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Accurate forecasts attract clients; biased forecasts keep them happy

Journal: International Review of Financial Analysis

Date: 2022

Author: Chao Zhang, David G. Shrider, Dun Han, Yanran Wu

Abstract:
We examine whether business relationships between mutual funds and sell-side analysts influence earnings forecasts using Chinese data from 2007 to 2019. Consistent with prior studies, our results support the commission pressure hypothesis. Analysts' forecasts are overly optimistic for the holdings of existing fund clients. Significantly, we propose the potential client hypothesis and show that analysts' forecasts are more accurate for the holdings of funds that are not clients than for holdings of clients or for stocks not held by any fund. Our results suggest that commission pressure from existing fund clients increases analysts' optimistic bias, while potential clients pressure inhibits analysts' optimistic bias to some extent. Finally, our evidence supports the conflicts of interest hypothesis. Commission pressure is reduced as economic uncertainty grows.

Link: Google Scholar

Background and Context

Research Setting

Study examines Chinese analyst forecasts from 2007-2019 to understand how business relationships between mutual funds and sell-side analysts influence earnings forecasts.

Market Structure

Chinese analysts work for brokerage firms whose revenue depends heavily on trading commissions from mutual fund clients, as underwriting business faces significant regulatory uncertainty.

Methodology

Analysis of 494,750 analyst forecasts examining how forecast bias differs between stocks held by existing mutual fund clients versus potential clients during different economic conditions.

Higher Forecast Bias for Existing Client Holdings vs Other Stocks

  • Analysts show highest optimistic bias (3.90%) when forecasting stocks held only by existing mutual fund clients
  • Forecast bias is lowest (2.89%) for stocks held only by potential clients who don't currently pay commissions
  • Demonstrates how commission relationships influence analyst objectivity

Commission Size Increases Forecast Optimism

  • Higher commission payments from mutual funds lead to greater optimistic bias in forecasts
  • One standard deviation increase in commission size increases forecast bias by over 11%
  • Shows direct relationship between financial incentives and forecast bias

Economic Conditions Impact Forecast Bias

  • Forecast bias is significantly higher (3.60%) during good economic times
  • Bias decreases to 3.00% during periods of economic uncertainty
  • Shows analysts become more conservative when economic conditions deteriorate

Client Holdings Impact on Forecast Bias

  • Size of client holdings significantly impacts forecast bias
  • One standard deviation increase in existing client holdings increases bias by 6.50%
  • Potential client holdings have an even stronger effect of 7.85%

Economic Uncertainty Reduces Commission Pressure Effects

  • Commission pressure effect is strongest during good economic times
  • Effect weakens significantly during periods of economic uncertainty
  • Shows how market conditions moderate the impact of business relationships on forecast bias

Contribution and Implications

  • First study to demonstrate how potential client pressure encourages analysts to produce more accurate forecasts to attract future business
  • Shows that commission relationships create systematic bias in Chinese analyst forecasts, with implications for investor decision-making
  • Provides evidence that economic uncertainty reduces conflicts of interest in analyst forecasts

Data Sources

  • Client relationship bias comparison based on Table 3 Panel A
  • Commission size effects derived from Table 7 coefficient estimates
  • Economic conditions comparison based on Table 4 Panel B
  • Holdings impact analysis based on Table 7 main results
  • Economic uncertainty effects from Table 8 interaction terms