With tens of thousands of securities in the investment universe, how do you decide which ones to own? One way is by taking a top-down approach.
Among professional investors, there are two schools of thought. The bottom-up method emphasizes share selection. Investors choose what to buy based on a set of criteria like fast sales growth or low prices relative to earnings. For example, bottom-up fixed interest investors might seek securities with a given yield or credit rating.
That’s one strategy. To Fisher Investments Canada, the top-down method is viable too, and underappreciated.
Here, we start by determining an asset allocation—how much of your portfolio to place in equities, fixed interest, cash or other securities. In our view, this decision should be based on your long-term financial goals, ongoing cash flow needs, time horizon (defined as the length of time your assets must be invested to reach your goals) and risk tolerance.
After this analysis, we gradually narrow the universe with a series of filters.
The first filter is your benchmark, generally a broad equity or fixed interest index (possibly a blend of the two). This serves as your blueprint for portfolio construction and a measuring stick for performance.
The index should match your targeted asset allocation. For equities, we think a global index like the MSCI World is optimal, providing many opportunities for diversification. Companies are weighted according to their size. That simplifies an assessment of whether you may own too much or too little of a sector, category or single security. For fixed interest, Bank of America Merrill Lynch Canada Broad Market Index is an example of a commonly used, well-diversified index.
Once you have a benchmark, a next step is formulating and applying your outlook for markets. We think your portfolio should closely resemble the benchmark in terms of the share of equities and fixed interest you own. (Unless you forecast the most extremely negative scenario—a fundamentally driven equity decline of 20 per cent or more, often called a bear market.)
This is the most important decision you can make, Base your asset allocation decision on return expectations, including bad stretches. Deviating often can jeopardize earning the return needed to fund your goals.
That’s one filter. The second looks at the broad subcategories within asset classes. For equities, categories include sector, country, size and style (such as growth or value).
By spreading assets across categories, you are less likely to be overexposed to any one area. This reduces the potential impact if markets go against you. You don’t have to mirror the benchmark. Instead, you can analyze the benchmark’s sector and country weights. So you might end up owning more than the benchmark in areas you expect to do better (overweighting), and owning less in areas you expect to trail (underweighting).
Your benchmark can serve as a useful guide here, too. The MSCI World Index is 16.1 per cent Technology. If you are optimistic on Technology, you might decide to own a few percentage points more. Meanwhile, Industrials represents 11.2 per cent of the index. If you aren’t as keen on that sector, you may decide to own a bit less.
The same approach applies for geographic allocation. Eurozone and Japanese equities represent 11.2 per cent and 8.0 per cent of the MSCI World Index, respectively. Based on your outlook, you may choose different weightings, allocating more towards areas you favour and less towards those you don’t. Always be mindful of the risk of straying too far from the benchmark. For size considerations, we find it helps to use the average size of companies in the benchmark as a reference point.
Within fixed interest, you might want to filter selections by debt-security type. Choosing national government, international government, corporate and, in some cases, local debt narrows options. Here, your outlook for interest rates and inflation is key, as debt prices move opposite rates. Government debt is highly subject to interest rate pressures, while corporate debt is less so; profitability of the company matters, too.
You may also want to weigh your economic outlook. Why? Lower-quality corporate debt can be at risk of defaulting—missing principal or interest payments—if the company’s finances are pressured in a recession.
The third filter involves considering how categories in the second filter overlap, and narrowing down from there.
Within equities, cross-referencing sector and country picks within the index can guide you. For instance, if you want to overweight Technology you probably want to consider exposure to the U.S., where most of that sector is domiciled. You can fill out your European exposure with other sectors, like Health Care and Industrials. Let’s say you choose to get Industrials exposure from Germany. That narrows the field from 285 companies within the index globally to just 10 in Germany’s Industrials sector.
Finally, compare individual securities within sub-categories. That can help you decide which to own.
In equities, we think assessing potential security-specific risks can help eliminate some options, likely narrowing choices even further. Eliminating outliers within a category—those performing vastly different than peers—also helps investors hone in on selections.
In fixed interest, credit quality (the borrower’s willingness and ability to repay) is important to us, particularly within corporate debt. Assessing covenants (certain requirements issuers must meet) also helps to further narrow the field.
There are a range of factors to consider when building a portfolio. It’s smart to apply a process systemically. One that narrows the pool of securities, like the top-down method, can help you formulate an investing philosophy you can use for life.
Fisher Asset Management, LLC does business under this name in Ontario and Newfoundland & Labrador. In all other provinces, Fisher Asset Management, LLC does business as Fisher Investments Canada and as Fisher Investments.
Investing in stock markets involves the risk of loss and there is no guarantee that all or any capital invested will be repaid. Past performance is no guarantee of future returns. International currency fluctuations may result in a higher or lower investment return. This document constitutes the general views of Fisher Investments Canada and should not be regarded as personalized investment or tax advice or as a representation of its performance or that of its clients. No assurances are made that Fisher Investments Canada will continue to hold these views, which may change at any time based on new information, analysis or reconsideration. In addition, no assurances are made regarding the accuracy of any forecast made herein. Not all past forecasts have been, nor future forecasts will be, as accurate as any contained herein.
[i] Source: FactSet, as of 12/4/2019. MSCI World Index sector breakdown by market value on 12/4/2019.
[iii] Ibid. MSCI World Index country breakdown by market value on 12/4/2019.
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