Recovering Investor Expectations from Demand for Index Funds

Egan, M, MacKay, A and Yang, H (2022) Recovering Investor Expectations from Demand for Index Funds. Review of Economic Studies, 89 (5). pp. 2559-2599. ISSN 0034-6527

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 future returns across investors. Our analysis is facilitated by the prevalence of leveraged funds that track the same underlying asset: by choosing between higher and lower leverage, investors trade off higher return against less risk. Our estimates indicate 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 due to the presence of contrarian investors.