Informationless Trading

Abstract

The recent paper by Goetzmann et al. (2002) suggests that fund managers subject to aperformance review have an adverse incentive to engage in portfolio strategies that have the unfortunate attribute that they can expose the fund investor to significant downside risk. Weisman(2002) uses the term â¬Sinformationless investingâ¬? to describe this behavior, and argues that these strategies are â¬Speculiar to the asset management industry in general, and the hedge fund industry inparticularâ¬? and that these strategies â¬Scan produce the appearance of return enhancement without necessarily providing any value to an investor.â¬? Just how prevalent are these practices in the fundmanagement business? On the basis of a unique database of daily transactions and holdings of a set of forty successful Australian equity managers, we find evidence that individual managers do engagein this trading behavior, particularly when they form part of a team within a large decentralized money management operation and are compensated in the form of an annual bonus based on performance. This result is broadly consistent with the theoretical and empirical results of theprincipal agent literature which highlight the adverse consequences for the long term objectives of principals where agents are compensated based on observable short term performance. It is also consistent with recent results from the behavioral finance literature which suggest that agentsnarrowly focus on individual security gambles independent of overall portfolio value considerations.

Keywords: Informationless Trading, Sharpe Ratios, Performance Evaluation