The Real Cost of Benchmarking

Abstract

This paper provides causal evidence that benchmarking-induced asset price distortions have real effects on corporate investment. We document that increased benchmarking over the past 20 years fundamentally changed the cross-section of stocks' CAPM βs. We establish causality using exogenous variation in stocks' benchmarking intensity around Russell index reconstitutions. Stocks' CAPM βs increase upon index inclusion with larger effects for stocks which experience larger benchmarking intensity increases. Firm managers perceive this as an increase in their cost of capital and reduce investment. Treated firms have 7.1% less physical and 8.4% less intangible capital after six years. We find consistent results at the industry level using long-differences from 2000 to 2016. At the aggregate level, increase in CAPM βs caused by benchmarking largely offset the decline in the risk-free rate over the past 20 years and can explain 57% of the missing investment puzzle.

Keywords: Beta, Capital Allocation, CAPM, Cost of Capital, Index Inclusion, Investment, Investment Shortfall, Misallocation, Missing Investment, Passive Investing, Benchmarking

JEL Classification: D2, E22, G11, G23, G31