Working Paper: CEPR ID: DP16909
Authors: Anna Pavlova; Taisiya Sikorskaya
Abstract: Benchmarking incentivizes fund managers to invest a fraction of their funds’ assets in their benchmark indices, and such demand is inelastic. We construct a measure of inelastic demand a stock attracts, benchmarking intensity (BMI), computed as its cumulative weight in all benchmarks, weighted by assets following each benchmark. Exploiting the Russell 1000/2000 cutoff, we show that changes in stocks’ BMIs instrument for changes in ownership of benchmarked investors. The resulting demand elasticities are low. We document that both active and passive fund managers buy additions to their benchmarks and sell deletions. Finally, an increase in BMI lowers future stock returns.
Keywords: benchmark; preferred habitat; index effect; demand elasticity; mutual funds; russell cutoff
JEL Codes: G11; G12; G23
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Changes in BMI (I12) | Demand elasticities for stocks (D12) |
| Stocks added to benchmarks (G10) | Price increases (E30) |
| Stocks deleted from benchmarks (G10) | Price decreases (D41) |
| Changes in BMI (I12) | Changes in ownership of benchmarked investors (G23) |
| Changes in BMI (I12) | Price impact of institutional investor trades (G14) |
| Increase in a stock's benchmarking intensity (BMI) (G24) | Lower future stock returns (G17) |