Front End Load: Who’s more accurate?

Investors rarely have access to the buy-side analyst reports of institutional investors, and according to a new study by a trio of Harvard Business School researchers, they likely aren’t missing much. The study finds buy-side analysts are more optimistic and less accurate than their sell-side counterparts, who freely distribute their recommendations.

Buy-side analysts work for institutional investors like hedge and pension funds and, for the most part, their research is internal only. Boris Gorysberg, Paul Healy and Craig Chapman—all researchers affiliated with Harvard Business School—were given access to the forecast reports of an unnamed buy-side firm that, they say, is one of the 10 largest in the U.S. Over the period studied, they compared the quality of research from the buy-side firm to that of freely disseminated sell-side reports.

The resulting study, which is published in the latest issue of the CFA Institute’s Financial Analysts Journal, found that between 1997 and 2004, sellside analysts who tend to work for large brokerage firms put out much more accurate forecasts than the closely guarded reports of buy-side firms.

The study estimates that for a typical firm with earnings per share of $2, the mean difference between buy- and sell-side absolute forecast errors is $0.21 for a zero- to threemonth investment horizon, $0.18 for a 10- to 12-month horizon, and $0.30 per share for a horizon of more than 18 months. That results in a mean difference of accuracy that ranges from 11% to 15% of actual earnings.

The study’s authors don’t offer a definitive reason for the discrepancy, but they do have some guesses. One of the key differences is resources. The authors note that even though the buy-side firm they studied was a top 10 firm, it had only about 20 to 30 analysts whereas the average sell-side firm has upward of 186 senior analysts.

The result is that a sell-side analyst can spend much more time covering a specific security or sector. In fact, the study found that the typical buy-side reports at the sample firm were only two pages long and were far less comprehensive than those of typical sell-side analysts.

Sell-side analysts also had an information advantage, since the firms they represent tend to function as the underwriters of new security issuances and debt of the companies they cover. It was widely believed that sell-side firms had additional sources of info over the buy-side, including larger sales forces and traders who may have intimate knowledge of certain markets, a relationship with the managers of the companies they are underwriting and the ability to solicit feedback from their institutional clients.