The Return Expectations of Institutional Investors
Research Retrieved: May 2018
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What do institutional investors believe about the expected returns of the asset classes in which they invest, and how do they set these expectations? The literature has devoted considerable attention to estimating investor beliefs about expected returns as parameters of portfolio choice models; however, there has been little direct, large-sample evidence about the beliefs of institutional investors across a range of asset classes. Drawing on newly-required disclosures for U.S. public pension funds, a group that manages approximately $4 trillion of assets, the authors find that institutional investors rely on past performance in setting future return expectations. These extrapolated expectations affect their target asset allocations.
- Pension discount rate and the expected portfolio return differ: the expected portfolio return generally does not match the pension discount rate, exceeding it in 65% of observations and falling short of it in 16% of cases. The riskiness of the portfolio can only explain around 22% of the variation in the expected return.
- Past returns form expected returns: average returns experienced in the past ten years add substantial explanatory power. Each additional percentage point of past return raises the expected return by 35 basis points. This relation is driven completely through the positive effect of past returns on the real return assumption, not inflation or the expected risk-free rate of return.
- Unfunded liabilities drive expected returns: an unfunded liability equal to an additional year of total government revenue raises the Portfolio ER by 21 basis points.
- Extrapolating past returns cannot be justified: pension funds extrapolate from past returns in asset classes where there is little or no performance persistence, especially in all risky asset classes (public equity, real assets, private equity, and hedge funds).
Expected returns are one of the fundamental inputs to many canonical asset pricing models. While the relationship between beliefs and past experience has been clearly demonstrated for retail investors, this study is the first to make this determination for institutional investors. Extrapolating past returns could reflect persistent differences in the skill of pension funds, but the evidence suggests that it does not. This unjustifiable extrapolation of past returns could lead pension funds to seriously misallocate their assets.