Calpers Shows Masters of Hedge-Fund Universe Have No Clothes

The most surprising thing about the California Public Employees' Retirement System's announcement Monday that it will be exiting its $4 billion investment in hedge funds over the next year may not be the decision itself, but that it took so long.

In the fiscal year that ended this June, the pension fund's hedge-fund investments returned just 7.1%. That compares with a 12.5% return for the Vanguard Balanced Index Fund, which follows the allocation of 60% stocks, 40% bonds that pension funds have historically followed. In the prior year, Calpers's hedge-fund investments returned 7.4% versus 10.8% for the index fund.

 

It isn't just Calpers. Hedge-fund tracker HFR's composite index, which measures the equal-weighted performance, after fees, of over 2,000 funds, has been underperforming the passive bond-and-stock portfolio since 2009. During the crisis year of 2008, it lost 19%, only marginally better than the index fund's 22.2% loss. That performance made it a bit harder to accept the idea that hedge funds' ability to offer downside protection justifies the hefty fees they charge—typically a 2% management fee and 20% of investment profits.

What has happened to the onetime masters of the investing universe? Hedge funds may have become a victim of their own success. With assets under management tripling to $2.8 trillion from their 2004 level, according to HFR, the field has become so crowded that it isn't as easy for managers to consistently deliver strong performance. Indeed, just as actively managed mutual funds struggled to deliver returns commensurable with their fees and expenses as they boomed in the 1990s, hedge-fund returns have suffered over the past decade.

Certainly, within the broad universe of hedge funds there are managers who can consistently deliver strong performances. But within an increasingly crowded field, picking them is a skill in itself. That further reduces their allure for big investors like Calpers. Such funds can hire outside managers to do this, and incur additional fees, or develop that expertise in-house, and incur additional costs.

Indeed, Calpers said it wasn't hedge-funds returns, but the costs and complexity of running a portfolio of hedge-fund investments that drove its decision. Hedge funds represent just a tiny fraction of the $298 billion Calpers manages, so regardless of whether they performed very well or very poorly, they wouldn't do much to move the needle. For hedge funds to be worth the effort, the pension fund would have had to dedicate a far larger chunk of its portfolio to them.

Given how big Calpers is, and how crowded many hedge-fund strategies have become, such a move would further cut into hedge-fund returns. That is a particular risk since other pension funds, seeing Calpers as a bellwether, might have followed suit.

Instead, other pension funds may follow Calpers's lead and cut or reduce their hedge-fund exposures. One place the money might go is lower-cost strategies that mimic the aggregate returns of various hedge-fund strategies—something that Calpers has begun doing. These promise to provide institutional investors index-like investments that can round out the risk profile of their portfolios like hedge funds do—but without the high fees.

Calpers's move is hardly a death knell for hedge funds. There will always be smaller, sophisticated investors with the patience and experience to find great hedge-fund managers. And there will always be others, seduced by the mystique hedge funds offer, who invest in them even though they shouldn't.

But the high-water mark for hedge funds may have passed. Increasingly, investors will question why hedge funds charge so much for what they do. Hedge-fund managers who don't have a performance-based answer will be in trouble