Top down investment approach, also known as macro-driven investment approach, refers to a systematic investment approach that starts from macroeconomic analysis. It examines the global economic landscape first, then drills down step-by-step to country analysis, industry analysis, and finally company-specific analysis. This approach allows investors to identify attractive investment sectors and individual securities that are poised to benefit from macroeconomic tailwinds. The top down approach is commonly used by large institutional investors like pension funds, endowments, sovereign wealth funds etc. It stands in contrast to the bottom up approach which focuses intensely on individual company analysis. In this article, we will dive deeper into the top down investment approach and walk through an example.
Top down approach starts with macroeconomic analysis
The top down investment approach starts by examining major macroeconomic factors like GDP growth, inflation, interest rates, fiscal and monetary policies. The investors identify key macro trends, business cycles, and inter-country dynamics. For example, an aging population in developed countries may suggest increasing healthcare spending and attractive investment opportunities in healthcare sector globally. Or rising interest rates in the US may point to potential currency appreciation and decreased competitiveness of US companies. Such macro analysis allows investors to determine high-level sectoral and geographic allocation of their portfolios.
Top down approach follows a systematic process
After initial macro analysis, the top down approach follows a very systematic process of narrowing down investment targets:
1. Analyze global macro trends and identify attractive countries/regions based on growth prospects, policy environment etc.
2. Conduct analysis of specific industries and sectors within those attractive geographies. Identify sectors poised to benefit from positive macro forces.
3. Analyze individual companies within the attractive sectors shortlisted from previous steps. Look for strong fundamentals, competitive advantages, growth runways etc.
4. Construct portfolio by selecting individual stocks that made it through the filtering process. Manage risk through prudent diversification.
Top down approach example
Here is an illustrative example of the top down investment approach:
Macro analysis indicates rising inflation globally due to supply chain constraints. This motivates investors to seek inflation-hedging assets like real estate, infrastructure, commodities etc.
Analysis of Asia region points to strong post-pandemic demand recovery and growth in countries like India. Infra sector stands out as a key beneficiary of strong growth.
Analysis of Indian infrastructure companies shows several well-run firms with strong order book and execution track record.
Final portfolio includes stocks ofselect infrastructure companies in India that fit the initial macro thesis.
Top down approach allows exploiting macro trends
The top down approach provides investors a systematic framework to exploit macroeconomic trends and cycles. For instance, it allows investors to increase weighting in inflation-benefiting commodities when inflation is high globally. Or increase exposure to export-oriented sectors when dollar is weakening. Such flexibility to adapt to evolving macro landscape is a key benefit of the approach.
Caveats of top down investing
While useful in many ways, the top down approach also comes with some limitations:
– It is dependent on accurate macro forecasting which is very difficult. Errors can impair the entire analysis.
– Can miss out on specific investment opportunities that do not fit the macro narrative.
– Involves periodic restructuring of portfolio as macro environment evolves. This can increase transactions costs.
In summary, the top down investment approach offers a systematic framework to investors to construct portfolios aligned with macroeconomic trends. It involves analysis of macro factors, regions, sectors and companies in a step-by-step manner. While powerful, the top down approach also requires accurate macro forecasting and periodic restructuring which pose headwinds.