The Investor's Dictionary: Top-down vs. bottom-up

Morningstar's Ben Johnson breaks down the often misunderstood difference between top-down and bottom-up approaches to investing.

Jess Morgan 1 October, 2015 | 5:00PM Ben Johnson, CFA

 

 

Ben Johnson: In terms of the difference between top-down and bottom-up investing, it’s really two different paths that lead to roughly the same destination.

So a top-down approach really just starts from a different point. It starts from assessing broad trends that are buffeting the global economy, what’s happening at a regional level, what's happening in various countries, what's happening in different sectors of the market, oil and gas, basic materials, consumer staples, you name it. And winnowing down, starting from the very mouth of the funnel, to the point where you've identified a specific sector and a specific security within a given sector that you think is favorably positioned, that you think is attractively priced.

Now bottom-up investors tend to start from a different and indeed almost a mirror image of the position that top-down investors begin from. They are looking at individual securities very closely. They are assessing their balance sheets. They are thinking about their cash flows and then they are expanding out and looking at the competitive dynamics in their industry and their sector, what's going on in the country in which they are either domiciled in or otherwise operate in. And then thinking about how all of these various macro forces that are the starting point of top-down investors are going to affect that particular geography of the sector, the individual security.

So ultimately at the end of both these paths lies a decision, which is security selection. They are just two very different means to approaching that same task.

Which of these approaches is more common today?

So where investors are placing their new investment capital, where they are investing their incremental dollar, is really more towards top-down investing. So you are seeing in particular amongst individuals and intermediaries a migration away from individual security selections picking single stocks or single bonds. You are seeing even a movement away from the selection of security pickers. So a movement away from actively managed funds and into passively managed ones. So the real manifestation of this movement is the flows that we've seen into passively managed or index funds and exchange traded funds or ETFs. Those flows have been in a secular uptrend now for quite some time.

Which approach is better in bear markets?

If you look at the relativities in bear markets, what you see is that oftentimes individual security selectors tend to, on average, fare a bit better vis-à-vis sort of a broad-based index exposure and more often than not – I'll use the example of the energy sector as a case in point – they are able to consciously avoid some of the, I'll call them junkiest securities in a given sector. So those companies that have a large degree of sort of negative operating leverage so that decline in energy prices is going to hit them or affect them disproportionately relative to their peers.

So individual security selectors in the downdraft such as we've seen off late tend to benefit to the extent that they tend to craft higher quality portfolios vis-à-vis something that just looks to capture the entire market, like an index fund.

About Author

Jess Morgan

Jess Morgan  Jess Morgan is the associate editor of Morningstar Canada’s website. She began her career as a television producer and freelance writer, often making appearances on TV and radio as a commentator on politics and culture. She holds a BA in communications from the University of Winnipeg and a diploma in Creative Communications from Red River College.