Analyst Recommendations, Mutual Fund Herding, and Overreaction in Stock Prices

Abstract

Standard-Nutzungsbedingungen:Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden.Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen.Sofern die Verfasser die Dokumente unter Open-Content-Lizenzen (insbesondere CC-Lizenzen) zur Verfügung gestellt haben sollten, gelten abweichend von diesen Nutzungsbedingungen die in der dort genannten Lizenz gewährten Nutzungsrechte. This Draft: March 2007 † We thank Mark Chen, Pedro Matos, Tong Yao, and workshop participants at the University of Southern California and University of Texas -Dallas for helpful comments and suggestions. We thank Thomson Financial for providing the I/B/E/S analyst forecast and recommendations data. All errors are our own. Terms of use: Documents in EconStor mayElectronic copy of this paper is available at: http://ssrn.com/abstract=972731 Analyst Recommendations, Mutual Fund Herding, and Overreaction in Stock Prices AbstractThis paper documents the tendency of mutual fund managers to follow analyst recommendation revisions when they trade stocks, and the impact of analyst revisioninduced mutual fund "herds" on stock prices. We find that mutual fund herds follow consensus revisions in analyst recommendations, controlling for common investment signals that affect both analyst revisions and mutual fund trading. Consensus upgrades result in herds of funds buying a stock, while consensus downgrades result in even bigger herds of funds selling.Our most important finding is that mutual fund herding impacts stock prices to a much larger degree during our sample period (1994 to 2003) than during prior-studied periods. Further, we find the first evidence that mutual funds appear to overreact when they herd in their trades-stocks heavily bought by herds tend to underperform their size, book-tomarket, and momentum cohorts during the following year, while stocks heavily sold outperform. These reversal patterns are even stronger when herds of mutual funds (especially funds with poor performance records) follow analyst recommendation revisions. An investment strategy that accounts for the direction of both analyst revisions and mutual fund herding generates a return (adjusted for size, book-to-market, and momentum) exceeding six percent during the following year. Our results remain robust when we condition fund herding on analyst earnings forecast revisions instead of recommendation revisions. Overall, our study finds that the interaction between sell-side analysts and mutual fund managers plays an important role in setting prices in equity markets.The efficient markets paradigm endures as a central focus of empirical tests by academic researchers, with many recent papers providing strong evidence against efficiency in U.S. equity markets. For instance, several researchers examine patterns in stock returns to find evidence suggestive of large groups of investors exhibi...

Industry herding and momentum strategies

“…level is high is consistent with Brown et al (2014) that fund managers have a greater tendency to herd on negative stock information due to reputational concerns and greater litigation risk for holding losing stocks. It is also consistent with several studies in the herding literature documenting directional asymmetry in herding (e.g.…”

“…To that end, it can be argued that correlated actions of investors in a market where investors follow the trades of others can further contribute to possible return momentum in that market. In fact, focusing on herding among institutional investors in the U.S., studies including Nofsinger and Sias (1999) and Sias (2004) document that subsequent asset returns follow the direction of the herd resulting in return momentum while others including Dasgupta et al (2011), Singh (2013) and Brown et al (2014) document return reversals in the long run as a result of institutional herding. Moskowitz and Grinblatt (1999) suggest that investors can capture much of the momentum effect through industry portfolios rather than individual stock portfolios and that momentum profits for individual stocks become significantly weak after adjusting for industry effects.…”

Bond market investor herding: Evidence from the European financial crisis

“…Tan, Chiang, Mason, and Nelling (2008) examine dual-listed Chinese stocks and find evidence of herd behavior by both domestic individual investors and foreign institutional investors. Brown, Wei, and Wermers (2013) present recent evidence that mutual fund managers "herd" into (out of) stocks with consensus sellside analyst upgrades (downgrades). They further argue that manager career concern is the main reason for this behavior and that the herding effect is stronger for downgrades since there is higher risk (reputational/litigation risk) in holding a losing asset.…”

Buy-side trades and sell-side recommendations: Interactions and information content

“…Their clients include both pension-plan sponsors and money managers, and the databases identify each client by a numeric code. 4 Recent work by Brown, Wei, and Wermers (2007) examines, using quarterly data, whether fund trades in the same direction as revisions lead to price pressure. Our findings indicate that the frequency of fund trades and revisions that occur in the same direction is fairly small.…”