Law and Economics Workshop: Alpha Duties: The Search for Excess Returns and Appropriate Fiduciary Duties

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) welldiversified, (ii) low-cost, and (iii) expose one’s portfolio to age-appropriate stock-market risk. The law governing trustees, 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 which 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 5% and 15% before being willing to entirely forego the benefits of diversification and hold an individual stock (and that during a financial crisis 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 be informed about these alpha tradeoffs and 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 duty to diversify of trustees of personal trusts and of employee retirement plans should likewise strengthen during such periods.