At most brokerage firms, analyst compensation is based on two major
factors. The first is the analyst’s perceived (external) reputation. The annual
Institutional InvestorAll-American Research Teams poll is perhaps the
most significant external influence driving analyst compensation (see Stickel,
1992). All-American rankings are based on a questionnaire asking over 750
money managers and institutions to rank analysts in several categories:
stock picking, earnings estimates, written reports, and overall service. Note
that only the first two criteria are directly related to accurate forecasts and
recommendations.
The top analysts in each industry are ranked as first-, second-, or third-
place winners or (sometimes several) runner-ups. Directors of equity research
at brokerage firms refer to these results when they set compensation levels for
analysts. Polls indicate that analysts’ being “up to date” is of paramount im-
portance. The timely production of earnings estimates, buy and sell opinions,
and written reports on companies followed are also key factors. Polls also in-
dicate that initiation of timely calls on relevant information is a valuable
characteristic in a successful (and hence, well-compensated) analyst.
An analyst’s ability to generate revenues and profits is a very significant
factor in his or her compensation. An analyst’s most measurable profit con-
tribution comes from involvement in underwriting and merger deals. Arti-
cles in the popular financial press describe the competition for deal-making
analysts as intense. Analysts who help to attract underwriting for clients
have in the past received a portion of the fees or, more likely, bonuses that
are several times those of analysts without underwriting contributions. The
distinction between vice president and managing director (or, partner) for
analysts at the largest investment banks has been highly correlated with
contributions to underwriting fees (see Galant 1992, for example). Despite
recent reforms designed to eliminate or moderate compensation for ana-
lysts directly tied to investment banking fees, Boni and Womack (2002a)
suggest that it will be quite difficult to devise a compensation scheme where
the implicit incentive to report more positively on more highly profitable
investment banking transactions will be subverted.^16 The reality is that
commissions from trading do not cover the cost of research departments
completely. Some estimates put the subsidy from investment banking to-
ward research department costs at higher than 50 percent.
Another potential source of revenues, commissions generated by transac-
tions in the stock of the companies the analyst follows, may also be a factor
in the analyst’s compensation. It is difficult, however, to define an analyst’s
precise contribution to trading volume. There are many other factors, includ-
ing the trading “presence” of the investment bank that affect it. Moreover,
MARKET EFFICIENCY AND BIASES 415(^16) Several brokerage houses, such as Merrill Lynch, recently announced that in the future,
their analysts’ compensation would be independent of their contribution to the revenue stream
of the investment banking division.