Top-down Strategies

Instead of picking individual stocks, top-down managers use broad market ETFs and contracts linked to financial instruments to adjust their portfolios. They put more money in markets they expect to do well and less in those expected to perform poorly.
Here are some ways top-down managers categorize markets:

• Country/geography.
• Industry/sector.
• Volatility (by way of derivatives).
• Thematic investment strategies (blockchain, clean energy, etc.).

Top-down country/geography allocation can be combined with insights from a fundamental bottom-up approach, which values a market based on aggregating individual companies.

Structured products and ETFs have made it easier for managers to implement passive factor investing (also known as smart beta). This allows targeting specific styles or sectors when they are expected to outperform without replicating an entire index.

Smart Beta

At first, the CAPM theory said investors who take on market risk (beta) should earn a return based on that risk. Later, the CAPM model added more factors, such as size and value.

Smart beta is like a further step from those ideas. If certain factors can predict returns well, managers add them to their strategies.

So, smart beta is a type of top-down analysis. It looks at basic factors that drive returns, unlike bottom-up analysis, which focuses on finding individual stocks that are priced incorrectly.

Question

Smart beta can most appropriately be thought of as an extension of?

1. The Black-Scholes Merton Model.
2. The original CAPM Model.
3. The H-model.

Solution

The correct answer is B:

Smart beta is similar to the idea of a CAPM model. However, instead of using Beta as the sole factor driving equity returns for the individual security, other factors are added.

A is incorrect. The BSM Model is used for options pricing and is not a relevant starting point for discovering individual equity investment factors.

C is incorrect. The H-model is used to value equities with alternating super growth and normal growth periods.

Reading 25: Active Equity Investing: Strategies

Los 25 (c) Analyze top-down active strategies, including their rationale and associated processes