Benefits of a designation

By Gus De Franco
Illustration: Susanna Denti

A study on the economic role of the CFA charter indicates that it might in cases provide a critical difference

Why get a professional designation? There are two schools of thought on the role of education and certification. The human-capital theory represents the traditional view of education in which people improve their skills as a result of the knowledge they directly acquire during their educational program. ^1‚2 The signaling view of education ^3,4,5 characterizes a situation in which talented individuals cannot directly prove their worth to potential employers. Instead, these talented people obtain educational credentials, such as a degree from a prestigious university or a hard-to-obtain designation, which requires a certain level of talent, time and effort to enter and complete. Employers observe the educational signal and then hire the more talented employees. In this theory, it is not necessary that you learn anything, only that the educational credential is correlated with your ability.

Given this educational context and an interest in sell-side analysts, an empirical experiment about the chartered financial analyst (CFA) designation⁶ was conducted. Our purpose was to determine whether sell-side equity analysts with a CFA charter actually perform better than analysts without one. If so, which theory of education helps to explain the differential performance? Rich and publicly available data on equity analysts, the characteristics of their annual earnings forecasts and whether they hold a CFA designation makes such an investigation possible. The sidebar on page 41 provides an overview of our research design, including data, measures and method.

CFA designation
Investment professionals, broadly defined to include analysts, investment managers, financial executives and accountants, can join the CFA Institute. Passing a series of examinations, along with meeting other criteria, earns them a CFA designation. Demand for the CFA designation continues to grow. According to the CFA Institute, the number of charterholders rose to more than 82,000 charterholders by 2008 as compared with 10,000 charterholders in 1990. These charterholders work in 134 countries and territories. Tens of thousands of candidates will take the CFA examination this year. Clearly CFA charterholders and candidates exercise significant influence on the global capital markets as well as the financial decisions of corporations. US regulators have even awarded special status to charterholders. (For more in-formation on the CFA designation please go to www.cfainstitute.org.)

Finding #1: analysts with a CFA designation perform better
We find evidence that charterholders issue earnings forecasts that typically run ahead of the other analysts that cover the same firm (i.e., timelier forecasts). Charterholders also tend to issue forecasts that deviate more from the consensus view of other analysts (i.e., bolder forecasts) and that are less optimistic than other analysts. But we also find that CFA charterholders are average in terms of their forecasting accuracy — perhaps because other analysts have the advantage of observing the forecasts issued by CFA charterholders before developing their own.

The economic significance of these differences, however, is modest. Our very large sample allows us to document a difference in performance in a statistical sense. Actual performance-measure differences are in the range of 4% or less. This result is interesting because of the significant effort that people exert to become charterholders. This relative lack of economic significance could simply be because analysts acquire the CFA designation to address a relative deficiency with respect to other analysts. Non-charterholders could have acquired similar skills via MBA or CA or CPA training. Non-charterholders could also have unique and relevant experience in particular industries. For example, some analysts hold degrees such as a PhD or MD; others have industry work experience or a large network of industry contacts.

The fact that analysts with a CFA designation perform better is consistent with both the human capital and signaling theories of education. To disentangle the effects associated with each of the two theories we turn to the next two tests.

Finding #2: analysts with a CFA designation perform better even before they obtain their CFA charter
For a subset of our charterholders, we can determine when they became charterholders and hence measure their performance in the period prior to obtaining their CFA designation. In this pre-CFA period, we find that the forecasts of future charter-holders are timelier and bolder than a carefully matched group of non-charterholder forecasts. This result is consistent with the signaling theory of education. More talented analysts decide to obtain the CFA designation, consistent with their desire to signal their ability.

Finding #3: analysts with a CFA designation perform better after they get their CFA charter
For the same subset of charterholders, we measure the change in performance from before to after they obtain their CFA designation. We find that charterholders improve the timeliness of their forecasts during this period. This result provides support for the human-capital view of education. In our setting, charterholders acquire additional financial knowledge and skills via the CFA program, which in turn leads to improved forecasting performance.

Finding #4: investors respond more strongly to forecasts issued by analysts with a CFA designation
We find that when charterholders revise their earnings forecasts up, equity prices of those stocks tend to rise more than when non-charterholders revise forecasts upward. Similarly, with downward forecast revisions, the equity returns are more negative for charterholders. In other words, the market reacts more strongly to forecasts issued by charterholders. This result is consistent with credentialism, a variant of signaling theory.⁷ Instead of employers using the CFA designation as a signal, the real value of the designation is to let potential client investors know the quality of the analyst. It is not easy for investors to figure out which analysts are better than others. Since CFA certification is based on standardized tests administered by one organization, the CFA designation is an objective signal. The highly visible placement of the letters CFA following the analyst’s name in reports to investors is consistent with charterholders’ desire to advertise this trait.

Research design

DaTA The sample includes 798,272 annual forecasts for 4,920 firms issued by 909 charterholder and 2,794 non-charterholder analysts. The period studied ranges from January 1, 1999, to December 31, 2005. Detailed information on analysts’ forecasts is from I/B/E/S. Charterholders are identified by the letters CFA after their names on their reports (from Investext).

Measures We have four performance measures. First, analysts' timeliness, which follows the work of Cooper et al⁸, is based on the pattern of forecasts surrounding the forecast of interest. The intuition is that a timelier analyst will be ahead of the pack, interpreting the news more quickly than other analysts. A less timely analyst will be at the back of the pack, either reacting to the earnings forecasts of other analysts or interpreting the same news that other analysts interpret but at a slower rate. Second, analyst forecast accuracy is the absolute value of the difference between an analyst’s forecast and the actual earnings number reported by the firm. The more the analyst’s forecast misses the mark (in either a positive or negative direction), the less accurate we consider the forecast. Third, we measure the optimistic bias in analysts’ forecasts. For example, an analyst who issues a forecast that is 10¢ above the reported earnings number is optimistic and relatively more optimistic than a miss of 5¢ above the reported number. Optimism is important because analysts are notorious for issuing positive comments. Fourth, the greater the degree to which an analyst’s forecast revision deviates from the current forecasts of analysts, the bolder the forecast. Analysts take a risk by deviating from the consensus view; however, investors may appreciate this more, particularly if the analyst is correct.

Method In addition to multivariate regressions, we also use a matched-pair design in which we directly match charter-holder and non-charterholder forecasts for the same firm, the same forecast period, and the same day. Less-skilled analysts can simply wait a day and mimic the forecasts of more skilled analysts, so matching the day of the forecast is important.

Concluding comments and discussion
Our study provides empirical evidence that analysts with a CFA designation perform better than other analysts, at least in part. The results are consistent with analysts being more talented to begin with and then further improving as they progress through the CFA program. Hence our results support both human-capital and signaling theories of education. Would we expect to find similar effects in other investment occupations? There is no obvious reason why we shouldn’t. The CFA designation is available to individuals in a variety of financial roles.

The real benefit of a designation is a way for professionals to signal their skills to employers and clients. This benefit will be much greater for professionals who operate in fields in which their output is intangible or private. When a client has no idea whom to appoint, having a designation may be the critical difference.

References:
1. Mincer, J. 1974. “Schooling, experience and earnings,” New York: Columbia University Press.
2. Becker, G.S. 1975. “Human capital,” Chicago, Illinois: University of Chicago Press.
3. Spence, M. 1973. “Job market signaling,” Quarterly Journal of Economics 87: 355–374.
4. Arrow, K.J. 1973. “Higher education as a filter,” Journal of Public Economics 2: 193–216.
5. Stiglitz, J.E. 1975. “The theory of ‘screening,’ education and the distribution of income,” The American Economic Review 65 (2): 283–300.
6. De Franco, G. and Y. Zhou. 2009. “The performance of analysts with a CFA designation: The role of human-capital and signaling theories,” The Accounting Review 84, 383–404.
7. Lazear, E. 1977. “Academic achievement and job performance: Note,” The American Economic Review 67 (2): 252–254.
8. Cooper, R.A., T.E. Day and C.M. Lewis. 2001. “Following the leader: A study of individual analysts’ earnings forecasts,” Journal of Financial Economics 61 (September): 383–416.

Gus De Franco is an assistant professor at the Joseph L. Rotman School of Management at the University of Toronto. He can be reached at Gus.Defranco@Rotman.Utoronto.ca

Technical editor: Christine Wiedman, PhD. FCA, School of accounting and finance, University of Waterloo