Top-down and bottom-up approaches of portfolio construction

Gone are the days of casually investing in mutual funds, today's investors need to know how to create a portfolio of funds and what are the strategies and approaches used to construct a portfolio. This article deals with the two basic approaches used to construct mutual fund portfolios.

Top-down approach

The top-down approach is nothing but starting from bigger thing to smaller aspects. That is this approach includes at looking at the macro factors like GDP, economic growth, interest rates, inflation which defines the economic condition firstly, and then at micro factors. Here the fund managers analyses the segment and sectors which are doing well or are expected to do well as per the economic environment and then segregates the companies or stocks within that sector.

Bottom-up approach

On the contrary, the bottom up approach considers micro aspects first and then macro aspects. This approach focuses on the individual attributes of the company considering its strong attributes. Here the fund manager picks the fundamentally strong stocks which are financially strong and have good cash flows and sound management  considering their valuation. This approach believes in the performance of the company based on its attributes more than the economic environment.

Fund managers of the mid-cap and small-cap schemes usually follow bottom-up approach for portfolio construction. The primary reason behind this is the volatility in the earnings of the mid-cap and small-cap companies due to which it becomes very important for them to look into the financials of these companies. A top-down approach suggests a strong sector, but a poor company among that sector can underperform. On the other hand, the fund managers of the large-cap funds follow the top-down approach as the sector growth suggest the overall growth of these blue-chip companies, so the choice becomes easier for them. However, both of these approaches have their own risks, so the investor should check the portfolio well and then only  make his investment decision.