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Why America’s largest pension fund dumped hedge funds

Often, when a person ages, a small ailment is a symptom of a bigger disease. Such is the case with Calpers’ decision to drop hedge funds from its $300 billion portfolio. The decision isn’t likely to kill the decades-old industry immediately. But some serious changes may be in order.

The country’s largest pension fund said on Monday that it would not invest in hedge funds (investments that bet stocks, bonds, and currencies will rise and fall often by using complicated products like derivatives.) The fund’s manager said, simply, that the investments had become too complex, too expensive, and Calpers couldn’t “scale” them to make it worthwhile. The move means hedge funds need to face two important realizations.

First, the industry has lost sight of its true role. Hedge funds are meant to “hedge” risk. This doesn’t mean goosing portfolio returns, as many expect. Rather, managers can mitigate the risks associated with market fluctuations and can level out a portfolio’s performance when the equity markets are strong. If the allocation is small, hedge funds can do their job without being too detrimental to returns.

This brings us to the second problem. Hedge funds need to promise high returns because they charge extraordinarily high fees. Unlike mutual funds, which often charge a 1.25% management fee or less, hedge funds take a 2% management fee and 20% of any profits. The off-kilter fees have attracted subpar investment advisors. Now, too many bad managers are piggybacking off too few good ones, and to justify high fees, managers make promises they cannot (and aren’t meant to) fulfill.

An entire subculture has popped up to help. “Funds of funds” and other advisory services try to help managers like Calpers find the best funds. But they layer on more fees and simply add to the problem. (Too many subpar managers of managers give bad advice.) Given the small role hedge funds are meant to play, it’s no wonder Calpers has decided to throw in the towel.

Ultimately, any investment decision should be fairly simple. If investors do not see value, they will pull their cash. It’s not that hedge funds lack value. Investors are just paying too much for the service. The hedge fund industry is in need of a lifestyle change. Ignoring the problem, however, could ultimately put the industry in its grave.