For much of the second half of the 20th century, critics of Wall Street charged that brokerage research was tainted by the tight relationship between analysts and investment bankers. These well documented “agency” issues remained until April 2003 when leading financial institutions signed a deal with the SEC to reimburse investors and put an end to the cozy relationship between the research departments and i-banking departments of major US financial institutions. Many thought this put an end to the conflicts of interest that had plagued the industry. But, apparently, they may have been wrong.
A recent study by Sung-Gon Chung and Melvyn Teo of Singapore Management University provides evidence that analysts have run from the arms of the i-bankers and into the arms of the hedge fund managers. Write Chung and Teo:
[S]ell-side analysts tend to issue buy and strong buy recommendations on stocks predominantly held by hedge funds… in a post-Spitzer era, Wall Street research departments having been forcibly weaned off investment banking revenues now contend with new hedge fund-induced conflicts of interests.
The study is an indictment of analyst objectivity that invites rebuttal, but then provides a cogent defense to many of the criticisms you might want to lob its way.
Chung and Teo describe their findings as “striking.” They find that an analyst is nearly 15% more likely to upgrade a stock that experienced an increase in hedge fund ownership in the previous quarter. Adding to the intrigue: Analysts are more than 13% more likely to downgrade a stock that experienced a reduction in hedge fund ownership.
“But wait!” you say. “Maybe the analysts are just behind the curve by a couple of months and eventually come to know that the hedgies knew the previous quarter.”
Chung and Teo call this alternative explanation the “superiority hypothesis”. In order for this explanation to hold, hedge funds would have to actually display superior stock-picking skills. But when they correlated stock returns to both hedge fund holdings and analyst buy recommendations, they found that the analysts actually performed better than the hedge funds.
Further, if analysts were just taking their lead from the hedge fund community, you might expect inexperienced analysts to take their lead from (i.e. “blindly follow”) hedge funds. But the opposite was actually found to be true. Turns out it was the experienced analysts that tended to issue more buy recommendations on stocks with which hedge funds had fallen in love the previous quarter.
“Okay, you say, “But just because an analyst has more years of experience doesn’t mean they’re any good. Maybe the truly skilled analysts don’t just recommend last quarter’s hedge fund favorites.”
Once again, Chung and Teo anticipate this line of questioning. Using Alpha Magazine’s analyst rankings, they suggest what amounts to a creeping conspiracy among hedge funds and analysts. They suggest that hedge funds are more likely to give high marks to analysts who agree with them, even if their recommendations aren’t the best.
We find that all-stars, prior to achieving all-star status, are more likely to issue overly optimistic recommendations on stocks held by hedge funds than are non all-stars… This suggests that hedge funds ameliorate the reputational cost of issuing an optimistic report by voting biased analysts as all-stars.
But just because analysts seem to lavish praise on stocks held by hedge funds, that doesn’t mean those recommendations are bad ones, right? Alas, Chung and Teo also found that returns of stocks that are issued positive ratings by analysts and are held disproportionately by hedge funds perform worse than average. In other words:
[S]tocks predominantly held by hedge funds do not deserve the buy and strong buy recommendations lavished on them by analysts… this suggests that analysts issue overly optimistic reports for stocks predominantly held by hedge funds.
This is thought-provoking research to be sure. And it does shine a light on the brokerage research business model. But we might stop short of Chung and Teo’s conclusion. The duo suggests that there may be something nefarious going on here. In fact, they wonder if this “trading against the herd” is not only orchestrated by unwitting industry players, but is a major source of hedge fund alpha:
Taken together, these results offer tantalizing insights into how hedge funds generate alpha. One view is that by trading against the herd, hedge funds can take advantage of the short-term reversals in stock prices… Another view is that hedge funds, by pressurizing analysts into issuing buoyant reports on the stocks that they hold and thereafter trading against those optimistic recommendations, are able to induce the short-term price reversals in the first place. In any case, this provides prima facie evidence that by influencing sell-side analysts, hedge funds are able to ameliorate the illiquidity-induced price impact of a stock sale when extricating from their equity positions.