19-EquityPort Page 566 Friday, March 12, 2004 12:40 PM
566 The Mathematics of Financial Modeling and Investment ManagementACTIVE INVESTING
In contrast with passive investing, active investing makes sense when a
moderate to low degree of capital market efficiency is present in the
financial markets (or areas thereof). This happens when the active inves-
tor has (1) better information than most other investors (namely, the
“consensus” investors); and/or (2) the investor has a more productive
way of looking at a given information set to generate active rewards.
In general, active strategies can be classified as either a top-down
approach or a bottom-up approach. We discuss each approach below.Top-Down Approaches to Active Investing
Before delving into the “top-down” active approach to investing, we must
first reflect on the different connotations of top-down investing. In princi-
ple, one can distinguish between three types of top-down investing—one of
which is passive, while two are active. We’ll first explain the top-down pas-
sive connotation. Specifically, we know that modern portfolio theory
emphasizes that investors should hold efficient portfolios. As we explained
in Chapter 16, an efficient portfolio is one that maximizes expected return
for any given level of expected risk. The MPT framework can in turn be
viewed as a top-down passive approach to investing because an investor is
only concerned with portfolio choices—albeit efficient ones at that—rather
than stock selection choices by company, industry, and even market sector.
Indeed, the top-down maximization of expected portfolio return for a
given risk level occurs without any direct interest by the investor in the
specific names of companies that comprise the efficient portfolio—other
than to say that an individual company, industry, or sector has the poten-
tial to enhance portfolio return and reduce risk through efficient diversifi-
cation. Since an efficient portfolio—such as the market portfolio—is a
passively constructed portfolio, one must therefore be careful to distin-
guish between top-down passive investing and top-down active investing.
Given the amount of the portfolio’s funds to be allocated to the
equity market, the manager must then decide how much to allocate
among the sectors and industries of the equity market. In making the
active asset allocation decision, a manager who follows a macroeco-
nomic approach to top-down investing often relies on an analysis of the
equity market to identify those sectors and industries that will benefit the
most on a relative basis from the anticipated economic forecast. Once
the amount to be allocated to each sector and industry is made, the man-
ager then looks for the individual stocks to include in the portfolio. The
top-down approach looks at changes in several macroeconomic factors
to assess the expected active return on securities and portfolios. As noted