Bill Clark June 1007

ASSET ALLOCATION FOR A LARGE PENSION SYSTEM Adjusting to our own “New Normal” June 2007

William Clark, Director New Jersey Division of Investment

New Jersey Division of Investment    

Manages $81 billion in pension fund assets 13th largest pension system in the U.S. 50th largest money manager in the U.S. Pension system supports 800,000 employees/retirees

New Jersey Division of Investment Current Asset Allocation - 4/30/07 International Equity 21.0

Cash 7.3 Hedge Funds 2.0

Fixed Income 26.9 Other 4.5

Private Equity 1.1

Medium-Term Goal = 19%

Real Estate 1.0 Commodities 0.4

US Equity 40.3

New Normal #1 Liability Driven Investing What’s Driving the Change? 

Corporate Plans 

  



SFAS 158: “Employers’ Accounting for Defined Benefit Pension and Other Post Retirement Plans” Phase II of FASB Review – Income Statement Recognition?

Pension Protection Act of 2006 SEC Inquiries/Subpoenas

Public Plans  

GASB Exposure Draft to require greater disclosure Commenced a more detailed review of pension accounting and reporting standards

New Normal #1 Liability Driven Investing Why It’s Driving Changes – Hypothetical Example Assumed Asset Class Returns/Risk Asset Class

Expected Return

Standard Deviation

Correlation to US Equities

US Equities

7.67%

14.39%

1.00

REITS

7.30%

16.00%

0.65

Non-US Equities

8.25%

18.00%

0.70

Emerging Mkts Equities

8.65%

24.00%

0.70

Lehman Aggregate

4.80%

4.00%

0.35

30-Yr US Treasury

4.55%

12.00%

0.40

High Yield

6.50%

12.00%

0.55

Non-US Bonds

4.70%

9.00%

0.10

Private Equity

10.85%

25.00%

0.75

Real Estate

6.30%

10.00%

0.30

Absolute Return

7.45%

5.70%

0.30

Commodities

3.25%

18.00%

-0.15

TIPS

4.40%

6.00%

0.00

Cash

3.00%

1.00%

0.10

New Normal #1 Liability Driven Investing Assumed Liability Returns Asset Class

Expected Return

Standard Deviation

Correlation To US Equities

TIPS (30%)

4.40%

6.00%

0.00

Citigroup Liability Index (70%)

5.23%

9.00%

0.35

Proxy intended to capture duration and inflation-sensitivity of projected liabilities. Actual duration on New Jersey’s accrued liabilities (i.e., ABO) = 12.7 years.

New Normal #1 Liability Driven Investing “Efficient Frontier” of Plan Surplus Return/Risk 100%

SD = 2.85

SD = 3.84

SD = 5.69

SD = 7.76

SD = 9.85

90% 80% 70% 60% 50% 40% Alternataives

30%

Other Fixed Income

20%

30-Yr Treasury

10%

Public Equity

0% 0

0.5

1.0

1.5

2.0

New Normal #1 Liability Driven Investing Plan Sponsors Have Been “Burned” By The Traditional Asset Allocation Index Index

Cash

Weight

’97

’98

’99

’00

’01

’02

’03

’04

’05

‘06

6.49

4.97

1.75

1.04

1.22

3.17

4.89

8.44

10.25

4.10

4.34

2.43

4.33

5%

5.72

5.48

4.24

LB Aggregate

30%

9.65

8.69

-0.82

S&P 500

60%

33.34

28.55

21.03

9.09

-11.86

-22.08

28.69

10.87

4.89

15.81

5%

2.08

20.24

27.32

13.87

-21.11

-15.64

39.17

20.70

14.02

26.87

Assets

100%

22.99

21.39

13.72

2.49

-5.40

-11.40

20.05

8.93

4.60

12.26

RL Liability Index

100%

19.57

16.42

-12.02

3.20

18.78

2.25

10.25

10.64

1.46

3.42

4.97

25.74

-8.60

-30.18

17.80

-1.32

-6.05

10.80

97.90

73.03

85.74

84.71

80.08

88.60

MSCI EAFE Int’l

Assets - Liabilities

11.63

26.56 29.05

100.00 102.86 107.25 138.62 Funding Assumptions: Ratio Program is full funded on January 1, 1997 106.80

Annual contributions = Normal cost Assets portfolio rebalanced monthly RL Liability Index is a proxy for pension plans Source: Ryan Labs, Inc.

New Normal #1 Liability Driven Investing What are Plan Sponsors Doing/Planning to do?

Immunization of liabilities

4%

10%

11%

Portable alpha strategies Reduction of equities/increase of fixed-income assets

8%

Efficient portfolio strategies utilizing derivatives or other synthetic instruments

Implemented Expect to Implement

Source: Greenwich Associates, February 2007

10%

21%

Absolute return strategies

Other

13%

10%

12% 9%

3% 2% 0%

5%

10%

15%

20%

25%

30%

35%

New Normal #2 “Fat Tail” Risk/Return Distributions While there are fundamental reasons for risk to reprice, financial market liquidity has been a driving force 1.0 0.8 0.6 0.4 0.2 0.0 -0.2 -0.4 -0.6 -0.8 -1.0

92

94

96

98

00

02

04

06

Financial market liquidity

Source: Bank of England, “Financial Stability Report”, April 2007

New Normal #2 “Fat Tail” Risk/Return Distributions It is my contention that many new financial instruments/strategies incorporate “short” volatility positions, contributing to the decline in market implied volatility.

50 45 40 35 30 25 20 15 10 5

5/ 30 / 12 199 /3 7 1/ 19 9 7/ 31 7 /1 2/ 998 26 /1 9/ 999 30 /1 4/ 999 28 / 11 200 /3 0 0/ 20 0 6/ 29 0 /2 1/ 001 31 /2 8/ 002 30 /2 3/ 002 31 /2 0 10 /3 03 1/ 2 5/ 003 31 / 12 200 4 /3 1/ 20 7/ 0 29 4 /2 2/ 005 28 /2 9/ 006 29 /2 4/ 006 30 /2 00 7

0

VIX Index

New Normal #2 “Fat Tail” Risk/Return Distributions Short Volatility Strategies Example – IRR of BBB – rated 3-6% CDO Tranche vs BBB CDS Portfolio

Source: Barclays Capital

New Normal #2 “Fat Tail” Risk/Return Distributions Short Volatility Strategies On-the-run CDO Tranche Spreads 350

80

300

70 60

250

50 200 40 150 30 100

20

0

0 2-

1-

05 305 405 605 705 805 905 10 -0 5 12 -0 5 106 206 306 506 606 706 806 10 -0 6 11 -0 6 12 -0 6 107 307

10

05

50

3%-7%

7%-10%

The perceived attractiveness of this “trade” has caused CDO spreads to narrow significantly--This also helps explain tightness in the cash markets

New Normal #2 “Fat Tail� Risk/Return Distributions Hedge funds have also employed short volatility strategies to generate returns. Question: Is this really alpha?

Hedge Fund Up/Down Betas

Style

Overall

Up Market Beta

Down Market Beta

Index

0.44

0.08

0.77

Short

-0.99

-0.22

-1.82

Emerg mkts

0.69

0.08

1.16

Event

0.37

0.18

0.47

Global Macro

0.31

-0.08

0.66

Long/Short Eqty

0.65

0.19

1.18

Source: Dr. John Cochrane, University of Chicago

New Normal #2 “Fat Tail” Risk/Return Distributions Option-like return example: Merger “Arbitrage”

•Cash offer. Borrow, buy target.

•Large chance of a small return if successful. (Leverage: a large return) •Small chance of a large loss if unsuccessful.

•The strategy seems unrelated to the overall market, “beta zero” •But…offer is more likely to be unsuccessful if the market falls!

•Payoff is like an index put!

New Normal #2 “Fat Tail” Risk/Return Distributions Increased use of leverage is another factor contributing to “fat tail” distributions Total Worldwide LBO Transactions (1) $682

$700

$600 $156

$500

$400

$300

$261

$273 $526 $67

$200

$160 $129

$100

$0

# of Deals $2Bn+:

$79

$80

$57

$52

$22

$29

2002

2003

2004

2005

2006

2007YTD

6

9

21

25

69

21

$131 $65

Deals>2.0Bn

Source: Morgan Stanley

$207

$94

Deals<2.0Bn

(1)

All transactions greater than $100 million.

As of May 8, 2007

New Normal #2 “Fat Tail” Risk/Return Distributions Increased Use of Leverage Multiples paid in buyouts are increasing as deal size increases and frothy financing markets continue 10.0

10.0 9.0

8.7

8.8

8.2

8.0 7.0

10.0

9.1 7.5 6.6

6.6

7.1

7.3

6.0

6.0 5.0 4.0 3.0 2.0 1.0 0.0

Corporate Buyers 2002

2003

2004

2005

2006

2007 YTD

LBO Deals

Price gap between LBO and corporate buyers is narrowing Source: Standard & Poor’s Leveraged Commentary & Data, Mergerstat

New Normal #2 “Fat Tail” Risk/Return Distributions 8 7 6

7.1x

6.9x 6.4x 6.0x

1.5 2.0

5

2.0

2

6.5x

0.7

5.7x

1.9

5.1x 4.6x

4.9x

1.5

4 3

6.1x

1.6

2.0

2.4 2.9 6.4

5.4 4.4

4.0

4.6 3.6

3.0

1

2.9

3.7 2.8

0

Total Debt/EBITDA

1997 1998

1999

2000 2001

2002 2003

2004

2005 2006

Senior Debt/EBITDA

Leverage multiples have increased and debt/enterprise value ratios have also increased Source: Standard & Poor’s LCD, JPMorgan estimates

New Normal #2 “Fat Tail” Risk/Return Distributions Increased Use of Leverage – What Happened to Creditor Protections Volume of Covenant-Lite Loans

Volume of Second Lien Loans $30

$50

$25 $40

$20 Billions

Billions

$30

$15

$20

$10 $10

$5

2007

2006

2005

2004

2003

2002

2001

2000

1999

1998

1Q07

2006

2005

2004

2003

2002

2001

2000

1999

1998

1997

1997

$0

$0

For 2007, roughly 50% of institutional loans have been second lien or junior in the capital structure, vs. less than 15% in 2004

New Normal #2 “Fat Tail” Risk/Return Distributions Moody’s Annual High-Yield Default Rates 1970 to March 2007; Forecast 2007-2009 Trailing 12-Month Default Rate (%) 10.0% 9.0% 8.0% 7.0%

March 2007

6.0% 5.0% 4.0%

Mean 3.5%

3.0% 2.0%

Default Rate

1.0% 0.0% 1970

1975

1980

1985

1990

1995

Source: Moody’s, Lehman Brothers Fixed-Income Research

2000

2006

2009

New Normal #2 “Fat Tail” Risk/Return Distributions If I’m right, when defaults kick in (eventually), recovery rates will plummet $ Billions 160,000

70

140,000

60

120,000 100,000

50 40

80,000 60,000 40,000 20,000

19 8 19 6 8 19 7 8 19 8 8 19 9 9 19 0 9 19 1 9 19 2 9 19 3 9 19 4 9 19 5 9 19 6 9 19 7 9 19 8 9 20 9 0 20 0 0 20 1 0 20 2 0 20 3 0 20 4 0 20 5 06

0

% Recovery

30 20 10 0

N o rt h A m e ric a Iss ue r D e f ault V o lume A nnua l D e f a ult B o nd & Lo a n R e c o v e ry R a t e s

New Normal #2 “Fat Tail” Risk/Return Distributions Global Credit Derivatives as a Multiple of Global Credit Index Outstanding (1997 – 1H2006; Forecast 2006 – 2009) $ Billion

Multiple

80,000

7.00 6 .59

70,000

6.00

5.8

60,000

5.1

5.00

4 .4 9

50,000

4.00

3 .9 5 3 .71

40,000

3 .3 5

3.00 30,000 2.00 20,000

1.58

10,000

1.00

0 .78 0 .52

0 .56

0 .54

0

0.00 2000

2001

2002

2003

Credit Deriv.Outstndng

2004

2005

1H2006

2006

Credit Index Prin. Outstndng

2007

2008

2009

2010

Credit Deriv. as Mult. of Credit Index

Because of the growth in CDS, the risk of contagion from defaults/drop in recovery rates may be multiples of anything we’ve seen in our lifetime Source: ISDA; Lehman Brothers Fixed-Income Research

New Normal #3 Asset Class Boundaries are Becoming Blurred The search for Alpha 

Pension Funds have given managers greater flexibility to achieve returns     

Hedge Funds “Sidepockets” Portable Alpha “Distress for Control” Investing 130/30 Strategies (Hedge Funds “Lite”) Real Estate LBOs (Blackstone-EOP)

New Normal #3 Asset Class Boundaries are Becoming Blurred Common component in prices of â&#x20AC;&#x153;Risky Assetsâ&#x20AC;? (global equities, emerging market equities, high-yield spreads and commodities) Percent

70 60 50 40 30 20 10 0 98

99

00

01

02

03

04

05

06

07

Common component in asset prices

The impact of rising liquidity has caused correlation to increase Source: Bank of England, Goldman Sachs, Merrill Lynch, MSCI

New Normal #3 Asset Class Boundaries are Becoming Blurred Price/Book 4.5 4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0 97

98

99 North Am erica

00

01 Europe

02

03

04

Asia Pacific x Japan

05

06

Latin Am erica

Investors have sought return by â&#x20AC;&#x153;arbingâ&#x20AC;? equity valuation differences around the globe. The same can be said for fixed income.

Strategies for the New Normal Strategy #1: Infrastructure Definition of Infrastructure: Permanent assets that a society requires to facilitate the orderly operation of an economy Infrastructure Sectors Energy generation fossil and renewable

Transport roads

Water •Drinking

water

Social

•Energy

•Toll

•Education

facilities

•Electricity

•Bridges

•Wastewater

•Healthcare

•Natural

•Tunnels

•Sewage

•Housing

•LNG

•Parking

facilities

transmission gas pipelines and storage infrastructure

garages

(e.g. student , military, government sponsored)

•Telecommunications

(e.g., cell phone towers) •Electricity

and gas local utilities

•Airports

•Seaports •Rail

Source: Babcock & Brown

Strategies for the New Normal Strategy #1: Infrastructure Buyers of Infrastructure Assets •Strategic (Cintra, Autostrade, Transurban) and Financial (Macquarie, Babcock & Brown, major investment banks, pension funds, insurance companies) •Pension fund investors typically public sector funds •Infrastructure a long-established asset class for many Australian and Canadian funds Pension Funds Investing in Infrastructure Domicile

Total Portfolio Assets (USD mm)

Target Allocation

Ontario Teachers

Canada

$71,677

8%

$5,734

Ontario Municipal (OMERS)

Canada

29,941

15%

4,491

Canada Pension Plan (CPP)

Canada

86,194

10%

8,619

OPSEU Trust

Canada

9,073

10%

907

Institutional Investor

Infrastructure Allocation

State Super NSW

Australia

19,829

3%

595

UniSuper

Australia

8,262

7%

537

Telstra Super

Australia

5,783

3%

145

MTAA

Australia

1,652

25%

413

Illinois State Board of Investments

US

11,000

5%

550

BT Pension Scheme/Hermes

UK

69,857

1%

699

Source: Macquarie

Strategies for the New Normal Strategy #1: Infrastructure Characteristics of Infrastructure Assets Opportunities: • Stable and predictable cash flows: privatization can allow assets to be levered • Natural monopoly characteristics: pricing power, lower return volatility • Low correlation to other asset classes: diversification benefits • Inflation hedge: CPI adjustments built into some assets (e.g., toll roads) • Long-lived assets with high tangible value: match for long-term liabilities • Capital structure arbitrage: can increase value in addition to revenue growth • Recession resistant: returns not highly sensitive to short-term GDP growth • Nascent asset class: investor interest growing Risks: • Deal flow risk: will there be adequate deal flow • Operational risk: risk of asset being mis-managed • Headline risk: public opposition to privatization • Investment/timing risk: lots of recent fundraising; too much money chasing few deals?

Strategies for the New Normal Strategy #2: Hedged Equity

One Year S&P 500 Put Premiums as Percent of Index 100% Put Premium

90% Put Premium

90-100% Put Spread

Historical Aug (1993-2005)

6.48%

3.48

2.99

Current

3.67%

1.50

2.17

Difference

2.81%

1.98

0.83

Basis of Strategy: Take advantage of low implied volatility to reduce equity risk Source: Goldman Sachs

Strategies for the New Normal Strategy #2: Hedged Equity 50 Yr Backtest of 90-100% Put Spread Collar at Current Implied Volatility

Unhedged Annualized Returns Volatility Sharpe Ratio

Annual 90-100% Put Spread

Difference

8.31%

8.09%

(0.22)

16.18%

13.59%

(2.59)

.18

.21

.03

Strategies for the New Normal Strategy #3: Activist Investing Activist Investing is best defined as a combination of Tactics & Objectives Tactics

Objectives

Communicate with Board Management

Improve company efficiency

Seek Friendly Board access

Change capital structure

Formal shareholder proposals

Change business strategy

Proxy fight for board representation

Sale of company

Proxy fight to replace board

Governance changes

Sue company Take over bid

Strategies for the New Normal Strategy #3: Activist Investing Results from 110 Activist Hedge Funds and 374 Hedge Fund Target Ratios - 2004-2005 Window (days) Before/After 13D Events

Abnormal Return

T-Stat

Before

After

20

20

6.8%

5.822

-10

10

6.0%

6.238

0

2

2.3%

5.663

0

10

4.2%

6.577

0

20

4.8%

5.509

Source: â&#x20AC;&#x153;Hedge Fund Activism, Corporate Governance and Fund Performance,â&#x20AC;?

September 2006, Brav, Jiang, Partnoy,Thomas