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E-MailAnil K. Kashyap is Stevens Distinguished Service Professor of Economics and Finance at the University of Chicago; Natalia Kovrijnykh is Associate Professor of Economics at Arizona State University; Jian Li is Assistant Professor of Finance at Columbia Business School; and Anna Pavlova is Professor of Finance at London Business School. This post is based on their recent paper.
Since the 1980s economists have known that when stocks are added to the S&P 500 index their prices rise. There are now many theories that aim to explain this fact. Yet almost all of the related research has focused on how indices influence asset prices, with much less attention paid to other possible implications. In The Benchmark Inclusion Subsidy, we look at the repercussions of index inclusion for corporate decisions.
Asset management practices affect corporate decisions
Most fund managers’ performance is judged against benchmarks. Because the asset management industry is estimated to control more than $100 trillion worldwide, this means that there is a huge pool of money where the people making investment decisions have strong incentives to favor buying stocks inside the index instead ones that are outside it. We construct a model to analyse the consequences of these incentives.
The model predicts that firms that are part of a benchmark have a different cost of capital than similar firms outside the benchmark. When a firm adds risky cash flows, say, because of an acquisition or by investing in a new project, the increase in the shareholder value is larger if the firm is inside the benchmark. Hence, a firm in the benchmark could accept a project that an otherwise identical non-benchmark firm would not. This runs contrary to standard corporate finance theory. In the special case where there are no fund managers—as is standard in corporate finance—investors always value equivalent cash flows of benchmark and non-benchmark firms in the same way.
The underlying reason for why benchmark inclusion affects firms’ investment decisions is performance evaluation of fund managers. In keeping with prevalent industry practices and academic evidence such as Ma, Tang, and Gómez (2019), in our model a fund manager’s compensation depends on her relative performance compared to a benchmark index.
We show that the fund manager’s optimal portfolio is a combination of the usual mean-variance portfolio and the benchmark portfolio—the latter appearing because of the relative performance considerations. Underperformance relative to the benchmark is an additional source of risk for the fund manager and she hedges this risk by holding a fixed fraction of her portfolio in benchmark stocks. She does so regardless of the benchmark stocks’ prices and characteristics of their cash flows—in particular, irrespective of cash-flow variance. An extreme special case of our model is when our funds are passive; in that case they invest their entire portfolio in the benchmark, regardless of its risk-return trade-off.
When a firm inside the benchmark adds risky cash flows (e.g., invests in a project), fund managers buy more claims to these cash flows than of equivalent cash flows of a peer that is outside the benchmark. The increase in the shareholder value is thus higher if the firm is inside the benchmark rather than outside. We call this the “benchmark inclusion subsidy.”
For instance, consider a benchmark and a peer non-benchmark firm contemplating investing in a risky project. When the benchmark firm invests, the extra variance of its cash flows resulting from the project will be penalized less than that of an identical non-benchmark firm. Why? The reason is the mechanical demand of fund managers for stocks inside their benchmarks, regardless of the variance. Thus investing in a project increases the firm’s stock value by more if the firm is in the benchmark. Put differently, investment is effectively subsidized for the benchmark firm. Because the subsidy is tied to cash-flow risk, however, the two firms will still value risk-free projects identically.
We have additional cross-sectional predictions regarding for the size of the benchmark inclusion subsidy. We show that the higher the cash-flow risk of an investment, the larger the benchmark inclusion subsidy. Moreover, the size of the subsidy rises as the asset management sector grows in size. Finally, the larger is the fraction of assets managed by passive managers, the larger the subsidy. The latter implication is due to the fact that passive managers invest their entire portfolio in the benchmark while active managers split it between the mean-variance portfolio and the benchmark.
Adding correlations
The results described so far do not require any correlation between a new investment (or acquisition) and the firm’s assets-in-place. Allowing for correlations brings out additional effects and predictions. As before, fund managers’ excess demand for benchmark stocks raises those stocks’ prices. Now, the stock prices of firms whose cash flows are correlated with those of the benchmark stocks also rise. This happens because, in seeking exposure to the benchmark’s cash-flow risk, investors substitute away from expensive benchmark stocks into stocks that are positively correlated with them. This same reasoning means that new investment projects or acquisitions that are positively correlated with the benchmark should be valued more by all firms, both inside and outside the benchmark.
Benchmarks and ESG investing
Our model also points to the importance of benchmark design for ESG funds. As long as a company with a low ESG score remains part of the benchmark, it receives the benchmark inclusion subsidy. Dropping such “brown” companies from the benchmark and replacing them with “green” companies not only gives a cost-of-capital advantage to the green companies but also encourages other firms in the economy to mimic the green companies. The latter implication is due to our result that cash flows that are positively correlated with those of benchmark firms have higher values.
The magnitude of the cost of capital reduction
Our estimates of the reduction of the cost of capital owing to a benchmark is around 1 percentage point, though it could easily half that size or twice it, depending on the assumptions you make about the volatility of cash flows, their correlation with firms in the benchmark and the amount of institutional ownership.
Conclusions
While there is empirical evidence that speaks to some of our predictions, there are others that have yet to be tested. For example, the literature on index inclusion has only looked at the average effect of inclusion. We have specific cross-sectional predictions for the size of this effect. It would also be interesting to test the model’s predictions about how the presence of benchmarks can alter the incentives regarding mergers.
Asset managers already hold sizeable fraction of the global stock and bond markets. As the industry continues to grow, the benchmark inclusion subsidy will only get bigger.
The complete paper is available for download here.
