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 “Risky Assets� (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 “arbing� 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: “Hedge Fund Activism, Corporate Governance and Fund Performance,� September 2006, Brav, Jiang, Partnoy,Thomas