Top-Down Investing
May 21, 2021
What is “Top-Down Investing”?
Generally, there are two most common approaches to portfolio construction – “Top-down” and “Bottom-up” investing. The former pays attention to broader macro-related factors such as GDP growth, interest rates and employment. “Top-down” does also consider more sector and company-specific ones but this tends to be via screening (for size, performance etc) rather than by individual company performance. The second approach focuses on business fundamentals first. “Top-down” investors spent a lot of their time analyzing the wider macro picture and what would be the key impact on different areas of the market. Once potential attractive opportunities are identified, then investors use the security selection process to execute the strategy.
Key Learning Points
- The two major approaches to investing are “top-down” and “bottom-up”
- The “top-down” approach primarily focuses on macro-related factors in order to find attractive potential opportunities in the market before the selection of individual securities, funds, ETFs, or indices
- “Top-down” investing relies on screening the markets, which can be international, by market capitalization and/or by industry to seek out areas of potential growth in the market
- Rather than selecting individual companies, “top-down” investing tends to find particular sectors that offer growth opportunities, and selections are made across a wide diversified universe
- Over the long-term, a “top-down” approach may produce smoother returns if investing in a diversified portfolio as exposure to company specific risks is limited
- It can be more time-efficient to look at investing from a “top-down” perspective as it can be easier data to screen and analyze, although it may mean missing out on company specific growth opportunities
Breaking Down “Top-down” Investing
“Top-down” investors believe that asset allocation is key for the majority of returns – a portfolio constructed of different asset classes such as equities, fixed income, cash, and others is the best way to invest. Setting up the portfolio’s strategic asset allocation may be more important over the long-term than the individual security selection. “Top down” investing also allows for a broader investment portfolio, as it doesn’t rely solely on purchasing single stocks: other investment vehicles such as funds (both passive and active) ETFs, specific asset classes, broader country or sector investments can be used which can offer a more balanced spread across the market than a stock-specific strategy.
For example, if an all equity portfolio is compared against an all bonds portfolio, its performance profile might differ a lot over the long-term – therefore it is very important to consider various factors when building the right mix of assets that can deliver the optimal risk-reward outcome for investors.
When analyzing potential opportunities, equity investors for example should consider the overall market climate, the countries economic outlook, sector perspectives and factors such as investment style and size, as well as the current point in the market cycle.
Some of the drivers that “top-down” investors consider in their analysis include:
- Economic factors such as interest rates, economic growth and unemployment
- Political risk factor – stability, government policies and trade practices as well as capital barriers
- Asset valuations – analysing the profit potential of a specific area of the market
- Investor sentiment – this is more subjective area, but some of the drivers include capital flows into the researched area, professional forecasts, reporting standards and information barriers
Advantages and Disadvantages
While “bottom-up” investing uses company fundamentals as a starting point in the selection process, that involves huge sets of data which might not be so easy to access. Whilst reporting accounts are publicly available, this approach often requires the use of professional financial software. In addition, picking securities that perform well is not a guarantee for future success and depending on portfolio concentration, returns could be more volatile.
On the other hand, “top-down” investing focuses more on data that is easier to find and analysis on macro factors such as GDP growth and market forecasts, for example. Also, the universe of individual securities is huge compared to the opportunity set offered by regions, asset classes sectors. Asset allocators often prefer to invest in products that provide passive exposure to the areas in which they see potential growth and as a result their portfolio is well-diversified.
