CEO Incentives and Institutional Trader Monitoring are Substitutes: Theory and Evidence

Abstract

We show that stock price signals of future value that are extraneous “noise” from the perspective of inferring managerial actions from stock price movements are ameliorated by informed trading. Managerial actions are now reflected in more informative stock price inducing higher managerial productivity and pay, even though we show that only a limited form of complementarity is possible and that substitution occurs with the sum of equity and bonus incentives falling. Our theoretical predictions are supported by empirical evidence from the top 1500 U.S. companies over the period, 1992-2007. Aggressive “swing” trades by institutional investors result in subsequent reductions in the use of CEO’s equity-based and bonus pay allocations but nevertheless raise total pay due to induced higher managerial effort.