INVESTOR PROFILE

New Jersey doubles allocation to alternatives

New Jersey’s public pension fund is looking to almost double its allocation to alternatives, particularly hedge funds, lifting that allocation to a third of its assets, and is scaling back on equities despite it being its best performing asset class this year.

The $74.7 billion fund recently released its 2012 asset allocation targets, which reveal a proposed long-term goal to allocate 33.2 per cent of the fund to alternatives.

New Jersey’s pension fund, which is providing benefits for more than 780,000 members, is set to record a strong result this financial year, achieving a 18.16 per cent return for the financial year to the end of May.

The fund currently allocates 17.3 per cent of its fund to alternatives. Of that amount hedge funds make up 5.3 per cent, private equity 6.7 per cent, real estate 3.5 per cent and commodities 1.9 per cent.

It has received legislative approval to increase its allocation to alternatives.

The long-term target allocations are dependent on the completion of an asset-liability study but the fund is already moving to boost its allocation to alternatives in 2012, targeting a 25.6 ($5.97 billion) per cent allocation.

To reach its long-term alternatives goal the fund is proposing to more than double its current allocation to hedge funds to 14 per cent of total assets. It would also double allocations to commodities and real estate and marginally increase its allocation to private equity.

It will reduce its exposures to fixed interest and cash equivalents and equities, particularly domestic and developed world shares.

Tim Walsh, the director of the New Jersey treasury’s investment division, says that the hedge fund strategy aims to gain exposure across a number of asset classes, particularly ones not managed internally, and is designed to decrease dependence on public equity markets for returns.

“We have a target that involves pretty substantial increases in hedge funds, real estate and commodities,” Walsh says.

“But those are targets and nothing is set in stone. We are not going to throw money at an asset class just to quote ‘have it filled’. We try to be opportunistic and we do spend a lot of time to do our due diligence.”

Walsh rejects the notion that hedge funds necessarily involve more risk and raise concerns about liquidity and fees.

Instead, under his direction the investment division is treating its hedge fund strategy as another way of getting exposure to a range of different asset classes, from credit to both long and short equity strategies.

“I really think there are bad characterisations of just putting money in a hedge fund,” he says.

“In my mind a hedge fund is just various ways to run different asset classes. Saying: ‘I am going to put x amount in hedge funds’ is a mistake.”

“We are looking at pretty much all of them macro, long, short credit etc and we have a large allocation in distressed credit on the long side with a hedge fund manager. Just because it is a hedge fund manager doesn’t necessarily mean it will naturally be selling something short either.”

In Walsh’s latest monthly report on performance the hedge fund portfolio had generated a 11.42 per cent return for the financial year to date, comfortably above its bench mark return of 8.33 per cent.

In that time period all segments of the portfolio had produced positive results, with equity long/short and event driven producing the highest returns.

The fund had flagged that it would move out of equities, particularly domestic and developed world equities in 2010. But over the course of the year it re-adjusted its targets as equities continued to perform strongly.

At the start of the 2010-11 financial year the fund had a target allocation to domestic equities of 19 per cent versus a fairly sizeable overweight of 26.5 per cent by the end of May.

Domestic equities were the best segment of the fund, returning 35.12 per cent for the financial year against its benchmark return of 33.93 per cent to the end of May.

“Myself and the council have been purposely overweighted equities at the expense of fixed income and that has contributed a lot of extra return for the fund,” he says.

However, in keeping with its long-term strategy to rebalance its portfolio away from equities, the fund is forecasting it will sell off $2.15 billion of its large-cap domestic holdings, reducing its share of the overall fund to 21.5 per cent. Developed world (non-US) equities will also be reduced by $1.2 billion to account for 15 per cent of the fund.

“New Jersey, as well as most public funds and endowments, want to reduce their exposure to quote ‘the S&P 500’,” Walsh says.

“And, I don’t just mean the S &P 500 but public markets whether they are international or in the US. The key is diversification.

“Essentially, pension funds can’t have a repeat of the 2000 to 2010 decade. The S&P over that 10-year time span returned approximately 1 per cent with dividends and most funds have target rates of 7.5 per cent and we are currently at 8.25 per cent.”

Achieving high single-digit returns in a low-returns environment is a challenging task for any fund.

The structure of the fund requires the investment team to focus solely on the returns and not the liabilities. But New Jersey’s has the unenviable status as one of the country’s least funded public pension funds.

Since the financial crisis, New Jersey’s fund has hovered around the mid-60 per cent funding levels, and this year its shortfall stands at more than $30 billion.

New Jersey has been at the forefront of moves to scale back pension commitments. Its Republican Governor Chris Christie has taken on unions to pare down the government’s pension liabilities.

This includes freezing cost-of-living adjustments and raising the retirement age to 65. The Governor’s office claims it will save $125 billion by 2026.

While the investment team does not focus on liabilities, it still has maintained a high level of liquidity in the fund to meet ongoing commitments.

Despite an increase in alternatives, Walsh says the fund will maintain high levels of overall liquidity in the fund.

In a report in May says the 2012 asset investment plan will keep 76 per cent of assets in traditional, liquid strategies, a slight decrease from the current mix of 83.7 per cent in liquid assets.

Since arriving from the much smaller $8.5 billion Indiana State Teachers Retirement Fund in mid- 2010, Walsh has changed the way the fund divides its assets into categories.

Forgoing more traditional buckets, Walsh decided on five broad categories capital preservation/uncorrelated assets, liquidity, income, real return and global growth.

Capital preservation/uncorrelated assets includes hedging strategies, and absolute return and dedicated short hedge fund strategies. Its objective is to provide downside protection during market corrections. Similarly, when asset prices spike, the investment team believes this asset class will provide an uncorrelated source of return.

Liquidity includes highly liquid income securities such as cash equivalents and US treasuries and is primarily aimed at funding near-term withdrawals, with current income and downside protection secondary considerations.

Income includes public and private credit-orientated fixed income assets.

Recently, the fund has gone into direct (non-bank) lending credit through a $200 million allocation to TPG Specialty Lending. TPG typically lends to small-to-medium sized US companies. This asset fits the objectives of the income asset category to provide interest income and capital appreciation, with a higher yield than securities in the liquidity asset class.

“Most direct lenders I have seen have done a better job at lending than most US and European banks,” Walsh says.

“I think that in many ways they get better risk-adjusted returns than most banks do and you are not buying the baggage that comes with a bank.”

The real return asset class includes public and private real estate, commodities, natural resources, and inflation-linked assets. Exposure is designed to provide diversification and a hedge against inflation.

Walsh says that despite a recent pull-back in commodity markets, the fund is still looking to increase its allocation to commodities over time.

While seeing a recent decline in returns over the past two months, the fund’s commodity portfolio returned 35.51 per cent for the year to date, against the fund’s benchmark of 32.60 per cent.

The global growth asset class includes public and private-equity orientated returns.

“Previously, and still to a degree, we had things broken down into antiquated accounting rules. The idea is to gradually change those to make them more investment friendly,” Walsh says.

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