CUHK Study: Financial Analysts And Mutual Fund Managers Manipulate Market For Personal Gain In China


A section of the Financial Analysts and Mutual Fund Managers are manipulating the market for personal gain using their mutual friendship that could be detrimental to investment in China, according to a study by the Chinese University of Hong Kong (CUHK) Business School.

For the working paper “Friends in Need are Friends Indeed: The Effect of Social Ties between Financial Analysts and Mutual Fund Managers”, Prof. George Yang, Associate Professor at the School of Accountancy of CUHK Business School, collaborated with fellow academic and Prof. Zhaoyang Gu, Director of the School of Accountancy and Guangqing Li at China Galaxy Securities Co., Ltd. as well as Prof. Zengquan Li, Dean of the School of Accountancy at Shanghai University of Finance and Economics.

The paper is the latest in Prof. Yang’s work to examine irregularities in financial markets such as insider trading and the economic effects of business relationships, and the first study to show that benefits run both ways.

“If analysts speak positively about stocks, how do fund managers benefit? We also look at how the analysts benefit themselves from their advice,” says Prof. Yang who has been able to pick out various ways by which both sides seem to be able to dispense rewards without being detected.

Unlike business relationships, friendship between such analysts and fund managers could have started under various circumstances like their having worked together, been classmates at University or even childhood as school students.

Prof. Yang investigated fund managers and analysts who have previously worked in the same brokerage. “They’re more likely to establish social ties, either directly or indirectly through common colleagues,” he says.

Deriving financial benefits from such friendship network affect markets worldwide. But as a large and emerging economy, China is known for the importance “guanxi” (connections) in daily life. With institutions meant to police irregularities in business being relatively powerless, Prof. Yang is of the view that social networks could be exploited to obtain privileged access to scarce resources or to collude against the public interest.

Analysts in China are powerful figures in the markets, which see more business from individual retail investors than in other countries. Chinese have the highest savings rate in the world and individuals pursue investment opportunities keenly. Thus, they are more likely than institutional investors to rely heavily on tips from established analysts.

Ever since China set up its first stock exchange in 1990, equity markets and the financial analyst industry have grown rapidly. By the end of 2012, some 110 brokerages employed more than 2,400 sell-side analysts who regularly issue stock research reports.

Prof. Yang claims that fund managers exploit their links with analysts to win positive reports of stocks they hold within a portfolio. “So, as an analyst, I would try and help a fund manager by speaking favourably about the stocks he or she holds, which would encourage a boost in value of their portfolio,” he says.

Some 1,200 funds in China managed by 70 mutual fund companies are periodically ranked on performance, based on the price of stock in their portfolios. These rankings play a vital role in winning new investors which dictates fund managers’ pay and promotion chances.

How do fund managers repay the favours. One way for them is to cast their ‘Star analyst’ votes in favour of that person. For the analysts, this vote brings them publicity and a resultant dramatic rise in income. Significantly, fund managers are the main voters for this honour.

“We found those with more social connections to fund managers are more likely to be selected as star analysts,” Prof. Yang says.

Another way of rewarding is to push more trading through the preferred analyst’s brokerage. Commission fees from institutional investors are the main — if not the only — form of revenue for analysts’ pay. So those who are socially connected to fund managers are more likely to receive commissions from their companies, the research found.

“It’s natural to question why this commission fee relationship emerges only between certain pairs of fund companies and brokerages and not others,” Prof. Yang says.

However, such links do not pass unnoticed in the market which tends to discount recommendations from such connected analysts to buy certain stock within a short time frame only to have stock returns go down in a few months.

Such types of analysts would not issue negative comments if the stocks held by their fund manager friends turn bad but would wholeheartedly recommend the company if there is good news.

“Admittedly fund managers would prefer accurate and high quality reports before they purchase a stock,” says Prof. Yang. “However, once they’ve established a position, they would like analysts to issue favourable opinions, or at least to withhold any negative ones to maintain the stock price at a high level.”

Those fund managers who appear to be in the know about the real value despite their analysts’ recommendations are more likely to dump the stock and buy only those recommended by analysts who are not connected.

“These results suggest that the positive nature of connected analysts’ recommendations serve to help connected fund managers to ‘pump and dump’ a stock,” says Prof. Yang. The relatively unsophisticated smaller Chinese investors are likely to follow the bogus recommendations and end up being cheated of their money.

But then, the analysts do not want to lose their credibility. So they would mix the odd biased report with genuine recommendations made on sound judgements, says Prof. Yang.

He considers that the analysis, focussing only on Chinese market, has broader implications and such ‘hard to detect’ links and biases might operate in other international markets. “The main audience of this paper will be in the US. I definitely believe that a similar phenomenon could be observed in the US and possibly Europe,” he says.

“It’s so hard for regulators to set rules. Analysts’ opinions are purely subjective — you can’t tell if they’re biased and they can say whatever they want. The analyst ratings from fund managers are also not subject to regulation. And social networks are much less conspicuous and more difficult to regulate,” he says.

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“It’s virtually impossible to prosecute analysts for their bias. Unless you have hard evidence, you can’t establish deliberate bias in court. Opinions aren’t illegal,” he adds.

However, Prof. Yang is still optimistic and believes that as tighter regulations would be in place as China moves towards greater economic liberalisation, further market reforms and closer ties with Hong Kong.

“Hong Kong has stronger controls against insider trading. Also, as more educated and market savvy investors enter the field, the markets themselves might be able to achieve what the government can’t,” he adds.

“I would rely more on market discipline. If this behaviour becomes too rampant, the markets will no longer believe the recommendations. That’s the purpose of this paper — to help investors become more aware and sophisticated. Eventually, I believe these types of personal relationships will grow weaker,” says Prof. Gu, co-author on the paper.


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