Noise Trading, Delegated Portfolio Management, and Economic Welfare

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Abstract
In 1992, turnover on the New York Stock Exchange was 48 percent. While there is no convincing theoretical prediction for assessing this number, observers may have the view that turnover is very high. The increase in turnover has been accompanied by a rise in institutional ownership. A regression of turnover on institutional ownership and real commissions per share shows that institutional ownership is still highlysignificant in explaining turnover. The available evidence is at least suggestive of a causal link between turnover and institutional control. It seems difficult to explain the level of trading activity purely on the basis of 'rational' motives for trade. The authors argue that the motive stems from a contracting problem between professional traders and their clients or employers. The contracting problem in the authors model is whether the delegated portfolio manager can convince the client/employer that inactivity was his best strategy. The difficulty is that the employer cannot distinguish "actively doing nothing" in this sense from "simply doing nothing." If the contract allows a reward for not trading, portfolio managers may simply do nothing; the contract may either attract incompetent managers or lead competent managers to shirk. If this makes it impossible to reward inactivity, and limited liability prevents punishing ex post incorrect decisions, then the optimal contract may induce trading by the portfolio manager which is simply a gamble to produce a satisfactory outcome by change. The authors call this noise trading or churning and show that the noise trade will occur in equilibrium. The paper then considers the implication of noise trading for agents welfare. Noise trading would appear to be costly for the employer since it lowers the expected rate of return on the portfolio. It will benefit hedgers; if managed portfolios earn lower rates of return, then uninformed hedgers earn higher returns. The higher return earned by the h
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