Why? It captures what financeprofessors like to call external shocks (for the rest of you this means that things that are beyond the control of manager). For instance if you are paid by stock, for better or worse you are at least partially at the mercy of the stock market. So essentially the peer group is a control group.
Surprisingly the empirical literature has found mixed results when examining how well this works. That seemingly has changed with a new paper by Ana Albuquerque. She suggests the the reason that previous researchers have used the wrong peer groups.
SSRN-Peer Firms in Relative Performance Evaluation by Ana Albuquerque:
From the abstract:
"External shocks and flexibility in responding to the shocks are functions of, for example, the firm's technology, the complexity of the organization, and the ability to access external credit, which depend on firm size. When peers are composed of similar industry-size firms, evidence is consistent with the use of RPE in CEO compensation."A later look in:
"...difficulty in defining the ideal peer group. Such a group should include firms that are similar along several characteristics (e.g., industry, size, diversification, and financial constraints). Yet considering all such characteristics simultaneously is not practical because it could result in peer groups composed of too few firms, which would be too noisy to filter external shocks. In this paper, I show that industry and firm size capture many of these characteristics. When peer groups consist of firms within the same industry and size quartile, my empirical results show systematic evidence supporting RPE usage in CEO pay."and to compare this to previous work in the field:
"To compare with previous studies,I test whether RPE is used when measuring peer performance with two common peer group definitions, namely, the S&P 500 index and firms within the same industry. I fail to find consistent evidence of RPE usage with either peer definition"Good stuff. Interesting.
Albuquerque, Ana M.,Peer Firms in Relative Performance Evaluation(March 26, 2009). Available at SSRN: http://ssrn.com/abstract=1368893