Expectation gap widens between institutional investors and financial advisors

Results from the South African Investor Confidence Index – a monthly survey conducted by the Institute of Behavioural Finance (IBF) among institutional investors and financial advisors

Institutional investors and financial planners greatly differ in their opinions of the current market valuation and expected equity returns over the next 12 months, according to the latest South African Investor Confidence Index.

The findings of a survey conducted in February by the Institute of Behavioural Finance (IBF), which form the basis of the index, reveal that the structural gap between the two groups’ confidence levels is widening. It is almost at the highest level since the survey was initiated in 2007.

Institutional investors, namely the managers of large pools of money such as pension funds and unit trusts, “have increased concerns about the level of equity market valuations,” says Theo Vorster, chairman of the IBF. “Some 74 percent of the institutional participants think the market is expensive, and the remaining 26 percent see the market as neutral. None thinks the market is cheap.”

This view is further emphasised by institutional investors’ expectations for low returns from local equities. Almost two-thirds of the respondents expect near zero returns over one-, three- and six- month periods and a low 4 percent return over the next 12 months. This confirms the majority of institutional investors anticipate the market to move sideways during most of 2011.

“This decline in confidence is not as widely shared by financial advisors who predominantly guide and manage the funds of private clients,” say Vorster. Half of the advisors surveyed view the market as being fairly priced and a few see the market as cheap.

“This more positive sentiment is reflected in the advisors’ higher expected returns from equities,” he says. “They anticipate that markets will trade higher over all the periods tested.”

While institutional investors remain cautious regarding market valuations, the survey shows they are not overly pessimistic about market volatility. Almost three quarters of the institutional respondents expect the market to rebound the day after a 3 percent selloff.

The latest Crash Confidence Index supports this view, with two-thirds of institutional respondents believing there is less than a 10 percent chance of a catastrophic market correction occurring. “It is surprising that the financial advisors are slightly less confident about a market rebound and the Crash Confidence Index,” says Vorster.

“Based on the survey results, it seems positive news is needed for local equities to outperform, be it economic or, probably more importantly, earnings surprises on the upside,” he says. “After the strong outperformance in equities since March 2009, it may be concluded that investors would want to see confirmation of the earnings recovery before pricing in further positive news.”

On the other hand, bad earnings news could result in lower valuations, as the market is already pricing in a strong earnings recovery.

Gerda van der Linde, executive director at the Institute of Behavioral Finance, believes the structural gap between the market valuation confidence and expected return confidence of institutional investors and financial advisors is due to availability and confirmation biases.

“The confidence levels of financial advisors and their clients can be attributed to the most recent, available and prominent information on the markets communicated through the media,” says Van Der Linde. “With daily reminders that the JSE is testing previous highs, it is normal for advisors and investors to be biased in the direction of this positive confirmation regarding market returns. The more often the information is repeated the more intuition leads one to believe the market will continue on its winning streak.”

She says behavioral finance studies have found that investors tend to be myopic and overly fixated on recent occurrences while they tend to ignore the longer-term picture. “This must be a warning bell for investors not to become too confident and overestimate their ability to forecast events. With strong returns reported by most funds for the previous year, investors may be tempted to invest more money into the hottest performing funds and ignore their risk tolerance and risk capacity.”

Leading investment commentators recently wrote that it is regarded as wise to build broadly diversified portfolios during a period of comparative calm – now, for instance – to prepare for the next downturn. This may assist investors to control and possibly lessen the impact of risk in the market on their investment portfolios, but not eliminate it.

“With substantial amounts of money remaining in money market accounts whilst the JSE has almost reversed the fall from its previous high, playing too safe may have proved to be risky as well,” says Van Der Linde.