Hedge funds were once the domain of the rich. Today, it is the teachers, firefighters and other public employees in the country’s biggest pension funds who are among the industry’s main investors.
So when the California Public Employees’ Retirement System, the nation’s largest pension fund, said on Monday that it planned to eliminate all $4 billion of its hedge fund investments over the next year, the industry took note.
“More institutions have been getting on the bandwagon and getting into hedge funds,” said Rodger F. Smith, a managing director at Greenwich Associates. “The fact that Calpers is jumping off is an important time for reflection.”
For the $2.8 trillion hedge fund industry, the size of the Calpers investment is minuscule. But losing it is important because Calpers has long been a trendsetter among public pension plans, and the reasons for its decision resonate with many public workers, retirees and the plans’ trustees: Hedge funds can just seem too complicated and costly.
“A lot of the employees’ labor unions will applaud this,” said Christopher J. Ailman, chief investment officer of California’s big pension fund for teachers. He said organized labor tended to be wary of Wall Street in general; big fees for hedge fund managers are seen as siphoning away money from public workers.
His crosstown rival, Ted Eliopoulos, chief investment officer at Calpers, indicated that he expected the decision to have a ripple effect.
“We certainly had a very thoughtful and deep conversation with our peers in the institutional investor network, as well as a wide variety of talented active external managers, and so we considered those opinions in forming our own conclusion,” Mr. Eliopoulos said.
Public pension funds make plans on the assumption that over the long haul their investments will earn average returns of 7 to 8 percent a year. If they fall short, it causes political problems because local taxpayers must then be called upon to replace the missing money. In recent years, some public plans added hedge funds to their portfolios after traditional stocks and bonds missed the target.
But since about 2009, plain old stocks, as measured by the Standard & Poor’s 500-stock index, have generally performed better than hedge funds, raising the question of what the fees are really buying.
“I think the industry is changing. There is less tolerance for underperformance in an environment when you have a relative huge outperformance with more liquid opportunities like an S.&P.-500 index fund,” said Elizabeth R. Hilpman, chief investment officer at Barlow Partners.
“There is a lot of disappointment that hedge funds have not been able to capture more of the market results,” she added.
The Calpers decision pushed the fee issue to the forefront. Hedge funds follow a “2 and 20” model: They charge investors 2 percent of their total investment and 20 percent of any profit.
“It’s no secret it is one of the concerns within the institutional investor community,” Mr. Eliopoulos said.
The prospect of paying 20 percent off the top of any profit is supposed to serve as an incentive to produce big returns. But some fear it may promote excessive risk-taking, especially because asset managers that use more conventional and conservative investment approaches tend to earn much less.
While there is a range, fees tend to swing like a pendulum from one end of the spectrum to the other. They have fallen incrementally each year from 2005 to 2013, according to the data provider Preqin. However, that trend began to reverse in 2014.
Even as some pension fund managers reassess their investments, new investors have continued to flock to the industry in search of better returns while interest rates are historically low. The industry has seen flows of nearly $57 billion into hedge funds in the first two quarters of this year, according to data from the research firm HFR.
And other public pension officials said they were committed to investing with hedge funds no matter what Calpers decided.
“In theory, you get smart people” at hedge funds, said Brendan Thomas Byrne Jr., vice chairman of New Jersey’s State Investment Council, the body responsible for investing that state’s pension assets. “And you get a degree of flexibility that you wouldn’t get in certain other asset classes.”
He said New Jersey had been investing with one hedge fund, Brevan Howard, that produced a return of almost 20 percent amid the chaos of 2008. “Right now, the stock market is doing great, so it would be easy to say, ‘Let’s take money out of Brevan Howard and put it into stocks,’ ” Mr. Byrne said. But New Jersey still sees value in that hedge fund’s ability to offset bear markets, he said.
Hedge fund managers, for their part, indicated they were not worried that the Calpers decision would set off a mass exodus or even dampen the fees they demand. They pointed to the flows coming into the industry as proof there is still strong demand.
“Calpers has always been a leader, and so other funds may similarly consider leaving funds like they did,” said David D. Tawil, president of the hedge fund Maglan Capital. But he added, “I think, on the whole the fundamental arguments for hedge funds have been solid.”