NOISE TRADING, DELEGATED PORTFOLIO MANAGEMENT, AND ECONOMIC WELFARE

We consider a model of the stock market with delegated portfolio manag ement. Managers try, but sometimes fail, to discover profitable tradin g opportunities. Although it is best not to trade in this case, their clients cannot distinguish ''actively doing nothing,'' in this sense, from ''simply doing nothing.'' Because of this problem, (i) some portf olio managers trade even though they have no reason to prefer one asse t to another (noise trade). We also show that (ii) the amount of such noise trade can be large compared to the amount of hedging volume. Per haps surprisingly, (iii) noise trade may be Pareto-improving, Noise tr ade may be viewed as a public good. Results i and ii are compatible wi th observed high levels of turnover in securities markets. Result iii illustrates some of the possible subtleties of the welfare economics o f financial markets. In our model, all agents are rational: some trade for hedging reasons, investors optimally contract with portfolio mana gers who may have stock-picking abilities, and portfolio managers trad e optimally given the incentives provided by this contract.