The Association between Institutional Ownership and the Accuracy of Analyst Earnings Forecasts: A Simultaneous Equations Analysis*

Abstract

In this study we examined the association of analyst earnings forecast error with a refined measure of institutional ownership for different groups of institutional investors (transient, dedicated, and quasi-indexers) applying a simultaneous equations analysis. We hypothesized that, due to different investment strategies, only transient investors will pay attention to corporate earnings predictability and will have higher investment in companies with more predictable earnings (lower forecast error). We also assumed that earnings predictability is not relevant for the investment decisions of dedicated investors and quasi-indexers. Therefore, we didn't expect to find any association between analyst earnings forecast error and extent of ownership by dedicated investors and quasi-indexers in those companies. Empirical evidence suggests that transient investors are indeed drawn to companies with lower forecast errors, while dedicated investors largely ignore earnings predictability in their investment decisions. Surprisingly, however, (1) ownership of quasi-indexers is associated with higher forecast error, and (2) the higher institutional ownership by any of three groups consequently results in the bigger forecast error. These findings should be of relevance for financial analysts and for researchers examining earnings management/earnings forecast accuracy. They highlight the importance to adjust for investors' heterogeneity in research models rather than to cast institutional investors as a homogeneous group. It also appears that, whether they are aware of it or not, in their attempts to achieve predictable earnings both management and analysts appeal only to one type of institutional investors: transient.