Curse of the benchmarks

Vayanos, Dimitri ORCID: 0000-0002-0944-4914 and Woolley, Paul (2016) Curse of the benchmarks. Financial Markets Group Discussion Papers (747). Financial Markets Group, The London School of Economics and Political Science, London, UK.

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Abstract

Obsession with short-term performance against market cap benchmarks preordains the dysfunctionality of asset markets. The problems start when trustees hire fund managers to outperform benchmark indexes subject to limits on annual divergence. For multi-asset portfolios the benchmark is generally the performance of peer group funds, also based on market cap. In the absence of formal instructions, asset managers, as well as off-the-peg mutual funds, are still keen to demonstrate their ability against the competition in the short run. If securities markets were efficiently priced in the sense of reflecting best estimates of fundamental value, there would be no problem in using market cap benchmarks. But the terms under which most professional investment is handled ensure that markets are not efficient. Benchmarking causes, first, the inversion of the relationship between risk and return so that high volatile securities and asset classes offer lower returns than low volatile ones. Second, it fosters the pursuit of momentum strategies which then earn profits at the expense of benchmarked funds. The paper explains how these problems arise using rational models of asset mispricing and proposes an incentive-based solution.

Item Type:	Monograph (Discussion Paper)
Official URL:	https://www.fmg.ac.uk/
Additional Information:	© 2016 The Authors
Divisions:	Finance LSE
Subjects:	H Social Sciences > HC Economic History and Conditions H Social Sciences > HG Finance
JEL classification:	G - Financial Economics > G1 - General Financial Markets > G10 - General
Date Deposited:	08 Jun 2023 10:42
Last Modified:	01 Apr 2024 08:00
URI:	http://eprints.lse.ac.uk/id/eprint/118990

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