Read the marketing material for any fund and you'll often find the manager saying that they take either a "top-down" or a "bottom-up" approach. Sometimes they claim to do both: "the fund combines a top-down approach to country selection with a bottom-up approach to security selection" is a favourite with funds that are allowed to invest in shares around the world.
For anybody who isn't familiar with investment jargon, this distinction can seem baffling. So what's the difference between top down and bottom up and is one better than the other?
Top-down versus bottom-up
Top-down investing means making investment decisions based on the outlook for the economy and what that is likely to mean for individual assets. So a top-down investor would begin by analysing what trends they expect to see in areas such as growth, inflation, interest rates and currency movements. These are macroeconomic trends, hence top-down investing is also known as macro trading.The investor then looks for ways to profit from these developments.
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For example, if they expect the US to raise interest rates faster than the UK, they might buy the US dollar and sell sterling. When the Japanese economy is likely to grow strongly, they could invest in stocks that are more sensitive to growth and sell more defensive ones. The prospect of another flare-up in the eurozone crisis might lead them to switch their money into German bunds as a safe haven and so on.
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Bottom-up investing sometimes known as stockpicking is very different. The investor focuses on individual securities rather than wider trends. For example, they might invest in a stock because they believe that it offers an attractive dividend yield that's likely to rise over time.
Or they could expect it to improve profitability by selling off poor-quality parts of the business and focusing on what it does well. The performance of a company will depend on the overall economy to some extent, so bottom-up investors may give some weight to this. But their strategy involves understanding the company rather than forecasting the economy they won't buy a stock purely to play an economic trend.
Simple but not easy
So which approach makes most sense? In some areas, such as currency trading or commodities, a top-down approach is the main way to trade: returns are entirely dependent on macroeconomic factors. The bond markets tend to be macro-focused, but there are niches where a bottom-up approach dominates because the choice of individual securities is crucial.
These include distressed-debt investing (buying bonds in companies that are in trouble) and some high-yield bond strategies (buying bonds in the riskier companies).
Shares are the main asset class where investors have a choice of a top-down or a bottom-up approach. More equity managers tend to be stockpickers (or at least claim to be), but there is no shortage of funds that focus on big trends and themes. What's more, the growing number of sector and thematic exchange-traded funds (ETFs) makes it easier to invest like this yourself.
However, while top-down investing may seem to be simpler (it means less digging around in accounts), it may be significant that almost all notable equity investors have been bottom-up investors including one of the world's most famous economists. Macro trading is undoubtedly harder than it looks.
Why Keynes became a stockpicker
John Maynard Keynes (1883-1946) was one of the most influential economists of the 20th century. His work as an investor is less well known, but throughout his career he managed money for himself and others. Perhaps the most interesting aspect of his investing is that he attempted both top-down and bottom-up strategies, with very different results.
Keynes began as a macro trader and followed this approach throughout the 1920s, running the endowment fund for King's College, Cambridge, and various small investment pools (essentially hedge funds before that term was used).
Given both his stature as an economist and his connections at the top level of government, on paper it is difficult to imagine anybody more qualified for this style of investing. Yet his returns varied between mediocre and disastrous. The King's College endowment modestly beat the UK index over the period, but with enormous volatility. Other investments did far worse.
He was wiped out speculating on currencies in 1920, needing a large loan from a friend to bail himself out. His stock investments underperformed the UK market in five out of seven years from 1922 to 1929. Commodity trading was more successful, but he incurred large losses on rubber in 1928.
At the start of the 1930s, Keynes' views shifted drastically and he evolved into a bottom-up stock picker, using an approach that today would be called value investing. From this point on, his performance improved. The King's College endowment outperformed the UK index by an average of around eight percentage points per year from then until Keynes' death.
His own investments continued to be very volatile, largely because he ran a highly concentrated portfolio (in 1931, more than 60% of his portfolio was in two UK carmakers), but performance was generally strong. At the time of his death his net worth was around £500,000 (equal to around £19m today).
