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Friends in Need are Friends Indeed: The Effects of Social Ties between Financial

Analysts and Mutual Fund Managers

李增泉 副院长、教授、博导

上海财经大学会计学院2014.12

Friends in Need are Friends Indeed: The Effects of Social Ties between Financial

Analysts and Mutual Fund Managers

Zhaoyang GuChinese University of Hong Kong

Guangqing LiZengquan Li

Shanghai University of Finance and Economics

Yong George YangChinese University of Hong Kong

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2014年 11月 28日，由新财富杂志社主办、证券时报联合主办的“第十二届新财富最佳分析师”颁奖盛典在深圳香格里拉大酒店隆重举行，分析师年度大考终于放榜。

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Motivation

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● Recent works in economics and finance find that social networks play important roles in business decisions● facilitate information transfer among executives, fund

managers, and analysts● Possibly compromise board independence

● This is particularly relevant in the China setting where business is essentially relationship-based

时势

兴趣

Research questions

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● Do social networks between analysts and mutual fund managers lead to biased behaviors?

● Analyst: recommendation bias?

● Fund managers: 1) Voting of Star analysts?2) Allocation of trading commission fees?

Why China?

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Why China?

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猫论 先富论

Is China unique?

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Probably not East Europe, Emerging economies, Russia, East

Asia

Even developed countries

Is US different for our research?

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Stronger legal system

However, Analysts’ opinions are subjective, difficult to

prosecute their bias

Fund managers’ trading allocation and star analyst vote decisions are purely business decisions, not subject to any legal constraint

Related research – social networks and information transfer

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Cohen, Frazzini, and Malloy (2008): fund managers invest more in firms with whose executives they share common education background and make more profits.

Cohen, Frazzini, and Malloy (2010): analysts’ recommendations perform better if they have school ties with the firm’s executives.

Hochberg, Ljungqvist, and Lu (2007): in investment syndications, venture capital firms at better networking positions enjoy better performance.

Cao, Dhaliwal, Li, and Yang (2014): Independent directors with social ties with senior officers obtain more info about their firm.

Related research– social networks and corporate governance

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Hwang and Kim (2010): executives are paid more when they have social ties to board directors.

Board interlocks

Contributions

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A new source of bias, independent of those documented

How? Incentives documented in the literature are

concrete and definite in the form of exchange (banking business, commissions, etc)

Social networks are long-term, indefinite in horizon and forms of exchange

Even may not be monetary (social animals, socializing needs)

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Complete a circle of the elite participants of capital markets Public firm (managers) --- fund managers (Cohen et al. 2008)

Public firm (managers) --- analysts (Cohen et al. 2010)

Fund managers --- analysts (THIS STUDY)

Methodologically: We successfully demonstrate the reciprocity feature of

social connections in our research design and empirical analysis

Prior studies typically study just one aspect of the benefit or cost of social connections

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Our study suggests social networks could be a primitive type of incentive for analyst bias

Social networks

Com

mis

sion

s Sta

r voti

ng

I B

an

kin

g

Ow

ners

hip

re

lati

on

ship

Measure of social networks

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Workplace ties: a pair of fund manager and financial analyst is defined to be socially connected if the fund manager worked for the analyst’s brokerage in the past.

May (strong?) or may not (weak?) overlap

Why not educational ties?

Hypotheses

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Fund managers:Extremely competitive professionPeriodically ranked by net asset value (return to date), tied to compensationManagement fee directly based on net asset value strong incentive to keep their investment value high, obtain favorable opinions for stocks they have invested.

Analysts: strong influence in the market

H1: After a fund manager builds a significant position in a stock, an analyst’s subsequent recommendations for that stock will be more optimistic if she has worked in the same brokerage as did the fund manager than if she has not.

OPM profession

Height of red woods

Hypotheses

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Fund managers:Primary voters of “Star” analysts

Anonymous

Analysts: becoming a “Star” means a big lift of publicity and dramatic increase in compensation

H2: An analyst is more likely to be voted into the star analyst list if she has job-related connections with more fund managers.

Hypotheses

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Fund companies:Trading must be allocated to brokerages, with substantial commission fees

Analysts: trading commission fees from institutional investors are the primary source of income of research departments in brokerages.

H3: A brokerage is more likely to obtain trading commissions from a fund company if the brokerage has analysts who have job-related connections with the fund company’s fund managers.

Data and sample

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Period: 2005-2012

Work experience from vita of fund managers

CSMAR, WIND, RESSET: analyst recommendations

CSMAR: Top 10 stock holdings of funds at the end of each qtr Stock prices/returns Financial information

TX Investment Consulting Ltd: Commission fees and broker’s ownership in mutual fund management companies

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Distribution of recommendations

Connections and recommendation bias

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Unit of analysis: analyst-stock-quarters

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Connections and Opinion Bias –Regressions

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0.3780.435:15%0.4630.505: 9%

0.4270.472: 11%

The devils are in the detail…

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Connections and star analyst status

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Unit of analysis: analyst-years

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Connections and star status– regressions

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0.0430.065 : 51.2%

0.0710.102 : 43.7%

0.0920.133 : 44.6%

Connections and commissions

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Unit of analysis: brokerage-fund company-half years

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Connections and commissions – regressions

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0.2690.334: 24.2%

0.5680.612: 7.7%

0.5890.689: 17%

Devils?

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Market (naïve investors’) reaction to the bias

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Sophisticated investors’ reaction

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Connections and opinion timeliness

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Conclusions

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Connected analysts issue more optimistic recommendations for stocks held by their friend-fund managers.

Fund managers return the favor by 1) voting connected analysts into star analyst list2) allocating more commission fees to connected analysts’ brokerages.

Market and funds discount the favorable recommendationsBut 1) The market was fooled and2) Fund managers are much smarter.

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