Is There Too Much Benchmarking in Asset Management? (2023) with Anil Kashyap, Natalia Kovrijnykh, and Anna Pavlova

American Economic Review

Abstract: The use of benchmarks for performance evaluation is commonplace in asset management, and yet, surprisingly, such contracts have not received much attention in the  literature. This paper builds a model of delegated asset management in which benchmarking arises endogenously and analyzes the unintended consequences of benchmarking. The fund managers' portfolios are unobservable and so is the asset management cost. We show that conditioning managers' compensation on performance of a benchmark portfolio partially protects them from market risk and encourages them to generate more alpha. In general equilibrium, however, the use of such incentive contracts creates a pecuniary externality. Benchmarking inflates asset prices and  gives rise to crowded trades, thereby reducing the effectiveness of incentive contracts for others. We show that  privately-optimal contracts chosen by fund investors diverge from socially-optimal ones. A social planner, recognizing the crowding, opts for less benchmarking and less incentive provision. Privately-optimal contracts end up forcing managers to excessively pursue alpha, at too high a cost, and the planner corrects this. The planner's choice of benchmark portfolio weights also differs from the privately-optimal one.

The Benchmark Inclusion Subsidy (2021) with Anil Kashyap, Natalia Kovrijnykh, and Anna Pavlova

Journal of Financial Economics

Abstract: We study the effects of evaluating asset managers against a benchmark on corporate decisions, e.g., investments, M&A, and IPOs. We introduce asset managers into an otherwise standard model and show that firms inside the benchmark are effectively subsidized by the asset managers. This "benchmark inclusion subsidy" arises because asset managers have incentives to hold some of the equity of firms in the benchmark regardless of their risk characteristics. Due to the benchmark inclusion subsidy, a firm inside the benchmark values an investment project more than the one outside. The same wedge arises for valuing M&A, spinoffs, and IPOs. These findings are in contrast to the standard result in corporate finance that the value of an investment is independent of the entity considering it. We show that the higher the cash-flow risk of an investment and the more correlated the existing and new cash flows are, the larger the subsidy; the subsidy is zero for safe projects. We review a host of empirical evidence that is consistent with the model's implications.

Working Papers

Investor Composition and the Liquidity Component in the U.S. Corporate Bond Market  with Haiyue Yu 

(Conditionally accepted, Journal of Finance)

Abstract: The link between corporate bond credit spreads and secondary market illiquidity in the cross section has grown stronger since 2005, resulting in higher liquidity component in credit spreads. Using U.S. investor holdings data, we show that short-term investors (e.g., mutual funds/ETFs) increase trading activities in the secondary market, amplifying the effect of secondary market frictions on prices. We provide a model featuring heterogeneous investors with different trading needs and heterogeneous bonds to investigate the impact of the rapid growing mutual fund/ETF sector on the corporate bond market. We find the change in investor composition can quantitatively explain the aggregate trend.

The Market for Sharing Interest Rate Risk: Quantities and Asset Prices with Umang Khetan, Ioana Neamțu and Ishita Sen 

Abstract: We study the extent of interest rate risk sharing across the financial system using granular positions and transactions data in interest rate swaps. We show that pension and insurance (PF&I) sector emerges as a natural counterparty to banks and corporations: overall, and in response to decline in rates, PF&I buy duration, whereas banks and corporations sell duration. This cross-sector netting reduces the aggregate demand that is supplied by dealers. However, two factors impede cross-sector netting and add to substantial dealer imbalances across maturities: (i) PF&I, bank and corporations' demand is segmented across maturities, and (ii) hedge funds trade large volumes with time-varying exposure. We test the implications of demand imbalances on asset prices by calibrating a preferred-habitat investors model with risk-averse arbitrageurs, who face both funding cost shocks and demand side fluctuations. We find that demand imbalances play a bigger role than arbitrageurs’ funding cost in determining the equilibrium swap spreads at all maturities. In counterfactual analyses, we demonstrate how demand shocks, e.g., regulation leading banks to hedge more, affect the hedging behavior of PF&I. Our paper provides a quantity-based explanation for empirically observed asset prices in the interest rate derivatives market.

Corporate Bond Multipliers: Substitutes Matter with Manav Chaudhary and Zhiyu Fu

Abstract: Textbook theory tells us that the price impact of demand shocks depends on the ability of investors to identify close substitutes and trade against the mispricing. Corporate bonds' salient characteristics, such as credit rating and maturity, make identifying such substitutes particularly easy. Yet existing estimates of corporate bond multipliers (the price increase in response to demand shocks) typically assume all bonds, regardless of their characteristics, are equally good substitutes. In this paper, we introduce rich heterogeneous substitution patterns among bonds and demonstrate that security-level multipliers are an order of magnitude smaller than previously estimated and are essentially zero. Nonetheless, aggregated portfolios exhibit substantially larger multipliers, reflecting the reduced availability of near substitutes for more aggregated portfolios. The price impact of demand shocks reverts after a quarter. Finally, we find that the multiplier is larger for high-yield bonds, longer-maturity bonds, and bonds with greater arbitrage risks.

Intermediation via Credit Chains  with Zhiguo He

Abstract: The modern financial system features complicated financial intermediation chains, with each layer performing a certain degree of credit/maturity transformation. We develop a dynamic model in which an entrepreneur borrows from overlapping-generation households via layers of funds, forming a credit chain. Each intermediary fund in the chain faces rollover risks from its lenders, and the optimal debt contracts among layers are time invariant and layer independent. The model delivers new insights regarding the benefits of intermediation via layers: the chain structure insulates interim negative fundamental shocks and protects the underlying cash flows from being discounted heavily during bad times, resulting in a greater borrowing capacity. We show that the equilibrium chain length minimizes the run risk for any given contract and find that restricting credit chain length can improve total welfare once the available funding from households has been endogenized.

The Value of Data to Fixed Income Investors with Jennie Bai and Asaf Manela

Abstract: Using a structural model, we estimate the value of data to fixed income investors and study its main drivers. In the model, data is more valuable for bonds that are volatile and for which price-insensitive liquidity trades are more likely. Empirically, we find that the value of data on corporate bonds increases with yield, time-to-maturity, size, callability, liquidity, and uncertainty during normal times. However, these cross-sectional differences vanish as the value of data falls during financial crises. Using a regression discontinuity based on maturity, we provide causal evidence that investor composition affects the value of data. 

Borrowing from a Bigtech Platform with Stefano Pegoraro

Abstract: We model competition in the credit market between banks and a bigtech platform which offers a marketplace for merchants. We show that, unlike banks, the platform lends to merchants based on their revenues and network externalities. To enforce partial loan repayment, the platform increases borrowers' transaction fees. Credit markets become partially segmented, with the platform targeting borrowers of low and medium credit quality. The platform benefits from advantageous selection at the expense of banks, reducing equilibrium welfare for intermediate-credit-quality merchants. When revenues, network externalities, or advantageous-selection rents are large, the platform does not value superior information about credit quality.

The Convenience Yield, Inflation Expectations, and Public Debt Growth with Zhiyu Fu and Yinxi Xie

Abstract: U.S. long-term treasury debt serves the important role of safe and liquid assets in the economy, hence carrying significant convenience yields. We present two new findings relating the convenience yield to inflation and government fiscal policy. First, the convenience yield of treasury debt is negatively correlated with inflation expectations. Second, inflation expectations predict future debt-to-GDP growth at different horizons. To explain these findings, we incorporate convenience yields into a staggered-price model with an active fiscal policy. The convenience yield for long-term debt is the discounted value of future convenience service flows, thus is negatively correlated with future debt supply. Furthermore, a government deficit shock leads to both higher debt in the future as well as higher expected inflation simultaneously. The model rationalizes the two empirical findings, and provides a natural framework to study the interactions among inflation, debt growth, and cost of borrowing, particularly the convenience yield component.

Investor Concentration, Liquidity and Bond Price Dynamics  with Haiyue Yu 

Abstract: Existing work on investor heterogeneity in corporate bond markets mainly focuses on the shares of different types of investors. We find that investor concentration also plays an important role in corporate bond pricing dynamics and secondary market liquidity, even after controlling the shares of different investor types. First, we provide evidence that there is considerable dispersion of investor concentrations across bonds within a firm. We then show that bonds with lower investor concentration are more liquid. Moreover, during the COVID-19 crisis and 2008 financial crisis, bonds within a firm with lower investor concentration experienced larger initial price drops but faster recovery (shorter half-lives). A one standard deviation increase in investor concentration is associated with a 94bps (120bps) decrease in drawdown during the COVID crisis (Great Recession). In both crises, the magnitude of the drawdown is more strongly associated with investor concentration than with the share of life insurance investors. We explain our findings by extending the dynamic model of Vayanos (1999) to incorporate multiple risky assets and investors with heterogeneous risk aversion. Our findings shed new light on how investor concentration affects liquidity and price dynamics in illiquid asset markets.

The Pricing and Welfare Implications of Non-Anonymous Trading with Ehsan Azarmsa

Abstract: A key distinction between over-the-counter markets and centralized exchanges is the non-anonymity of the transactions. In this paper, we develop a model of non-anonymous trading and compare its prices, liquidity, and efficiency of asset allocations against a baseline with anonymous transactions. The non-anonymity improves the market liquidity by reducing the concerns for adverse selection. More specifically, it allows the market participants to learn valuable information about their counter-parties through repeated interactions and consequently enables them to form trading relationships. However, it could harm the market liquidity by increasing the dealers' bargaining power, as the dealers learn more about their clients' liquidity needs. Our theory predicts that the bid-ask spread is smaller in non-anonymous markets, and more so for bonds with low credit-ratings, and at times of high uncertainty. The non-anonymity improves the allocative efficiency for assets with high volatility, with higher degree of asymmetric information, and with less interest among liquidity traders. Using a novel dataset of U.S. corporate bond trades, we find confirming evidence that for high-yield bonds, the bid-ask spread for non-anonymous orders is 20% smaller than that for anonymous orders, while no such price improvement is observed for investment-grade bonds. By examining the waiting times and execution probabilities in our dataset, we present evidence that differentiates our channel from search-based theories.