The benchmark inclusion subsidy

We argue that the pervasive practice of evaluating portfolio managers relative to a bench-mark has real effects. Benchmarking generates additional, inelastic demand for assets in-side the benchmark. This leads to a 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. This overturns the proposition that an invest-ment's value is independent of the entity considering it. We describe the characteristics that determine the subsidy, quantify its size (which could be large), and identify empirical work supporting our model's predictions. (c) 2021 Elsevier B.V. All rights reserved.