Mutual fund managers use a variety of investment strategies and criteria when selecting their assets. Managers can choose from many different investment strategies, so when choosing an investment fund, look carefully at the manager’s investment style to ensure it suits your risk-reward profile.
“Investment style is incredibly important because of the way investing works,” says Chris Geczy, professor of finance at the Wharton School of the University of Pennsylvania. “Both risk and return are linked to style. According to current practical portfolio theory, you can optimize a mix of styles for diversification, balancing reward and risk.”
Here is an overview of six popular investment strategies among fund managers.
Top-down investing
Top-down investment strategies involve choosing assets based on a macroeconomic theme.
For example, if a fund manager expects the economy to grow sharply, he or she can buy stocks across the board, or the manager can simply buy cyclical stocks in certain economic sectors that he or she thinks will do particularly well.
If the manager expects the economy to slump, this may prompt him to sell or buy stocks in defensive sectors such as healthcare and consumer staples.
“The big advantage of top-down is that you look at the forest instead of the trees,” says Mick Heyman, independent financial advisor at Heyman Investment Counseling in San Diego.
Of course, managers can be wrong about their big idea. And even if they are right, that doesn’t mean they will choose the right investments.
“A good example is gold,” says James Holtzman, president and CEO of Legend Financial Advisors in Pittsburgh. “That would make sense for a top-down investor. But what if you look at a gold mining stock and the company gets run into the ground? The stock in question could be on the verge of collapse, even if investing in gold makes sense.”
Bottom-up investing
Bottom-up managers choose stocks based on the strength of an individual company, regardless of what is happening in the economy as a whole or the industry in which that company is located.
A bottom-up manager benefits from thorough research into an individual company, and a good manager can sometimes find attractive investments even in out-of-favour sectors. Often the best investments are found where ‘the baby has been thrown out with the bathwater’.
While bottom-up investing can help managers identify good investments with upside potential, it may not prevent losses in a down market. A market downturn often drags down even the strongest investments, but over time, an individual company’s strong fundamentals can lead to attractive returns.
Fundamental analysis
Fundamental analysis involves evaluating all business factors that influence the performance of an investment. For a stock, this would mean reviewing all of the company’s financial information, and it could also involve meeting with company executives, employees, suppliers, customers and competitors.
“You want to analyze the management, really understand what drives the company and where the growth is coming from,” says Heyman.
Most managers emphasize fundamental analysis because they want to understand what will drive growth. For example, investors expect the stock to rise if a company grows earnings. So it’s important to understand whether a company is well poised for growth in order to predict the future direction of its stock. Managers will also look closely at the valuation to understand whether they are paying an attractive price for the company.
But the fundamental factors are not always decisive.
“There may be a period where the market moves on a technical level,” Holtzman says.
Technical analysis
Technical analysis involves choosing assets based on past trading patterns. Technical analysts look at the trends of an investment’s price rather than the fundamentals of the company.
Heyman sees power in technical analysis because he believes that the price of an asset at any time reflects all available information.
However, technical analysis does not provide a holistic view of what is happening ‘under the hood’. Technical analysis does not include the underlying driving forces behind what affects the price of the asset, for example economic forces or business developments within a particular sector.
The best managers use both fundamental and technical data, says Holtzman. “If a stock has good fundamentals, it should be stable to rising. If the price doesn’t go up, the market is telling you that you are wrong, or that you should focus on something else.”
Contrarian investing
Contrarian managers choose assets that are out of favor. They determine the market consensus on a company or sector and then bet on it if the investment case indicates that they should do so.
The contrarian style generally aligns with a value investing strategy, one that involves buying assets that are undervalued by some statistical measure, says Wharton’s Geczy.
“Over the long term, value has beaten asset growth around the world, but in certain periods that is not true,” he says. “The contrarian style tends to reward investors, but you have to choose the right assets at the right time.”
The risk, of course, is that the consensus is correct, resulting in wrong bets and losses for a contrarian manager.
Dividend investing
As the name suggests, dividend funds buy stocks with a strong track record of earnings and dividend payouts. Due to the stock market volatility in recent years, many investors are in favor of the idea of a fund that offers them a regular payout.
“Even if the price goes down, at least you get some income,” said Russ Kinnel, director of manager research at Morningstar. “It’s a nice way to supplement your income in retirement.”
However, beware of funds with extremely high returns. That could be a sign that companies are taking excessive risks and heading for a decline.
Things to consider when creating an investment strategy
- Diversification
- As the experts pointed out above, it’s a good idea not to keep all your eggs in one basket. Investing across different sectors and different types of assets is an important first step in determining the strategy for your investments.
- Active versus passive investing
- You will have to decide whether you want to actively participate in your investments on a daily basis or prefer to invest passively, taking a buy-and-hold approach. Here are other important differences between passive and active investing.
- Asset allocation
- Your asset allocation – how much you have invested in different asset classes such as stocks, bonds and even cash – makes a big difference in your performance. For example, an investor who invests entirely in bonds will achieve a different return than an investor who invests entirely in shares. Fund managers allocate assets to their clients based on their objectives, and it’s important to know how they do that.
- Time horizon
- Another important aspect of any investment strategy is the time horizon. Asset managers and individual investors can allocate investments based on how quickly they need their money. Money that will be needed soon should be invested in safer assets such as CDs or bonds, while investors with a longer time horizon can wait for the higher but more volatile returns on stock investments.
Most experts recommend diversifying between investment styles.
“Ultimately, a balanced way of looking at things results in fewer mistakes,” says Heyman.
In short
There are different investment strategies that fund managers use to allocate your money, and it is important to choose a fund or manager that aligns with your personal investment goals. Whether your fund manager focuses on technical analysis or fundamental research, getting to grips with a fund’s investment strategy can help you make better investment decisions.
Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making any investment decision. In addition, investors are advised that the past performance of investment products does not guarantee future price increases.
