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

Abstract:     
This study provides evidence that mutual fund trading in response to the release of analyst information destabilizes U.S. stock prices. Specifically, we show that, during the 1995 to 2006 period, mutual funds "herd" (trade together) into stocks with consensus sell-side analyst upgrades and (especially) herd out of stocks with consensus downgrades. Further, downgraded stocks heavily sold by herds initially underperform, then outperform their size, book-to-market, and momentum benchmarks, while upgraded stocks that are heavily bought exhibit the opposite pattern. An investment strategy that exploits these reversals generates a benchmark-adjusted return exceeding six percent per year. Moreover, the sharpest return reversals occur when mutual funds with poor recent performance ("unskilled fund managers") herd in selling stocks they own in common following a consensus analyst downgrade. The response of herds to analyst revisions and the resulting stock return reversals have both increased from 1985 to 2006, which is consistent with the rapidly increasing proportion of unskilled mutual fund managers over this period. Overall, our evidence indicates that herding by mutual fund managers with short-term reputational concerns in response to the release of sell-side analyst information leads to significant stock return reversals.

Keywords: mutual funds, stock market efficiency

JEL Classifications: G11, G12, G14

Working Paper Series