Research / BFI Working PaperDec 12, 2018

The Benchmark Inclusion Subsidy

Anil Kashyap, Natalia Kovrijnykh, Jian Li, Anna Pavlova

We study the impact of evaluating the performance of asset managers relative to a benchmark portfolio on firms’ investment, merger and IPO decisions. We introduce asset managers into an otherwise standard asset pricing model and show that firms that are part of the benchmark are effectively subsidized by the asset managers. This “benchmark inclusion subsidy” arises because asset managers have incentives to hold some of the equity of firms in the benchmark regardless of the risk characteristics of these firms. Contrary to what is usually taught in corporate finance, we show that the value of an investment project is not governed solely by its own cash-flow risk. Instead, because of the benchmark inclusion subsidy, a firm inside the benchmark would accept some projects that an identical one outside the benchmark would decline. The two types of firms’ incentives to undertake mergers or spinoffs also differ and the presence of the subsidy can alter a decision to take a firm public. We show that the higher the cash-flow risk of an investment, the larger the benchmark inclusion subsidy; the subsidy is zero for safe projects. Benchmarking also leads fundamental firm-level cash-flow correlations to rise. We review a host of empirical evidence that is consistent with the implications of the model.

More Research From These Scholars

BFI Working Paper Dec 22, 2022

Monetary Policy When the Central Bank Shapes Financial-Market Sentiment

Anil Kashyap, Jeremy C. Stein
Topics:  Monetary Policy