Confidence games: the mutual fund scandal is unintentionally driving investors into lightly regulated hedge funds and private equity vehicles.

THE upper class in the money culture changes as much as it needs to change to maintain its distance from the lower class.

It's always hard to know where the smartest, biggest money is heading. But if you set out to describe the financial class structure today--to list the general ways in which a dollar might be invested according to prestige and the likelihood of high returns--you'd come up with something like this:

* Private Equity

* Hedge Funds 

* High Net-Worth Brokers/Private Banking

* Ordinary Brokers/Mutual Funds

* Bank Deposits/Mattresses

The categories aren't clean: Certain kinds of hedge funds are indistinguishable from certain kinds of private equity funds. There are distinctions worth making within each category. And there are exceptions: Ordinary investors can buy Berkshire Hathaway Inc. and get roughly the same deal as Warren Buffett.

But the general point remains: The financial markets have a class structure. Ordinarily prosperous Americans invest their capital differently than very rich or very shrewd Americans.

One unstated role of financial regulation is to disguise this inequity--to make it appear that the financial playing field is level when it never has been and never will be. It seeks to preserve the illusion of equality.

The mutual-fund scandal is just another case in point. The scandal suggests that if only mutual-fund managers were honest, mutual-fund investors would get a fair shake and all would be right in the investment world. The little guy would get the same deal as the big guy.

But this plainly isn't the case. The big guy's money would never go anywhere near a mutual fund--unless it was there to exploit the inefficiencies caused by mutual fund pricing.

No line for Incompetence

That is the first big problem with the mutual-fund scandal, and why it isn't nearly as morally gratifying as it should be.

After all, a genuine crime has been committed against the American investor, and the New York attorney general has uncovered it. It's egregious--and surprising--that mutual funds designed as a safe harbor for the small investor gave preferential treatment to hedge funds.

But the real problem with mutual-fund managers isn't their dishonesty. It's their incompetence. And the real scandal in the financial markets isn't that the insiders are exploiting the outsiders. It's that they live in a different world. There's one set of institutions for the rich and powerful; for everyone else there are mutual funds.

The millions of dollars that mutual funds have, in effect, stolen from their small customers are dwarfed by the billions they have wasted for them.

In his just-published book, "A Random Walk Guide to Investing," Burton Malkiel shows that over the past two decades index funds have outperformed 88 percent of managed funds. That is, investors paid the vast majority of mutual-fund managers to grow their capital more slowly than if they had simply invested it in market indexes.

More narrowly, in the past five years, while mutual fund investments were growing to $7 trillion from $5.3 trillion, the Standard & Poor's 500 Index has outperformed 53.4 percent of large-cap equity funds.

There is no need to enter into an argument about market efficiency to win an argument about the idiocy of investing in mutual funds. No matter how you slice the numbers, you wind up with the same conclusion: the mutual-fund industry has been lucrative mainly for the people who work for mutual funds. The financial markets may not be efficient, but they apparently are efficient enough to prevent the sort of people who run mutual funds from beating them.

Enter the regulators, and their post-bubble zeal. If one consequence of the mutual-fund scandal is to drive small investors away from their faith in mutual-fund stock pickers, some good might come of it. But that isn't likely. What's likely is that the scandal will leave ordinary investors with the impression that the main trouble with their financial institutions is that they are dishonest.

In this respect, the mutual-fund scandal resembles the (phony) Wall Street analyst scandal: It is likely to create the illusion of reform rather than the genuine article. The settlement with Wall Street firms over their analysts' exuberance for Internet stocks created the illusion that Wall Street research, once tainted by self-interest, is now "objective" and therefore reliable. But you'd be as much of a fool to follow Wall Street stock-picking advice today as you would have been three years ago--and as likely to come out of it well.

The mutual-fund scandal will have the beneficial effect of scaring the bejesus out of mutual-fund managers who survive it. But it won't make them meaningfully more likely to invest capital wisely.

Just the reverse: Larded with even more regulation, more legal costs, more cover-your-butt provisions, mutual funds will see their costs rise. The added costs will be passed along to investors. Mutual-fund returns will be even less likely to justify fees.

Brain drain 

A second, equally perverse, effect of this scandal will be to drive what talent there is in the mutual-fund industry out. In the wake of the scandal, the mutual-fund industry will become an even deeper drainage ditch for financial mediocrity than it already is.

Let's assume that financial markets aren't efficient--that talented professional money managers can indeed systematically outperform the market by enough to justify their existence. If you were one of these talented young money managers, where would you want to work? A mutual fund? Hardly.

You'd take one look at this mess of a business--in which you not only fail to participate much in the upside of your shrewd decisions, but now face the scrutiny of zealous, press-hungry regulators as well--and run as fast as you could for the nearest hedge fund.

There are signs that this is already happening. People and institutions that have a choice are increasingly sticking their money into hedge funds. In the past five years, while heavily regulated mutual funds have grown their funds under management by less than a third, virtually unregulated hedge funds have more than doubled their assets. The Wall Street Journal recently reported that the University of Virginia now invests 90 percent of its endowment in 26 different hedge funds--and is doing quite well, thank you very much.

The mutual-fund scandal--instigated by hedge funds!--will only accelerate this trend. Thus a third bizarre consequence of the mutual-fund scandal: to hasten the movement of capital that is free and empowered to move out of heavily regulated sectors and into lightly regulated ones. Go figure.

Michael Lewis, whose books include "MoneyBall" and "Liar's Poker," is a columnist for Bloomberg News.