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

By Ayres, Ian; Fox, Edward | Texas Law Review, February 1, 2019 | Go to article overview

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


Ayres, Ian, Fox, Edward, Texas Law Review


(ProQuest: ... denotes formulae omitted.)

I. Introduction

Investment fiduciaries-like trustees, investment advisers, brokers, and 401(k) plan managers-help direct trillions of dollars of savings, including most of the nonhousing wealth of ordinary savers.1 Because these fiduciaries play a variety of roles in the investment process, no single body of law applies to all of them. Nevertheless, the fiduciary duties imposed by these different branches of law are aimed at a common problem: ensuring that savers' funds are invested prudently, with a level of risk appropriate for each investor's circumstances and earning the highest expected return given that level of risk. The question of how to invest prudently is often viewed by retail investors as daunting, but today's consensus is actually easily described: absent some opportunity to beat the market, one should invest in vehicles (such as mutual funds or ETFs) that are (1) well-diversified, (2) low-cost, and (3) expose one's portfolio to age-appropriate stock market risk.2 This consensus arose from decades of empirical and theoretical finance research. The laws governing investment fiduciaries have evolved to reflect this consensus and to push fiduciaries towards recommending (or executing) strategies consistent with it. There remains ample scope, however, for fiduciaries to recommend investing instead in specific assets that promise to deliver abovemarket returns. This is known in the argot of finance as "seeking alpha."3 Alpha investment opportunities often involve a tradeoff: investors gain expected excess returns but are required to sacrifice some of the benefits of diversification, low fees, or appropriate risk.

The laws governing fiduciaries have paid too little attention to identifying when seeking alpha is prudent, i.e., when the expected excess returns outweigh the costs of departing from the low-cost, diversified, appropriate-risk baseline. Indeed, we are not aware of any systematic attempts to provide estimates of how much alpha is needed to justify underdiversification costs or taking on the wrong level of market risk. Y et, these estimates are necessary before one can rationally distinguish beneficial alpha seeking from the imprudent chasing of excess returns. Our first contribution in this Article is to provide a methodology for evaluating these costs and then to empirically estimate them.4

Our estimates of the required offsetting alpha are often substantial. For example, we calculate that an investor with average risk aversion would need to expect an annual alpha between 6% and 15% before being willing to entirely forego the benefits of diversification by holding only an individual stock. Moreover, during a period of market upheaval she would need to expect an alpha between 9% and 18%. Alpha of this magnitude would easily more than double the risk premium normally paid on stock.5

Of course, most alpha opportunities are not so extreme as to necessitate investing solely in an individual stock. But some diversification is always sacrificed when investors adopt an alpha-seeking strategy. This is because the choice to concentrate one's investments in an alpha opportunity implies some movement away from the portfolio that would have best diversified risk. This results in the investor bearing some risk that is specific to the alpha investments-called "idiosyncratic risk"-which could otherwise have been diversified away. Even more modest departures from full diversification can, as we later show, impose substantial losses in alpha-seeking portfolios as large as 50 stocks.

In this Article, we identify two other benefits that alpha investors sometimes sacrifice in their attempts to achieve above-market returns. Besides sacrificing the benefits of diversification, investors also at times take on too much or too little exposure to stock market risk when pursuing alpha investment opportunities. While the diversification tradeoff involves bearing a nonoptimal amount of idiosyncratic risk in return for alpha, the exposure tradeoff involves taking on nonoptimal amounts of stock market risk, often called "systemic risk," to get alpha. …

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