The Return Expectations of Institutional Investors

Institutional investors rely on past performance in setting future return expectations, and these extrapolative expectations affect their target asset allocations. Drawing on newly-required disclosures for U.S. public pension funds, a group that manages approximately $4 trillion of assets, we find that cross-sectional variation in past returns contributes substantial power for explaining real portfolio expected returns and expected risk premia in individual asset classes. Pension fund past performance affects real return assumptions across all risky asset classes, including in public equity where the relative performance of institutional investors is not persistent. In private equity, the extrapolation of past performance is driven by stale investments. State and local governments that are more fiscally stressed by higher unfunded pension liabilities assume higher portfolio returns, both through higher inflation assumptions and higher real returns, but this factor does not attenuate the extrapolative effects. Expected risk premia in public equity, private equity, and real assets are all correlated with funds' target asset allocation. Realized past returns affect the target asset allocation through an extrapolation channel.