Calpers (the California Public Employees’ Retirement System), one of America’s largest pension funds has announced its decision to withdraw its entire $4bn hedge fund allocation. What does this mean for the hedge fund industry? Laura MacPhee investigates

As a teenager, I once read a magazine article on the so-called “hedge fund set” and lusted after their impossible and mysterious glamour. More than a decade later, much has changed. I have learned what a hedge fund actually is just in time to see their lustre fade. This much is clear from US pension fund Calpers’ decision to pull out of the asset class entirely.

In recent years, hedge funds have often been criticised for being expensive and complex, and for lacking transparency. There is also a definitional issue, since the term “hedge fund” is used to describe a number of investment vehicles which work in different ways.

The aim of a hedge fund is to generate high returns using a combination of strategies, including leveraged, long, short, and derivative positions. Many pension scheme trustees will have shuddered as they read the last sentence since these approaches have come to be associated with high risk and high fees.

Investors have finally had enough. The hedge fund industry cannot ignore the $300bn US scheme’s decision to abandon them.

The Calpers scheme has been moving in that direction for some time. Hedge funds first appeared in the fund’s portfolio in 2002 when they were still the darlings of the investment world. Earlier in 2014 the scheme halved its allocation, and has now removed it.

“My understanding is that Calpers made a poor choice of what particular funds to invest in,” says Peter Astleford, partner and head of the financial services group at law firm Dechert LLP. Astleford works with a number of hedge fund clients and thinks the US fund’s withdrawal is a “one-off”.

But the ripples are being felt on this side of the pond, where the £4.5bn London Pension Fund Authority has echoed its criticism of the hedge fund fee structure.  

“Managing the whole of the LGPS scheme is costing tax payer £471 million a year in management and administration overheads,” an LPFA spokesperson told Pensions Insight. “LPFA is keen to ensure we are reducing our costs where possible. This means looking at the fees we pay investment managers. We are not alone in this endeavour and were pleased to see Calpers in America is taking similar steps”.

“Cost was advanced by some commentators as the reason [why Calpers has pulled out of hedge funds]. Clearly the time of the two and twenty is over – that pressure is not new,” says Fabrice Cuchet, head of alternatives at Candriam Investors Group.  “Since 2008 we have seen pressure on fees. Now many funds are building and manage accounts of specific fund of funds with lower fees”. Standard Life has responded to fee pressure by introducing Global Focused Strategies, a lower cost version of its Global Absolute Return Strategy (GARS).

It is clear that hedge funds will have to adapt and meet the demands of the market to survive. This imperative will be even stronger come April 2015 when the 0.75% charge cap comes in for schemes used for auto-enrolment.

The decline of hedge funds has presented certain other asset managers with new opportunities. Sukhail Shaikh, chief investment officer at Fulcrum Asset Management, says the death of the hedge fund has heralded the birth of alternative or “smart” beta strategies.

“Over the last ten years or so there’s been a lot of innovation on the academic side, as well as on the practitioner side, to really dig into how hedge funds generate returns, and if they’re capturing sources of returns that can be captured more cost effectively, more transparently,” says Shaikh. “This is really where alternative beta has kicked in”.

He points out that although there is a skilful set of hedge fund managers who can generate returns which cannot be obtained elsewhere, many focus on strategies like capturing equity or credit market returns, or “trend following or carry strategies”. Pension funds can access this type of return through other investment vehicles, like diversified growth funds, without paying the higher hedge fund fees. 

“Nothing has changed in the world of pension funds – they need to have absolute returns, many of them have deficits, many of them need to improve their diversity of earnings and so their need to invest in different asset classes including hedge funds is as great as ever,” says Astleford.

But with so many new options, they no longer have to pay such a high price for the privilege.