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Investment insights

Asset allocation: Top down, or bottom up?

Within a multi-asset class balanced portfolio, there are different ways to manage the asset allocation. Some managers prefer to follow a ‘top-down’ strategy, others a ‘bottom-up’ approach. It is also possible for a manager to implement a combination of a ‘top-down’ and ‘bottom-up’ approach.

‘Top down’ begins with an assessment of the economic environment

Investors tend to be more familiar with a ‘top-down’ process. This process typically begins with an assessment of the overall economic (macro) environment. Variables such as inflation, interest rates and economic growth are forecast and then, based on this information, a decision is taken as to which asset classes to invest in – and in what proportions. As a result, one team (or individual) is responsible for the asset allocation and another team (or individual) for selecting securities within the asset class. The team selecting the securities can only do so to the extent of their allocation, as determined by the asset allocation team. As a result, there may be dissociation between stock selection and asset allocation.

‘Bottom up’ focuses on the attractiveness of assets

A bottom-up asset allocation process, on the other hand, focuses on building a portfolio of assets based on the attractiveness of those assets. The asset allocation is the result of the individual securities that the manager finds attractive from a bottom-up perspective. This process links the asset allocation process to the stock selection process and the portfolios have a higher weighting to those securities that the manager finds attractive and less to those they don’t. This is different to the ‘top-down’ approach where the asset allocation is determined by a ‘top-down’ view rather than a view of the attractiveness of the individual securities.

It is important to note that because a ‘bottom-up’ process is driven by the attractiveness of individual securities, it is possible that there may be times when for example, despite the stock market being expensive on the whole, a manager may still have a high weighting in equities if he or she can identify sufficient shares that are still cheap relative to the other securities.

From an equity perspective, to the extent that the manager can find attractively priced equities relative to other securities, their portfolio will have a higher exposure to equities. When equities are expensive relative to other securities, the manager will ‘retreat’ to those securities that he or she believes are more attractive than equities. The manager’s overall equity weighting would thus be the result of the number of shares that he or she finds attractive in the market at a point in time rather than a macro view on equity markets.

Bottom-up stock selection also influences the manager’s relative sector weightings

If the manager is able to find a number of attractively valued stocks in a particular sector, he or she will naturally have an overweight position in that sector. This won’t be a result of an active decision to have an overweight position relative to a particular benchmark; rather, it will be the result of the bottom-up stock selection process finding attractive investment opportunities in that sector relative to others.

This bottom-up approach allows a manager the freedom to pay little attention to benchmarks and starting from a clean sheet, to pursue investment opportunities in which he or she has the highest conviction. This process works well for multi-asset class portfolios as the manager is able to invest in those individual securities that he or she believes are the most attractively priced. Where a manager is given a specialist mandate, their ability to select the most attractive assets across all asset classes is removed. In an equity-only mandate for instance, the manager is forced to hold the equities he or she finds most attractive on a relative basis, even if he or she believes equities do not offer fundamental value or are expensive relative to other asset classes such as bonds or cash.

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