Rethinking corporate finance theory

The use of benchmarks to measure both stock-price movements and the performance of asset managers in relation to market averages is so widespread as to be taken for granted. Assets under management total $85 trillion globally, a figure that is expected to grow further, and most of those funds are managed against benchmarks.

One particularly striking figure comes from S&P Global, the financial intelligence group, which reports that, at the end of 2017, there was just under $10 trillion managed against the Standard & Poor’s 500 index alone. In the AM industry, performance is normally evaluated relative to benchmarks. Otherwise, how would one compare a bond fund manager with a stock fund manager? The two asset classes have very different risk. The managers’ benchmark-adjusted performance, however, is more of an apples-to-apples comparison. This use of benchmarks, in turn, creates incentives for managers to allocate a fraction of their assets under management into benchmark stocks. They do so irrespective of characteristics of benchmark stocks, and in particular regardless of their risk.

There has been some research into the effect of benchmarking on the price of stocks included in benchmark indices as opposed to those excluded, and into the differing impacts of benchmarking on, respectively, institutional and retail investors. But, until now, there has been no analysis of the effect of benchmarking on corporate decision-making.

The benchmark inclusion subsidy

Together with Anil K Kashyap, Professor of Economics and Finance at the University of Chicago Booth School of Business, Natalia Kovrijnykh, Associate Professor of Economics at Arizona State University and Jian Li, PhD candidate in economics at the University of Chicago, I have sought to remedy this deficiency, but in doing so have found ourselves cutting across conventional corporate finance theory, which holds that the value of an investment project is calculated solely in relation to its cash-flow risk.

One of the main things we stress when we teach basic corporate finance is that you should not confuse the cost of funding for a firm’s assets in place with the appropriate discount rate for new projects. The most extreme version of this is to explain why public utilities do not have a comparative advantage in funding fintech start ups. They might have some debt capacity that is idle, but that does not mean they should apply that to an unrelated project with different risk. We argue that benchmarking creates an exception to this rule.