The top down investment approach is a method used by large investment firms and asset managers to identify market opportunities. By analyzing macroeconomic trends, major events, and industry cycles, investors can determine which sectors or asset classes may outperform. This approach typically begins with a broad macroeconomic outlook before progressively narrowing focus to region, country, industry, and finally company-specific factors.
Large firms such as BlackRock, Vanguard, and Wellington employ entire teams of economists, strategists, and analysts to formulate an investment thesis using the top down methodology. For example, expectations for rising inflation and interest rates may lead a firm to overweight commodity producers and underweight growth stocks. The firm would then analyze leading companies in the materials and energy sectors as potential investments. Throughout this process, the higher level investment approach directs the security analysis and selection.
Macroeconomic analysis identifies broad market themes
The first step of the top down approach involves assessing the global economic environment, including factors like GDP growth, currency moves, fiscal and monetary policies. This stage aims to determine the current market cycle phase and expected trajectory over the medium term horizon. A team of economists develops projections for growth, inflation, interest rates, etc. that serve as inputs to the sector selection process. Currently, for instance, persistently high inflation has become a dominant theme influencing investment decisions.
Major events shape expected returns across asset classes
Beyond macro trends, discrete events can significantly impact asset prices and expected returns. Examples include elections, global trade disputes, regulatory changes, and exogenous shocks like COVID-19. Around these watershed moments, investment managers adjust their asset allocation models to favor asset classes likely to benefit. The pandemic led to a rush towards bonds, gold, and growth stocks, while value sectors lagged. More recently, defense and energy stocks have outperformed on geopolitical turmoil.
Analyze how industries fit within business and market cycles
The industry analysis phase takes a deeper look at how sectors are positioned within long-term business cycles as well as shorter market cycles. Cyclical groups like materials and industrials tend to outperform early in an economic expansion when activity rebounds. Defensive sectors like healthcare and staples hold up better late in the cycle. This analysis results in over- and underweights to certain sectors depending on their expected returns over the investment horizon.
Screen for leading companies based on competitive position
After identifying attractive sectors, the investor screens for well-positioned companies based on criteria like market share, balance sheet health, valuation, and management quality. For example, top down investors favoring commodities may further analyze potential investments in oil majors like Exxon and Chevron or metals miners like Rio Tinto and BHP. Stock selection combines a qualitative assessment of competitive position with a quantitative screen based on projected earnings growth and other metrics.
The top down investment approach used by large asset managers and hedge funds provides a framework for developing market views that ultimately guide security selection. By weighing macroeconomics, major events, business cycles, and industry trends, investors seek to overweight asset classes and stocks likely to outperform the broader market over their timeframe.