CalPERS shocks market with promise to dump hedge funds

CalPERS shocks market with promise to dump hedge funds

CalPERS shocks market with promise to dump hedge funds
The hedge fund industry was rocked yesterday when the massive California Public Employees' Retirement System announced plans to dump its $4 billion hedge fund portfolio.

According to the fund the sophisticated products are too expensive and too complex. As a result, the fund is going to dump its hedge fund holdings, an announcement that will reverberate through the industry.

There are not many investment funds larger than CalPERS. The state-managed fund invests the pension assets of California state employees. It currently manages over $300 billion, a chunk of money larger than any other American company but Wal-Mart and Exxon. But the fund has also ended up disappointed with the performance of its hedge fund holdings.

The fund has a return goal of 7.5 percent, but hedge funds have only returned 4.8 percent over ten years. Which is a basic problem.  

Famously, hedge fund managers have demand fees of 2% of assets under management, as well as 20% of the ‘alpha’ (return) generated by the fund. The argument of hedge fund managers has long been that only with such generous compensation schemes could managers in the industry summon the wherewithal to generate the fantastic promised returns. Now that the returns have failed to appear, it seems CalPERS is calling bluff on the industry. This is happening largely out of pure necessity.

CalPERS famously lost a third of its value in the global financial crisis. The fund was forced to increase contributions from taxpayers to cover losses. Investments in hedge funds were considered one way the fund would increase returns. But as the promised returns have failed to materialize, the company decided to eliminate its book of 24 hedge funds and six hedge fund-of-funds.

The question now: Will other big state-sponsored pension funds follow suite? "I would expect their decision to divest from hedge funds will cause some public pension funds to re-evaluate their hedge fund strategy, although many public pension funds consider hedge funds to be a vital part of their diversified portfolios," said one source quoted by Bloomberg news.

Hedge funds have gathered $2.8 trillion in assets over the past several years as institutional investors poured money into the alternative investment sector. The growth was expected to continue. McKinsey & Co. released a report just month that suggested assets in alternatives would balloon to $14.7 trillion by 2020. It will be interesting to see if that actually happens. Will hedge funds finally be forced to dump the “two and twenty” fee structure in a bid to maintain business?

More on this story to come.  

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