Key Takeaways
- • Large U.S. public pension funds have significantly increased allocations to hedge funds and alternative assets, with approximately $660 billion currently deployed across hedge funds and private equity, representing a material shift in portfolio strategy since the 2008 financial crisis.
- • Hedge fund performance has persistently lagged equity benchmarks, with 2016 average returns of 7.4% falling substantially short of the S&P 500's 12% total return, while charging management fees of 2% and performance fees of 20%, intensifying scrutiny of cost-benefit rationale.
- • Major pension fund redemptions have accelerated, including California Public Employees' Retirement System's 2014 exit from a $4 billion hedge fund allocation, New York City's $1.45 billion redemption, New Jersey's 52% reduction, and Rhode Island's 50%+ cut—signaling institutional reassessment of hedge fund utility in diversified portfolios.
- • The largest public pension plans demonstrate divergent performance outcomes in hedge fund investing, with some funds achieving 11% gains, suggesting skill and manager selection differentiation in an asset class characterized by inconsistent alpha generation.
- • Academic research and industry analysis increasingly challenge the long-standing justification for hedge fund allocations, questioning whether hedge funds deliver the superior, less-correlated returns that initially motivated pension fund entry into the asset class.
Summary
The allocation of public pension assets to hedge funds has become a subject of acute institutional debate, marked by a fundamental divide between funds exiting the space and those remaining committed. Approximately $660 billion of U.S. public pension capital is currently invested in hedge funds and private equity funds, representing a substantial commitment that emerged as part of broader post-financial crisis portfolio diversification. The California Public Employees' Retirement System, the nation's largest public pension fund, pioneered institutional pension investment in hedge funds a decade prior to 2014. However, CalPERS reversed course in late 2014, redeeming its $4 billion allocation and citing the need to "reduce complexity and price"—citing insufficient scale relative to the total fund.
The decision by CalPERS has proven prescient in light of subsequent performance data. Hedge fund returns have consistently underperformed broader equity benchmarks despite elevated fee structures. In 2016, the average hedge fund returned 7.4% compared to the S&P 500's 12% total return, continuing a pattern of underperformance that began in 2015, when hedge funds averaged only 2.02% returns. This persistent performance shortfall, combined with the 2% management fee and 20% performance fee structure standard across the industry, has created a compelling case for capital reallocation. Industry data from eVestment documented $83 billion in outflows by November 2016, reflecting broad-based pension fund reassessment.
Following CalPERS' departure, a cascade of major pension funds initiated significant redemptions. The New York City Employees' Retirement System redeemed its entire $1.45 billion hedge fund position in April 2016. New Jersey's State Investment Council reduced its allocation by 52% in August 2016. Rhode Island slashed more than half of its $1.1 billion commitment in September 2016, while Kentucky withdrew at least $800 million of its $1.1 billion allocation in early November 2016. These sequential exits by major institutional investors underscore growing skepticism regarding hedge fund value proposition in the context of broader portfolio construction.
Despite the trend toward exits, some of the largest public pension plans have continued to realize positive returns from hedge fund allocations, with certain portfolios posting 11% gains—indicating that performance outcomes are materially dependent on manager selection and investment governance. This bifurcated outcome has prompted renewed institutional examination of the fundamental thesis supporting hedge fund allocation. Academic research, including analysis from the Roosevelt Institute, has begun questioning whether hedge funds deliver the superior and less-correlated returns that historically justified their adoption by pension trustees seeking downside protection and enhanced diversification in an increasingly challenging return environment.
The decision by CalPERS has proven prescient in light of subsequent performance data. Hedge fund returns have consistently underperformed broader equity benchmarks despite elevated fee structures. In 2016, the average hedge fund returned 7.4% compared to the S&P 500's 12% total return, continuing a pattern of underperformance that began in 2015, when hedge funds averaged only 2.02% returns. This persistent performance shortfall, combined with the 2% management fee and 20% performance fee structure standard across the industry, has created a compelling case for capital reallocation. Industry data from eVestment documented $83 billion in outflows by November 2016, reflecting broad-based pension fund reassessment.
Following CalPERS' departure, a cascade of major pension funds initiated significant redemptions. The New York City Employees' Retirement System redeemed its entire $1.45 billion hedge fund position in April 2016. New Jersey's State Investment Council reduced its allocation by 52% in August 2016. Rhode Island slashed more than half of its $1.1 billion commitment in September 2016, while Kentucky withdrew at least $800 million of its $1.1 billion allocation in early November 2016. These sequential exits by major institutional investors underscore growing skepticism regarding hedge fund value proposition in the context of broader portfolio construction.
Despite the trend toward exits, some of the largest public pension plans have continued to realize positive returns from hedge fund allocations, with certain portfolios posting 11% gains—indicating that performance outcomes are materially dependent on manager selection and investment governance. This bifurcated outcome has prompted renewed institutional examination of the fundamental thesis supporting hedge fund allocation. Academic research, including analysis from the Roosevelt Institute, has begun questioning whether hedge funds deliver the superior and less-correlated returns that historically justified their adoption by pension trustees seeking downside protection and enhanced diversification in an increasingly challenging return environment.
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