International Asset Allocations and Capital Flows: The Benchmark Effect

We study different channels through which well-known benchmark indexes impact asset allocations, capital flows, and asset prices across countries, using unique monthly micro-level data of benchmark compositions and mutual fund investments during 1996-2014. Benchmarks are useful for identification and have important effects on equity and bond mutual fund portfolios, including both passive and active funds. Benchmark effects are important after controlling for industry, macroeconomic, and country-specific time-varying effects. Reverse causality and common shocks do not drive the results. Exogenous, pre-announced changes in benchmarks result in movements in asset allocations and capital flows mostly when these changes are implemented. Moreover, assets in the benchmarks experience abnormal returns when benchmark changes become effective, suggesting that the reallocations implied by those changes are not immediately arbitraged away. By impacting country allocations, benchmarks explain apparently counterintuitive movements in capital flows and asset prices, for example, generating outflows and depressing prices in countries being upgraded.