Hedge Funds and Analyst Optimism

Abstract

This study explores the relationship between hedge fund equity holdings and sell-side analyst recommendations. In line with anecdotal evidence which suggests that sell-side analysts are now under tremendous pressure to generate brokerage commissions from their lucrative hedge fund clients, we show that sell-side analysts tend to issue buy and strong buy recommendations on stocks predominantly held by hedge funds. These stocks do not deserve the flattering reports lavished by analysts. Relative to other buy and strong buy recommendations, these favorable recommendations parlay into poorer three-month and six-month stock returns going forward. Hedge funds take advantage of the flattering reports by concurrently offloading their stock holdings. We obtain similar conclusions with analyst upgrades and downgrades, relative recommendations, and 12-month price targets. The findings are robust to adjustments for analyst stock coverage, and are stronger for seasoned analysts, indicating that analysts are not simply incorporating information embedded in hedge fund holdings. Consistent with the notion that analysts are driven by brokerage commissions, analysts are more likely to craft optimistic reports for stocks held by high dollar turnover hedge funds than for stocks held by other less important hedge fund clients. Finally, hedge funds ameliorate the reputation cost of a buoyant recommendation by voting biased analysts as all-stars. Our results suggest that 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.