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When America’s largest public pension fund, the California Public Employees’ Retirement System, announced in late 2014 that it was exiting its $4 billion allocation to hedge fund investments, it cited the need “to reduce complexity and price” as a reason. The then-$300 billion fund said it couldn’t achieve the necessary scale or impact with such a small allocation — despite a decade earlier being the very fund that legitimized the act of a large pension plan investing in hedge funds.

Critics had another way of putting it: To many the move was just CalPERS being CalPERS. Some, ranging from Elliott Management Corp.’s Paul Singer to Fortune magazine, shrugged off the decision as a mistake. A minority argued that CalPERS had actually waited too long, that hedge funds for a decade had failed to generate excess market returns despite rich 2 percent management and 20 percent performance fees. And some academics insisted that alpha itself is a kind of mirage, certainly at the levels hedge funds claimed.

But since then CalPERS has looked prescient.

As hedge fund performance has continued to lag — average 2016 returns rose to 7.4 percent (versus the S&P 500’s total return of nearly 12 percent), according to alternative-asset data provider Preqin, after returning only 2.02 percent in 2015 — outflows have mounted: some $83 billion by the end of November, according to investment analysis and analytics firm eVestment. And a pack of public pension funds have joined the flight: The New York City Employees’ Retirement System redeemed all of its $1.45 billion in hedge fund assets last April; the New Jersey State Investment Council, the investment arm of the New Jersey pension system, cut its allocation by 52 percent in August; Rhode Island slashed more than half of its $1.1 billion commitment in late September; and Kentucky pulled at least $800 million of a $1.1 billion allocation in early November.

Adding insult to injury, the $129 billion Teacher Retirement System of Texas (TRS) — a well-respected fund that peers and media watch religiously, with an 8.3 percent hedge fund allocation — said in November it would put its commitment up for review. “It seems like at the next gas station, we should stop and tell these guys to get out and get us something to eat, and then drive away as fast as we can,” The­Street quoted TRS chairman R. David Kelly, speaking at a trustees meeting.

Nearly all of these moves were attributed to nosebleed hedge fund fees and mediocre returns, and have been accompanied by fratricidal attacks on the policymakers who built the allocations in the first place. For instance, in mid-­October the New York State Department of Financial Services took direct aim at Comptroller Thomas DiNapoli, who oversees the state’s pension, in a report with a rambling, tabloidlike headline: “State Comptroller-Managed Common Retirement Fund Pays High Fees Year After Year for Poor Hedge Fund Performance and Lacks Transparency on Costs of Other Alternative Investments.”

But in criticizing hedge fund fees, performance, and transparency, critics almost never answer the more fundamental question: What’s the alternative?

Much of the recent hand-wringing over hedge funds has had an apocalyptic air: Are hedge funds, which had amassed $3.2 trillion in assets globally by the end of 2015, dying like dinosaurs? Third Point founder Daniel Loeb famously declared last April that “we are in the first innings of a washout in hedge funds and certain strategies” and said the industry would have to rethink its fees. In May, Blackstone Group president Tony James predicted the business would shed a quarter of its assets in the next year. Still, it will take much greater outflows to significantly shrink the industry, which has continued to grow — albeit more slowly than in its high-flying past.

Part of the problem is that too much money has been chasing too few opportunities. Markets have wrong-footed active managers with concentrated positions, and iconic funds like Paul Tudor Jones’s Tudor Investment Corp., Och-Ziff Capital Management Group, and London’s Brevan Howard have been hit by redemptions. Others, like Perry Capital, Chesapeake Partners, and Tyrian Investments, have announced they are shutting down altogether.

Related to this is the larger, if still incipient, asset management trend toward passive investing. Despite the postelection market rally, the past 30 years of exceptional returns — a product of globalization, financial deregulation, and technological innovation — may now be winding down. If so, high-beta returns can most efficiently be captured by low-fee passive strategies. But will those returns continue? A recent McKinsey & Co. report with another unsettling title — “Thriving in the New Abnormal” — anticipates that some $8 trillion in “benchmark-hugging active assets will be up for grabs over the next few years” in a low-return era that could last two decades. Mc­Kinsey predicts these trends will drive investors toward private market alternative investments.

Prediction, however, is always risky. From the 1970s to the 1990s, many pensions could essentially fund themselves with 7 to 9 percent returns that were relatively risk-free because that was roughly what 30-year Treasuries paid, writes Donald Boyd, director of fiscal studies at the Rockefeller Institute of Government at the State University of New York. Today that roughly remains the target return for most pensions, even though the Federal Reserve hammered down short-term Treasuries almost to zero after the financial crisis, and the risk-free rate skidded to 2 to 3 percent. The result: Funds had to shoulder more risk to hit their returns. Even worse, the ratios of workers to beneficiaries, and the cash flows, of some pensions went negative as long ago as 1993 — at about the time they discovered hedge funds — and has accelerated as baby boomers have hit retirement. In a maturing pension, short-term investment gains and losses grow larger relative to payroll and government contributions, and the odds soar of an ugly underfunding crisis in which investments have to be sold to pay retirees.

Many pension funds reacted to these pressures by embracing strategies associated with Yale University endowment chief David Swensen, who for years generated outperformance with hefty allocations to alternative assets — initially, private equity and hedge funds — seeking returns in exchange for illiquidity and risk. Hedge funds sold an absolute-­return strategy that was not correlated to broader equity markets, providing a theoretical hedge against slumps. However, few pension fund managers possess Swensen’s patience, ability to extract lower fees, and capacity to invest for the long term in top-quartile funds. Furthermore, endowments don’t suffer from aging demographics. And even Swensen, who remains at Yale, took a major hit in 2008.

Meanwhile, hedge funds became a target. Increasingly, critics, many affiliated with unions, attacked the fees that often-opaque alternative-­asset strategies charge. After Wall Street nearly collapsed in 2008–’09 and concerns over income inequality surfaced, the controversies surrounding fees grew rawer, more pervasive, and more populist. (Private equity also drew criticism for fees and carried interest, but buyout shops were generally viewed as longer-term investors, whereas hedge funds were short-term speculators.)

Pension funds often resemble a man on a high wire in a hurricane, frantically swaying to and fro. Many are strapped — the Employees Retirement System of Texas last year said it had not been fully funded for 19 of the past 20 years — with rising numbers of beneficiaries living longer and short-staffed and underpaid investment teams. Their exposure to politics makes them vulnerable to sudden shifts. Today’s conventional wisdom, often demanded by union critics, pushes pensions toward low-fee indexed funds or exchange-traded funds (ETFs) — John Bogle rather than Swensen — that have mushroomed as stock markets have set record highs. Still, although fees for passive investments are very low — and, as Bogle has long preached, a fine approach for individual investors — these investments may not be able to achieve the returns pension funds require, particularly in volatile postrecovery markets without a lot of returns.

Would anyone be shocked if pension funds zigged when they should have zagged? The Fed has finally raised interest rates despite an aging recovery and as the Trump administration, which many believe will fire up inflation with infrastructure spending and tax cuts, enters the White House. In short, there’s been a broad flight from active management — including hedge funds — just as stock picking seems to be making a comeback. Meanwhile, pension funds must generate enough performance to meet daunting return targets. Rhode Island, which underwent a tempestuous reform process led by now-Governor Gina Raimondo, has been discussing the possibility of reducing its target rate from its current 7.5 percent. The problem: The state would have to raise taxes to close its funding gap, or reduce benefits further — neither a popular step.

New Jersey, which for years has been embroiled in a struggle over its pensions, is in worse shape and a telling example of all that can go wrong, and right, at the nexus of public money and high-fee hedge funds.

The scene: The $73 billion New Jersey public employee pension fund was only 37.5 percent funded last year, according to a Bloomberg study— the largest deficit in the U.S. — and infighting between unions and Governor Chris Christie had grown bitter. Christie drove through a bipartisan bill to force unions to pay more for their members’ pensions, then failed to meet state funding targets. Public sector unions attacked alternative investments, which had doubled under Christie, charging the firms with political ties to the governor and complaining about a lack of transparency and steep fees. Pension administrators argued that alternatives — hedge funds, private equity, and real estate — had overperformed net of fees.

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