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

US Equity 40.3

Fixed Income 26.9 Hedge Funds 2.0

Private Equity 1.1

Real Estate 1.0

Commodities 0.4

Other 4.5

Cash 7.3

International Equity 21.0

Medium-Term Goal = 19%

New Normal #1 Liability Driven Investing

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

What’s Driving the Change?


Asset Class Expected Return Standard DeviationCorrelation to US

Equities

US Equities 7.67% 14.39% 1.00REITS 7.30% 16.00% 0.65Non-US Equities 8.25% 18.00% 0.70Emerging Mkts Equities 8.65% 24.00% 0.70Lehman Aggregate 4.80% 4.00% 0.3530-Yr US Treasury 4.55% 12.00% 0.40High Yield 6.50% 12.00% 0.55Non-US Bonds 4.70% 9.00% 0.10Private Equity 10.85% 25.00% 0.75Real Estate 6.30% 10.00% 0.30Absolute Return 7.45% 5.70% 0.30Commodities 3.25% 18.00% -0.15TIPS 4.40% 6.00% 0.00Cash 3.00% 1.00% 0.10

Assumed Asset Class Returns/Risk

Why It’s Driving Changes – Hypothetical Example


Asset ClassExpectedReturn

StandardDeviation

CorrelationTo US Equities

TIPS (30%) 4.40% 6.00% 0.00

Citigroup Liability Index (70%) 5.23% 9.00% 0.35

Assumed Liability Returns

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.


0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

0 0.5 1.0 1.5 2.0

AlternataivesOther Fixed Income30-Yr TreasuryPublic Equity

“Efficient Frontier” of Plan Surplus Return/Risk

SD = 2.85 SD = 3.84 SD = 5.69 SD = 7.76 SD = 9.85


Index Weight ’97 ’98 ’99 ’00 ’01 ’02 ’03 ’04 ’05 ‘06

Cash 5% 5.72 5.48 4.24 6.49 4.97 1.75 1.04 1.22 3.17 4.89

LB Aggregate 30% 9.65 8.69 -0.8211.63

8.44 10.25 4.10 4.34 2.43 4.33

S&P 500 60% 33.34 28.55 21.03 -9.09

-11.86 -22.08 28.69 10.87 4.89 15.81

MSCI EAFE Int’l 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 -12.0226.56

3.20 18.78 2.25 10.25 10.64 1.46

Assets - Liabilities 3.42 4.97 25.74 -29.05

-8.60 -30.18 17.80 -1.32 -6.05 10.80

Funding Ratio 100.00 102.86 107.25 138.62106.80

97.90 73.03 85.74 84.71 80.08 88.60

Plan Sponsors Have Been “Burned” By The Traditional Asset Allocation Index

Assumptions: Program is full funded on January 1, 1997Annual contributions = Normal costAssets portfolio rebalanced monthlyRL Liability Index is a proxy for pension plans

Source: Ryan Labs, Inc.


4%

11%

8%

21%

10%

3%

10%

13%

10%

12%

9%

2%

0% 5% 10% 15% 20% 25% 30% 35%

Immunization of liabilities

Portable alpha strategies

Reduction of equities/increase of fixed-incomeassets

Absolute return strategies

Efficient portfolio strategies utilizing derivativesor other synthetic instruments

Other

ImplementedExpect to Implement

What are Plan Sponsors Doing/Planning to do?

Source: Greenwich Associates, February 2007

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

-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

While there are fundamental reasons for risk to reprice, financial market liquidity has been a driving force

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


0

5

10

15

20

25

30

35

40

45

50

5/30/1

997

12/31

/1997

7/31/1

998

2/26/1

999

9/30/1

999

4/28/2

000

11/30

/2000

6/29/2

001

1/31/2

002

8/30/2

002

3/31/2

003

10/31

/2003

5/31/2

004

12/31

/2004

7/29/2

005

2/28/2

006

9/29/2

006

4/30/2

007

VIX Index

It is my contention that many new financial instruments/strategies incorporate “short” volatility positions, contributing to the decline in market implied volatility.


Short Volatility StrategiesExample – IRR of BBB – rated 3-6%CDO Tranche vs BBB CDS Portfolio

Source: Barclays Capital


0

50

100

150

200

250

300

350

1-05

2-05

3-05

4-05

6-05

7-05

8-05

9-05

10-05

12-05 1-0

62-0

63-0

65-0

66-0

67-0

68-0

610

-0611

-0612

-06 1-07

3-07

0

10

20

30

40

50

60

70

80

3%-7% 7%-10%

Short Volatility StrategiesOn-the-run CDO Tranche Spreads

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


Style OverallUp Market

BetaDown

Market BetaIndex 0.44 0.08 0.77Short -0.99 -0.22 -1.82Emerg mkts 0.69 0.08 1.16Event 0.37 0.18 0.47Global Macro 0.31 -0.08 0.66Long/Short Eqty 0.65 0.19 1.18

Hedge funds have also employed short volatility strategies to generate returns. Question: Is this really alpha?

Hedge Fund Up/Down Betas

Source: Dr. John Cochrane, University of Chicago


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!


$22 $29$65

$131

$526

$207

$57 $52$94

$129

$156

$67

$0

$100

$200

$300

$400

$500

$600

$700

2002 2003 2004 2005 2006 2007YTD

6 9 21 25 69 21# of Deals $2Bn+:

Increased use of leverage is another factor contributing to “fat tail” distributions

Total Worldwide LBO Transactions (1)

Source: Morgan Stanley

(1) All transactions greater than $100 million.

As of May 8, 2007

$79 $80

$160

$261

$682

$273

Deals>2.0Bn Deals<2.0Bn


8.78.2

7.5

9.110.0 10.0

6.66.0

6.67.1 7.3

8.8

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

8.0

9.0

10.0

2002 2003 2004 2005 2006 2007 YTDCorporate BuyersLBO Deals

Increased Use of LeverageMultiples paid in buyouts are increasing as deal size increases and frothy financing markets continue

Price gap between LBO and corporate buyers is narrowing

Source: Standard & Poor’s Leveraged Commentary & Data, Mergerstat


5.44.4 4.0 3.6

3.0 2.9 2.83.7

4.6

6.4

1.5

2.02.0

1.51.6 2.0

2.92.4

1.9

0.7

0

1

2

3

4

5

6

7

8

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006Total Debt/EBITDASenior Debt/EBITDA

Leverage multiples have increased and debt/enterprise value ratios have also increased

Source: Standard & Poor’s LCD, JPMorgan estimates

6.9x6.4x

6.0x

5.1x4.6x 4.9x

5.7x6.1x 6.5x

7.1x


$0

$10

$20

$30

$40

$50

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

1Q07

Bill

ions

$0

$5

$10

$15

$20

$25

$30

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

Bill

ions

Increased Use of Leverage – What Happened to Creditor Protections

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

Volume of Covenant-Lite Loans Volume of Second Lien Loans


0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

7.0%

8.0%

9.0%

10.0%

1970 1975 1980 1985 1990 1995 2000 2006 2009

Default Rate

Moody’s Annual High-Yield Default Rates 1970 to March 2007; Forecast 2007-2009

Trailing 12-Month Default Rate (%)

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

Mean3.5%

March2007


0

20,000

40,000

60,000

80,000

100,000

120,000

140,000

160,000

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

$ Billions

0

10

20

30

40

50

60

70

% Recovery

North America IssuerDefault VolumeAnnual Default Bond &Loan Recovery Rates

If I’m right, when defaults kick in (eventually), recovery rates will plummet


0.52 0.56 0.540.78

1.58

3.35

3.713.95

4.49

5.1

5.8

6.59

0

10,000

20,000

30,000

40,000

50,000

60,000

70,000

80,000

2000 2001 2002 2003 2004 2005 1H2006 2006 2007 2008 2009 20100.00

1.00

2.00

3.00

4.00

5.00

6.00

7.00

Credit Deriv.Outstndng Credit Index Prin. Outstndng Credit Deriv. as Mult. of Credit Index

Global Credit Derivatives as a Multiple of Global Credit Index Outstanding (1997 – 1H2006; Forecast 2006 – 2009)

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

Multiple$ Billion

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)


0

10

20

30

40

50

60

70

98 99 00 01 02 03 04 05 06 07

Percent

Common component in asset prices

Common component in prices of “Risky Assets” (global equities, emerging market equities, high-yield spreads and commodities)

The impact of rising liquidity has caused correlation to increase

Source: Bank of England, Goldman Sachs, Merrill Lynch, MSCI


0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

97 98 99 00 01 02 03 04 05 06

North America Europe Asia Pacific x Japan Latin America

Price/Book

Investors have sought return by “arbing” equity valuation differences around the globe. The same can be said for fixed income.

Strategies for the New NormalStrategy #1: Infrastructure

Infrastructure SectorsEnergy Transport Water Social

•Energy generation fossil and renewable

•Toll roads •Drinking water •Education facilities

•Electricity transmission

•Bridges •Wastewater •Healthcare facilities

•Natural gas pipelines and storage

•Tunnels •Sewage •Housing (e.g. student , military, government sponsored)

•LNG infrastructure •Parking garages •Telecommunications (e.g., cell phone towers)

•Electricity and gas local utilities

•Airports

•Seaports

•Rail

Definition of Infrastructure: Permanent assets that a society requires to facilitate the orderly operation of an economy

Source: Babcock & Brown

Strategies for the New Normal Strategy #1: Infrastructure

Pension Funds Investing in Infrastructure

Institutional Investor DomicileTotal Portfolio

Assets (USD mm)Target

AllocationInfrastructure

Allocation

Ontario Teachers Canada $71,677 8% $5,734Ontario Municipal (OMERS) Canada 29,941 15% 4,491Canada Pension Plan (CPP) Canada 86,194 10% 8,619OPSEU Trust Canada 9,073 10% 907State Super NSW Australia 19,829 3% 595UniSuper Australia 8,262 7% 537Telstra Super Australia 5,783 3% 145MTAA Australia 1,652 25% 413Illinois State Board of Investments US 11,000 5% 550BT Pension Scheme/Hermes UK 69,857 1% 699

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

Source: Macquarie

Strategies for the New Normal Strategy #1: Infrastructure

Characteristics of Infrastructure AssetsOpportunities:• 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

UnhedgedAnnual 90-100%

Put Spread Difference

Annualized Returns 8.31% 8.09% (0.22)

Volatility 16.18% 13.59% (2.59)

Sharpe Ratio .18 .21 .03

Strategies for the New NormalStrategy #3: Activist Investing

Activist Investing is best defined as a combination of Tactics & Objectives

Tactics ObjectivesCommunicate 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 Fundsand 374 Hedge Fund Target Ratios - 2004-2005

Window (days) Before/After13D Events

AbnormalReturn T-Stat

Before After20 20 6.8% 5.822-10 10 6.0% 6.2380 2 2.3% 5.6630 10 4.2% 6.5770 20 4.8% 5.509

Source: “Hedge Fund Activism, Corporate Governance and Fund Performance,” September 2006, Brav, Jiang, Partnoy,Thomas

Documents

Bill Clark June 1007