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What the Calpers exit means for hedge funds

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It’s been two days since the California Public Employees’ Retirement System made headlines by announcing that it is pulling all the money it has invested in hedge funds. All $4 billion. The country’s largest public pension fund cited “cost” and “complexity” as its chief reasons for essentially firing two dozen hedge funds.

Since the announcement, people have been standing on opposite sides of the fence when it comes to what the move means for the hedge fund industry in general. On the one hand, $4 billion is just a drop in the bucket when you consider the industry currently manages an all-time record $2.8 trillion in assets. In a quantitative sense, the decision won’t move the meter an inch.

On the other hand, Calpers is a monster pension fund that tends to predict the behavior of other institutional investors, which hedge funds rely on more than ever. Individual wealth accounts for just a sliver of assets under management at most large hedge funds.

“The fact that Calpers is jumping off is an important time for reflection,” Rodger F. Smith, a managing director at Greenwich Associates, told the New York Times. What institutional investors are likely reflecting upon is the relative cost of dealing with hedge funds.

Most hedge funds attempt to apply the “2 and 20” pricing model, where they charge a 2% fee on any assets under management plus 20% of all annual investment profits. In reality, few are actually hitting their targets. The averages are said to be more like 18% for performance fees and 1.6% for annual charges.

That said, hedge funds have underperformed the market by a significant margin over the last two years. And it’s not just that they are hedging safely in a bull market. A Barclays’ index of traditional bond funds is outperforming the average hedge fund this year, Richard Beales keenly points out. That shouldn’t be happening in the current market.

However, not all funds are the same. If you look at the 24 hedge funds and six hedge fund-of-funds that Calpers employed, they didn’t exactly do a bang up job. An annualized rate of 4.8% over the last decade. Calpers reportedly used its leveraged as a monster pension fund to convince funds to offer below-market fees. It seems they went shopping at a discount store and paid the price.

Likely, the hedge fund industry is plenty safe. If you’re good, people will stay. If you’re mediocre, they’ll leave. But the Calpers situation will give investors more leverage when it comes to the fees they pay. Even good hedge funds may need to be more flexible this time around. Some institutional investors have already signaled that they’re preparing for that conversation.

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