When institutional investors use benchmarks to manage their portfolios, they can inadvertently be creating market problems. That is the assessment by Lorenzo Bini Smaghi of European Central Bank. Speaking at a conference in Geneva, Bini Smaghi said excessive focus on benchmarks leads to a herding behavior among institutional investors, which “can be a recipe for asset misalignments, in particular over the short term, and for the emergence of self-fulfilling price setting.”

Herding also can lead to market concentration – he noted that pension funds now hold 40% of outstanding government bonds – and can reduce market efficiency. Bini Smaghi noted, for example, that domination by a few large institutional investors in the fixed-income market that sets out to beat a benchmark, could affect prices in a way that would reveal little about fundamentals. As a result, he said, asset prices may be set by expectations of other investors and “on anticipation of central bank policy over the short term.”