Do Sell-Side Analysts and Hedge Funds Collude?

Abstract

The hedge fund industry often boasts that it delivers superior returns compared to alternative investments. We document that one reason behind this success is because sell-side analysts issue optimistic research forecasts that facilitate profitable trades by hedge funds. Investors do not see through analyst incentives to cater to hedge fund trades and react more strongly to analyst forecasts issued for stocks with large hedge fund holdings. Hedge funds take advantage of temporary stock overpricing and sell their holdings in stocks where analysts issued optimistic forecasts. Analysts cater to hedge funds in return for broker votes, which are an important determinant of analyst compensation and career outcomes. Our evidence on collusion between analysts and hedge funds partially explains the success of the hedge fund industry.