Country music icon Johnny Cash was famous for many things, not least his rebellious streak, playing in prisons and wearing black. It’s fair to say he was not known for writing lyrics about manager research.
But for James McGrath, the lyrics of Cash’s hit song I Walk the Line – a pledge to the singer’s new wife to be responsible – contain a lesson for all investors, especially those managing money on behalf of others.
‘There are a lot of distractions out there: new products and some ideas that are more flash than substance,’ he says. ‘Many of them may not lead to good results for the end client.
‘We are fiduciaries for our clients’ assets,’ McGrath adds. ‘We have to be true to our values, stay focused and put their interests first. That metaphor of “walking the line” is a great touchstone as we work to identify the best tools to implement client portfolios.’
Life-long Cash fan McGrath is director of research at Forbes Family Trust and LGL Partners, two multi-family offices that formed a strategic partnership in 2013.
The two firms started life as single-family offices for the Forbes and Lenfest families respectively, both of which made their fortunes in the media.
Despite the sophistication of the firms’ clients, McGrath believes that Cash’s humble, unflashy approach is the right one when it comes to finding investment opportunities.
‘His songs have that characteristic of being more down-to-earth and straightforward,’ he says. ‘And good investment research is practical. It’s not necessarily that sexy or overproduced.’
Understand your manager
McGrath certainly has a very narrow line to walk. He leads a team of seven, which is responsible for the selection and due diligence of a tight recommended list of 12 to 15 mutual funds, 15 to 20 ETFs, 50 limited partnerships (LPs) and three separately managed accounts (SMAs). These are run by 15 to 20 traditional managers and 40 to 50 non-traditional managers and are used to populate customized portfolios for around 60 ultra-high-net-worth families.
The bulk of the $4.5 billion overseen by the firm is in LPs (58%), with 20% in ETFs, 16% in mutual funds and 6% in SMAs.
McGrath co-chairs the investment committee with Bill Luterman, president and chief investment officer of the two firms. He and Luterman have the final say on which strategies are added to or removed from the recommended list.
So, other than humming the Folsom Prison Blues mid-meeting, what can managers do to win over McGrath?
First, there are some ground rules. On the traditional side of the equation, mutual funds and ETFs must have around $500 million, as the firm always wants to hold less than 25% of assets for liquidity reasons.
‘Generally, overall AUM is the best predictor of sufficient liquidity for us to use a vehicle across most of our accounts,’ McGrath says.
As a result, this can lead to well- established names such as BlackRock, Dimensional Fund Advisors and Matthews Asia being picked on the traditional side. However, the rules are more lenient for LPs, meaning that allocations to boutiques are more common here.
‘We don’t use a lot of boutique managers in mutual funds and ETFs, but in hedge funds, I really think that’s one of our competitive advantages in terms of being able to rigorously underwrite some of these boutique managers,’ he says.
‘We do have some allocations to bigger managers in alternatives, such as Renaissance [Technologies], which is a huge manager now, but we have often started analyzing managers with $100 million in the hedge fund space. We make an investment and all of sudden they have $2 billion. That’s actually OK.’
Talk it out
McGrath splits his time evenly between phone interviews and face-to-face meetings with managers, but wants these to be conversations, not lectures.
‘[I don’t like] the meetings where managers are tone deaf and there’s a lot more talking,’ he says. ‘I think that we’re pretty structured, but we’re also pretty conversational.
‘If they have 30 minutes of the meeting that are being run according to their flight plan and they still don’t engage, then that meeting is going to be failure.’
One thing a manager can do to boost their chances is homework, anticipating questions rather than just running through a generic pitch. Often, a good meeting can help to set up a lifetime of mutual respect, McGrath says.
‘One manager that has been pretty effective from that point of view is the master limited partnership manager Harvest Fund Advisors,’ he says. ‘They really went out of their way to be accommodative from a time perspective and almost anticipated the areas we would probe a little bit.
‘We were really thorough and they actually had most of the things we would ask about out on hand.’
McGrath is not the only one impressed by Harvest. Private equity giant Blackstone acquired the firm in October 2017.
‘Basically, a perfect meeting goes like a wedding where you have a wedding planner and you went through the rehearsal. Hopefully, there will be no surprises,’ McGrath says.
He does not consider quantitative analysis a starting point for a search, but rather an ongoing process that is used periodically throughout both the research and due diligence processes.
The team uses a proprietary risk analysis and research platform, which it calls the AlphaBeta system. It focuses on value-at-risk and conditional value-at-risk, spending a lot of time on higher moments of return distributions, he says, because most capital market returns are not normally distributed.
The team also looks at dispersion and statistical deviations from the mean, in addition to factor analysis. This helps them to understand the underlying drivers of returns and allows them to uncover
risks at the standalone portfolio level, McGrath says.
Sticking with it
Another important element of the due diligence process is portfolio manager succession, which McGrath deals with on a case-by-case basis. In some situations he will follow a big name manager after a move, but in others he will stay with the shop and back its succession plan.
Two of the biggest and most acrimonious manager moves of the past decade demonstrate this ad hoc approach. When Jeffrey Gundlach left TCW in 2009, McGrath was happy to follow him to new firm DoubleLine Capital.
‘We were a fairly early investor in the DoubleLine Total Return fund,’ he says. ‘We thought he had a strong edge, centered in non-agency mortgage-backed securities, and was able to build out DoubleLine very quickly with an experienced team. There was continuity from TCW.
‘We liked the strategy and thought he was well-equipped… we’ve actually used that as a complement to the Pimco Total Return fund because they’re both total return but they’re very different.’
The Pimco Total Return fund is another fund where McGrath and his team had to decide whether to stick or twist following the departure of Bill Gross in 2014 for Janus Capital.
‘[Pimco’s parent] Allianz was smart when Gross left, elevating three people who had arguably deserved top billing for years to share oversight responsibility,’ he says. ‘Total Return, in my view, continues to be as solid a choice as it was with Bill Gross. The fixed income markets are different today. Gross was the right guy at the right time, but times change.’
Indeed, as McGrath’s hero once sang, time changes everything.