Alpha Duties: The Search For Excess Returns and Appropriate Fiduciary Duties

71 Pages Posted: 30 Aug 2017 Last revised: 12 Aug 2019

See all articles by Ian Ayres

Ian Ayres

Yale University - Yale Law School; Yale University - Yale School of Management

Edward G. Fox

University of Michigan Law School

Date Written: February 1, 2019

Abstract

Modern finance theory and investment practice have shifted toward “passive investing.” The current consensus is that most savers should invest in mutual funds or ETFs that are (i) well-diversified, (ii) low-cost, and (iii) expose their portfolios to age-appropriate stock market risk. The law governing trustees, investment advisers, broker–dealers, 401(k) plan managers, and other investment fiduciaries has evolved to push them gently toward this consensus. But these laws still provide broad scope for fiduciaries to recommend that clients invest instead in specific assets that they believe will produce “alpha” by outperforming the market. Seeking alpha comes at a cost, however, in giving up some of the benefits of the well-diversified, low-cost, appropriate-risk baseline. Too little attention has been given in fiduciary law to this tradeoff and, thus, to when seeking alpha is prudent and beneficial for savers, and when it is not.

This Article begins to fill that gap by making two contributions. First, we provide the first benchmark estimates of how much alpha is required before ordinary investors would be better off departing from the consensus. For example, we estimate that a person of average risk aversion would annually need to beat the market by (i.e., obtain alpha of) between 6% and 15% before being willing to entirely forego the benefits of diversification and hold an individual stock (and that during a financial crisis such a person would need an annual alpha between 9% and 18%). Second, we consider the implications of our results for the various branches of law governing investment fiduciaries. We propose generally that fiduciaries should prudently weigh these alpha tradeoffs, and then should explain them to their clients before recommending (or executing) investments that deviate from the low-cost, well-diversified, age-appropriate exposure standard. We argue that through new technology, this kind of information can be given to retirement savers and others at quite low cost. Our results also have a variety of more specific applications. For example, our work shows that the value of diversification increases during periods of market upheaval, and therefore the duty of trustees to diversify personal trusts and employee retirement plans should likewise strengthen during such periods.

Keywords: Fiduciary Law, Excess Returns, Alpha, Diversification

JEL Classification: G11, G28, G01, K22

Suggested Citation

Ayres, Ian and Fox, Edward G., Alpha Duties: The Search For Excess Returns and Appropriate Fiduciary Duties (February 1, 2019). Yale Law & Economics Research Paper #583; NYU Law and Economics Research Paper No. 17-36. Available at SSRN: https://ssrn.com/abstract=3028334 or http://dx.doi.org/10.2139/ssrn.3028334

Ian Ayres

Yale University - Yale Law School ( email )

P.O. Box 208215
New Haven, CT 06520-8215
United States
203-432-7101 (Phone)
203-432-2592 (Fax)

Yale University - Yale School of Management

135 Prospect Street
P.O. Box 208200
New Haven, CT 06520-8200
United States

Edward G. Fox (Contact Author)

University of Michigan Law School ( email )

625 South State Street
Ann Arbor, MI 48109-1215
United States

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