In the investment business, terms are often used that only appear to have sharp and precise meanings. Upon closer examination, these terms are blurry or – in other words – they suggest something that is not always congruent with reality, Stefano Lecchini writes.
By Stefano Lecchini, portfolio manager at LGT Capital Partners
The terms «bottom-up» and «top-down» refer to investment approaches that are best illustrated by equity strategies. When selecting stocks according to a «bottom-up» approach, individual companies are closely assessed, their income and cost structures and their market strategy, etc. are analyzed.
The analyst uses this information to determine how successful the company will be in the future by assessing its strengths, weaknesses and its positioning, without – as he or she believes – relying heavily on macroeconomic correlations. The «top-down» approach, on the other hand, is based on the assessment of macroeconomic correlations, analyses, and trends. The resulting stock selection is shaped more by this bird's eye view than by key company-specific figures.
Unclear Distinction
These two terms are often used in an either/or context, giving the impression that one approach excludes the other: «bottom-up» analysts do not seem to care much about the macroeconomic picture, i.e. they find little use for a «top-down» approach.
However, one has to ask oneself whether the distinction is really that clear: do «bottom-up» analysts not also make macroeconomic observations?
If they analyze a company’s market strategy or its annual results, they will most likely also put on the macro glasses to evaluate the strategy and results in the market context. In this sense, «top-down» considerations are included unconsciously or in a “hidden” manner – only the analysts think they can block them out.
Macro views, although not explicitly articulated as «top-down views», are therefore definitely included in «bottom-up» analyses. However, this is also to be expected, since companies do not operate in a vacuum, but are embedded in the overall market dynamics where macroeconomic factors play a role. The clear difference suggested by this duo («bottom-up», «top-down») is therefore somewhat more blurry than many think.
Complementary – Really?
To increase a portfolio’s degree of diversification, you can invest in different asset classes. But even within the same asset class, different strategies are often implemented in parallel. In this second case, the approaches taken for these strategies can differ along different factors: geographic focus (Europe, Asia, U.S., etc.), investment universe (sectors, instruments, etc.), investment style (concentrated vs. broadly diversified, higher or lower trading frequency, private vs. public, active vs. passive, «top-down» vs. «bottom-up», etc.).
Such parallel mandates are considered complementary. The term «complementary» has positive connotations. In other words, implementing parallel mandates would appear to be a good thing because they apparently complement each other. But parallel mandates are not per se – just because they are lined up «side by side» in the portfolio – always complementary – they often contain contradictions or are redundant.
Further Contradiction
Contradictions may arise, for example, at the exposures or risk profile level. For example, one strategy in a mandate may be overweight in an equity sector, while the other strategy in a parallel mandate may be underweight in that sector. On balance, this results in an undesired neutral exposure.
A further contradiction can arise if the strategies’ risk settings are the opposite. A parallel mandate could also be redundant if you do not realize that the expected return and volatility of two mandates are practically identical. A deeper analysis thus shows that parallel does not necessarily mean complementary, which is why this term is also not quite as precise as it seems.
These are just two examples of terms that can mislead investors because of their apparently clear-cut meaning. And the more you are aware of their fuzziness, the more attentive you become when you use them.
Stefano Lecchini is a portfolio manager at LGT Capital Partners and develops hedge fund solutions for institutional clients. He completed a master’s degree in Theoretical Physics at ETH Zurich and a master’s degree in Philosophy at the University of Bern. Following his studies, he, who is a fan of literature and soccer, gained initial professional experience in the consulting and investment banking industries.
