In 2014, the California Public Employee Retirement System, or CalPERS, announced that it would liquidate $4 billion in hedge fund investments. Since then, a number of public pensions have followed suit.

While at face value this looks like the intensifying of an industry-wide exodus, public pensions continue to seek the benefits that hedge funds are designed to provide. The trend is, instead, a highly publicized experimentation to reconcile a low return environment, an antiquated fee structure and the need for downside protection. The approach across pension funds differs wildly.

“Each fund is unique, and their decision is based on their unique circumstances,” said Keith Brainard, research director for the National Association of State Retirement Administrators. “They're not doing it because someone else is doing it, but because they have made a decision that it needs. It is a trend, but it's also an individual choice.”

In 2016 alone, three large pension funds decided to ditch a total of $11 billion in hedge fund investments. The New Jersey State Investment Council voted in August to cut its hedge fund allocation by half; the Illinois State Board of Investment plans to reduce its hedge fund exposure to 3 percent from 10 percent currently; and the New York City Employees’ Retirement System announced in April to eliminate its hedge fund strategy altogether.

Yet overall, public pensions aren’t reducing their exposure to hedge funds. Rather, in the past two years, the average hedge fund allocation of U.S. pension funds has increased to 9.2 percent from 7.2 percent despite a number of high-profile exits, according to Preqin’s 2016 Global Hedge Fund Report.

The California State Teachers’ Retirement System (CalSTRS), for one, is looking to increase its hedge fund holdings. It plans to replace its 1.5 percent allocation in absolute return (as of June 30, 2015) with 9 percent in the newly created “risk mitigating strategy,” which includes global macro and a number of other hedge fund-like instruments, according to CalSTRS’ 2016 investment plan.

For hedge funds defectors, low returns are the number one concern. HFRI, a benchmark index measuring hedge fund performance across sectors, shows little in the way of outperforming public markets in recent years. Over the past ten years, The HFRI Fund Weighted Composite Index, an equal-weighted index of hedge funds, returned just 3.4 percent annually. S&P 500 Index returned 6.8 percent over the same period.
 

Amid years of floundering returns, investors find it hard to justify hedge funds’ conventional “2 and 20” fee structure, when buying stock funds often cost less than 1 percent of the amount invested. 

However, not everyone buys this frequently invoked comparison of market indices. Adopting or ditching hedge funds can have more complex reasons than merely return.

“The purpose of hedge funds is not to beat the S&P 500 necessarily. Often hedge funds are designed to simply not lose money; sometimes they're designed to beat the bond index,” Brainard said. 

CalSTRS’ Chief Investment Officer Christopher Ailman told Bloomberg TV earlier this month that hedge funds are important in the long run in hedging against volatility in public markets, which the $179 billion plan invests more than half of its assets in.

Sometimes allocation decisions take account of non-return factors. Betty Tse, chief investment officer of Alameda County Employees' Retirement Association, says pensions with a younger population in membership are typically more risk-tolerant than those with a more mature membership, as they face more immediate payout pressure.

Still, fees remain a dire problem, especially to public pensions, many of which are already underfunded and therefore draw criticism more easily than other types of institutional investors over hiring expensive fund managers.

Massachusetts Pension Reserves Investment Management Board, or PRIM, took a softer path in solving this problem. Instead of eliminating or reducing hedge funds allocation, in 2011, PRIM switched from the industry standard commingled fund arrangements to a managed account structure, which allows for more transparency and control.

“Because the money is in a managed account, should some unforeseen circumstance arise, our internal people could stop the activity with a phone call,” PRIM’s spokesperson Eric Convey said.

This strategy has helped save PRIM 40 to 50 percent in fees in most new hedge fund commitments, Convey said.

The New Jersey State Investment Council, in addition to planning to cut hedge funds by half, also aims at lowering management fees to “1 and 10,” Bloomberg reported.

A June report by Cambridge Associates says hedge funds are still an attractive de-risking strategy for public pensions, given the current low interest rate environment. However, the report points out that it only makes sense to invest with hedge funds when returns are high enough to offset fees.