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

This paper documents the tendency of mutual fund managers to follow analyst recommendation revisions when they trade stocks, and the impact of analyst revisioninduced mutual fund “herds” on stock prices. We find that mutual fund herds follow consensus revisions in analyst recommendations, controlling for common investment signals that affect both analyst revisions and mutual fund trading. Consensus upgrades result in herds of funds buying a stock, while consensus downgrades result in even bigger herds of funds selling. Our most important finding is that mutual fund herding impacts stock prices to a much larger degree during our sample period (1994 to 2003) than during prior-studied periods. Further, we find the first evidence that mutual funds appear to overreact when they herd in their trades—stocks heavily bought by herds tend to underperform their size, book-tomarket, and momentum cohorts during the following year, while stocks heavily sold outperform. These reversal patterns are even stronger when mutual fund herds follow analyst recommendation revisions. An investment strategy that accounts for the direction of both analyst revisions and mutual fund herding generates a return (adjusted for size, book-to-market, and momentum) exceeding six percent during the following year. Our results remain robust when we condition fund herding on analyst earnings forecast revisions instead of recommendation revisions. Overall, our study finds that the interaction between sell-side analysts and mutual fund managers plays an important role in setting prices in equity markets. The efficient markets paradigm endures as a central focus of empirical tests by academic researchers, with many recent papers providing strong evidence against efficiency in U.S. equity markets. For instance, several researchers examine patterns in stock returns to find evidence suggestive of large groups of investors exhibiting irrationality, such as Jegadeesh and Titman (1993), who find evidence of investor underreaction, and DeBondt and Thaler (1985), who find evidence of overreaction. However, the literature provide little evidence on which investors exhibit such patterns of irrational trading, nor does it address the mechanism through which such patterns of trading might occur. Simply put, which investors move stock prices, and what motivates their trades? Although some research has shown a tendency for individual investors to exhibit irrationality, such as Odean (1998), it is difficult to imagine individuals systematically moving the market by acting in concert. By contrast, institutional investors are wellknown to receive correlated information (see, for example, Coval and Moskowitz (1999)) and to exhibit correlated trading patterns (see, for example, Nofsinger and Sias (1999) and Sias (2004)). In addition, the scale of trading by institutional managers magnifies the effect of any correlated trading patterns that may exist, relative to the small trades normally placed by individuals. Among institutional investors, the strongest evidence of correlated trading exists for equity mutual funds. For instance, Grinblatt, Titman, and Wermers (1995) document that momentum investing strategies are used by the majority of equity mutual funds during 1975 to 1984, while Wermers (1999) finds that mutual funds tend to exhibit high levels of “herding” (simultaneous buying or selling) in growth stocks, small stocks, and