Do Institutional Incentives Distort Asset Prices?

Abstract

I show that fund managers who are compensated for relative performance optimally shift their portfolio weights towards those of the benchmark when volatility rises, putting downward price pressure on overweight stocks and upward pressure on underweight stocks. In quarters when volatility rises most (top quintile), a portfolio of aggregate-underweight minus aggregate-overweight stocks returns 2% to 5% per quarter depending on the risk adjustment. Placebo tests on institutions without direct benchmarking incentives show no effect. My findings cannot be explained by fund flows and thus constitute a new channel for the price effects of institutional demand.

Keywords: Intermediary Asset Pricing, Benchmarking, Delegated Asset Management

JEL Classification: G11, G12, G14, G23