I recently came across an interesting paper, published in March 2018 on SSRN, titled “How Skilled Are Security Analysts?”, that found a large majority of the nearly 5,000 equity analysts it examined between 1993 and 2015 appeared skilled. Consistent with prior literature, the authors, Alan Crane and Kevin Crotty, of Rice University, also found:
- Analyst revisions are more informative than recommendations.
- Analysts issuing higher numbers of recommendations per year are negatively associated with the conditional probability of being a skilled analyst.
- Analysts with a higher fraction of buy recommendations also are less likely to be skilled.
- Less favorable analysts (those with fewer buy recommendations as a fraction of their total recommendations) are more accurate in terms of recommendations and revisions.
- Analysts with consistently good picks are less likely to win The Wall Street Journal’s “Best on the Street” designation, while analysts with more volatility in the success of their recommendations are more likely to win.
- Tenured analysts are more skilled.
The apparent prevalence of analyst skill stands in stark contrast to research demonstrating that only a small fraction of actively managed mutual funds outperform on a risk-adjusted basis.
For example, in their study, “Luck versus Skill in the Cross-Section of Mutual Fund Returns,” published in the October 2010 issue of The Journal of Finance, Eugene Fama and Kenneth French found that fewer active equity managers (about 2%) than would be expected by chance were able to outperform their three-factor (market beta, size and value) model benchmark.
Stated differently, the very-best-performing traditional active managers have delivered returns in excess of the Fama-French three-factor model. However, their returns have not been high enough to be confident in concluding that such managers have enough skill to cover their costs, or that their past performance will persist.
Fama and French concluded: “For (active) fund investors, the simulation results are disheartening.” They did concede that active managers’ results appear better when looking at gross returns (returns without the expense ratio). But gross returns are irrelevant to investors unless they can find an active manager willing to work for free.
A more recent study, an August 2016 research paper by Philipp Meyer-Brauns of Dimensional Fund Advisors titled, “Mutual Fund Performance through a Five-Factor Lens,” reached similar findings.
His data sample included 3,870 active funds over the 32-year period 1984 to 2015. Benchmarking active fund returns against the newer Fama-French five-factor model, which adds profitability (RMW, robust minus weak) and investment (CMA, conservative minus aggressive) to the three-factor model, he found an average negative monthly alpha of 0.06% (with a t-stat of 2.3). Moreover, he found that about 2.4% of the funds had alpha t-stats of 2 or greater, which is slightly fewer than what we would expect by chance (2.9%).