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24 Feb 2020Working Paper Summaries

Recovering Investor Expectations from Demand for Index Funds

by Mark Egan, Alexander J. MacKay, and Hanbin Yang

Understanding investor beliefs and their dynamics is important in many settings. This paper proposes a framework that uses observed ETF trades to reveal the full distribution of investor expected returns. The authors apply the framework to the S&P 500 and other asset classes over the period 2008-2018. This approach to measuring expectations and risk preferences can be applied quite broadly and provides a potentially useful signal of investor beliefs.

Author Abstract

We use a revealed-preference approach to estimate investor expectations of stock market returns. Using data on demand for index funds that follow the S&P 500, we develop and estimate a model of investor choice to flexibly recover the time-varying distribution of expected returns. Despite the fact that they are generated from a different method (realized choices) and a different population, our quarterly estimates of investor expectations are positively and significantly correlated with the leading surveys used to measure stock market expectations. Our estimates suggest that investor expectations are heterogeneous, extrapolative, and persistent. Following a downturn, investors become more pessimistic on average, but there is also an increase in disagreement among participating investors. Our analysis is facilitated by the prevalence of “leveraged” funds, i.e., funds that provide the investor with a menu over leverage. The menu of choices allows us to separately estimate expectations and risk aversion.

Paper Information

Full Working Paper Text
Working Paper Publication Date: January 2020
HBS Working Paper Number: NBER Working Paper Series, No. 26608
Faculty Unit(s): Finance; Strategy

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Mark L. Egan

Assistant Professor of Business Administration

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Alexander J. MacKay

Alexander J. MacKay

Assistant Professor of Business Administration

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