Reviewing the managers from top to bottom

Top-down fund managers have had a lean time of the past 3-4 years compared to their bottom-up counterparts, notes researcher Angela Ashton. But changing fashions and investment landscapes could easily turn all that upside-down.

As part of our recent Australian Equity Manager Review, we examined performance trends for 28 fund managers, comparing the success of different management styles across an assortment of variables.

Of the 28, 22 were bottom-up managers while six were top-down. Our analysis show that over eight years the top-down managers outperformed the bottom-up managers quite clearly. Yet over three years, bottom-up managers outperformed.

Cumulative excess returns (see graph) show a period of strong outperformance by the top-down managers followed by a period of little value added. Over the same period, bottom-up managers struggled early but have steadily added value since 1994.

To explain this, let's consider the broad economic and market environments during the 1990s.

The most important global economic event of the decade has been the systemic decrease in inflation. Technological advancements have increased productivity, while production in the developed economies shifted to the service sector and their secondary industries emigrated to areas of cheaper labour and land. The Asian crisis and the Japanese slow-down have assisted by decreasing demand and prices for commodities.

The Australian stock market has seen a change in the traditional relationships between industries and stocks. For example, during the 1980s most industries or market sectors showed much higher correlations with the All Industrials Index than in the 1990s.

In other words, it has been a stock-picker's (or industry-picker's) market throughout the decade, particularly since 1994. But this does not necessarily preclude top-down managers from outperforming their bottom-up counterparts over the period.

The best examples of divergent performance since 1994 has been the outstanding performance of large-cap stocks, particularly the banks, and the dreadful performance of resources stocks.

Top-down managers seem to have missed the boat during the most recent 3-year period. Logically, they should be able to make an industrial/resource sector decision better than bottom-up managers, since their investment styles often begin with an overview of the likely direction of international and Australian economies.

Undervaluation of an industry should be more identifiable by examining the economy as a whole rather than each company in it. Part of the re-rating of bank stocks, for example, occurred because the sector was significantly undervalued globally. Mercantile Mutual have held a significant overweighting to banks since 1994 partly due to their top-down view.

So perhaps the top-down managers we surveyed missed some fundamental issues that bottom-up managers picked up. But that might be hasty.

Top-down managers must contemplate the economic future when considering how best to set portfolios to take advantage. The year 1994, however, marked a turning point and the period since has been nothing like the past 20 years.

Structural change and events like the Asian crisis have made it more difficult to assess the environment, so top-down managers have been up against it. It is actually quite difficult to "think outside the square" and those who do are usually discounted by the herd mentality.

Nonetheless, the fall in the number of strong top-down managers in Australia over the past few years is noticeable. Many groups have now shifted emphasis from their top-down inputs to take more account of their bottom-up work.

So future comparisons may be less valid - there will simply be fewer top-down managers. Of course, this trend could be due to the current fashion for bottom-up managers. When the world (or consultants and researchers) swings back to top-down once again, closet top-down managers may re-emerge

And just because the last three or four years have been difficult for top-down managers does not mean the next three or four years will be. If the coming period stabilises and there are fewer paradigm shifts, the top-down approach may return to its former glory of the early 1990's.

<I>Angela Ashton is senior analyst, van Eyk Research.

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