N.J. presses for hedge fund savings

Even before the dramatic decision to significantly reduce its reliance on hedge funds and to cut hedge fund fees, the $71.5 billion New Jersey Pension Fund had been chipping away at those costs.

“We've been getting more aggressive and using our buying power to negotiate fees,” said Brendan Thomas Byrne Jr., chairman of the New Jersey State Investment Council, in an interview Aug. 4, the day after the council voted unanimously for several hedge fund policy changes. “Our average management fee is slightly under 1.5% and the incentive fee is around 18.5%.”

The traditional hedge fund formula is 2% and 20%, but the investment council unanimously voted for a new policy that requires a 1% management fee and 10% incentive fee for future hedge fund investments.

Mr. Byrne said he believes there are enough high-quality hedge fund managers who will accept the new policy called FAIR, or fund alignment and incentive reform. “People are still going to have to show us performance,” Mr. Byrne said.

New Jersey's decision contrasts with those of the New York City Employees' Retirement System — one of the five funds in the city's $163.1 billion pension system — and the $302.7 billion California Public Employees' Retirement System, Sacramento. Governing boards for both pension funds have voted to divest all hedge funds.

“We didn't want to throw out the baby with the bathwater,” Mr. Byrne said. “We didn't want to abandon an entire category if some investments made sense.”

The policy changes could produce $127 million in annual cost savings “once portfolio restructuring is complete,” said an Aug. 3 report by the Division of Investment. “On a pro forma basis, the division projects a 60% reduction in management fees and a 73% reduction in incentive fees.” A date for completion of the restructuring was not provided.

Another policy change approved by the council affects risk-mitigation strategies, whose asset managers now will be subject to a flat fee of 0.75% to 1.25% and no incentive fee.

The council approved reducing the number of hedge funds to fewer than 25 from about 40. The number “would be further consolidated in order to reach the proposed target allocation for fiscal year 2017,” said the Division of Investment report.

The overall hedge fund target allocation would shrink to 6% from the 12.5% target for the 2016 fiscal year.

The target allocation to risk-mitigation hedge funds — market neutral and global macro funds — remained at 5%. However, the allocation to equity-oriented hedge funds was cut to zero from 3.75%, and credit-oriented hedge funds, cut to 1% from 3.75%.

These allocation targets were proposed by the Division of Investment. Mr. Byrne said the council agreed to divest equity hedge funds because of poor performance. “We couldn't justify the fees,” he said.

According to the division's May 31 investment report, the equity hedge fund portfolio returned -11.98% for the 10 months ended April 30 vs. the benchmark's-5.14%. (The portfolio reports on a one-month lag.)

As of May 31, the investment report shows, the risk-mitigation portfolio produced a return of -2.21% compared to a benchmark of 2.94%. Credit-oriented hedge funds produced a return of -3.24% vs. a benchmark of -7.15%, as of May 31.

As of May 31, the combined market value of the three hedge fund categories represented 11.75% of total pension fund assets.

New Jersey's hedge fund policy is a compromise between business executives and union representatives on the investment council. In May, the Division of Investment proposed to the council that the hedge fund allocation be cut to 9.5% for the 2017 fiscal year from 12.5%.

However, union members on the council, led by Vice Chairman Adam Liebtag, said at the time that the allocation should be reduced to 4%. Some board members said the 4% cap might harm the pension fund's ability to cope with downside risk.

But Mr. Liebtag sought a vote at the May meeting, which resulted in a 7-7 tie and a rejection of the 4% proposal. Staff members went back to the drawing board, looking to reduce the hedge fund exposure without increasing investment risk.

The division analyzed the impact of a 4% hedge fund cap and presented its findings in a report to council members for the Aug. 3 meeting.

Asset mixes “that imposed a 4% maximum constraint on hedge fund investments prove to be less efficient” than the 6% solution, said the division report, emphasizing the importance of “adequate flexibility” in overall pension fund management when markets fluctuate.

“This really was a compromise agreement,” Mr. Liebtag said in an interview Aug. 4 as he praised the division staff for its efforts. Mr. Liebtag is president of Local 1036, Communications Workers of America, AFL-CIO, West Trenton, N.J.

Union members and beneficiaries have provided “a lot of positive feedback” about the council's new policy, he said. “Our concern about alternative investments has been building up over several years” as the New Jersey Pension Fund expanded exposure to hedge funds, private equity and other investments.

“The beneficiaries have been advocating a change in hedge funds for several months,” he added.

Even with its new policy, the New Jersey Pension Fund will hold a greater percentage of assets in hedge funds than public pension funds that have voted to eliminate their hedge fund exposure.

For example, hedge funds now account for $1.39 billion, or 2.6% of the total $53.26 billion in assets at NYCERS, whose trustees voted in April to divest all hedge funds. They didn't set a timetable for the divestment.

CalPERS announced in September 2014 that it would divest its $4 billion in hedge funds, which at the time represented 1.3% of total assets. As of Dec. 31, 2015, CalPERS still held $463 million in hedge fund investments. CalPERS now has $299.4 billion in total assets.

However, when it reduces its hedge fund exposure, the New Jersey Pension Fund will hold a lower percentage than the average hedge fund investment among North America-based public pension plans, the division report said. Citing research by Preqin, an alternatives investment research firm, the division report said that average this year is 9% of total public pension fund assets.

Even before last week's council vote, the pensin fund had been redeeming hedge fund investments, according to the division report presented at the council meeting.

Between June 30, 2015, and April 30, 2016, the division redeemed $1.58 billion from hedge funds. Between June 30, 2016, and July 29, 2016, the pension fund submitted redemption notices to hedge funds totaling an additional $649.7 million.

And by the end of this year, the division predicted that total hedge fund redemptions since June 30, 2015, will reach about $2.9 billion.

At the same time that the council was voting to change hedge fund policies, the Division of Investment announced it would invest up to $1 billion in a separate account managed by BlackRock Alternative Advisors, a unit of BlackRock Inc. The separate account will be part of the FAIR program.

BlackRock “will identify a diverse range of hedge fund strategies with a focus on risk-mitigation strategies,” according to a separate division report issued at the council meeting. “The underlying hedge fund fee is targeted to average a 1% management fee and a 10% incentive fee, with hurdles at the underlying hedge fund level if possible.”

Both Mr. Liebtag and Mr. Byrne said the BlackRock investment won't push the pension fund's risk mitigation allocation past the 5% threshold. “We are cutting more than we are adding,” Mr. Byrne said. n