Fund Managers and Misallocation of Capital

I study the real effects of benchmarking in the professional fund management industry. Stocks of the productive sector are traded in a competitive equity market. Investors delegate their portfolio decisions to managers whose performance is benchmarked against an aggregate stock market index. Benchmarking affects market prices and returns, which consequently changes firms' investment behaviour. Managers hedge themselves by tilting their portfolio toward the index which increases the demand and price of the stocks that feature prominently in the index. Higher prices lead to even more investment by larger firms, generating a positive feedback loop. In equilibrium there is an inefficient shift towards extreme states in which big sectors dominate the economy. In presence of benchmarking, index inclusion is preceded by rise in firm's investment rate relative to its capital stock, which drops by a smaller degree after the inclusion