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April 6, 2006 4:46 pm

Reputation matters

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If an investment bank has lucrative underwriting relationships, will its analysts necessarily produce lower quality research to the detriment of investors, because of their compromised objectivity? It is a question that academics have debated for over a decade, but one that seemed to take regulators by surprise after the bursting of the dotcom bubble in 2001, and the subsequent wave of corporate accounting scandals.

In the ensuing years, a slew of regulation hit US companies, including: Rule 2711 from the NASD, the chief oversight body for self-regulation in the securities industry, which required investment banks to publish the distribution of recommendations made by their analysts; and the so-called “Global Settlement”, under which the US’s top investment banks agreed to collaborate with at least three independent research houses to provide “objective” investment advice.

The goal of these measures was to produce more transparent research. However, they also burdened banks without necessarily generating proportionate value for investors. Goldman Sachs, for example, has so far spent about $8m on independent research, but says the dedicated website on which this research is published receives only 722 visits per month on average. Moreover, the amount of high-quality research available is arguably in decline, as US banks continue to reduce the numbers of analysts they employ, and talented individuals flee to buy-side teams or hedge funds in the face of diminishing pay and incentives. In a closely watched move, Lehman Brothers moved some of its best analysts to the trading desk. To some investors, this is a loss of information from some of the best minds.

Our research suggests the governance of sell-side research would be more effective if it put greater emphasis on the personal reputation of analysts, via a performance-related pay structure in which individuals were rewarded based on the quality of their research and advice. Ideally, such a system would measure everything investors value in their analysts, from deep industry knowledge and timely reporting to accurate earnings forecasts and valuable investment recommendations.

Implementing such an all-inclusive performance measure would not be easy. However, an existing ranking process for US analysts – the so-called “All-American” title, based on the votes of buy-side managers at major asset management companies and awarded by Institutional Investor magazine – works well as a proxy.

A meaningful status symbol

For the purpose of two large scale studies, we divided Wall Street analysts along two dimensions: personal status (based on the All-American title); and the status of their employers. This gave us four groups to analyse: All-Americans working at top-tier investment banks; non-All-Americans working at top-tier investment banks; All-Americans working at lower-tier investment banks; and non-All-Americans working at lower-tier investment banks. We compared the performance of these groups based on the quality of their earnings forecasts and share recommendations.

In terms of earnings forecasts, we found that All-American analysts were significantly more accurate than those without the title – strong evidence for the efficacy of the award scheme. A more surprising finding was that the analysts who worked at top-tier investment banks such as Goldman Sachs generally made more accurate forecasts than their counterparts at lower-tier institutions, including the so-called “independent” research houses that lacked investment banking arms. This contradicted the hypothesis that analysts working at big investment banks produced lower quality research owing to conflicts of interest. It also suggested the job market for analysts was reasonably efficient. If jobs at Goldman Sachs are higher paid and harder to get, then a competitive job market should ensure better-qualified analysts tend to work there. Indeed, this process should be self-fulfilling, since the bigger budgets and richer resources of top-tier banks make it easier to access information.

For our second study, which examined investment values of analysts’ share recommendations, we collected recommendations as they were published and created portfolios that bought and sold stocks as these recommendations changed.

In this discipline, all four of our groups outperformed the S&P 500 on an unadjusted basis, and the ranking of their performance was significant. All-Americans working at top-tier banks delivered the best results, followed by All-Americans at lower-tier banks. Then came non-All-Americans at top-tier banks and, lastly, non-All-Americans at lower-tier banks. Further analysis determined that the only analysts to generate any “alpha” results (beating the S&P 500 and other benchmarks on a risk-adjusted basis) were the All-Americans working at top-tier banks.

These findings supported the view that the stock market remains hard to beat and, therefore, highly efficient. They also suggested that, far from being a mere “beauty contest”, the All-American title reflects a deservedly high reputation based on tangible returns for investors, while competition for jobs at top-tier investment banks serves as another screening device in the analysts’ labour market.

Neither study, however, ruled out conflicts of interest. In fact, we found that the accuracy of earnings forecasts dropped among analysts working at top-tier investment banks during stock market booms (for example, in the late 1990s). Since analysts can gain significant underwriting-related bonuses during hot markets, this coincidence of reduced research quality with market booms provided compelling evidence that there were indeed conflicts of interest.

As far as share recommendations are concerned, conflicts of interests are a bit harder to pin down, because even if a conflicted analyst recommends a “strong buy” on a stock, this will not reveal itself as poor advice while the stock is still rising. In other words, it is hard to tell whether a bullish call is overly bullish in rising markets. The true nature of overly bullish calls is, however, clearly revealed once the market starts to fall again. Indeed, we found that returns on buy recommendations made by analysts at top-tier banks were particularly high in rising markets, and suffered in the initial post-bubble years of 2000 and 2001.

Overall, our findings suggested conflicts of interest were present at top-tier banks during hot markets. Thus, while competition for jobs at top-tier banks does serve to pick out better analysts in general, these individuals seem to be more prone to conflicts of interest than their counterparts at other banks when the stakes are high.

So who is to blame? Interestingly, we found that the conflict-induced drop in performance around hot markets is driven entirely by non-All-American analysts working at top-tier banks. By contrast, All-Americans at top-tier banks do not become inaccurate during hot markets, and their buy recommendations continue to beat other groups and the overall market no matter what the prevailing market conditions. The contrasting behaviour of analysts with and without All-American titles at top-tier banks suggests that personal reputation, using this proxy at least, is an effective disciplinary device in sell-side research.

The exceptions to the rules

The conclusions above are based on broad evidence, but it is nevertheless true that several highly publicised investigations by US regulators have involved former “star” analysts.

One of the most vivid examples is that of Jack Grubman, a former All-American who infamously touted telecoms stocks to investors while privately loathing them, and was eventually banned from the securities industry for life. During the backlash against the celebrity culture that had fuelled the myths of analysts like Mr Grubman, some big investment banks, including Morgan Stanley, announced they would reduce the weight of analysts’ individual reputations in the calculation of their pay.

Our research shows they should be doing the opposite: incentivising status. So, the real question is: by how much? The answer is probably handsomely, but not to the point of obscenity. During the last stock market bubble, the compensation of some star analysts was colossal, and there is evidence to suggest this tempted some of them to pursue short-term gains against the best interests of investors.

Such trends are comparable to those of CEO compensation: the market recognises the need to reward top-performing CEOs, but it also recognises that when compensation scales go awry, a system designed to incentivise high performance can end up stimulating abuse.

Lily Fang is assistant professor of finance at Insead. Ayako Yasuda is assistant professor of finance at the Wharton School, University of Pennsylvania.

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