Thread by @SAH16928046

Top-Down Vs. Bottom-Up Style of Investment Analysis: Risk Versus Research Desk Perspectives
@GARP_Risk @CFAinstitute @CQFInstitute

In the field of Investment Risk and Research Analyses, the research/risk analyst has to make a choice between two asset selection and/or allocation approaches.
The first approach is referred to as the “Top-Down Analysis” and the second is its opposite, the “Bottom-Up Analysis”.

Firstly, what is the difference between allocation and selection?

A great deal of differences exists in real terms!!!

RULE OF THUMB =>
Allocations are made after selections are done. Simple.

In Portfolio Management, the investment selection and allocation processes are inextricably linked with one another.

Some academics and practitioners don’t even distinguish between the two phases (stages) of Investment Portfolio Management.
Maybe because both selection and allocation are considered to be the same stage, with huge overlapping in terms of trader semantics.

So, how would you describe the Investment Research and /or Risk Methods employed to select asset classes in financial markets?

How would a Financial institution go about doing this?

Ideally, a Six-step modus operandi is followed by all Investment Research Analysts/Financial Risk Managers at leading Investment Companies (NBFIs) and Retail Banks.

Step 1: Asset Screening / Scanning Strategy from a demarcated universe of asset class/es (Which assets shall be excluded or included within an investment portfolio based on certain quantitative parameters such as Altman Z scores, Betas, duration, VaR, Tracking Error, RAP-Ms etc.

Step2: Asset Selection Strategy (Decision to accept or reject assets)

Step3: Asset Allocation Strategy (Assigning weights within the portfolio)

Step4: Asset Trading Strategy ( This is the holding and liquidation strategy stage. which develops an entry and exit framework for all asset class/es over selected investment horizon/s )

Step5: Asset Performance Analyses and Review Strategy ( to develop risk-adjusted return performance measures to analyse the contribution of the ith asset/s to the Nth Portfolio/s)

Step 6: Asset Re-balancing Strategy (A decision is made by the fund manager to further add or remove the previously selected asset class/es within the portfolio/s)

HOWEVER=>

A word of caution, please !!

I know #MBA grads won't forgive me for repeatedly using the word strategy with each aforementioned stage.

We all know that in the lexicon of Management Sciences the words “Strategy”, “Philosophy”, “Policy”, “Goals”, “Objectives”, “Procedures”, “Best Practices”, “Guidelines”, "Actions", etc. May have different connotations (in an applied sense) from one another.

So to aptly describe our best blogging and coaching intentions, we have used the term “STRATEGY” => (as this implies, putting words and thoughts into “REAL” Action).

In the Financial World, it implies that we are translating our endless paperwork and our mathematical model numbers into real decision-making irrespective of whether we are undertaking “BOTTOM-UP” or “TOP DOWN” ANALYSIS.

Hope that settles it! …. 😉

Now going back to the main theme.

Well, we have a style choice as you know.

Research and /or Risk Analyses can be done using 2 different schools of thoughts, as discussed above.

Each school of thought is accompanied by a plethora of #Econometric Models, Industry Standards, Regulations and another set of academic requirements which make the entire investment analysis modality seem a bit gruesome task (next to impossible for a non-professional investor).

Well, it is.

No wonder, most of us, spend thousands of dollars at some leading US-based “Ivy League” MBA programs and the British“Red Brick” Business Schools to get our fancy degrees in Finance and Economics ;).

But what we probably never learn at the best business school is the difference between Research and #Financial #Risk #Management Professions.

That line has to be drawn in this thread.

I am sure had Wall Street known the difference, there would have been no #Global #Credit #Crises back in 2007!

This is my view, to this day, which you may challenge again and again.

But I stand firm on the following issues!

Risk Manager who undertakes Investment Analyses should focus on the “Downside Potential” (financial risks translated into losses)

The Research Manager who undertakes Investment Analyses should focus on the “Upside Potential” (Alpha/Beta factors translated into positive returns).

Both Risk and Research (i.e. If they exist independently in a firm) should not be encouraged to do the same job.

Otherwise, why have two distinct departmental entities in an office?

Avoid replication of work.
This may also create several operational risks for those managing the Investment Process on the trading floor.

Hence “TOP DOWN” or “BOTTOM-UP” Investment Analysis of proposals will be done differently by both the Risk and Research Managers.
The flow will generally be the same, but the thinking mindset and concepts applied will be contrasting to one another.

We shall discuss that in the tweets below.

IN TOP-DOWN STYLE OF INVESTMENT ANALYSIS :
Analyze the Macro-economy (Headline Inflation, GDP Growth, Output Gaps, Real Wages, Employment, Consumption, Investment, Production, International Trade, Accelerator and Multiplier Effects, Fiscal Policies,

Monetary Policies such as Exchange rates, Interest rates, and Money Supply Trends, Balance of Payments Position, Fiscal and Current A/c Deficits etc.) and its Microeconomic foundations.

-Analyze the Asset Class/es Performances and its Trading Market Micro-structures in general terms.
-Analyze the Sector / Industry.
-Analyze the Firm and its Business Model.

-Analyze the Fundamental Aspects of Listed or Non-listed Financial Security using Book Value, Required Rate of Returns, Price to Earning Multiples, Consensus and Trend Valuation Forecasts, Pre-Tax and Post-Tax Earning Records, Dividend History,

Yield to Maturity/Call/Worst (for bonds and other Fixed Income securities), Free Cashflow Worksheet, EBITDA, EBIT and so on etc.

Analyze the Technical Aspects of a Listed or Non-Listed Financial Security. This may include Charts, Scatter Trend Lines, histograms, Elliot Waves and so on etc.

Any other “Quantitative” Method of analysis allows the analysts or the risk manager to conclude whether the security meets or does not meet the set risk and reward acceptance criteria

The Bottom-Up Style of Analysis is completely the opposite.
You start with an analysis of Financial Security and end up analyzing the entire macroeconomy and other related Macro variables.

Just a difference in computational assessment methodology and style!

Right….got that ??

But but but ..hold your horses!

The Risk Manger ought to be developing the “Risk Matrix” whilst undertaking a top-down or bottom-up analysis.
His or her job is to find and highlight risks (Downside Potential) as he or she moves on from one stage to another!

Hence the risk unit ought to highlight the Credit, Market, Liquidity, Operational, Event, Legal and Other “Risky” threats that are involved in the overall investment decision-making process.

Also, the Risk Manager should ideally show the “Unexpected Loss Potential” and “Extreme Tail Loss Severity” of each Investment “Accept” or “Reject” Decision, irrespective of whether they are using the Bottom-Up or Top-Down Investing Rules!

Please, do note, that it’s not the job of a risk manager to show the “upside potential” in the first case! Avoid this sin to avoid methodical confusion.
Ostensibly, the risk desk should ALWAYS show the “Negatives -” first and leave the “Positives +” to the Research Unit.

The Research Manager on the contrary ought to be developing the “Reward Matrix” whilst studying the Fundamentals such as the Market Timing Points, Earning Multiple Forecasts, Dividend Yields, Macroeconomic and other “Upside Potential” Trends

to enhance the potential to maximize trader profits by adding an asset class/es to a particular portfolio of investments.

The research desk job is to find and highlight Positive Financial (Return) Contributions and market outperformance factors, as they move on from one stage to another!

Hence the research desk at buy-side firms should always be presenting the “Positives +” first and not the “Negatives -“.

Hence by choice of profession, a “Research Manager” tends to be “Bullish” in his judgements and on the contrary, a “Risk Manager” tends to be “Bearish” for reasons explained above.
That's the nature of their Job Description.

Such a state of confusion may exist between Risk and Research Management Desks, as also seen in many institutions, and that tends to harm the entire investment decision-making process due to inefficient applications of data and market bits of intelligence used for deal analysis.

Hence the Punch line is that the Financial Research and Risk Desks should not mix up their roles with one another when analyzing an asset class/es using either of the two investing methods!

The last call on incurring the Risk of Loss Severity belongs to the Risk Desk!
The last call on earning the Promise of Profitability belongs to the Research Desk!
But whose final call will it be?
Ideally, none of the aforementioned.

Let the IC – #Investment #Committee have the last say on all Investment “Accept” OR “Reject” Decisions using either of the two approaches (Bottom-Up or Top-Down).
#ERM #BOD #IAD #Governance

The IC has to put its foot down and analyze all model analytics and arguments, phase-wise (presented by both Research and Risk Desks) in an exhaustive manner!

Hence we shall expect any senior management to always incorporate both downside and upside inputs before signing-off authorizations concerning investment approvals.

The best they can do is to keep the two (Risk and Research Desks) apart from one another by developing proper SOPs-(Standard Operating Procedures).

That's my humble submission to all responsible FIs!

Take care until we meet again to discuss another contemporary issue in the life of a risk manager.

Hope you can give me your opinion as always.

Hint: you may also read excerpts from => (en.wikipedia.org/wiki/Investmen…) to further improve your understanding of roles of different departments that generally exist in a Financial Institution such as an Investment Bank.

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