New Jersey investment officials have directed increasingly large slices of state pension money into riskier investments, such as hedge funds, touting their strategy as a means of limiting exposure to a volatile stock market. They've argued that their approach would maximize overall returns and justify the higher fees paid to Wall Street money managers.
But in seven of the eight years since the state began shifting pension funds into so-called alternative investments, returns have fallen well short of the broader stock market, an analysis of state financial records shows. In those seven years, New Jersey’s alternative investment portfolio has produced gains of just more than half of the S&P 500, the widely watched index seen as a proxy for shares of large corporations.
Since Gov. Chris Christie took office, he has nearly tripled the amount of retiree cash invested in alternative investment firms -- many of whose employees have made financial contributions to political groups backing Christie’s election campaigns. In that time, the gap between New Jersey's alternative portfolio and the broader market has rapidly expanded, costing taxpayers billions in unrealized returns and threatening the financial stability of the $78 billion pension system. The state's pension funding shortfalls -- which have been exacerbated by Christie's market-trailing investment strategy -- were one of the factors cited by Fitch Ratings in its decision last week to downgrade the state's bond rating for the second time.
The below-market results from the state's $20 billion alternative investment portfolio belie repeated assurances from New Jersey officials who said the investments would overperform the stock market. Instead, the results buttress arguments by investors like Warren Buffett and some local lawmakers, who assert that pension money should be invested in stock index funds rather than hedge funds, private equity, venture capital, real estate and other alternative investments.
"The idea that hedge funds, private equity funds and other alternative investments beat stock-index funds over the long haul is an urban myth like the tooth fairy," said Jeff Hooke, a former Lehman Brothers investment banker who in 2012 published a study showing that higher alternative investment fees correlated to lower pension returns. "The managers of these big state pension funds are drinking the Wall Street Kool-Aid. The problem with these alternative investments is that they have a tough time beating the low-fee index funds because the fees for alternatives are so big."
Private equity executive Robert Grady, the Christie-appointed chairman of the New Jersey State Investment Council who championed alternative investments, did not respond to IBTimes’ request for comment, nor did Christie. However, the governor responded last month to criticism of his administration's investment strategy by pointing out that the pension has "overperformed" his own officials' projections.
Christopher Santarelli, a New Jersey Treasury Department spokesperson, told IBTimes that “the premise that alternatives are meant to outperform equity markets year in and year out is false.” That comment contradicts earlier statements from New Jersey officials about their investment strategy.
In 2005, for example, Reuters’ HedgeWorld reported that New Jersey’s alternative investment plan said pensioners should expect that the “alternative investments will produce a positive return significantly in excess of publicly traded equities.” The report quoted then-State Treasurer John McCormac saying alternative investments would protect “against swings in the market that can elevate risk for traditional investments in stocks and bonds."
Similarly, a 2010 memo by the State Investment Council’s consulting firm said “alternative investments have significantly outperformed public markets on a risk-adjusted basis, and we believe they will continue to do so over the long term.” Grady said the strategy would "maximize returns while appropriately managing risk." And Institutional Investor magazine reported that the state’s hedge-fund consultant “predicts that the pension could earn an additional 3 percent return above traditional asset classes from a diversified portfolio of alternatives.”
Santarelli told IBTimes that officials' "focus on diversification and strong risk adjusted returns have served the fund very well over the long term.”
Yet, as IBTimes reported last week, the New Jersey pension fund's overall returns have trailed median public-pension returns. And while Grady had promised to begin "lowering the burden of fees" on pensioners, state documents show those fees have tripled since Christie took office, costing state taxpayers almost $1 billion -- or roughly $300 for every household in the state.
In originally championing the push for more alternative investments, Grady argued that moving pension cash into hedge funds would provide assets "that evince very, very low levels of correlation” to the stock market, thereby better serving pensioners.
According to nearly a decade of state financial records, Grady is correct that the alternative investment portfolio has not correlated with the broader market. But those documents show that the divergence between stock returns and alternatives has not "maximized returns," mitigated risk or benefited pensioners. Instead, New Jersey’s annual audited financial statements show that the S&P 500 index generated a 19 percent return, while the state's Grady sculpted alternative investment portfolio generated just 10.4 percent in the same time.
Applying those returns to New Jersey's alternative investment holdings, pension consultant Chris Tobe estimates that New Jersey taxpayers lost more than $5.8 billion in unrealized returns since Christie took office. Put another way, Tobe’s calculations show that had Christie officials followed the path of Buffett and other pension funds that invested cash in low-fee stock index funds rather than with high-fee Wall Street money managers, New Jersey would have almost 7 percent more in its pension system than it does today. That $5.8 billion would be more than enough to fulfill the pension payments Christie recently opted to cut.
"Alternative investments were sold to many pension trustees as delivering as good or better returns than the S&P, but as New Jersey and other states show, that has proven to be false," said Tobe, author of the book "Kentucky Fried Pensions" and a former public-pension trustee. "While this has been a good stock market, it will be almost impossible for alternatives to catch up in the foreseeable future given the drag on their returns due to the high fees."
In response to questions about the pension fund’s performance, Santarelli downplayed New Jersey's exposure to alternatives, insisting that as of May, alternatives accounted for only 26 percent of the Garden State's pension fund. State documents show New Jersey has authorized a total of $29 billion to be committed to alternatives -- or roughly 37 percent of its entire pension fund. Grady in 2011 championed a plan to allow Christie officials to invest up to 38 percent of the fund in alternatives. A recent report by Pensions and Investments found that New Jersey is the second-largest public pension investor in hedge funds.
Financial executive Thomas Byrne, the vice-chair of the New Jersey State Investment Council, told IBTimes that it is important to remember that much of "the money that we put into alternatives came out of fixed income rather than [stocks], so it clearly did better than it would have in those fixed-income assets."
Byrne’s assertion is supported by data from 2010 to 2014, when New Jersey’s fixed-income portfolio of assets like bonds generated slightly lower returns than its alternative investment portfolio, 9.4 percent contrasted to 10.22 percent. Yet, over a longer term, the numbers tell a different story: Since 2007, the state’s fixed-income portfolio has generated 8.5 percent returns as contrasted to 5.25 percent for its alternative investment portfolio. In addition, a study by the Vanguard Group, one of the nation's largest marketers of stock-index funds, recently warned pension funds about the long-term dangers of moving money out of fixed income accounts and into alternatives. In Vanguard's analysis of data from 1995 to 2012, the firm concluded that “funding an alternatives strategy with bonds increased the risk of the pension portfolio.”
Lawmakers in other states have pushed public pension funds to shift assets out of alternatives and into stock-index funds. For example, just across the Delaware River from New Jersey, in Pennsylvania's Montgomery County, Commissioner Joshua Shapiro, a Democrat, earned national attention for firing the private money managers overseeing his county’s $450 million pension fund and then reinvesting much of the cash in index funds.
“Over the long haul, the overall market has an impressive record that almost no managers can beat,” Shaprio said in promoting the move. “The record is clear that passively managed, broad-based index funds have substantially lower fees than actively managed funds, and asset managers rarely beat the market over the long run.”
Grady has asserted that one benefit of the alternative investments is that “you dampen the effect of a big drop” in the stock market. That proved true in 2008 -- the one year out of eight that New Jersey’s alternative portfolio outperformed the S&P 500. But the principle did not hold up since then, as the state’s alternative investment portfolio trailed the S&P in weak stock market years such as 2009 and 2012. And the one year in which the alternatives outperformed the S&P was not enough to wipe away losses from unrealized gains in all the other years.
“Over long periods of time, whatever minimal protection against drops you might get from alternative investments is sacrificed by underperforming for the other eight or nine years,” said Hooke, who is now vice president of the business-led Committee for Economic Development. “If you are worried about one down year, then rather than buy expensive alternatives, you can just buy cheaper forms of portfolio insurance to protect against a huge market drop. That would save billions of dollars.”