Calpers has decided to pull its investments out of the various hedge funds where it has money. They're the experts paid to place that pension money where it will do best so possibly better not to try and second guess them. However, we can look back all the way to 1776 and the foundation text of modern economics, Adam Smith's "Wealth of Nations" and find a reasonable explanation of what's happening here. Essentially, hedge funds were a great idea but the innate structure of free market capitalism means that no idea stays great over time.
The news itself is here:
The largest pension fund in the US, Calper (the California Public Employees’ Retirement System), has decided to put an end to its hedge fund investments due to investments becoming expensive and complex.
The fund, in charge of over $300 billion, will liquidate its $4 billion investment across 24 hedge funds. Calper oversees the retirement benefits and investments of more than 1.6 million people.
Smith's point depends upon a few simple axioms: ones that we're all going to agree with. The first being that capitalists are greedy people (and we can include any investors here as "capitalists"). They'd prefer to get a higher return than a lower one. In more modern times we refine this to say that people would prefer to have higher risk-adjusted returns than lower, to account for that risk that might be taken chasing those higher returns (putting it all on an outside in the 3.30 race at Haydock might produce fabulous returns but there's a slightly larger amount of risk associated with that than sticking the cash into Treasuries).
Our second is that capitalists (or investors) are observant. They can observe what's happening in the economy, see who is making better profits than other people and get at least some grip upon how they're making that better profit. There's no need for perfect information here at all: we're not talking about the axioms of neoclassical economics or perfect markets. Just that if we see the greengrocer driving a Rolls Royce then we can start to make assumptions about the profits to be made in greengrocery.
The third is that there's some average (and as above, nowadays risk-adjusted) profit rate in the economy. That's just a simple matter of mathematics: any distribution will have an average.
The fourth is that capital, investments, are mobile. They can move from one class of investments over into another.
If we put the four together then we can see that, when the capitalists (investors) spot someone making those above average profits then they'll move their investments over into that sector so that they can get them some of those excess returns. All of which is entirely fine and is a reasonable enough description of what happened to hedge funds from their small start in the 60s and 70s up to recent times. They were making higher (risk-adjusted) profits and people were moving more of their capital into them in order to get those higher returns.
However, Smith goes on to point out what happens next. That increased capital in that sector introduces more competition into that sector. Such competition, umm, competes away those excess profits and it's thus, in the end, the very movement of capital (or investment) in chase of higher returns that leads to the higher returns disappearing. This would be a reasonable description of the hedge fund industry in more recent times.
Certainly, some funds have done very well indeed, but others have tanked. The average return from the industry (after fees, a vital point to consider) is now lower than many if not most other investment strategies. At which point we should see capital flowing out of the industry and that's just what Calpers is doing.
Another way of making the same point is that much of what hedge funds were doing was arbitrage. And here we can call Ricardo in to support Smith. It's the very nature of the beast that people exploiting arbitrage opportunities, by their very act of doing so, close those arbitrage opportunities. There's enough, perhaps too much in fact, capital in the hedge fund industry that there's not a great deal of arbitrage profit left to be had.
All of this doesn't mean that the industry is dead: if it all went away entirely then those opportunities would arise again, excess profits would again be possible and the corpse would rise from its grave. Rather, given the now lower average returns it's an argument that the industry should probably shrink a bit. To the point where it's making the same average risk-adjusted returns as other investment classes. Which again means capital moving out and again that's what Calpers is doing.
It's possible to make much more sophisticated, elegant and detailed arguments about what's going on, sure it is. But at heart the above is a reasonable theoretical pencil sketch of the background situation. Above average returns get competed away by more people chasing them and that's happened to this sector just like it has to every other before it.
