TRENTON, N.J. (HedgeWorld.com)–New Jersey’s public pension funds, which for years have been managed in-house and have assiduously avoided any investments that weren’t stocks or bonds, will soon start investing in various alternative strategies, including hedge funds.

Recently the state’s Division of Investment, which oversees roughly US$70 billion in assets belonging to seven public employee retirement plans, adopted rules and procedures for a new Alternative Investment Program. That followed a November 2004 vote to allocate 13% of the division’s investment portfolio to alternative investments.

According to the policy, the state will target allocations of between 4% and 5% to so-called absolute return strategies–essentially hedge funds and funds of funds–between 4% and 5% to “real assets”–meaning real estate–and between 5% and 7% to private equity.

Division of Investment officials said they would reach the 13% threshold over five to seven years. Tom Vincz, spokesman for the New Jersey Department of the Treasury, under which the Division of Investment falls, said the first steps toward funding the 13% allocation would not begin until May, when the state’s investment council gives final approval to the plans.

The goal behind the alternatives plan is to improve the division’s risk-adjusted returns through diversification, said New Jersey State Treasurer John McCormac.

“Portfolio diversification provides New Jersey with the ability to significantly improve its overall risk-adjusted returns and better meet the financial obligations of the public pension system,” Mr. McCormac said in a statement. “An alternative investment program provides the right balance to protect the long-term interests of the taxpayers of the state and the participants of the system against swings in the market that can elevate risk for traditional investments in stocks and bonds.”

To implement the plan, the Division of Investment crafted new policies and procedures. The policies outline goals and guidelines for each asset class and assign risk control responsibilities for the investment council, Division of Investment and the Department of the Treasury. The division also created a new pension fund, Common Pension Fund E, through which the seven public employee plans will invest in alternatives.

According to the new policies, the goals of the new Alternative Investment Program is simple: Enhance the risk-adjusted returns of the pension funds and generate returns, net of fees, in excess of equity markets. “While specific investments may incur losses of all or part of the capital invested, it is expected that a diversified portfolio of alternative investments will produce a positive return significantly in excess of publicly traded equities,” according to the new alternatives policy. The program seeks “to reduce overall risk in the portfolio even though some individual investments may have greater risk.”

Specifically with respect to the absolute return, or hedge fund, portion of the program, the Division of Investment appears open to exploring just about any strategy. Among those mentioned specifically in the policy are various arbitrage strategies, event-driven, distressed debt, equity long/short, global macro, managed futures and dedicated short sales.

The division will be subject to a number of constraints on how state pension funds can invest in hedge funds. For arbitrage, event-driven and distressed strategies–referred to by the division as “low volatility” strategies–pension funds or annuities investing in Common Fund E can have no more than 0.2% of their total assets invested with any single hedge fund manager, and no more than 2% of their assets can be invested in the low-volatility category.

The benchmark for this category will be 300 basis points above 12-month LIBOR over a trailing five-year period, net of fees and expenses, according to the policy.

For equity long/short, funds and annuities investing in Common Fund E can have no more than 0.3% of their total assets with any one manager and no more than 3% of those assets in the category. The benchmark is 400 basis points above 12-month LIBOR over the trailing five-year period, net of fees and expenses.

For opportunistic funds–which according to the policy include global macro, long opportunistic, managed futures and dedicated short bias–state pension funds can invest no more than 0.15% of their total assets with a single hedge fund, and their participation in the category is limited to 1.5% of their total assets. The benchmark is 500 basis points above the 12-month LIBOR over a trailing five-year period net of fees and expenses.

In terms of risk control, the division’s head of alternative investments, Cesar Baes, will work with the division’s general consultant, Strategic Investment Solutions Inc., San Francisco, and separate consultants to be hired for private equity, real estate and hedge funds to evaluate managers. Those identified as potential investments will then undergo extensive due diligence and, if selected, continuous monitoring. They also will be subject to prohibitions on making campaign contributions to state politicians.

“Each step of the AIP process has built-in protections to ensure integrity, internal controls, vigilant supervision and risk management,” Mr. McCormac said.

Historically, New Jersey’s state pension fund assets have been actively managed in-house by Division of Investment employees. The state has eschewed outside managers and index funds. When hedge fund manager Orin S. Kramer took over as chairman of the investment council in 2002, he started shaking things up.

An analysis by Mr. Kramer showed the state ranked among the worst in terms of risk-adjusted returns over a three-year period ending June 30, 2002. The state’s pension funds lost US$24 billion between June 2000 and September 2002.

As a result, the Division of Investment’s old director, Steven Kornrumpf, stepped down. He was replaced by Peter A. Langerman, former chief executive of Franklin Mutual Advisors, Short Hills, N.J. In 2003, the state retained Strategic Investment Solutions to conduct a top-to-bottom review of the division’s investments, including an asset-liability study Previous HedgeWorld Story). Later the fund hired Strategic as its general consultant.

Mr. McCormac called the approval of the alternative investments policy and procedures a “significant step” toward stabilizing and strengthening the state’s investment program and the culmination of a “methodical reform process.”

The move to hire outside managers for the alternatives program is a big step for New Jersey. When Mr. Kramer took over as chairman of the investment council, there were concerns in the state legislature that he would push to open investment management to outside firms, which some feared could lead to out-of-state money managers injecting campaign contributions into New Jersey politics.

But in 2004, the Division of Investment adopted safeguards that prohibit such campaign contributions by outside managers. Earlier, the division received an opinion from the state attorney general’s office that no legislative action was necessary to allow use of outside managers.

“We have been deliberate and thorough in diagnosing problems. We have been open-minded about prescribing solutions, and today we are prepared to move forward with sound, well-reasoned reforms,” Mr. McCormac said.

CClair@HedgeWorld.com

Contact Bob Keane with questions or comments at: bkeane@investmentadvisor.com.