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Structure of this new Jargon Busters series
This series will have five components and will be covered in 9 parts. Here is the structure of how this series will be covered :
Equity management strategies
Active strategies a. Top down
b. Bottom up - fundamentals based
c. Bottom up - technical based
Passive strategies
Fixed income management strategies a. Active and passive strategies
b. Advanced strategies
Performance measurement Risk management Introduction to modern portfolio theory
We have intentionally kept the theory aspect as the final piece instead of at the beginning, as we believe the theory may be better understood once we have some familiarity with the actual practice of portfolio management, which we will attempt to cover in the preceding articles.
This article - the first of this series - will cover A.I.a. : Top down active equity strategies.
Active vs Passive strategies
As we all probably know, passive strategies are those where the fund manager merely replicates an index, without really applying his/her mind on the merits of individual constituents of the index. So, if there is a passive Nifty tracker fund, the fund manager's job is to ensure that the portfolio mimics the Nifty 50 in terms of the constituent 50 stocks and their weightages - to the maximum extent possible. If he has a very dim view on say 10 out of the 50 stocks, he does not hold a mandate to eliminate these 10 in favour of the balance 40. His job is to passively track the index that his fund is mandated to track.
An active strategy is one where the fund manager is not tied to an index, but has freedom - within the mandate given in the fund - to look beyond the index in his quest to deliver alpha. He actively seeks out investment ideas which in his opinion will enable him to outperform the benchmark - the index that he is mandated to try and beat.
The approach of active vs passive is therefore fundamentally different - passive seeks to replicate the index to the closest possible limit while active seeks to beat the same index by the widest possible extent.
From a portfolio theory perspective, it is believed that in a perfect market, where every participant has the same access to information and insights - ie in a market that is "efficient" - delivering alpha through superior insights into some stocks or sectors will be difficult and as such as a market becomes more "efficient", passive investing strategies may make more sense - as the advantage of better information gets arbitraged away. Most markets are not in reality so efficient. There is a premium that can be attached to superior understanding of businesses and indeed the overall environment, which can enable a fund manager to deliver alpha. A case in point is that despite the information overload that is now available on Indian markets - various fund managers' calls on the extent, speed and timing of an economic recovery were different - which led to different sectoral compositions of portfolios - and resulted in some portfolios outperforming the market while others did not.
Top down active equity strategies
Within active equity strategies, two primary approaches are top down and bottom up strategies. In a previous Jargon Busters - Mutual Funds article, we had touched upon Top Down vs Bottom Up strategies (Click Here). In this article, we will explore top down strategies in a little more detail.
A top down investor lays greater emphasis on getting his "big-picture" view right as his central assumption is that it is the big picture that drives equity portfolio performance. His emphasis is on getting his macro call right and less on getting the micro calls right, in order to deliver performance.
4 approaches to top down active equity investing
There are different macro calls that top down investors could focus on, which in turn gives rise to four distinct top down strategies within the equities space :
1. Country approach
Equity portfolio managers who have a global mandate would typically first want to get their country allocations right. They are less fussed on which stock to own within a country and relatively more focussed on getting the weightages between different countries right. This decision could be a function of the macro economic environment and prospects of each country, its political situation, the fund flow trends and projections of global money into the country, etc. A top down equity manager who, say has 20 countries that he can allocate money to (for example a global emerging markets fund) might focus on country allocations primarily as he would typically take a view that when one country performs, its key indices will anyway reflect the performance. To be in India and Indonesia at the right time and out of them at the right time in favour of say Brazil and Israel, would add a lot more to his overall performance than working through whether TCS or Infosys is a better bet within the Indian IT space, and not giving enough attention to his view on Indian market vs Brazil for instance. It is quite possible for such a top down equity manager to effectively employ an active top down strategy for his country allocations, but a passive index strategy within the individual country allocations. So, if he has decided to deploy 10% of his assets into India, he can just buy a liquid global ETF that tracks Indian large cap indices and not work through individual stock selection.
2. Macro economic approach
Equity managers who have a mandate to invest in only one country (the majority of Indian equity funds) can take a top down macro economic approach to drive portfolio strategies. The fund manager in this case would pay the largest attention to his macro economic calls on factors like GDP growth forecast, interest rate forecast, inflation forecast, IIP numbers and other such macro indicators, which will influence his views on sectors and themes that he believes will do better than others. Once he has formulated his macro economic call, he will cast his portfolio on a thematic and sectoral basis and decide weights for each sector. Once those weights are decided, he would then turn his attention to stocks within each sector that he fancies most, and would allocate money to stocks, within the overall sector weightage that he has decided from his top down approach. It is important to note here that once the fund manager has taken his top down call based on a macro economic approach, he can then go bottom-up for individual stocks within a sector or can go passive and buy into a sectoral ETF to the extent of his desired weightage within the sector.
Macro economic calls are very relevant when an economy is passing through a down cycle, as the divergence between good and bad fundamentals across sectors tends to be the sharpest in such times. Sectors that are very sensitive to interest rates (real estate, automobiles, banks) typically don't do well in a down cycle. The same sectors tend to recover in the market very fast when consensus opinion builds on a sustainable economic recovery. Getting one's macro economic call right can therefore materially influence portfolio performance.
As we write this piece (Oct 2013), one of the biggest dilemmas confronting Indian equity fund managers is the macro economic call that they should take, if a top-down approach fits into their scheme of things. Should they now take a view that interest rates will cool off because inflation will cool off and therefore bet more on rate sensitive sectors or should they continue to take a more cautious approach on the economy and therefore have larger positions on defensives. So, whether Bajaj Auto is a better bet than Hero Honda in the two wheelers space is less important for a top down manager than first figuring out whether he wants to be in the two wheelers space at all, if he has a dim view on interest rates, growth and consumer demand.
3. Style active approach
In this variant of top down investing, the fund manager's biggest call will be on what kind of investing style is likely to deliver the best results at a point in time. Will value investing style work better in a particular market environment or will growth investing be a better idea? As we write this piece, there is a view in the market that this is a good time for value investing, while other prefer GARP - growth at a reasonable price. Value investors like to buy stocks that are quoting at less than their intrinsic value (ie where they get a comfortable margin of safety) while growth investors focus more on the growth prospects of a firm and pay a price for that expected growth. If a fund manager's top down view is that this is the time for value investing, this call will significantly influence the way he casts his portfolio, as he would have in place a number of value filters to screen stocks and make his short-lists.
4. Market cap oriented approach
This is a fairly popular top down approach in our market. The fund manager's top down call here is more influenced by a general pattern he sees in stocks within a market cap group - large caps, mid caps and small caps, than other factors. For example, there are some fund managers who currently hold a view that the best place to invest now with a 3 year view is mid and small caps and not really the large caps. There can be many drivers of this view - relative valuations between large caps and their smaller counterparts being one of them. The overarching decision on casting a portfolio in this approach would be relative allocations to large, mid and small caps and then the next level could get decided with a sectoral approach (macro-economic approach).
Use of top down approaches for advisors
Top down approaches are increasingly relevant for advisors - especially those who manage portfolios of high net worth individuals, where goal-based planning is less relevant in the eyes of many of these investors as opposed to delivering performance on their portfolios. Advisors in practice use the 2nd, 3rd and 4th approach and are now also beginning to see the merits of using the 1st - the country allocation.
When your client expects you to manage his portfolio in a manner that beats the Sensex / Nifty over a 3 to 5 year period, you would in most cases be an active top down manager of his money. Within the overall asset allocation to equity, you may take tactical calls based on your overall market view to be relatively under or over weight equity. You can take a call to allocate a certain portion of the equity portfolio to another geography - the US or China or ASEAN for example, based on a top down country call. Based on your macro economic call, you can decide to allocate money to specific sectoral ETFs that you believe will do better than other sectors. You may decide to allocate money to a value fund, if your top down call is in favour of value at a point in time. You may decide to switch out of a large cap fund and go into a mid or a small cap fund, if your market cap call is in favour of smaller caps. As can be seen, advisors do take from time to time, a number of top down calls in their bid to drive alpha in their clients' portfolios.
As advisors take on the mandate of making top down calls themselves, they would perhaps be better off investing into passive strategies that play to their specific calls, rather than have another active strategy that is employed by an active fund manager potentially clash with their own active call.
There is of course another approach which says that an advisor's job is to focus on financial planning and strategic asset allocation, and leave the nitty-gritties of how to manage the equity component to equity fund managers they trust. It would then be upto the fund manager to decide what strategy he thinks is best in the current market situation, and within the boundaries of the fund mandate he operates within.
At the end of the day, it all boils down to what your client expects you to do and what mandate you effectively take from your client.
Share your thoughts and perspectives
Do you have any observations or insights or perspectives to share on this issue? Did this help you understand the topic better? Do you disagree with some of the observations? Please post your comments in the box below ..... it's YOUR forum !
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