Download - 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?
New Normal #1 Liability Driven Investing
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
New Normal #1 Liability Driven Investing
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.
New Normal #1 Liability Driven Investing
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
New Normal #1 Liability Driven Investing
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.
New Normal #1 Liability Driven Investing
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
New Normal #2 “Fat Tail” Risk/Return Distributions
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.
New Normal #2 “Fat Tail” Risk/Return Distributions
Short Volatility StrategiesExample – IRR of BBB – rated 3-6%CDO Tranche vs BBB CDS Portfolio
Source: Barclays Capital
New Normal #2 “Fat Tail” Risk/Return Distributions
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
New Normal #2 “Fat Tail” Risk/Return Distributions
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
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
$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
New Normal #2 “Fat Tail” Risk/Return Distributions
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
New Normal #2 “Fat Tail” Risk/Return Distributions
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
New Normal #2 “Fat Tail” Risk/Return Distributions
$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
New Normal #2 “Fat Tail” Risk/Return Distributions
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
New Normal #2 “Fat Tail” Risk/Return Distributions
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
New Normal #2 “Fat Tail” Risk/Return Distributions
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)
New Normal #3 Asset Class Boundaries are Becoming Blurred
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
New Normal #3 Asset Class Boundaries are Becoming Blurred
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