Dynamic Incentives for Buy-Side Analysts

Abstract

We develop a dynamic adverse selection model where a career-concerned buy-side analyst advises a fund manager about investment decisions. The analyst's ability is privately known, as is any information she learns over time. The manager wants to elicit information to maximize fund performance while also identifying and retaining high-skill analysts. We characterize the optimal dynamic contract, show that it has several features supported by empirical evidence, and derive novel testable implications. The fund manager's optimal contract both maximizes the value of information and screens out low-skill analysts by incentivizing the analyst to always provide honest advice.

Keywords: buy-side analysts, career concerns, analyst recommendations, forecasting, dynamic mechanism design

JEL Classification: D82, D83, D86, G11, G14, G23