC for targeting success….” They say that the successful firms are merely identifying inefficiencies in the market and are making money by capitalizing on those inefficiencies.

Efficient market theories say that this is possible in the short term, identifying market inefficiencies brings about efficient markets because those inefficiencies disappear due to the identification. However, it is hard to believe that one or more firms can consistently identify problems in a manner that lets them beat the market in the long run. According to the efficient markets theorists, long term returns in excess of the market return can come about from either trading on inside information, e.g. Raj Rajaratnam or by outright lying, ala Bernie Madoff. Either way, the means would be illegal.

In terms of the finance industry, the insistence that the market can be beaten on a consistent basis is a negation of the theory of efficient markets. Wall Street is constantly touting that the small player, the middle class saver and 401k or IRA owner, can trust in the future of their investments because the market is efficient. However, the existence of long term gains in excess of market returns is a strong indication that markets may not be efficient. Wall Street’s screaming is understandable only in the self-serving context that legal scrutiny would reduce its profits.

The Street cannot have it both ways. Either markets are efficient and long term gains in excess of the market need to be scrutinized or they are inefficient and the small player needs to stay out of the big boys’ game. In either case, Wall Street profits will suffer.