07.03.2012
By Terry Flanagan

Pension Innovator


Some pension plans buy and hold stocks and bonds. Others augment that plain- vanilla strategy by allocating money to alternative investments, which typically include hedge funds, private equity, and real estate.

The New Jersey Division of Investment has taken the alternative-investment strategy one step further in the never-ending quest to generate more return. The $85 billion plan has forged a groundbreaking partnership with private-equity giant Blackstone Group, and Chief Investment Officer Tim Walsh is on the lookout for more out-of-the-box deals.

The New Jersey Division of Investment is on the path of public-pension innovation.Michael Maduell, president of the Sovereign Wealth Fund Institute

“The New Jersey Division of Investment is on the path of public-pension innovation,” said Michael Maduell, president of the Sovereign Wealth Fund Institute, which studies long-term government investors.

The Blackstone pact, announced in December 2011, calls for the New Jersey Division of Investment to invest up to $1.8 billion in co-mingled and separate accounts managed by Blackstone. The draw for New Jersey is fee reductions of more than $120 million over the life of the deal compared with a standard private-equity investment, plus a closer working relationship.

The deal “is more of a real partnership — it wasn’t I give you $100 and come back in 10 years and hopefully it’s $200,” Walsh said. “We have almost daily dialogues with them, trying to source ideas from them that we can try to do internally or with them. It’s been a very good relationship so far.”

The New Jersey Division of Investment had about $72 billion in its pension plan as of April 30, covering 769,000 members, about one-third of which active employees and the rest retired. All the pension money is managed as one large investment pool, as opposed to breaking it down by state- or local-government employees or teachers and firefighters, as some other states do. There is also $13 billion in a cash-management fund.

In-House Model

About 55% of the pension money was allocated to Global Growth, which spans U.S. and non-U.S. stocks, equity-oriented hedge funds, private equity and venture capital; 26% was invested in Income, which includes investment-grade and high-yield bonds as well as debt-oriented hedge funds; and 10% was in Real Return, which consists of assets that tend to do well amid inflation, such as commodities, Treasury Inflation Protected Securities, and real estate.

The New Jersey Division of Investment is somewhat unique among public pension plans in that it manages all but its $16 billion alternative-investment program in-house, Walsh told Markets Media in a May 25 interview from his office in Trenton, New Jersey, which overlooks the golden-domed New Jersey State House and the Delaware River. Walsh cited Alabama, South Dakota, Tennessee, and Georgia as public pensions that similarly manage internally rather than hand over money — and responsibility — to external managers.

“In the outsourced model, if a manager is not doing well they’re terminated. We don’t really have that luxury,” Walsh said. “The buck stops here. You don’t get to blame XYZ manager in Chicago, or L.A., or Boulder, Colorado. We do it all here, on the 9th floor in Trenton.”

Maduell of SWF Institute noted that many U.S. public pensions use both external and internal fund management, so categorizing a plan as one or the other is tricky. “There is a trend to bring more in-house, but it takes strong corporate governance, size, time, and financial resources,” Maduell said.

Walsh, 49, joined New Jersey Division of Investment in August 2010 from Indiana State Teachers Retirement Fund, where he managed $8 billion. “Here we have about 10 times the assets and 10 times the employees,” Walsh said.

Born and raised in Lowell, Massachusetts, Walsh is a die-hard Boston Celtics fan who enjoys spending time with his wife of 18 years and two teenage children. Prior to managing the Indiana teachers’ fund, he traded bonds and foreign exchange at private-sector enterprises including Bank of Montreal and Nationsbank, and he ran his own wealth-management firm.

Walsh has made things happen since moving back east almost two years ago. Aside from the private-equity deal with Blackstone — which Walsh called “the most innovative one I’ve seen” — the New Jersey Division of Investment generated a return of 18% on its pension assets for the fiscal year ended June 30, 2011, its best year in 13 years and about 1 percentage point more than its benchmark. “That is $700 million that theoretically wouldn’t have been in the pension fund if we were at the benchmark,” he said.

Under Walsh, the New Jersey Division of Investment also restructured its asset allocation away from the standard categorization of U.S. equities, non-U.S. equities, fixed income, and alternatives.

“We had this big bucket called alternatives which to me had a lot of similarities with fixed income, equities, and international equities,” Walsh explained. “So we broke it down and instead of just four big accounting-dominated asset classes, we actually looked at the assets in them. We now have 22 subsections — we went away from the accounting format dictating how we invest to looking more at what the assets are and what returns we’re trying to get out of those assets.”

To be sure, an innovative approach to institutional money management provides no assurance of better returns; a plain-vanilla portfolio consisting of a Standard & Poor’s 500 Index fund plus a global bond fund might beat a portfolio with lots of bells and whistles.

But Walsh has delivered alpha. The New Jersey Division of Investment’s pension fund returned 3.48% in the 10 months spanning July 2011 and April 2012, the most current information available for its fiscal year to date. That’s more than twice the 1.39% benchmark return.

Money Management Letter, a unit of Institutional Investor, earlier this year named New Jersey Division of Investment its Large Public Plan of the Year for 2011.

New Jersey Division of Investment was the 37th-biggest pension fund in the world as of year-end 2010, according to a Pensions & Investments/Towers Watson report. The only U.S. states with larger plans were California, New York, Florida, Texas, Wisconsin, North Carolina, and Ohio; New Jersey’s plan was bigger than those of corporate giants General Electric, Royal Dutch Shell, and Ford Motor.

Dark Clouds

U.S. public-pension plans were scarred by the global financial crisis of 2008-2009, which cratered equity values and reduced funded statuses by about 30% or more in some instances. The darkest hour of the crisis arguably was the September 2008 collapse of Lehman Brothers.

Some observers say the European sovereign-debt crisis may result in the next Lehman Brothers, if a country or large bank requires a massive bailout to stay solvent. With the situation unfolding slowly and expected to linger perhaps for years, Walsh is watching closely.

“We’re very concerned about what’s going on in Europe,” he said. “The market is also smart enough to look ahead to what’s going on in the U.S., where you have an election coming up, tax cuts expiring, and potential medical legislation. There are a lot of issues.”

“Everybody in my seat is always concerned about something going on in the world. The question is, is it priced in?” Walsh continued.

The New Jersey Division of Investment’s 55% global-growth allocation as of April 30 was slightly more than the plan’s target allocation of 54%, but Walsh is no raging bull. He noted that comparable state pensions typically have equity allocations exceeding 60%, and he has been pounding the table on diversification.

”Even though we’re over our growth benchmark, we’re probably more conservative than most,” Walsh said. “We’re very concerned about what’s going on.”

The buck stops here. We don’t get to blame XYZ manager in Chicago, or L.A., or Boulder, Colorado, Walsh said.

Walsh, a self-described “investaholic,” described the market ascent from late 2011 through the first quarter of this year as a “risk rally” that was cut short when Greece and Spain re-emerged as vexing issues. “That’s the point as to why we try to stay diversified,” he said.

The New Jersey Division of Investment’s largest equity holdings as of April 30 were Apple, ExxonMobil, General Electric, and Microsoft. The pension plan owned a larger proportion of information-technology and industrial stocks compared with the Standard & Poor’s 500, and it held less in financials and telecommunications.

“Pension funds are long-term providers of capital,” Walsh said. “We buy Apple, IBM, Exxon — we have had those stocks for 20 years, and I would imagine five or 10 years from now we’re still going to own shares. We’re not hedge funds, we’re always going to own a certain amount of U.S. stocks, a certain amount of international stocks, and a certain amount of Treasuries and corporate bonds.”

The New Jersey pension plan recently decided to sell some investment-grade corporate bonds to buy high-yield bonds. That may seem paradoxical given Walsh’s cautious market outlook, but as he explained, the puny yields on high-grade bonds — less than 3% for an A-rated 10-year bond, for example — are just too low.

“If we’re going to take the risk of being in fixed income, one could argue at that point you might as well just own U.S. Treasuries,” Walsh said. “When the world blew up in 2008, all of a sudden you realized you had a lot of risk, including equity risk embedded in fixed income. So if we’re going to take equity risk, we prefer to take it in the equity as opposed to having a once-every-five-or-10-year scenario where you look at your corporate fixed-income book that you thought was high-grade, and maybe it wasn’t so high-grade.”

Daily Trading

Walsh said the New Jersey Division of Investment’s equity trading totals to about $30 billion per year. The pension fund’s traders are in the market every day, but turnover in the portfolio is “not very aggressive,” Walsh said; more trades are being routed through execution-only rather than full-service brokers, and many trades cost less than a penny a share. “We’re able to negotiate pretty low transaction costs,” he said. “We look at it very closely.”

New Jersey’s in-house investment model allows for quicker action, as traders can get into or out of a position on the spot rather than having to go through an outside manager.

“Tim’s trading philosophy is to be nimble so that we can respond effectively to the rapid, almost instantaneous changes in today’s daily investment environment,” said Michael Wszolek, chief trading officer for the New Jersey Division of Investment. “When he first took over, he emphasized that our tradition of in-house trading gave us an ability to react to market conditions that many other large public plans simply don’t possess. Tim makes sure we leverage that capability every day.”

With almost $20 billion in bonds under management, the New Jersey Division of Investment fits the profile of an institution that might trade on Aladdin, BlackRock’s planned buy-side-to-buy-side crossing network that is meant to fill in liquidity gaps if developing regulation constrains Wall Street desks. “The Blackrock crossing platform has some merit,” Walsh said. “Whatever can be done to lessen transactions costs, we support.”

“Everybody in my seat is always concerned about something going on in the world. The question is, is it priced in?” Walsh said.

Walsh has mixed feelings about the Dodd-Frank Wall Street Reform and Consumer Protection Act, the sweeping legislation that was signed into law two years ago and continues to move in fits and starts toward finalization. The giant California Public Employees’ Retirement System was among public pension plans who came out in favor of Dodd-Frank for its perceived capacity to head off financial crises, but Walsh worries that specific thrusts of the legislation will result in fewer counterparties and more trading friction.

“On the micro level, what’s happening with Dodd-Frank is a concern. I think it’s going to be a lot more problematic for pension funds than some expect, and a lot of the pension funds that supported Dodd-Frank didn’t know what they were talking about,” Walsh said. “Because we manage internally, we deal with Wall Street every day, so when liquidity goes down, it isn’t something we find out about in six months. We find out in six minutes.”

Walsh noted that liquidity in corporate-bond markets has decreased over the past two years, making sell orders especially difficult to execute efficiently, and looming regulation stands to exacerbate the situation.

“They’re making it very difficult for traditional broker-dealers to hold fixed-income inventories,” Walsh continued. “Dodd-Frank concerns me…There are some good aspects to it, but there are also a lot of potentially negative aspects.”

For an institutional investor with flexibility such as the New Jersey Division of Investment, one possible benefit of Dodd-Frank in the U.S. and Basel in Europe is that some banks may be forced to divest assets. “Some of them are good assets,” Walsh said. “If we get the right price and maybe get a Blackstone to work with us, we have interest in that.”

Macroeconomic turmoil and tightening regulation are among complicating factors in U.S. public pension plans’ quest to hit annual return targets. “Another major issue is attracting and retaining talent by developing long-term incentive packages and fostering and rewarding innovation,” said Maduell of SWF Institute. U.S. state pension plans’ “compensation lags against endowments and the Canadian pensions, and some other sovereign wealth funds,” he said.

Alternative Initiatives

New Jersey includes commodities in its alternatives bucket, along with the more traditional alternative asset classes of private equity, hedge funds, and real estate. The defined-benefit plan has almost $5 billion in hedge funds, and Walsh and his colleagues have pushed for better terms than the standard 2% management fee plus 20% of investment gains.

“We try to minimize our exposure to the traditional two-and-20 manager, and in my opinion we’ve done a real nice job negotiating fee reductions,” Walsh said.

Some of the New Jersey Division of Investment’s largest hedge-fund investments as of April 30 were with Goldman Sachs and RC Woodley Park, via funds of funds; Centerbridge Credit Partners, a distressed-debt hedge fund; Pershing Square, an event-driven fund; and global-macro shop Winton Futures. The pension plan had $1.57 billion invested in funds of hedge funds, $883 million in equity long-short funds, and $727 million in event-driven funds.

Walsh said New Jersey invests in hedge funds mostly for alpha capture and exposure to asset classes it can’t get involved in directly rather than to hedge, because the investment team can hedge internally. “Downside protection is something we use to rate all of our managers, but it’s not quite as important to me as someone who can invest in an asset space that we can’t,” Walsh said.

“We have one lawyer here. We can’t do distressed bonds because we don’t have a distressed bankruptcy lawyer or law firm like some other firms do. You have to pay for that expertise,” he continued. “If we can invest in the asset class internally we’re not going to pay somebody two-and-20 to do it, but if it’s an asset class that we just can’t invest in, that’s more attractive to us because hopefully we’ll get better returns and it will bring down the risk of the portfolio.”

The New Jersey Division of Investment pushes its private-equity managers for better deals just as it leans on hedge funds. Specifically, Walsh is concerned with a preferred return, or hurdle rate, that stipulates a manager must generate a certain return before collecting fees.

“We have been very aggressive in pushing for some form of preferred returns,” Walsh explained. “As a private-equity manager, you should get no incentive, or ‘carry’, until you give me 8% per year. Then you get to participate.”

Interest rates near historical lows have made that arrangement more difficult for alternative managers and more favorable for institutional clients. “Twenty years ago when this became standard, the 10-year Treasury (yield) was about 6% or 7%,” Walsh said. While the benchmark bond yield has contracted to about 1.7%, the preferred rate of return has stayed at 8%. “It’s pretty attractive when our target is 8.25% and our managers get no incentive until they make me 8%,” Walsh added.

New Jersey looks for managers that ante up their own money into their enterprises, Walsh said. This means executives owning their company’s stock in traditional investing, and hedge-fund and private-equity managers having a good chunk of their own money in their alternative funds.

“The negative on private equity, as a general rule, is they don’t put a lot of skin in the game,” Walsh said. “Just like with our public equity, we like to see our corporate CEOs have a lot of their own money in the stock. That is a good alignment of interests, and it’s even better if they write the check to buy the stock as opposed to getting it in stock options.”

“The positive with hedge-fund managers is that a lot of them have a huge portion of their net worth in the fund,” he added. “If a guy has 75% of his net worth in the same fund we do, that’s a pretty good alignment of interests.”

The New Jersey Division of Investment has shown strong returns recently, but longer-term performance is less impressive. Excluding a Police & Fire Mortgage Program, the pension plan generated a 2.96% average annual return over the past five years, less than the 3.53% return for the fund benchmark; over the past 10 years, the plan’s 5.58% return lagged the benchmark’s 7.08% average annual gain.

“The division has done quite well with risk-adjusted returns since 2009,” Walsh said. “We had problems back in the early 2000s, when they weren’t diversified. The division got hurt quite a bit in 2002, as they had much too much exposure to telecom, media and technology. So now the concept is better diversification, and to not take big tactical bets like that, which worked great from 1996 to 1999 but not so great in 2000 to 2002.”

Regarding risk management, Walsh said the New Jersey Division of Investment recently hired a risk manager who had been retired from a senior position on Wall Street, and the pension plan is working on estimating the probability of portfolio losses, a system known as Value at Risk (VaR). “We’re trying to get a better quantifiable number for the board on a daily basis, just like many banks and investment firms do,” Walsh said, adding that the process remains under development.

‘Big Battleship’

Walsh likened the New Jersey pension to a “big battleship” navigating financial markets. “We can change a little bit here and there, but we’re long-term investors…We’re always going to have to be able to ride fluctuations, down and up.”

The New Jersey pension asset allocations can exceed its specified targets. “Our board is not uncomfortable with us being overweight in something, as long as it’s within approved guidelines and if we have a good rationale,” Walsh said. “If we’re overweight and we get uncomfortable, then we’ll either try to tactically sell something, raise cash, move money into bonds, or move money from bonds into stocks if we think stocks are cheap. We also do quite a bit of options hedging to try to take in some income and reduce risk.”

 “Dodd-Frank concerns me…There are some good aspects to it, but there are also a lot of potentially negative aspects.” Walsh said.

Walsh reports to the New Jersey State Investment Council, which currently has 12 members including the son of former New Jersey Governor Brendan Byrne plus representatives from teachers’, police & fire, and union organizations. According to its website, the SIC “was created by the New Jersey Legislature in 1950 to formulate policies governing the investment of funds by the Director of the Division of Investment, and to consult with the Director with respect to the work of the Division.”

Walsh speaks highly of how he and his investment colleagues are allowed to do their work without undue external influence. “One of the most important things for people in my position is to have a good board,” he said. “Sometimes I hear other CIOs complain about having a board that’s either micromanaging or politically driven. Those are your two big concerns at a public board with a governor, treasurer or legislature that has an agenda.”

New Jersey Treasurer Andrew Sidamon-Eristoff meets with Walsh monthly, but he does not get involved in day-to-day investment decisions, Walsh said. Members of the State Investment Council vary in their political leanings, but they check their differences at the door at meetings, according to Walsh.

“When you get into the room where we actually vet investments, you would never know who is appointed by the governor’s office and who is appointed by the NJEA,” the teachers’ union that is often at odds with New Jersey Governor Chris Christie, Walsh said. “They do their fiduciary duty.”

New Jersey government leaders “let us do our job,” Walsh said. “If you’re an investaholic like I am, it’s about as good as it gets.”

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