The first stage is denial. Photographer: Mark Elias/Bloomberg
The first stage is denial. Photographer: Mark Elias/Bloomberg

During the past few months, we have posted a few words here on the quandary that is hedge funds. The first such effort was titled “The Hedge-Fund Manager Dilemma,” and it explored the public’s fascination with the hedge-fund crowd. The second, “Why Investors Love Hedge Funds,” looked at why, despite stunning underperformance during the past decade, so much money was still flowing to the hedge funds.

Now, we are seeing early signs that some institutional investors are losing patience. Case in point: California Public Employees' Retirement System. The Wall Street Journal noted that the pension fund is looking to reduce hedge-fund holdings by as much as 40 percent. “Public pensions from California to Ohio are backing away from hedge funds because of concerns about high fees and lackluster returns.”

Although this might be a rational response to issues of costs and performance, I would hasten to add that this is only anecdotal evidence. When we look at data such as money flows, it suggests hedge funds are continuing to pull in cash at an astounding pace. The hedge-fund-industrial complex now commands more than $3 trillion in assets. That is up from $2.04 trillion in 2012, and a mere $118 billion in 1997.

Calpers has a reputation for being a thought leader in the institutional-investment world. I have spoken with various pension funds and foundations over the past few years, and while the issue of hedge funds is under discussion, there is no consensus. Based on what various folks in the U.S. and Europe say, there still is great interest in hedge funds. Many investors are more than willing to forsake beta (returns that match the market) in the mad pursuit of alpha (above-market returns).

Still, this looks like it might be the start of something interesting. Given hedge-fund performance relative to the costs, I assumed a shift would have happened years ago. That it hasn’t likely reflects some combination of institutional inertia at big institutional and pension funds and perhaps the impact of consultants.

The Wall Street Journal noted that before 2004, “public pensions favored plain-vanilla investments and avoided hedge funds almost entirely.” The attempt to “boost long-term returns” was driven by the funding gap between assets and future obligations.

This is the crux of the issue: Expected returns. For reasons that remain unexplained, anticipated returns for hedge funds are always far higher than those of bonds and equities. There is no evidence for this erroneous assumption. Unless you are one of the lucky few in a top-performing hedge fund -- that means a small fraction of that $3 trillion in assets -- there is simply no logical or statistical basis for this expectation. It is false, a demonstrably wrong perception, yet one that has become widely accepted.

If anyone has an explanation for how these unfounded expectations came about, or why they persist, please let me know. I am well aware that politicians have embraced these false numbers, as it reduces the amount of contributions they need to make each year to public-pension funds. But it also kicks the can down the road, creating an even bigger hole in future budgets. At this stage, I shouldn't be surprised at irrational policies from innumerate politicians -- but I am.

Regardless, this is a trend that bears watching. The top funds in each category of alternative investment -- venture capital, private equity and hedge funds -- likely have little to fear. The remaining 90 percent of the players in this space should pay close attention. Some changes might be coming.

To contact the author of this article: Barry Ritholtz at britholtz3@bloomberg.net.

To contact the editor responsible for this article: James Greiff at jgreiff@bloomberg.net.