Top Down

Top Down

As the name suggests, in contrast to bottom-up strategies, top-down strategies use an investment process that begins at a top or macro level. Instead of focusing on individual company- and asset-level variables in making investment decisions, top-down portfolio managers study variables affecting many companies, such as the macroeconomic environment, demographic trends, and government policies. These managers often use ETF’s or derivatives to capture macro dynamics of a market sector and generate portfolio return.

These are some of the various top-down approaches we will Go through

Edit Content

Investors using country allocation strategies form their portfolios by investing in different regions depending on their assessment of each regions’ prospects. For example, the manager may have a preference for a particular region and may establish a position in that region while limiting exposure to others. Managers of global equity funds may, for example, make a decision based on a trade-off between the US equity market and the European equity market, or they may allocate among all investable country equity markets. Such strategies may also seek to track the overall supply and demand for equities in regions or countries by analysing investment fund flows, the volumes of initial public offerings, and secondary share issuance.

Edit Content

Just as one can formulate a strategy that allocates investment to different countries or regions in an investment universe, one can also have a view on the expected returns of various sectors and industries across borders. Industries that are more integrated on a global basis—and therefore subject to global supply and demand dynamics—are more suitable to global sector allocation decisions. Examples of such industries include information technology and energy. On the other hand, sectors and industries that are more local in nature to individual countries are more suitable to sector allocation within a country. Examples of these industries are real estate and consumer staples. The availability of sector and industry ETFs globally and locally greatly facilitates the implementation of sector and industry strategies for those portfolio managers who cannot or do not wish to implement such strategies by investing in individual stocks.

Edit Content

Thematic investing is another broad category of strategies. Thematic strategies can use broad macroeconomic, demographic, or political drivers, or bottom-up ideas on industries and sectors, to identify investment opportunities. Disruptive technologies, processes, and regulations; innovations; and economic cycles can present investment opportunities and can also pose challenges to existing companies. Investors in this category constantly search for new and promising ideas or themes that will drive the market in the future.

It is also important to determine whether any new trend is structural (and hence long-term and ongoing) or short-term in nature. Structural changes can have long-lasting impacts on the way people behave or how a market operates. For example, the development of smartphones and tablets and the move towards cloud computing are examples of structural changes. On the other hand, a manager might attempt to identify companies with significant sales exposure to foreign countries as a way to benefit from short-term views on currency movements. The success of a structural thematic investment depends equally on the ability to take advantage of future trends and the ability to avoid what will turn out to be just fashionable for a short time.

Edit Content

A factor is a variable or characteristic with which individual asset returns can be correlated. It can be broadly defined as any variable that is believed to be valuable in ranking stocks for investment and in predicting future returns or risks. A wide range of security characteristics have been used to define “factors.” Some factors (most commonly, size, value, momentum, and quality) have been shown to be positively associated with a long-term return premium and are often referred to as rewarded factors. In fact, hundreds of factors have been identified and used in portfolio construction, but a large number have not been empirically proven to offer a persistent improvement in return.

Broadly defined, a factor-based strategy aims to identify significant factors that can predict future stock returns and to construct a portfolio that tilts towards shares that are rich in such factors. Some strategies rely on a single factor, are transparent, and maintain a relatively stable exposure to that factor with regular rebalancing. Other strategies rely on a selection of factors. Yet other strategies may attempt to time the exposure to factors, recognizing that factor performance will vary over time.

For new factor ideas, analysts and managers of portfolios that use factor strategies often rely on academic research, working papers, in-house research, and external research performed by entities such as investment banks.

Equity style rotation strategies, are a subcategory of factor investing which are based on the belief that different factors—such as size, value, momentum, and quality—work well during some time periods but less well during other time periods. These strategies use an investment process that allocates to stock baskets representing each of these styles when a particular style is expected to offer a positive excess return compared to the benchmark. While style rotation as a strategy can be used in both fundamental and quantitative investment processes, it is generally found more in quantitative investing.

An important test is the “smell” test: Does a factor make intuitive sense? A factor can often pass statistical backtesting, but if it does not make common sense—if justification for the factor’s efficacy is lacking—then a manager may just be data-mining. Investors should always remember that impressive performance during backtesting does not necessarily imply that the factor will continue to add value in the future.