Understand the difference between top-down and bottom-up investment strategies
Mutual fund managers typically use one of two investment strategies: top-down or bottom-up.
The top-down approach begins by looking at macroeconomic data and trends (e.g., inflation, interest rates and economic growth) to determine the regions, as well as the sectors within regions, that are most likely to perform the best over a specific time period. These regions and sectors will be given a greater weighting in the portfolio than those that are less likely to perform well.
The fund manager will then get sector exposure either through individual stocks or sector ETFs.
The bottom-up approach pays little-to-no attention to macroeconomic data. Instead, the portfolio manager screens all companies in a given geography based on a set of criteria designed to gauge the company’s health and prospects for growth.
A bottom-up portfolio manager combs through the company’s balance sheet, interviews its management, does on-site visits of its operations, and takes a host of other due diligence measures. The fund manager is looking for companies that are worth more than their market prices. The goal is to buy these companies when they are underpriced and reap the gains when market prices come into line with intrinsic value.
A bit of both
These two approaches are typically viewed as opposites, but they can be combined. For example, a fund manager may use the top-down approach to identify sectors that are most likely to perform well, and then use the bottom-up approach to choose individual stocks within each sector.