FundsIndia explains : Top-down and bottom-up approach to portfolio construction

You may have read about fund managers talk of a top-down or bottom-up approach to building their portfolio. Does he start with the first stock with highest weight and proceed down or pick the smallest stock in his portfolio and move up? Well, none of these actually. Let’ discuss what these approaches really are

Top-down approach
The top-down approach involves looking at the big picture(macro economic factors), such as GDP growth of an economy, inflation, interest rates and a host of other parameters that define the strength of the economy. The fund manager will then look at which segments/sectors of the economy are doing well or are expected to benefit more, given the macro picture. These sectors will have the highest weight in the portfolio. Correspondingly, the sectors that are expected to perform moderately will have lower representation. Having decided the sectors and their respective weights, the fund manager will then pick the stocks that are well placed to gain from the fortunes of that particular sector.

Bottom-up approach
In contrast, bottom-up approach focuses completely on individual attributes of a company and the assumption that backs this approach is that a good company will perform well irrespective of the sector it operates in. While picking a stock, the fund manager looks to pick fundamentally strong companies with good cash flows and sound management keeping in mind that its present valuation may provide room for appreciation in its stock as opposed to its future potential

Who uses what
It can be noted that a majority of the mid-cap and small-cap fund managers will be following a bottom-up approach to portfolio construction. Due to the volatile nature of the earnings of the companies in this basket, it becomes imperative to look for companies with strong fundamentals. A top-down approach may ensure that a sector has potential but a poor company within such sector would ultimately not deliver. Hence, the focus on company fundamentals first.

Similarly, a number of large-cap fund managers follow a top-down approach as once they know which sectors to go underweight or overweight on, they stick to the large companies in such sectors, as they make for a good proxy on the sector. By and large both the top-down and bottom-up approach methods are largely used in conjunction with each other in constructing a portfolio. The goal of both these approaches is to construct a good portfolio with stocks that deliver great returns for the investor.

Challenges and risks
A bottom-up approach is often challenging as it involves picking the right company at the right price. There is also a large huge universe of stocks to pick from. To this extent, the top-down approach may seem less challenging as once you filter the right sectors to go overweight on, the investment universe may narrow. However, the top-down approach has its own risks. A wrong call in the choice of the top sectors in the portfolio can weigh heavily on its returns. It will also take a lot of effort and time to change the construct of the portfolio once the mistakes are identified.