Does Benchmarking Affect Asset Prices?

/Does Benchmarking Affect Asset Prices?

Does Benchmarking Affect Asset Prices?

By | 2017-08-18T17:06:14+00:00 November 8th, 2014|Research Insights|3 Comments

The FT has a great piece called the “Risk-Return relationship has been upended.” The premise is that benchmarking distorts markets. The article inspired me to dig up some more academic research on the subject. Some of the papers/abstracts are below:


Asset Prices and Institutional Investors


We consider an economy populated by institutional investors alongside standard retail investors. Institutions care about their performance relative to a certain index. Our framework is tractable, admitting exact closed-form expressions, and produces the following analytical results. We find that institutions tilt their portfolios towards stocks that compose their benchmark index. The resulting price pressure boosts index stocks. By demanding more risky stocks than retail investors, institutions amplify the index stock volatilities and aggregate stock market volatility and give rise to countercyclical Sharpe ratios. Trades by institutions induce excess correlations among stocks that belong to their benchmark, generating an asset-class effect.

Asset Management Contracts and Equilibrium Prices


We study the joint determination of fund managers’ contracts and equilibrium asset prices. Because of agency frictions, investors make managers’ fees more sensitive to performance and benchmark performance against a market index. This makes managers unwilling to deviate from the index and exacerbates price distortions. Because trading against overvaluation exposes managers to greater risk of deviating from the index than trading against undervaluation, agency frictions bias the aggregate market upwards. They can also generate a negative relationship between risk and return because they raise the volatility of overvalued assets. Socially optimal contracts provide steeper performance incentives and cause larger pricing distortions than privately optimal contracts.


Asset pricing implications of benchmarking: a two-factor CAPM


The paper considers the equilibrium effects of an institutional investor whose performance is benchmarked to an index. In a partial equilibrium setting, the objective of the institutional investor is modelled as the maximization of expected utility (an increasing and concave function, in order to accommodate risk aversion) of final wealth minus a benchmark. In equilibrium this optimal strategy gives rise to the two-beta CAPM: together with the market beta a new risk-factor (termed active management risk) is brought into the analysis. This new beta is defined as the normalized (to the benchmark’s variance) covariance between the asset excess return and the excess return of the market over the benchmark index. The empirical test supports the model’s predictions. The cross-section return on the active management risk is positive and significant, especially after 1990, when institutional investors became the representative agent of the market.

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About the Author:

Wes Gray
After serving as a Captain in the United States Marine Corps, Dr. Gray earned a PhD, and worked as a finance professor at Drexel University. Dr. Gray’s interest in bridging the research gap between academia and industry led him to found Alpha Architect, an asset management that delivers affordable active exposures for tax-sensitive investors. Dr. Gray has published four books and a number of academic articles. Wes is a regular contributor to multiple industry outlets, to include the following: Wall Street Journal, Forbes,, and the CFA Institute. Dr. Gray earned an MBA and a PhD in finance from the University of Chicago and graduated magna cum laude with a BS from The Wharton School of the University of Pennsylvania.


  1. Michael Milburn November 8, 2014 at 10:38 pm

    Wes, from the FT article, I don’t understand why benchmarking quote: “gives managers a huge incentive to stay fully weighted in large, risky securities.” It seems it’s neither a “huge” or “not huge” incentive – but just an “average” incentive to buy the market in representative weights regardless of volatility. I know I’m missing a step in the logic, but it seems we could equally invert the statement and say that benchmarking gives managers a huge incentive to stay fully weighted in large, low-risk securities.” Or more generally, benchmarking gives incentives to stay fully weighted in X, regardless of whatever X is?

    Are we saying investors really don’t want an index at all, they want something more stable? That an index is more risky than investors desire “by design”?

    Am I correctly interpreting that the increased volatility and mispricing is generated not by those who are indexing, but by those who are attempting to do better than the index? (More directly: efforts to outperform the markets are destabilizing, and create inefficiencies that otherwise would not exist?)

    • Wesley Gray, PhD
      Wesley Gray, PhD November 9, 2014 at 9:44 am


      Check out the following post and read the Limits of Arbitrage paper highlighted in that post:

      There are some remarkable principle-agent problems in the asset management industry. Asset managers don’t have the same incentives as asset owners. If you find a strategy that earns 5% over the benchmark every year over 5 years horizons, but guarantees you will lose 10% to a benchmark in one of those years, many asset managers would pass that trade up. Passive investors HAVE TO STAY IN INVESTED. “Insane” you might say? Not really. A lot of managers are assessed based on a benchmark and the assessment period is usually short-term (<3yrs). If a manager were to lose 10% to a benchmark in a given year, that might mean he/she will no longer have a job. And because of this "short-term benchmarking" incentive, managers do things that may not be optimal over the long-haul.

      Of course, we believe all of these weird incentives in the professional money management business create true opportunities for investors who can take on tracking error risk and hold for 5-year+ periods.

  2. Denys Glushkov November 10, 2014 at 12:56 pm

    this is a very interesting topic. In fact, fixed-benchmark mandate generates frictions in the market place, which can created arbitrage (albeit, not entirely riskless) opportunities. In fact, it may potentially explain why institutions do not overweight low-vol stocks, as benchmark makes institutions less likely to exploit low-vol anomaly. As leverage-constrained managers seek to maximize IRs, they would not start over-weighting undervalued low beta stocks until mispricing exceeds a certain threshold, because by including these stocks into his portfolio his expected tracking error will increase by more than his expected active return (Baker, Bradley and Wurgler, FAJ, 2011). It may actually be that these stocks are candidates for underweighting for IR maximizing investment manager.

    Also, benchmarking constraints might contribute to the possibility that stocks with positive (negative) earnings surprises might have relatively stronger post-announcement drifts due to them being already overweighted (underweighted) in institutional portfolios vis-a-vis benchmark weights (i am not even talking about amount of flows being front-run by HFs around predictable recon dates for Russell indexes: one of the reasons why Vanguard switched to CRSP indexes recon of which is less likely to be front run).

    Benchmark constraints seem to introduce market-wide frictions which create sources of potential predictability in asset prices that are more likely to be exploited by managers without fixed benchmark mandates, and this predictability seems to be growing over time as increasingly more money is managed by institutions.

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