Constrained by law: The impact of fiduciary duties on portfolios and prices in US equity markets

We study the equity market implications of a reform in the fiduciary laws that govern trust investments (prudent man laws), implemented in a staggered fashion across U.S. states from 1985 to 2006. As trusts account for a substantial fraction of institutional equity holdings in our sample period, and since the reform does not pertain to other investors, our empirical setting provides a rare opportunity to study the impact of a regulatory change on institutional investor holdings and relative prices in the U.S. equity market. We show that, before the reform, trusts tilt their portfolios towards prudent stocks. After the law change, trusts undo these tilts, which leads to substantial changes in portfolio performance, investor demand, and stock returns, consistent with a model of inelastic equity markets. More broadly, our paper documents a striking case of investment distortions: while the concept of diversification has been playing a key role in asset pricing theory since the 1950s, fiduciary duties severely constrained trusts’ ability to diversify their portfolios for up to half a century later.