Institutional investor sentiment and aggregate stock returns

• Published date: 01 November 2021
• Author: Xiang Gao,Chen Gu,Kees Koedijk
• Date: 01 November 2021
• DOI: http://doi.org/10.1111/eufm.12292

DOI: 10.1111/eufm.12292

ORIGINAL ARTICLE

Institutional investor sentiment and aggregate

stock returns

Xiang Gao

1

|Chen Gu

1

|Kees Koedijk

2,3

1

Research Center of Finance, Shanghai

Business School, Shanghai, China

2

School of Economics, Utrecht

University, Utrecht, The Netherlands

3

Centre for Economic Policy Research

(CEPR), London, UK

Correspondence

Chen Gu, Research Center of Finance,

Shanghai Business School, 2271 West

Zhongshan Rd., 200235 Shanghai, China.

Email: chengu1031@126.com

Abstract

This paper examines the equity market return pre-

dictability of institutional investor sentiment, in com-

parison to individual investor sentiment. Our findings

suggest that institutional traders are informed and that

their sentiment helps to tilt stock prices towards the

intrinsic value. This is because the sentiment of in-

stitutions encompasses news regarding expectations on

future cash flows of underlying firms that impounds

itself into future price expectations. In this study, we

add to the large number of studies that investigate the

role and implications of investor sentiment, which has

long been viewed as a pure behavioural phenomenon,

on market efficiency and price discovery.

KEYWORDS

cash flows, institutional investors, retail traders, return

predictability, sentiment

JEL CLASSIFICATION

G14; G40; G41

1|INTRODUCTION

How investor sentiment can predict aggregate stock returns has drawn much attention both in

academia as well as in the investing community. It has been shown in many academic studies

that the Baker and Wurgler (2006) type of sentiment measure (

S

BW

hereafter), often interpreted

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899

The authors thank John Doukas (the Editor), an anonymous referee, Sugato Chakravarty, Diego Garica, and Alexander

Kurov for helpful comments. Chen Gu acknowledges the financial support from the Shanghai Pujiang Program

(19PJC077). All errors or omissions are our responsibility.

as indirectly representing individual investors' emotions, possesses some negative predictive

power on stock market returns (e.g., Baker & Wurgler, 2007; Baker et al., 2012; Doukas &

Milonas, 2004; Huang et al., 2015). Besides this market‐activity‐based BW composite, other

more direct sentiment proxies based on survey or textual data are employed by Brown and Cliff

(2004), Schmeling (2009), Garcia (2013), and Jiang et al. (2019), among others, to test the

predictability of retail investor sentiment. They also find a clear negative relationship between

individual investor sentiment and aggregate stock returns, especially over much longer

horizons of 2–3 years.

1

The explanation for these results is that investor sentiment affects

returns by driving stock prices away from the intrinsic value.

Institutional investor sentiment should do a much better forecasting job here, as it is

recognized by many that institutions have a clear information advantage over retail investors.

The reason is twofold. First, theoretically, retail investors are assumed to lack a cohesive level

of information that could have been allowing them to extract economic rents familiar to well‐

informed institutions. Second, practically, retail investors are often beaten by professional

institutions in terms of the pool of resources at disposal and the amount of time available to

perform intensive analysis. The information‐advantage argument is also consistent with in-

vestment thumb rules.

Clearly, one can tell that the literature on irrational sentiment (mostly focusing on in-

dividual investors) and the literature on sophisticated institutions have conflicting implications

for the informativeness of investor sentiment. To reconcile them, we need to understand more

about the collective attitude among financial institutions and the unique message contained

within it. Unfortunately, extant studies shed some light on such issues. Brown and Cliff (2005)

and Schmeling (2007) provide some evidence supporting comovement between institutional

investor sentiment and medium‐to long‐run stock market returns, but mixed results are

reported with regard to the short‐run return predictability brought in by institutional investor

sentiment (e.g., Brown & Cliff, 2004; Lee et al., 2002; Wang et al., 2006). In addition, the precise

mechanism of institutional investor sentiment having predictive power for aggregate stock

returns is unclear as well.

As a result, several research questions remain open, including: Can the sentiment of in-

stitutional investors forecast the future return of the market portfolio? Does institutional and

individual sentiment behave differently? And most importantly, why institutional investor

sentiment has return predictability?

The present paper addresses all these questions. Using an institutional investor sentiment

index published by the SENTIX (

S

IN

S

hereafter), we find that

S

IN

S

is able to positively predict

aggregated market returns over the next month. Moreover, this forecasting power is found to be

economically significant. Specifically, one standard deviation increase in sentiment leads to an

increase of 83 basis points in future stock returns.

One may worry that the forecastability of institutional investor sentiment is due to in-

stitutions utilizing a contrarian approach to bet against retail investor sentiment. To mitigate

this concern, we validate our results by controlling for a list of common sentiment indices for

individuals, such as the Baker and Wurgler (2006) investor sentiment (

S

BW

), the Huang et al.

(2015) aligned investor sentiment (

S

HJTZ

), the American Association of Individual Investor

sentiment (

S

AAI

I

), the SENTIX individual investor sentiment (

S

IND

) and the University of

1

Several studies find that sentiment based on qualitative information positively predicts future firm returns (e.g., see Gu

& Kurov, 2020; Tetlock et al., 2008).

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