Shout Bits often exposes government abuse that entrenches large companies’ power by blocking small competitors. While many reports focus on the disproportionate cost of complying with government paperwork and mandates, another effect of regulation is to deny small players opportunity. Regulatory structures originally intended to protect the public invariably morph into cozy protection for the largest industry players. A recent Study in the Financial Analysts Journal shows how the SEC harms small investors by denying them access to the most profitable investments.

The Study, led by finance luminaries Ibbotson and Cheng (Morningstar), thoroughly reviews the performance of hedge funds from 1995 through 2009. They concluded that in good times and bad, hedge funds outperformed mutual funds by wide margins – an annual return of over 11% on average. Not only did hedge funds outperform mutual funds, but they did so in an economically meaningful way. Investment returns are divided into two categories: Beta and Alpha. Beta is the part of total return that is due to taking market risk – simply putting money into the general market. Alpha is the part of total return that cannot be explained by the risks an investor takes and can only be explained by the investor’s brainpower. Any simpleton can build a portfolio that earns Beta returns (i.e. many index funds have betas of 1, or risk equal to the market). To earn Alpha, an investor must have insights and strategies no one else has yet employed, and for decades academics thought this was impossible. The Study found that hedge funds earned an average annual Alpha of 3.43%, while mutual funds’ average Alpha was zero or worse (a negative Alpha means the investor would be better off throwing darts at the stock pages).

What is a hedge fund, anyway? Hedge funds are surprisingly hard to define because they can be almost anything. Originally these funds would try to eliminate, or hedge, market risks and focus their bets on individual investments. Today, hedge funds pursue a huge variety of strategies which often involve short sales (bets that an investment will fall in value) or derivatives (highly leveraged bets about the future value of a security). Since the SEC largely bans short sales and derivatives in mutual funds, hedge funds are not directly available to the vast majority of US investors. While there are about $1.6 trillion in hedge funds, they are usually available only to very wealthy and certain institutional investors.

The Study shows that investors would be much better off if they had access to hedge funds, and it ends there. But what if the SEC is actually enabling rich people to earn more with their investments? The reason academics used to not believe Alpha was possible was fairly simple: once a new investment strategy becomes known, it can be mimicked until its profitability falls to that of the general market (Harry Markopolos, the Madoff whistleblower the SEC ignored for years, was unable to mimic Madoff, which proved he was a scam). If hedge fund strategies were directly available to the regular investor, rather than banned by the SEC, most, if not all of their Alpha returns would be siphoned away by mimics. With its regulations, the SEC created a protected class of investments available only to very wealthy investors, limiting the ability of mutual funds to mimic their strategies for regular investors.

The SEC bans mutual funds and many institutional investors from using hedge fund strategies because their misuse can be expensive. Derivatives and shorts can be used to limit risk and expose value, but they can also be reckless bets – just ask AIG. The SEC, like any good parent, wants to protect its children, the public, from making bad decisions. Still, the SEC thinks the very wealthy are wise enough to take these risks. As with so many regulations, the result was not the public’s protection, but an opportunity for big players to profit at the public’s expense. With their direct access to hedge funds, the rich are allowed to consistently earn more on their investments while taking less risk.

The SEC, like most of Washington, does not interact with ordinary citizens. The SEC meets with Wall Street titans and listens to their concerns. It is easy for the SEC to believe that a regular Joe cannot understand hedge fund strategies, so he must be protected. Still, every time Washington protects people from themselves, it seems to open the door for the elite to prosper at their expense. As with the rest of Washington, the SEC should stop trying be the nation’s nanny.