The Impact of Strategic Investor Activism on Institutional Trading and Portfolio Returns

Abstract

We investigate several implications of activism by institutional investors/monitors in the microstructure equilibrium postulated by Noe (2002). The decision whether or not to monitor, which reveals the firm's value to the fund, is stochastic. Empirically, we show that net-of-transaction-cost portfolio returns of the daily trades of active institutional fund managers are independent of their stock turnover rates. This is supportive of Noe's equilibrium in which the investor makes informed choices when she monitors and may trade "randomly" when she does not. We then identify the empirical counterpart to these "random" trades in the form of institutional "churning" trades of marginal profitability that have the effect of lowering rather than raising bid-ask spreads. These falls indicate the degree of success in camouflaging informed longer-term positions. While churning trades appear to be subject to psychological biases identified in the behavioral literature, we show that this is not the case, emphasizing their role in improving the institution's trading environment.

Keywords: Short-term Trading, Disposition Effect, Portfolio Turnover, Institutional Activism, Monitoring

JEL Classification: G23