Economics & Finance

How Benchmarking Can Increase Market Transparency

The expansion of institutional investors’ asset base affects the transparency of financial markets, asset prices, and the returns on investors’ portfolios.

How Benchmarking Can Increase Market Transparency
The expansion of institutional investors’ asset base affects the transparency of financial markets, asset prices, and the returns.

Endowments, commercial banks, mutual funds, hedge funds, pension funds, and insurance corporations currently make up the bulk of American equities holdings. They held just 7% of American equities in 1950, but by 2017 that percentage had jumped to an incredible 80%. Because of their size and influence, institutional investors may have a significant effect on asset prices. That is, it’s possible that the markets’ informational efficiency has worsened as institutional investing has increased.

In the world of finance, benchmarking is the method through which a manager’s results are compared to those of an established standard. With the benefits shared by investors and fund managers, it may be a useful investment instrument. When institutional investors generate returns in excess of a predetermined benchmark, they are rewarded monetarily for their efforts. Japan’s Government Pension Investment Fund, the world’s largest pension fund, is an example of a company that rewards its fund managers based on performance. That’s why these fund managers only get paid handsomely if their performance beats the benchmark.

The results of this frequently used benchmarking method are unclear. Is it helpful for the general health of markets and, by extension, society? It was noted in an April 2019 report by the International Monetary Fund, for instance, that “a larger share of benchmark-driven investments in total portfolio flows could increase the risk of excessive inflows or outflows unrelated to countries’ economic fundamentals and could, in some cases, have destabilizing effects” on emerging markets.

Along with Matthijs Breugem (Collegio Carlo Alberto), I develop a theoretical framework to investigate the impact of benchmarking on the effectiveness of markets, asset prices, and the returns on investors’ portfolios. We discovered for the first time that managers are less likely to acquire confidential information when the number of benchmarked investors grows. An article we wrote, “Institutional Investors and Knowledge Acquisition: Implications for Asset Prices and Informational Efficiency,” was recently published in The Review of Financial Studies.

Repressive exchange

As benchmarking causes pricing that are less representative of corporate fundamentals, it stifles innovation since it slows the acquisition of private information.

There are essentially two factors that impede the free flow of data:

1.As a result of benchmarking concerns, institutional investors bring their portfolio into closer alignment with the benchmark, and as a result, they end up with less private information (i.e. less information availability). If what you learn is never put to good use, there is no use in learning it. It’s especially pricey for a fund manager to educate themselves; they’ll need to spend time poring through financial statistics and conducting client interviews. The fund manager is not likely to follow up and make sure the stock price reflects this information if there are no incentives for doing so.

How Benchmarking Can Increase Market Transparency
Repressive exchange

2.Benchmarked funds make less aggressive use of the limited amount of confidential data at their disposal. For instance, benchmarked fund managers are not likely to trade aggressively on the basis of favorable information about a firm, even if that information exists (such as by buying many shares). In turn, the price of that company is little impacted, and less of the good information is reflected there (i.e. less information incorporated).

When this happens, information isn’t gathered, analyzed, and used as assiduously, and the cycle continues downward, hurting business and customers both. It means the stock price is no longer determined by the fundamentals of a firm. Stocks both within and outside of the benchmark see a drop in price informativeness. Less data is available about the companies in the index as a result of the influence of institutional investors, especially in the context of benchmarking. There is a greater reaction in the stock price of a firm to any new information about the company, making the stock price more volatile.

Too many eggs in one basket

One such type of investment that doesn’t always tie prices to underlying factors is passive investing. The Federal Reserve is wary of passive investing because of its potential to increase market volatility, and because, like benchmarking, it may concentrate too much wealth in a few hands (Vanguard, BlackRock, State Street, Fidelity, and Charles Schwab own 44% of the industry between them). Passive investing, like benchmarking, doesn’t promote the creation of new knowledge. However, the Financial Times noted that this practice, like benchmarking, contributes to market confusion and opacity.

Read more: How Universal Basic Income Might Rescue Capitalism

With institutional investors controlling such a large portion of the market and benchmarking in place, non-benchmarked funds that have access to private information may be in a better position to make sound investment decisions and beat benchmarked funds. Investors should expect increased returns over time if they have access to more data.

While it’s true that benchmarking has its benefits, it also has more unintended consequences than was previously recognized. No rules should be put in place, but institutional and individual investors alike should be cognizant of the potential for lagging data and the huge outperformance of better-informed, non-benchmarked investors. While benchmarking is useful, the greater the number of benchmarked funds, the greater the concentration of risk.

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