By Anastasia Donde

While many large U.S. pension funds are eager to invest more in hedge funds and other alternative investment funds, they are often hamstrung by strict legislative guidelines that set hard limits on how much they can allocate to these types of managers. But the state of New Jersey is fighting those limits in order to boost its exposure to these funds, a move that the state's former investment council chairman says is long overdue.

"If New Jersey had invested 12% each in hedge funds, private equity and real estate a decade ago and achieved median returns in each area, they'd have $20 billion more than they have today," says Orin Kramer, the former chairman of the State Investment Council, which oversees investment strategy and asset allocation for the state's pension, the $68 billion New Jersey Division of Investment.

Kramer, who is no longer chairman but still serves on the council, and the pension's consultant, Strategic Investment Solutions, argue that the pension fund could earn better returns with lower risk if it was allowed to put more money into hedge funds and other alternative investments. This could also improve the division's funding status, or the ratio of its existing assets to liabilities. To that end, the council recently voted to raise the limit on how much of its total assets the pension can invest in alternatives to 38% from 28%, and to raise the cap on hedge funds to 15% from 7%.

New council chairman Robert Grady says that raising the limits "could give the division more flexibility in achieving a diversified portfolio and maximize returns while appropriately managing risk." Grady, who is a managing director of the Cheyenne Capital Fund, a private equity vehicle, and former partner at the Carlyle Group, became chairman of the council in September. Kramer is also a general partner of New York hedge fund Boston Provident Partners.

The vote was a victory for Kramer, who has worked for several years to get the pension to ramp up its exposure to these investments, particularly hedge funds. Kramer recently conducted an analysis of U.S. pension plans' funding statuses and the historical returns produced by alternative investment funds versus traditional investments. He contends that pension funds, like many endowments and foundations, would have performed much better over the past 10 years had they invested more in alternatives.

The study was conducted with the help of Strategic Investment Solutions, which is based in San Francisco. Pete Keliuotis, a managing director at the firm, presented several different proposed asset allocation strategies to the council, and the pension said that the strategies with higher allocations to alternative investments had "a substantially higher expected return, with modestly higher risk than the current mix," according to the firm.

Grady also warns that, according to the consultant's findings, the plan would have to invest much more in equities in order to achieve the same returns it would generate by investing in alternatives-but this would also create a much higher level of risk. Strategic Investment Solutions proposed raising the pension's exposure to hedge funds to 15% of total assets, real estate to 9% and private equity to 12%. For now, the pension is allowed to invest only up to 7% to each of those investment styles.

New Jersey's investment council approved these moves at a September meeting, but the pension now has to work through the process of rewriting the investment policy documents to replace the old limits with the new ones, which should take about six months, Kramer says. During this time, the council will undergo a comment period, which will allow the various constituencies and unions represented by the pension fund to discuss their opinions and possibly argue against the new limits. After that point, the council and the division will be able to work together to set new targets if they choose, Kramer and Grady explain. So far, the council has voted only to increase the amount the pension can allocate to alternative investments, which doesn't necessarily mean that the targets, or how much New Jersey will actually plan to invest in these funds, will be raised as well.

The Kramer/SIS study also points out that New Jersey lags behind its large pension fund peers in terms of alternative investing. Large plan sponsors have allocated an average of 8.9% to alternatives, while New Jersey has invested 7%, putting it dead last among the top 20 state plans.

"For large pools of capital, I think it's prudent to have both private equity and hedge funds as part of the mix of a diversified portfolio," says Grady. "This is true of most large endowments and most large public funds in the country," he adds, noting that pensions likely allocate less than endowments to alternative investments.

"There will be increased exposure to hedge funds among many fiduciaries, in part because people are coming to understand the risk-adjusted return and in part because of liquidity relative to some other alternative classes," Kramer says. The public pension world has lagged behind foundations and endowments in terms of performance, he adds, because pensions haven't invested enough in alternatives. Kramer admits that endowments haven't performed perfectly-"in 2008, endowments were absolutely clobbered"-but he says that if you look at endowments over the past decade, "the returns are superior."

Cliffwater, based in Marina del Rey, Calif., acts as the pension's hedge fund consultant and also recommended raising the limits in July. Cliffwater works with New Jersey specifically on its hedge fund investment strategy, while SIS assists with its overall asset allocation and investment strategy, including traditional investments. Cliffwater predicts that the pension could earn an additional 3% return above traditional asset classes from a diversified portfolio of alternatives.

The actual or target mix with respect to alternatives and hedge funds will be a matter of judgment, Grady says, noting that the division usually goes through an annual asset allocation review process to adjust its targets. Grady says he will be working on this with the council and the pension's chief investment officer, Tim Walsh, after the limits are amended.

Walsh is also relatively new to New Jersey's pension. He joined the division in July, replacing William Clark, who left at the beginning of the year to run the Federal Reserve Bank's pension fund. Walsh was previously chief investment officer of the $8.5 billion Indiana State Teachers' Retirement Fund, which made the decision to start investing in hedge funds shortly before Walsh's departure. The plan had hired hedge fund consultant Aksia to assist with the initiative in January.

Kramer and Grady are not yet sure which hedge fund strategies New Jersey will pursue next, but they plan to work with Walsh, the investment staff and hedge fund consultant Cliffwater to devise an investment strategy. Kramer, who served as the council's chairman from 2002 until Grady's election in September, has helped the plan shift as much as $9 billion of its portfolio into alternative investments. The plan now invests about 4% to 5% of its assets in hedge funds. New Jersey started investing in hedge funds in 2006 and has been hiring new ones at a steady pace since then.

New Jersey so far has invested in a slew of brand-name hedge funds, including Level Global Investors, Brevan Howard Asset Management, Pershing Square Capital Management and Farallon Capital Management, to name a few. It also invests with a few funds of funds, including Goldman Sachs Asset Management and the Rock Creek Group.

Grady notes that the pension still has a long way to go before it can actually raise its targets to alternatives, but he says amending the limitations would be a first step in this process. "It's simply a proposal to begin a process of drafting regulations, which would give the council the flexibility to raise the regulatory ceilings," he says. AR