How do Funds Deviate from Benchmarks? Evidence from MSCI's Inclusion of Chinese A-shares

Abstract

This study investigates how benchmarking changes affect portfolio compositions in the cross- section of different investor types and stock characteristics. To that end, we exploit the phased introduction of Chinese A-shares to the MSCI Emerging Markets index, which was announced in June 2017 and implemented over the period from May 2018 to November 2019. This change presents a rare opportunity to estimate the impact of index changes and to shed light on cross-sectional implications. We document that particularly passive funds systematically deviate from the benchmark. Market capitalization, stock liquidity, correlation with A-shares and volatility explain how benchmark changes translate to portfolio adjustments of mutual funds and ETFs. We find some evidence indicating that these characteristics moderate the impact of benchmarking changes on financial market outcomes, suggesting that deviations from benchmarks matter.

Keywords: Index providers, benchmarks, financial integration, passive asset management

JEL Classification: G10, G14