Health Care and Utilities and Technology

BULLS & BEARS: How managing investments works from the top down

February 14, 2005

Another variation of the asset allocation and diversification theme that is common on Wall Street is what's called a "topdown" investment strategy to manage a portfolio.

Investors who practice this sort of money management are generally more concerned with the economic outlook and its effect on various "market sectors" than the business fundamentals of a particular company. The Standard & Poor's 500 index is the most commonly used measuring stick for the investment performance of many mutual funds and money managers. This index, for the most part, is composed of the 500 largest publicly traded companies in the stock market. Each of the 500 companies in the index is classified into one of 10 sectors, which are further subdivided into various industries. The weight of each sector in the index is simply determined by the cumulative market value of all the stocks in the particular sector divided by the $11.7 trillion market value of the entire S&P 500 index. Here are the 10 sectors of the S&P 500 and, in parentheses, the number of companies in the sector and their present sector weight in the index: financials (82 companies, 21 percent weighting) information technology (80, 16 percent) health care (55, 13 percent) industrials (57, 12 percent) consumer discretionary (87, 12 percent) consumer staples (36, 11 percent) energy (28, 8 percent) telecommunications services (10, 3 percent) materials (32, 3 percent) utilities (33, 3 percent). By overweighting or underweighting various sectors, the money manager hopes to outperform the index. For example, in 2004, the S&P 500 had a total return of 10.9 percent, but the energy sector returned 28.8 percent. Thus, an investment manager who significantly skewed his/her holdings toward oil and gas stocks in 2004 stood a good chance of outperforming the index return last year.

Using a top-down investment approach, the investment manager may hold the view that oil prices will continue to remain high. In this case, the fund manager will "overweight" the energy sector by purchasing a basket of oil stocks selected from the 28 energy companies in the index.

The manager will make sure the cumulative value of the oil stocks selected exceeds an 8-percent weighting in the total portfolio. And, to offset this overweight in the energy sector, the manager may underweight, say, consumer staples where his/her outlook is less enthusiastic.

Unfortunately, a top-down approach can often lead to a manager's playing things close to the vest with a tendency to not stray too far from the actual weightings of each sector. Betting too heavy on one particular sector can sink the performance of the overall portfolio. For example, the health care sector has been a longtime favorite of the Wall Street pundits, yet last year the sector had a total return of less than 1 percent.

With the financial industry's focus on quarterly results, many investment managers figure there is too much at risk if they stray too far from the performance of the market index.

Once again, we would point out that the investor at home can replicate a top-down strategy by investing in a low-cost index fund and supplementing this with a few individual stocks selected from a market sector the investor likes.

The top-down approach is considerably different from our firm's approach to investment management, which Wall Street labels a "bottom-up" investment philosophy. In our firm, analysis of an individual company's business fundamentals drives the investment decision, not the outlook for any particular economic sector.



Skarbeck is managing partner of Indianapolis-based Aldebaran Capital LLC, a money-management firm. Views expressed are his own. He can be reached at 818-7827 or ken@aldebarancapital.com.
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