A fund manager evaluated relative to a benchmark index optimally invests a fraction of the fund’s assets under management (AUM) in her benchmark, and such demand is inelastic. Using a dataset of 34 U.S. equity indices, we construct a stock-level measure of benchmarking intensity (BMI), which captures the inelastic component of fund managers’ demand. The BMI of a stock is computed as the cumulative weight of the stock in all benchmarks, weighted by AUM following each benchmark. Exploiting a variation in the BMIs of stocks that transition between the Russell 1000 and Russell 2000 indices, we show that the change in BMI resulting from an index reconstitution is positively related to the size of the index effect. Our measure allows us to compute the price elasticity of demand more accurately than in the literature. Furthermore, using fund holdings around the index cutoff, we present evidence of inelastic demand of active managers for stocks in their benchmarks. Finally, we confirm the prediction of our theory that stocks with higher BMIs have lower long-run returns.
Available on SSRN.