NEW JERSEY DIVISION OF

INVESTMENT

Review of IPC’s Asset Allocation Discussion

May 24, 2017

State Investment Council Meeting

The following slides summarize the

Investment Policy Committee (IPC)

discussion held on April 19, 2017

regarding asset allocation.

Agenda Item 4

2 2

Executive Summary: Current Investment Themes and Tactical Asset Allocation

• The Pension Fund has benefitted from increased allocations to Global Growth over the past six years• U.S. Equities remain the highest targeted allocation (30%) within the Fund as the S&P 1500 has realized an annualized return

of 13% since the start of FY11

• Following a period of strong returns driven by higher valuations and extraordinary monetary policy, the Division may tilt the Fund in favor of more conservative asset classes relative to the targeted AA

• valuations for U.S. Equities have reached their highest levels of the past decade and appear to be discounting strong earnings growth and fiscal stimulus, at the same time certain risks appear to be deemphasized

• while longer-term return prospects for fixed income are constrained by still low yields, the move to higher yields over the past nine months provides somewhat more attractive income prospects for an asset class with favorable defensive characteristics

• quarterly pension payments and an improved cash flow outlook for the Fund also favors fixed income relative to an allocation to cash where the return prospects are more modest

• The Division expects to maintain a pronounced home country bias within global equities, but may tilt the allocation somewhat in favor of non-U.S. equities relative to the targeted AA

• Non-U.S. equity valuations are viewed more constructively, particularly in light of more favorable earnings and economic growth potential within EM and an extended period of policy accommodation within DM

• any tilt would likely be modest, as risks remain elevated ahead of Brexit negotiations, continued pressure on the EU institution, elections in Germany, further deleveraging, and the eventual tapering of ECB monetary policy

• Notwithstanding higher valuations and strong returns, Private Equity and Real Estate remain attractive on a longer-term risk-return basis

• However, the pace of commitments should slow based on pacing model, and the current market environment

• Consistent with the FY17 Investment Plan, the Division is recommending modest adjustments to the Policy Benchmark for FY18 that reflect the ongoing implementation of the targeted asset allocation

• the changes would reflect ongoing hedge fund redemptions and a move towards the targeted allocation• the Policy Benchmark weight to U.S. Equities would increase from 28% to 29%, offset by a 1% decline in the weight to Equity-

oriented HF• the Policy Benchmark weight to IG Credit would increase from 9% to 9.5%, offset by a 0.5% decline in the weight to Credit-

oriented HF

Hedge Fund Program Redemption Update

3

Redemptions for the Hedge Fund Program remain on track to meet the allocation target of 6% by Calendar

Year End 2018. Progress in reducing the overall allocation to hedge funds supports a reduction in the weight

of hedge funds for the FY18 Policy Benchmark in favor of U.S. Equities and Investment Grade Credit.

0.00%

2.00%

4.00%

6.00%

8.00%

10.00%

12.00%

Sep-16 Dec-16 Mar-17 Jun-17 (Projected) Dec-17 (Projected) Jun-18 (Projected) Dec-18 (Projected)

New Jersey Hedge Fund Allocation

Absolute Return Hedge Funds Credit-Oriented Hedge Funds Equity-Oriented Hedge Funds

The HF Program is projected

to reach its targeted

allocation (6%) by the end of

2018

Forward S&P 500 Valuations and Subsequent Five Year Returns – March 1990 to present

-5

0

5

10

15

20

25

30

11 13 15 17 19 21 23 25 27

5 Y

ear

Retu

rn (

% A

nn

ua

lized

)

Forward P/E

The S&P 500’s Forward P/E

(measured quarterly) has been

higher than the current level twenty

times since March 1990. Over the

subsequent five-year period , the

average return was 0.85%.

The S&P 500’s Forward P/E

(measured quarterly) has been

lower than the current level sixty-

four times since March 1990. Over

the subsequent five-year period, the

average return was 12.05%.

Equity valuations have an important impact on forward-looking returns.

Higher beginning valuations tend to subsequently lead to subdued equity market returns.

Forward P/E

as of

12/31/16

Source: Bloomberg

4

5

U.S. Equity Market Is Pricing in Expectations For Favorable EPS Growth

While forward U.S. Equity EPS estimates suggest favorable growth,

current valuations in the marketplace remain high

Consensus estimates for S&P 500 EPS

suggest that earnings will grow at an

annualized pace of 11% in 2017 and

2018. From the 2009 low through 2016,

EPS grew, on average, 9.8% per year.

Over the same horizon, nominal GDP

expanded 3.2% per year.

While the forward PE multiple for the

S&P 500 currently appears stretched,

valuations are somewhat more

reasonable in light of current EPS

growth expectations. The market may

be discounting higher earnings

prospects ahead of proposed tax

reform, deregulation and repatriation.

U.S. Equity Valuations Appear High in Historical Context

Source: FactSet

S&P 500 Earnings

10

12

14

16

18

20

22

24

Mar-97 Mar-01 Mar-05 Mar-09 Mar-13 Mar-17

Price /

Ea

rnin

gs M

ultip

le (

X)

S&P 500 Forward P/E Ten Yr Avg Twenty Yr Avg

The S&P 500 recently traded at its highest

forward looking multiple since 2002

39.32

50.3446.70 45.49

51.77

56.78

47.4950.48

55.22

68.84

78.56

90.0887.48

73.74

62.02

87.10

98.97

105.25

111.36

118.96118.60 119.15

131.24

146.73

160.74

0

20

40

60

80

100

120

140

160

180

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017E 2018E 2019E

S&

P 5

00

EP

S

6

Non-U.S. Developed Markets and Emerging Markets: Earnings and Valuation

Forward earnings expectations in Europe, the Far East and in Emerging Markets suggest a

sharp rebound following an extended period of declining earnings. Current valuations appear

somewhat more reasonable in the context of strong earnings growth expectations.

EAFE Price / Earnings Multiple

Source: FactSet

EAFE Earnings

8

10

12

14

16

18

20

22

24

26

28

Mar-97 Mar-01 Mar-05 Mar-09 Mar-13 Mar-17

Price /

Earn

ings M

ultip

le (

X)

EAFE Forward P/E Ten Yr Avg Twenty Yr Avg

52.59 54.1249.98

60.48

45.39

52.01

73.38

98.71

110.17

136.13

162.13

97.90

82.02

126.57

119.47

111.99

121.67

111.54

105.57102.71

118.82

129.10

139.13

0

20

40

60

80

100

120

140

160

180

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017E 2018E 2019E

MS

CI E

AF

E E

PS

8

9

10

11

12

13

14

15

16

17

Oct-99 Oct-03 Oct-07 Oct-11 Oct-15

Price /

Earn

ings M

ultip

le (

X)

EM Forward P/E Ten Yr Avg Seventeen Yr Avg

34.57

22.01 21.26

24.54

32.53

49.88

55.6857.61

71.67

50.56

59.42

85.82

91.61

85.3183.48

74.46

60.02

64.25

76.39

85.03

94.68

0

10

20

30

40

50

60

70

80

90

100

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017E 2018E 2019E

MS

CI E

M E

PS

Emerging Markets Price / Earnings MultipleEmerging Markets Earnings

0

2

4

6

8

10

12

14

16

18

20

1 3 5 7 9 11 13 15

5 Y

ear

Retu

rn (

% A

nnualiz

ed)

Beginning Yield (%)

Bloomberg Barclays Agg Beginning Yields and Subsequent Five Year Returns – March 1976 to present

From 1976 through 2012, there

were 4 quarter end periods with

lower beginning bond yields versus

today. The highest subsequent five

year return was 3.1%

Analysis of historical returns suggests beginning yield is a good predictor of long-term returns.

Lower beginning yields may portend subdued fixed income market returns.

Yield as of

03/31/17

Source: Bloomberg

7

8

A Recent Backup in Bond Yields Makes Fixed Income Somewhat More Tactically Attractive

Source: Bloomberg

-4

-2

0

2

4

6

8

10

12

14

16

Feb-62 Feb-66 Feb-70 Feb-74 Feb-78 Feb-82 Feb-86 Feb-90 Feb-94 Feb-98 Feb-02 Feb-06 Feb-10 Feb-14

Yie

ld a

nd

Re

turn

(%

)

Ten Year U.S. Treasury Yield Next Ten Years Realized Real Return

Bond yields

remain near all-

time lows

Over longer-term time periods, ten-year Treasuries

have realized an average real return of 2¾%

Global Sovereign Yield Curve Comparisons

0%

2%

4%

6%

8%

10%

12%

14%

0

200

400

600

800

1000

1200

1400

1600

1800

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

De

fau

lt R

ate

Op

tio

n A

dju

ste

d S

pre

ad

(O

AS

) in

bp

s

Default Rate (RHS) HY OAS (LHS) Long Term Avg OAS

0

100

200

300

400

500

600

Jun-89 Jun-92 Jun-95 Jun-98 Jun-01 Jun-04 Jun-07 Jun-10 Jun-13 Jun-1620%

25%

30%

35%

40%

45%

Option A

dju

ste

d S

pre

ad (

OA

S)

in b

ps

BB

B a

s %

of Tota

l C

redit I

ndex

BBB as % of U.S. Credit Index (RHS) OAS U.S. Credit Index (LHS) Long Term Avg OAS

While absolute

yields remain

low, U.S. yields

are higher vs.

most sovereign

issuers

Yield seeking investors

have moved credit

spreads lower at the

same time that the credit

profile of the market is

weakening over time

HY spreads have

narrowed while

default rates have

moved higher

While bond yields remain low in an historical context, rates are somewhat more attractive vs a year ago. Tighter credit

spreads have tempered a move to higher Treasury yields at the same time that fundamentals are weakening.

IG Credit Spreads and Creditworthiness

Ten Year Treasury Yields and Real Returns

HY Credit Spreads and Creditworthiness

(800,000,000)

(600,000,000)

(400,000,000)

(200,000,000)

0

200,000,000

400,000,000

600,000,000

800,000,000

Net CF Contributions Distributions

(2,000)

(1,000)

0

1,000

2,000

3,000

4,000

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017E 2018E 2019E 2020E 2021E 2022E 2023E 2024E

Net Cash Flow Capital Commitments with NJ discretion

9 9

Private Equity: Update on NJ Portfolio

NJ Private Equity Portfolio Cash Flows

Source: RV Kuhns, State Street, and TorreyCove

Private Equity Pacing Analysis$ (millions)

(500,000,000)

(400,000,000)

(300,000,000)

(200,000,000)

(100,000,000)

-

100,000,000

200,000,000

300,000,000

400,000,000

500,000,000

600,000,000

Net CF Contributions Distributions

NJ Real Estate Portfolio Cash Flows

(1,000)

(500)

0

500

1,000

1,500

2,000

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017E 2018E 2019E 2020E 2021E 2022E 2023E 2024E

Net Cash Flow Capital Commitments with NJ discretion

Real Estate Pacing Analysis

The NJ allocation to Private Equity and Real Estate are both expected to gradually move towards

their respective TAAs as net distributions remain positive and the pace of new commitments slows

$ (millions)

10

Current and Secular Investment Themes: Implications for Asset Allocation

Risk Mitigation

• downside protection and less

correlated returns of risk mitigating

strategies are attractive in light of

high valuations in equity and fixed

income markets and escalating

geopolitical risk

• central bank policy divergence and

currency and commodity price

instability create higher capital

market volatility which present

trading opportunities for global

macro and relative value strategies

Liquidity

• more manageable projected cash

needs based on higher projected cash

inflows support a more moderate cash

allocation

• U.S. Government bond yields have

moved off their lows and are expected

move gradually higher over longer term

• lack of compelling opportunities in

other asset classes based on

valuations and fundamentals may lead

to slight overweight to government

bonds when excess cash is available

Income

• tightening spreads have lead to higher

valuation in credit markets at the same

time fundamentals have been

weakening

• allocations to investment grade and high

yield credit are expected to be at or

below the target allocation

• private credit markets investors continue

to provide investors with the ability to

lock up capital the opportunity to

generate outsized returns

Real Return

• real estate capitalization rates are near or

below pre-crisis lows

• Fundamentals remain strong across most

market segments, providing support for low

cap rates

• more defensive real estate sectors provide

the most attractive opportunities in the

current environment

• significant dry powder available in the real

estate market suggests a modest pacing

approach is warranted

Global Growth

• U.S. equity market valuations appear stretched relative to historical standards

absent significant earnings growth, perhaps driven by tax and/or regulatory

reform

• non-U.S. markets appear more reasonably valued relative to the US at the same

time as earnings growth appears to be accelerating

• non-U.S. markets are subject to greater geopolitical risk

• a conservative approach to a private equity vintage year diversification strategy

emphasizing value-based managers with a disciplined buy and sell track record

and less dependence on leverage is appropriate in environment characterized by

high multiples

Market Outlook By Asset Class and Recommendation for FY18 Policy Benchmark

11

Asset ClassCurrent

Allocation

Target

Allocation

Long Term

Target RangeCurrent View Relative to Target Allocation

FY 2017

Benchmark

Weight

Recommended

FY 2018

Benchmark

Weight

RISK MITIGATION 4.26% 5.00% 0-10% 5.00% 5.00%

Absolute Return HFs and

Risk Mitigation Hedging4.26% 5.00% 0-10%

Meaningful allocation to Risk Mitigating strategies warranted given high valuations

and increased geopolitical risk. Continue migration of program to FAIR mandate.5.00% 5.00%

LIQUIDITY 8.19% 8.50% 2-15% 8.50% 8.50%

Cash and Cash Equivalents 5.90% 5.50% 0-15%Cash flow projections suggest a more moderate cash allocation is warranted. Likely

to maintain below target allocation all else equal5.50% 5.50%

US Gov't Bonds 2.29% 3.00% 0-10%

Lack of compelling opportunities in other asset classes based on valuations and

fundamentals may lead to slight overweight to government bonds when excess cash

is available

3.00% 3.00%

INCOME 20.62% 21.50% 15-40% 21.50% 21.50%

Investment Grade Credit 9.70% 10.00% 5-20% Allocation to move toward target as credit hedge fund redemptions are received 9.00% 9.50%

High Yield 2.07% 2.50% 0-8% Fundamentals suggest a modest underweight is warranted 2.50% 2.50%

Global Diversified Credit 4.62% 5.00% 0-7% Allocation will move towards target as prior commitments are funded over time 5.00% 5.00%

Credit-Oriented HFs 2.69% 1.00% 0-6% Allocation will be reduced towards target as redemptions are realized 2.00% 1.50%

Debt-Related PE 0.95% 2.00% 0-4% Expected to be area of focus in 2017/2018 to move allocation towards target 2.00% 2.00%

Debt Related Real Estate 0.59% 1.00% 0-4%Conservative pacing expected moving forward. Allocation will move towards target

as prior commitments are funded.1.00% 1.00%

REAL RETURN 8.14% 8.75% 3-12% 8.75% 8.75%

Private Real Assets 2.58% 2.50% 0-7%Pacing suggests allocation will remain near target based on prior year and expected

future commitments2.50% 2.50%

Equity Related Real Estate 5.31% 6.25% 2-9%Conservative pacing expected moving forward. Allocation will move towards target

as prior commitments are funded.6.25% 6.25%

GLOBAL GROWTH 57.93% 56.25% 45-65% 56.25% 56.25%

US Equity 29.26% 30.00% 15-35% 28.00% 29.00%

Non-US Dev Market Eq 11.36% 11.50% 8-20% 11.50% 11.50%

Emerging Market Eq 6.52% 6.50% 5-15% 6.50% 6.50%

Buyouts/Venture Cap 9.26% 8.25% 4-12%Conservative pacing expected moving forward. Allocation will move towards target

over time.8.25% 8.25%

Equity-Oriented HFs 1.53% 0.00% 0-8% Allocation will be eliminated as redemptions are realized 2.00% 1.00%

High valuations suggest caution for overall global equity allocation. On a relative

perspective, Non-US markets appear more attractive. Preference is for equal to

small underweight in U.S. offset by small overweight to Non-U.S. markets