Personal Investing
Cameron Ho, Fidelity Personal Investing 14 Mar 2017 05:26pm

Bottoms up!

SPONSORED FEATURE: Most of the fund managers we interview stress their "bottom-up investment approach" so frequently that the term is almost cliché. If active managers are supposed to be creative thinkers who beat the market by seeing and doing what others miss, why are their marketing messages so banal?

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Caption: Why fund managers love to take a bottom-up approach.

Because according to a new study, a bottom-up approach - picking the most attractive stocks regardless of industry or country - is what delivers the lion’s share of outperformance.

In Global Equity Fund Performance: An Attribution Approach, three Australian academics and a Russell Investments strategist analysed the performance of 143 global equity funds between 2002 and 2012.

They found that the average global equity fund manager outperforms their benchmark by 1.2% to 1.4% per year before fees. And by unpacking this headline figure into its constituent parts, they determined that ‘bottom up’ stock selection contributed the bulk (0.9%) of the outperformance.

Crucially, the authors found that managers could beat their benchmarks by picking stocks in both developed and emerging markets. Active managers have recently come under fire for being unable to pick winning stocks in developed countries such as the United States. Their troubles have been attributed to these stock markets’ high degree of competitiveness and efficiency; thousands of highly skilled, well-equipped investors have access to the same information at the same time, so it is hard for one to gain an "edge". But the study’s results suggest that successful stock picking is possible across the developed markets of Japan, North America, Europe, and the Middle East.

Currency effects had a mixed effect on performance overall. The depreciation of the pound against the dollar has recently boosted the performance of sterling-denominated funds who invest in the US. But for the study’s sample of global equity funds, the implications of investing in foreign currencies was "if anything … marginally negative". The authors concluded that significant currency risk affects most global equity portfolios, and that investors should consider protecting themselves against currency exposure via hedging. This is consistent with Tom Stevenson’s preference for the hedged version of the Schroder Tokyo Fund, which is on the Select 50.

Country selection, which forms part of the "top-down" approach to investing (identify the best countries then choose the stocks), only made a small contribution to outperformance. In their view, the ability to identify the most promising regions is a skill ‘not broadly held among global equity managers’, and investors should thus be wary of fixating on a top-down approach.

That isn’t to say that top-down is a wholly unsuitable investment strategy. Dan Nickols of the Old Mutual UK Smaller Companies Fund is a notable proponent of blending top-down and bottom-up approaches. Similarly, top-down lends itself well to other asset classes. Bond investing, which depends more heavily on interest rates, inflation, and other macroeconomic factors, benefits from a high level view. So too do absolute return funds, which buy baskets of stocks instead of individual companies, and which also bet on economic trends such as changes in interest and exchange rates.

References

Gallagher, Harman, Schmidt, and Warren. ‘Global Equity Fund Performance: An Attribution Approach’. Financial Analysts Journal (First Quarter 2017).

Cameron Ho

Cameron Ho

Cameron Ho graduated from Exeter University with a degree in Middle East studies in 2015. He joined Fidelity in September 2016, and currently writes about funds.

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