Two Approaches To Portfolio Construction Followed By Fund Managers
May 25, 2019

Author: Aditi Murkute

(Image source: Image by Open Clipart- vector via Pixabay)

While analyzing multiple NFOs launched by several fund houses, I usually come across the "Investment Strategy" mentioned in the scheme information document. It is an essential part of the document explaining the different techniques applied in the construction of a mutual fund portfolio to facilitate growth.

The two kinds of investment approach most fund managers commonly use in the construction of an equity fund portfolio are:

1) Top-down approach

2) Bottom-up approach

The common goal of both approaches is to pick a stock that has the potential to generate better returns from a pool of market caps.

[Read: How To Improve Your Return On Investments?]

But they differ!

The top-down approach focuses on the big picture of the overall economy and breaks this down further into specific industry, sector, and company. Whereas, the bottom-up approach looks at a specific company's performance compared to its peers, along with the macro environment.

Basically, these two approaches are like identical twins with contrasting personalities.

Figure 1: Top-down Approach & Bottom-up Approach

Graph: FIIs ditching India


​As you can see from the above figure, both are the exact opposite of each other.

Let's look at them individually to understand each approach better.

Top-down Approach

An investment technique that involves looking first at the macro picture of the economy using the country's GDP, trade balances, currency movements, inflation, interest rates, and other aspects of the economy. This approach does appear to be the most logical starting point given its broad measure of economic growth. It highlights the impact of geopolitical tensions and it is a breeding ground of growing companies.

Then it trickles down to identifying growing industries and sectors, or regions within the macroeconomy. Most times, economic growth is due to growth in specific areas of the economy/regions/sectors at any given time rather than across all segments

These are the niche ones that tend to change a complete economic cycle, with technology and consumer products usually leading the way. It's also crucial to look if the selected segments are influenced by governments or not, as certain subsidies and policies help boost the profitability in the short-term but may not be in place permanently.

Finally, the next level down is to get into the nitty-gritty, to choose the best performing company stock based on its fundamental and technical aspects. Most often, fund managers check into the company's fundamentals which include the financial ratios, revenue growth, cash flows, and the value of the stock.

However, it is important to note that this approach of investing is used by fund managers of large-cap funds. And this is effective when the markets are rallying, and the economy is booming.

The top-down approach ensures that fund managers know which sectors to go underweight or overweight on, when they stick to the large companies in such sectors, as they make for a good proxy on the sector.

But in times when there is slow down in the economy, selecting the right company even in the well-performing sector could prove to be a miscalculated move. This is because the core focus is the economy, fund managers lack the expertise and resources to delve deep and do extensive detailed research.

Bottom-up Approach

This technique is exactly the opposite of the top-down approach as the core focus is picking up potential stocks of companies that are robust in nature, and keeps up with the changes in the economy.

It is assumed that individual companies can outperform the industry benchmarks even when performance is low. It includes looking at companies' products and services, its financial stability, and its research reports.

This entails identification of companies that have a good management team, good product line, high growth potential, and cheaper valuations compared to its peers. Making sound decisions based on a bottom-up investing strategy means gaining a thorough review of the company in question.

It is incorrect to assume that the fund manager completely ignores the macroeconomic factors; in fact, their approach is different while analysing the market. It is pronounced on the fundamentals of the company, the ability to cope under diverse economic conditions, and the potential to build upon growth prospects. After this, the fund manager zeros-in on a particular company.

The bottom up approach is generally used by the fund managers to find stocks that have value. A value fund could discover value bets in the mid and small-cap domain or even larger companies that could be beaten down but still hold the value proposition considering the financials and the qualitative aspects of the company under consideration. That's because it is often challenging to pick the right company at the right price. Due to the volatile nature of the earnings of companies, it becomes imperative to identify ones with strong fundamentals, instead of basing it on the overall economy.

But it is imperative to note that in times of high volatility, the bottom-up technique would not be the right approach. It is adopted by those managers who have substantial access to on-ground research resources so that the study is worthwhile, and the correct decision can be arrived at.

Conclusion:

Both the approaches do work effectively in unique circumstances. Hence, both approaches are valid, especially when designing a balanced investment portfolio. The top-down approach should be used to shortlist the sectors which can boom in the future combined with bottom-up technique to select the stocks from the shortlisted sectors.

Remember as an investor it is critical to be aware of your financial goal, risk profile, and time horizon, and to focus on one objective only, i.e. maximizing the profits, instead of debating which approach is better.

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