Understanding Asset Managers’ Expectations and Their Impact on Portfolios

sep. 04, 2023

Unlike retail investors, asset managers' equity premium expectations are countercyclical-- falling when markets are doing well and rising when they are doing poorly, a new study shows. These expectations do influence the allocation of mutual funds they manage, but investment mandates dampen their impact on portfolios.

Understanding investors' expectations is crucial in shaping investment decisions and portfolio strategies. A new study by Swedish House of Finance's Magnus Dahlquist and Copenhagen Business School's Markus Ibert, explored equity return expectations among major asset management firms to understand their impact on investment portfolios.

The researchers examined publicly available return expectations, obtained from capital market assumptions made by major asset management firms like BlackRock, J.P. Morgan, Morningstar, State Street, and Vanguard.

They found that large asset managers' equity premium expectations are countercyclical, rising with low equity valuation ratios and falling with high ratios, contrasting with retail investors' procyclical expectations. However, the impact of asset managers' expectations on portfolios is tempered by “investment mandates,” which are regulatory or client-led guidelines restricting their investment choices for clients' funds.

Outlook expectations among asset managers are diverse

The study discovered a diversity among asset managers in their outlook expectations. Their opinions on future returns differed significantly and similar to the diverse expectations observed among retail investors.

This finding challenges the common assumption of homogenous expectations in the financial world, the authors say.

Asset managers’ equity premium expectations are countercyclical

Unlike retail investors however, asset managers’ expectations for future stock market returns follow a different pattern. They tend to be lower when stock valuations are high and higher when valuations are low.

The study discovered that when a measure called the Shiller’s cyclically adjusted price-earnings ratio (CAPE) increases by ten percent -- indicating an overvalued market -- asset managers lower their long-term return expectations by 59 basis points.

It showed that when the CAPE ratio goes up and the market is considered overvalued, asset managers anticipate lower future returns. Conversely, when the CAPE ratio goes down and the market is considered undervalued, they may expect higher returns.

Linking expectations to portfolios

The study then investigated whether asset managers’' investment decisions align with their expectations. The authors used the asset managers’' allocation funds to analyze this.

Their findings showed that asset managers’' expectations do influence their investment choices. For example, when asset managers expect higher long-term returns from US equities, they tend to allocate more funds (around two to four percentage points more) to US equities in their portfolios. This sensitivity to expectations is stronger than what is observed in studies of regular retail investors.

However, the impact of asset managers' expectations on portfolios is still muted, as other factors, like investment mandates, can influence portfolio decisions. These mandates set specific rules on portfolio allocations (e.g., a preset 60% equity allocation). Taking these mandates into account, the portfolios' sensitivity to expectations decreases.

Asset managers vs. CFOs and other professional forecasters

Comparing asset managers with Chief Financial Officers (CFOs) and professional forecasters, the study found that asset managers' expectations focus more on long-term returns. Asset managers' expectations consistently demonstrate a negative correlation with stock market valuations, setting them apart from CFOs and professional forecasters.