The Real Cost of Benchmarking
with Sebastian Hanson
Abstract:
This paper provides causal evidence that asset price distortions induced by benchmarking have real effects on corporate investment. We document that the rise in benchmark-linked investing over the past two decades fundamentally changed the cross-section of stocks' CAPM βs. To establish causality, we exploit exogenous variation in benchmarking intensity generated by Russell index reconstitutions. Upon inclusion in benchmark indices, stocks experience an increase in CAPM βs, with larger effects observed among stocks subject to greater increases in benchmarking intensity. The cross-sectional changes in CAPM βs correlate with net flows into passive funds. Firm managers interpret the resulting higher CAPM β as an increase in their firm's cost of capital, leading them to reduce investment. Six years post treatment, firms exhibit reductions of 7.1% in physical capital and 8.4% in intangible capital. Supporting evidence shows that benchmarking similarly elevates the perceived cost of equity among equity analysts and regulators. We find consistent results at the industry level. Industries experiencing greater increases in CAPM βs due to benchmarking accumulated less capital over the past two decades. Furthermore, benchmarking creates excess dispersion in CAPM βs within industries, leading to inefficient capital allocation across firms. Increases in CAPM βs largely offset the decline in the risk-free rate over the last two decades. This mechanism can explain 57% of the “missing investment” puzzle.
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Selected Presentations:
SFS Cavalcade NA 2025*,
FIRS 2025*,
Four Corners Center*,
Northeastern University Finance Conference 2025*,
UIC Finance Conference 2025*,c,
Citadelc
( * scheduled, c co-author)
( * scheduled, c co-author)