America's largest pension ditches hedge funds

calpers investments
CalPERS, the mega pension fund for government employees and retirees in California, is getting out of hedge funds.

America's largest pension fund is saying goodbye to hedge funds.

The decision by the California Public Employees' Retirement System (CalPERS) to exit all hedge funds within the next year is making waves on Wall Street, where hedge fund assets are at record levels even as their returns have suffered.

That's because CalPERS, which manages roughly $300 billion on behalf of 1.6 million government employees and retirees, holds considerable clout in the investment community. When you're that big, people listen, and CalPERS has a history of activism. It's known to take large stakes in publicly traded companies and then aggressively push for corporate change.

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In a press release, CalPERS indicated that it's choosing to dump its approximately $4 billion in hedge fund investments because they've become too complex and costly to manage. CalPERS said it paid $135 million in hedge fund fees in the fiscal year that ended June 30th alone.

Hedge funds don't come cheap. While fees vary, most of these so-called alternative funds go by the "2 and 20" rule, whereby they take fees equal to 2% of assets under management as well as 20% of any profits they make. In regular business terms, that's a fee for service plus a performance fee.

Meanwhile, hedge fund performance has lagged. CalPERS said its hedge funds returned just 7.1% in the latest fiscal year. According to the Barclay Hedge Fund Index, hedge funds overall returned only 11% in 2013, while the S&P 500 gained 30%. They're up 4.5% so far this year, compared to the S&P 500's 8% advance.

The lagging performance isn't entirely surprising since hedge funds are designed to do well during times of market downturns and volatility. After a five year rally, many strategists are predicting some sort of drop. So it's possible that CalPERS is exiting the hedge fund world at a time when it should be doubling down.

"Generating uncorrelated returns that aren't directional to the market is very powerful," said David Druley, a managing director at Cambridge associates who advises pensions on hedge fund investments.

Druley surmised that there are around 10,000 hedge funds to choose from, but only a few hundred are really worth their weight.

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While he thinks CalPERS' maneuver will cause some other pension funds to reevaluate their holdings, he believes hedge funds will continue to receive positive inflows of pension money.

The Teacher Retirement System of Texas, for example, has added to its hedge fund exposure in recent years, and in 2012 took a direct ownership stake in mega hedge fund Bridgewater Associates.

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Don Steinbrugge of hedge fund consulting firm Agecroft Partners says public pension funds have about 8% of their assets in hedge funds.

CalPERS management is being short sighted when it comes to hedge funds, Steinbrugge argues. He believes their potential to generate big returns regardless of what the market does means that the right hedge are worth the cost.

He noted that stock valuations are getting lofty and persistently low interest rates have led to paltry performance for bonds. That doesn't leave a lot of good investment options on the table, especially ones that could protect against a downturn.

"Instead of being innovative, they're morphing more into a bureaucratic organization that wants to focus primarily on reducing fees," he said.

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