Types of Active Management Strategies: Top-down

If you've ever been to the top of the Burj Khalifa in Dubai, you're definitely not afraid of heights, as it's one of the tallest buildings in the world at over 2,700 feet. From that vantage point, you can most likely see for miles and miles. So how might you describe the number of focus points on a clear day?

Incorrect. If you can see for miles, there's going to be more than a few focus points.

Not quite. This is the tallest building in the world, so there's more than just an average number of focus points.

Exactly. From 2,700 feet up, you can see practically forever, so there are numerous focus points for you to see. And as you can already gather, this is similar to starting top-down analysis. Unlike bottom-up analysis, top-down analysis starts at the macro level, with variables like the business environment, demographic trends, and government policies. Many times, top-down managers are using ETFs, swaps, and custom portfolios to capture macro catalysts and generate excess returns. In fact, some managers will even mix top-down and bottom-up strategies together by establishing a target country and sector weights and then selecting stocks within these preset ranges.

In detail, there are several different approaches to top-down strategies. First, investors can focus on specific geographic regions depending upon their views of the region's prospects. In addition, top-down managers can study the overall supply and demand of equities in particular regions or countries. This type of analysis involves investigating investment fund flows, the volume of public offerings, and secondary share issuances. What else might help managers analyze the supply and demand of equities?

No. Dividend yields don't impact the supply and demand for equities.

That's not it. The return on equities doesn't factor into the number of shares outstanding.

Top-down analysis can also be extended to sectors and industries. For example, a manager may view a particular industry as having better prospects than others. Then top-down analysis can be applied to identify whether or not the industry is focused within a specific country (or countries) or if the industry operates at a global level. One example of a global industry would be energy, as it is traded worldwide. But think about more localized industries. Which of the following would be a local industry?

Definitely not. Technology is rapidly expanding around the world and making global finance more interconnected.

That's right. Real estate is an example of a localized industry because it's not transported around the world, so it's country specific. To aid in building these types of exposures, ETF creators have made sector and industry ETFs that allow managers to implement sector and industry rotation strategies. In addition to sector/industry strategies, top-down analysis can be extended to volatility-based strategies through the use of derivatives like futures, index options, or volatility swaps. In particular, investors can use straddle strategies where a call option and put option are purchased on the same index with the same underlying strike price and expiry date. This limits the max loss to the premiums paid for the options.

No, actually. In the global economy, food is shipped around the world for consumption.

Finally, top-down investing includes thematic investing, which uses broad macroeconomic, demographic, or political drivers to reveal investment opportunities. Essentially, thematic investing focuses on a specific theme to identify new investment ideas. These could include new technology, regulations, innovations, or economic cycles. However, this approach is not without specific risks, since some trends can be long term in nature while others only last for a short period. Think about the difference in these types of trends. Which of the following would be an example of a short-term opportunity?

Incorrect. Robotics is a long-term trend as it improves production and efficiency.

Incorrect. Smartphones have revolutionized communication, and increasing productivity is a long-term benefit.

Yes! Currency fluctuations usually last only a short time and with the help of interest rates will tend to revert any gains made, so this is strictly a short-term opportunity. This highlights the risks of using thematic investing in identifying specific themes, as the time horizon must match the trading opportunity. For this reason, most thematic investors are currently focused on new technologies, communication advancements, clean energy, FinTech, and medical advances. Speaking of risks—in many cases, bottom-up approaches to active management should be paired with top-down analysis to ensure that macro exposures are properly aligned. This can be achieved through a portfolio overlay—a mix of derivative positions that are managed separately from the portfolio to ensure that the portfolio weightings and exposure align with the manager's intent, the client's risk tolerance, and/or the benchmark's weightings.

To sum it up: [[summary]]

Correct! Share buybacks impact the number of shares outstanding within the market, so that's another key part of the analysis of equity supply and demand.

Minimal

Average

Substantial

Dividend yields

Returns on equities

Aggregate value of share buybacks

Real estate

Technology

Food and agriculture

Robotics used in production lines

Smart phones increasing productivity

Currency fluctuations leading to increased sales

Continue

Continue