The Systemic Effects of Benchmarking

53 Pages Posted: 20 Aug 2015 Last revised: 31 Jan 2019

See all articles by Diogo Duarte

Diogo Duarte

Florida International University (FIU) - Department of Finance

Kyounghwan Lee

Boston University - Department of Finance & Economics

Gustavo Schwenkler

Boston University - Questrom School of Business

Date Written: January 30, 2019

Abstract

We show that an institutional investor whose performance is evaluated relative to a narrow benchmark trades in ways that exposes a retail investor to higher risks and welfare losses. In our model, the institutional investor is different from the retail investor because she derives higher utility when her benchmark outperforms. This forces institutional investors to overreact (underreact) to cash flow news in bad (good) states of the world, increasing individual and aggregate volatilities. While asset prices and wealth are higher in the presence of benchmarking, the retail investor is worse off due to the exposure to higher risks. We empirically validate the mechanisms in our model using data on U.S. equity mutual funds with sector-specific mandates.

Keywords: Benchmarking, Institutional investors, retail investors, tail risk, heterogenous agents

JEL Classification: G2, G12, D51, D60

Suggested Citation

Duarte, Diogo and Lee, Kyounghwan and Schwenkler, Gustavo, The Systemic Effects of Benchmarking (January 30, 2019). Available at SSRN: https://ssrn.com/abstract=2646791 or http://dx.doi.org/10.2139/ssrn.2646791

Diogo Duarte

Florida International University (FIU) - Department of Finance ( email )

University Park
11200 SW 8th Street
Miami, FL 33199
United States

Kyounghwan Lee

Boston University - Department of Finance & Economics ( email )

595 Commonwealth Avenue
Boston, MA 02215
United States

Gustavo Schwenkler (Contact Author)

Boston University - Questrom School of Business ( email )

595 Commonwealth Ave
Boston, MA 02466
United States

HOME PAGE: http://www.gustavo-schwenkler.com

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