The Systemic Effects of Benchmarking

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