Hedge Funds Are Still Finding Love, Just Not at Calpers

I am here to defend the hedge funds, because, well, somebody has to.

You could sense the glee in the air last week, when the enormous California state pension plan known as Calpers announced that it would eliminate its investing program in hedge funds.

Commentators piled on, some calling hedge funds a doomed asset class helmed by greedy billionaires who overcharge for a too-complex asset. One columnist argued that “the industry’s best period is likely behind it.” Another said the “most surprising thing” about the maneuver was that “it took so long.”

Of course the people who operate hedge funds are greedy. Harvard M.B.A.s don’t go into hedge funds to save the world. Still, the decision by Calpers, the California Public Employees’ Retirement System, became a Rorschach test for people to convey their own personal views of hedge funds.

The California pension fund, with more than $300 billion in assets, itself explained the move with a statement by its chief investment officer, Ted Eliopoulos.

“When judged against their complexity, cost and the lack of ability to scale at Calpers’s size,” he said, hedge fund investment by the pension fund “doesn’t merit a continued role.”

The nuances of that statement have been lost. For hedge fund detractors, the decision by Calpers is a Waterloo and it is only a matter of time before other pension funds and investors join the retreat.

Never mind that hedge fund assets hit $2.352 trillion as of the second quarter of 2014, according to BarclayHedge, a data provider for hedge fund returns

A closer look at the hedge fund industry — and at the Calpers statement — tells a different story.

Let’s start with the issue of complexity. Hedge funds can indeed be opaque, but some are not that complicated at all. A simple long-short fund — or a fund that will bet on whether the market goes up or down — may invest in a small number of stocks. Other hedge funds, to be sure, employ complex trading strategies relying on arcane derivatives and computer programming. Yet are these any harder to monitor than private equity funds — investments that Calpers will retain?

Additionally, the California pension fund had two advisers to help with its hedge fund investing: the Pacific Alternative Asset Management Company, or Paamco, and UBS. It seems hard to believe that these experts could not help Calpers navigate the hedge funds’ complexity.

This leaves the fee problem that Mr. Eliopoulos referred to when he stated that the asset class was “expensive.” In the fiscal year that ended in June, Calpers paid $135 million in fees for hedge fund investments that earned 7.1 percent.

Private equity firms typically charge the same amount as hedge funds: a 2 percent administrative fee and 20 percent of the profits, though as is the case with hedge funds, a big institutional investor like Calpers almost certainly gets a discount. And the pension fund remains fully committed to investing in private equity, with 15 percent of its capital dedicated to the sector, or a total of $31.6 billion invested as of June.

Indeed, the pension fund has increased its allocation for private equity in recent years. In other words, high fees do not seem to deter Calpers when the profits are there.

Neither complexity nor fees appear to explain the exit. Instead, what does appear to be the reason is simply the one that Calpers gave — the asset class just isn’t working for the pension fund because of the strategy it has taken.

Calpers’s 7.1 percent return on its hedge fund portfolio is acceptable, but paltry when compared with the 18.4 percent the pension fund earned over all last year.

Hedge funds have always underperformed at Calpers. The pension giant earned only an average 4.8 percent annually in the last 10 years from hedge fund investments. This return is a full two percentage points below the target return that it had set for the asset class.

The poor performance appears to be motivating Calpers to exit hedge funds. Only 1.5 percent of its assets were dedicated to investment in hedge funds. One big reason for investment in hedge funds is to hedge returns. Hedge funds are intended to perform better when stock markets go down.

But given the relatively small amount invested, Calpers was in hedge funds for the wrong reasons. The returns were not there. And unless the pension fund scaled up its investment by tens of billions of dollars, the hedging aspect of hedge funds could not work.

Not only that, Calpers’s hedge fund strategy itself was lacking. The pension fund diversified its hedge fund strategies into a variety of classes: long-short, multistrategy, event-driven, international and funds of funds, among others. With more than 40 different hedge funds, Calpers had trouble picking a winner and had too little money in too many types of funds and strategies.

The pension fund also concentrated in investing in relatively unknown hedge funds, avoiding the megafunds that have earned outsize returns each year, such as Appaloosa or Bridgewater. In contrast, the Texas teachers’ pension fund has actually bought a stake in Bridgewater itself.

Calpers made an entirely rational decision to exit. The fees would have been wholly justified if the returns were there. But they were not.

Don’t feel sorry for hedge funds. First off, pension funds and other investors that can search for better yields and get the better hedge funds will stay in the business, including not only Texas’ teachers fund but also Massachusetts’s pension fund, which has about 9 percent of its assets in hedge funds. Second, hedge funds are a victim of market volatility, or the lack thereof. When markets eventually become more volatile, hedge funds will be back.

The move by Calpers is also a result of its unwillingness to ride the hedge fund craze toward activist investing. (The pension fund, in any case, gets the benefit of that activism in its stock portfolio.)

Calpers’s exit, then, is really about Calpers and not something broad about hedge funds’ being a “doomed” asset class.

So hedge fund titans, California may just not be that into you, but there are plenty of other starry-eyed, deep-pocketed investors to woo.