In defining their investment approaches, fund managers often use the terms top-down and bottom up. But what are these top-down and bottom-up approaches? Are they mutually exclusive? What are the pros and cons of each approach?
Let us understand these approaches.
Top down approach
The top-down approach involves looking at the broad economic, demographic and cultural changes in a country to identify the broad themes and drivers which in turn will determine the growth and profitability of sectors. In other words, analysis of macro factors is the key determinant.
For instance, a research shows that India in a few years would have 1.6 billion people between the age group of 20-50. So a fund manager would focus on companies targeting that niche consumer market.
Once they have selected the sector, the next step is to select stocks within that sector. Fund managers will study various stocks in that sector and after analyzing they will pick the best stocks.
Bottom up approach
In the bottom-up approach, fund managers examine the fundamentals of the stock, i.e. they look at variables that define the performance of the stock. In this approach, they study factors like company management, price to earnings ratios and other growth indicators to find the companies that could perform well over a period of time.
Fund managers study a particular company, try to understand their financial health and future opportunities, etc. and such parameters define their stock selection. Unlike top-down managers, they don’t focus on the bigger picture.
“When it comes to investing in equities for a long term or a medium term perspective bottom up is ideal. We should look at individual companies, their strengths, effectiveness and the opportunities. But it is not a thumb rule and both (top-down and bottom-up) are crucial. You always end up evaluating the macro and micro factors before investing,” says Chandresh Nigam, MD & CEO, Axis Mutual Fund.
Top down V/S bottom up
While both the approaches have their pros and cons, in reality, fund managers use both the approaches though the relative weightage they give to each approach could vary.
“We normally use bottom-up approach, i.e. we pick high quality stocks with reasonable valuations. Though we are essentially bottom-up stock pickers we also keep an eye on the broader economy and try to use both the approaches. When we invest through top-down approach we look at sectors which are going to reboot themselves and look for high quality stocks in that sector,” says Soumendra Nath Lahiri, CIO, and L&T Mutual Fund.
A big risk that looms in top down approach is that fund manager’s conclusion can be wrong. For instance, top fund managers across the globe had predicted a pickup in auto sales due to lower oil prices and invested heavily in auto and related sector but it did not turn out to be correct.
Another problem is being under invested in the market. In top-down approach, fund managers can select certain sectors which could make your portfolio less diversified and there could be an opportunity loss during a bull run.
