Peer Group Composition and Aggregation for RPE Purposes in Presence of Exposure Risk

Abstract

Agency theory suggests the use relative performance evaluation (RPE) to filter out systematic risks from a noisy performance measure. The presence of exposure risk, i.e. if the exposure to the systematic risks moves over time, however precludes complete filtering. In the present study I first estimate the exposure of a firm's performance to the performance of potential peer firms in order to construct a firm-specific peer group. Second, I investigate how the presence of exposure risk can affect the composition and aggregation of a peer group over time. Third, I show how these movements in the peer group composition and aggregation can reduce the effectiveness of the filtering purpose in RPE settings. I find that the firm-specific peer groups provide good filtering abilities ex post, but that simple indices, such as industry peer groups, are more stable and thus perform better out-of-sample.