How do Mutual Funds Managers pick Stocks ?

Mutual fund managers are like gardeners who use different techniques to
ensure that the money entrusted to them by the investors, grow and
blossom well. Investors may not know what such techniques are, but may
be keen to get an overview of the methods applied to manage mutual
funds.

Let us take a look at two popular investment methods adopted by mutual
fund managers - the top down investing method and the bottom up stock
picking method. Basically these terms are associated with equity
portfolio management and more specifically they are methods applied for
picking up stocks from the market in a bid to maximize returns on
investments.

What is a top down approach?

Mutual fund managers are assigned the job of investing money in the best
 available equity shares. In doing so, they choose to carry out research
 on the available investment prospects in the market.

What do the mutual fund managers following top-down approach, do?

Mutual fund managers start by studying the global and domestic macro
economic scenario before committing their funds. In simple terms this
means that they analyze how the world economy is shaping up and what it
could look like in the near and distant future. Top down managers also
look at the various other factors, which might have an impact on the
economy and this can include the political scenario, government policies
 and general global trends.

Once this macro level analysis has been done, the mutual fund manager
moves to more specific issues. He concentrates on analyzing the
different sectors within the economy and zeros-in on those specific
sectors that are likely to perform well under the prevailing economic
conditions.

How top-down actually works

Here is an example to explain this strategy. If the fund manager feels
that interest rates are likely to come down in the near future then they
 may seek those sectors that are most likely to benefit from this event.
 Automobile and real estate sectors are definitely going to benefit from
 lower interest rates and thus the fund manager could go on to commit
say 15% of his funds to each of these sectors.

Once it has been decided that 30% of the funds are to be invested in the
 two specific sectors – automobile and real estate, the fund manager
will move to the next stage of the top down approach. Then the fund
manager turns his attention to companies. The manager picks three or
four companies in each sector and analyses the fundamentals and merits
and relative valuations of each company individually.

The essence of top-down approach

In essence a top down approach is about analyzing the economy, followed
by the industry and then the company. The dictum that the top down
manager follows is that a company will do well only if the economic
factors are conducive to the growth and prosperity of the industry or
sector in which it operates.

Industries, which are cyclical in nature benefit from the top down
approach as macroeconomic factors have a bearing on the companies within
 these industries.

What is a bottom up approach?

Unlike the top down approach, the bottom up approach is just the
reverse.

Bottom up approach asks the fund manager to start with company and move
up to the industry prospects and ultimately to the economic forecasts.

Here the focus is more pronounced on the fundamentals of the company,
their ability to cope under diverse economic conditions and the
potential to build upon their growth prospects. It is wrong to assume
that the bottom up manager ignores the macro economic factors; rather it
 is his approach that differs while analyzing the market.

Once the company has been selected, the fund manager will do a scenario
analysis to determine how the company will fare under different economic
 conditions like interest rate change, change in tax laws, change in
price of raw material, etc.

The bottom up stock picker zeros in on a particular company that appears
 to have good potential irrespective of the sector it belongs. The fund
manager’s base criteria for adding the stock of a particular company to
his portfolio is the merits of the individual stock and his faith on its
 prospects.

Top Down or Bottom Up?

Let us look at the salient features of the top-down and bottom-up
approach:

Top down will deliver by picking on the right sectors
Bottom up will yield positive results by picking stocks of the right
companies.
Both will yield profit to the investors form the investments made.

Relative approach to each strategy

The bottom up research is more in-depth in nature and fund managers need
 to perform extensive studies of individual companies to find out the
best ones. This strategy is adopted by those fund managers who have
substantial access to on-ground research resources so that the study is
worthwhile and the correct decision can be arrived at.

Global investors like the FIIs’ usually prefer the top down approach.
This helps them to get their country specific allocations in place and
then they can concentrate on specific sectors within the countries that
they want to invest in.

Besides the FIIs’, fund managers who look to cash in on momentum choose
the top down strategy for their investment decisions. Some economists
feel that the top down approach is high risk-high return strategy as
compared to bottom up strategy that is a more cautious approach.

Conclusion

The actual working of the fund manager is based on a judicious mix of
top down and bottom up approach. The fund manager’s decision to go in
for bottom up strategy usually happens when he has sufficient research
resources to back his study.