Stars are treated differently

Equity analysts who make it into Institutional Investor’s (II) star ranking are far more influential than the average investor. Their reports move markets more and are focused on by the press. A new paper by Gil Ahroni and colleagues investigates what kind of forecasts star analysts make and how they become star analysts in the first place.

They find that the voters for II’s star analyst rankings reward high quality forecasts that create alpha for investors. That’s great, because that is exactly what these rankings should do, point out the best forecasters.

But if voters would only reward outperformance, they might elevate people to star analyst just because they were lucky. This is my everlasting grief with investment competitions run at schools and on investment platforms. They rank participants based only on performance. This provides an awful incentive. In essence, one simply makes the riskiest, most outrageous calls and investments and then hopes to get lucky. If the investments lose a ton of money, no downside for the participant, if they make a ton of money, the participant tops the charts and wins the competition.

Voters in the II survey account for that by punishing analysts for blunders, i.e. forecasts that have gone wrong. The result is that analysts tend to become star analysts when they give good recommendations and have relatively few blunders.

But things change once an analyst has been voted star analyst. Then, the analyst has an incentive to only make high conviction calls and refrain from making calls that could go wrong because they might lose their status in the next round of voting. Investors, meanwhile, want to get as much information from the star analyst as possible and in a timely fashion, not just the high conviction ideas.

To split the difference, voters in the II survey tend to ignore the blunders of star analysts and only look at the good forecasts. The result is that star analysts are now rewarded for making bold, headline-grabbing forecasts but are less penalised for blunders than the average (non-star) analyst.

Bottom line: To become a star analyst it pays to make good, high-quality forecasts. To stay a star analyst, it pays to make bold forecasts, rather than high quality forecasts.