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CalPERS hedge exit may be the first of many

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The $300 billion California Public Employees' Retirement System's move this week to divest itself of $4 billion in hedge fund holdings is galvanizing a debate among many other pension managers.

"It's a discussion that's going on everywhere in our industry right now, given the high fees and what's going on with hedge funds," Steve Yoakum, executive director of the $40 billion Missouri teachers retirement funds, said in a telephone interview with CNBC on Tuesday.

CalPERS, which according to an annual tally by Pensions & Investments is the second-largest pension fund in the country, has long been a trendsetter.

The California retirees fund, which invests in private equity, fixed income, and stocks, among other things, was one of the first big retirement funds to put money into commodities in 2007, for example, and ushered in an influx of other pension-fund investments in the asset class—only to pull back on those investments after a number of years where the fund failed to make money.

CalPERS says no to hedge funds

And despite generating decent returns of 7.1 percent as of June 30, hedge funds, which amount to a little more than 1 percent of CalPERS' portfolio in dollar terms, were one of the least-successful performers in its portfolio as well. Given the expense of investing with hedge funds—a factor that hedge fund managers who have dealt with CalPERS say the pension has been pushing back hard on recently—CalPERS decided after a lengthy review that there were more cost-effective ways to diversify, its acting chief investment officer said in a Tuesday interview.

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CalPERS' experience in the markets mirrored that of other investors, who have seen private equity outperform hedge funds by 3 or more percentage points on average for several years in a row, according to figures provided by Preqin. Public stocks as well have outshone hedge funds throughout the market rally of recent years.

As a result, industry watchers said that the CalPERS reduction may be the first of many.

"I have to think that this event will precipitate additional reductions in some institutions' allocation to hedge funds," Nick Bollen, a finance professor at Vanderbilt University's Owen School of Management who studies hedge funds, said in an email. "That said, pension funds and endowments need high returns to meet their funding obligations, and with bond yields still at historic lows there will likely remain a large aggregate demand for alternatives for the foreseeable future."

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The California State Teachers' Retirement System, the nation's third-largest pension, according to Pensions & Investments' annual tally, has also been experimenting with a small hedge fund investment in the so-called global macro space, which invests in various asset classes around the world.

Pensions in Hedges

Name Total Fund of Funds Direct
Teacher Retirement System of Texas$10,607  $10,607
New Jersey Division of Investment$7,501 $2,300 $5,201
Pennsylvania Public School Employees' Retirement System$6,554  $6,554
New York State Common Retirement Fund$5,495  $5,495
Texas County & District Retirement System$5,428  $5,428
Virginia Retirement System$5,382  $5,382
California Public Employees' Retirement System$5,175 $1,469 $3,706
State of Michigan Retirement Systems$5,028 $2,341 $2,687
Massachusetts Pension Reserves Investment Management Board$4,907 $1,089 $3,818
Ohio Public Employees Retirement System$4,832 $696 $4,136

"We are always re-evaluating the value proposition" with hedge funds, said CalSTRS chief investment officer Christopher Ailman in an email Tuesday, but "we're NOT selling."

Given the underperformance of global macro strategies in the low interest-rate environment around the world, Ailman added that CalSTRS would give its hedge funds more than the originally allotted three years to generate returns. Still, the investment was quite small, he noted, amounting to less than $1 billion.

Yoakum, the Missouri pension manager, stressed that he wasn't trying to burn any bridges with the hedge fund industry, but said he felt the investments worked best "when you don't see other alternatives."

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According to figures provided by Yoakum's CIO, the Public School and Education Employee Retirement Systems of Missouri's current hedge fund portfolio includes such blue-chip names as Pershing Square Capital, which with returns of 31 percent is one of the best performing hedge funds of the year, as well as funds managed by Bridgewater and York Capital.

Yoakum said his pension's commitment to hedge funds "is probably not going to increase. We have many of the same concerns that CalPERS has in terms of the complexity and costs. We view our hedge funds not as a permanent commitment, but more as a temporary parking place."

—By CNBC's Kate Kelly