Buy-side Analysts, Sell-side Analysts, and Fund Performance: Theory and Evidence

Abstract

We examine the role of financial analysts in helping fund managers make better investment decisions. First, we model how a fund manager utilizes reports on a stock produced by two analysts: a biased sell-side analyst who works for an outside brokerage firm, and an unbiased buy-side analyst who is employed by the fund. The fund manager's action is based on her optimal weighting of the two reports. We demonstrate that the optimal weight put on the buy-side analyst's report increases when the quality of the buy-side analyst's signal on the stock increases, or when the quality of the sell-side analyst's signal decreases, or when the sell-side analyst's degree of bias increases, or when the uncertainty in the bias of the sell-side analyst increases. Second, using a unique data set of U.S. equity funds, we find, consistent with our model, that fund managers rely more on buy-side research relative to sell-side and other research, when: 1) sell-side analysts' coverage on the stocks held by the fund decreases, 2) the average error in sell-side analysts' earnings forecasts on these stocks increases; 3) the size of assets under fund management is larger; and 4) the fund offers performance-based fees. Finally, we find that fund performance improves when the buy-side analysts are more experienced, or when the fund's reliance on buy-side research increases.