The SEC Believes in Efficient Markets

The U.S. Securities and Exchange Commission seal hangs on the facade of its building in Washington, DC.
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The U.S. Securities and Exchange Commission seal hangs on the facade of its building in Washington, DC.

Roger Lowenstein's long New York Times magazine piece on insider trading is useful in a number of ways. Let's start with what it says about the Securities and Exchange Commission and the efficient market hypothesis.

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Lowenstein reveals that the SEC appears to be operating under a hardcore efficient markets hypothesis. According to the efficient market hypothesis, it is impossible for a money manager to consistently beat the market.

The idea—most famously developed in Eugene Fama’s 1970 article “Efficient Capital Markets”— is that securities markets are extremely efficient in processing information about individual stocks and the broader economy. When new information arises it is incorporated into the prices of stocks almost instantaneously. This ruthless efficiency means that neither fundamental analysis of publicly available information nor technical analysis can enable investors to beat the market.

This view was absolutely dominant in academia by the end of the 20th century. More recently, however, it has faced a number of challenges.

Some studies demonstrated that short-term investor irrationality could produce predictable patterns that would allow agile traders to produce market beating results. Events such as the crashing of the internet bubble and the financial crisis seemed to indicate that the market was not as efficient as predicted.

But more than anything, the consistent out-performance of certain hedge funds seemed to present the strongest challenge to the efficient market hypothesis. Funds like SAC Capital, Goldman’s Global Alpha, AQR and others seemed to be doing what EMH said was impossible—consistently beating the market.

The SEC seems to have clung steadfast to the EMH. In its view, consistent outperformance is at least suggestive of illegality.

From Lowenstein:

In testimony to Congress, Khuzami said the S.E.C. was canvassing the industry for funds with “aberrational performance,” on the theory that above-average funds may be benefiting from tips. Khuzami went further at the hearing and declared that “anybody who is beating market indexes by 3 percent and doing it on a steady basis” could be a suspect,

It is interesting, to say the least, that while the EMH has come under fire—especially from mainstream economists—it forms the core of the SEC’s approach to insider trading.

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