NEW YORK (MainStreet) — The largest public pension plan in America is cashing in its $4 billion stake in hedge funds. The California Public Employees’ Retirement System (Calpers) says it’s not because of performance issues but because the investments are too complex – and costly.

The liquidation of 24 hedge funds and six fund-of-funds, known internally as the Absolute Return Strategies (ARS) program, will occur over the course of nearly a year. Calpers has not yet determined how the assets will be reinvested.

“We are always examining the portfolio to ensure that we are efficiently and cost-effectively achieving our risk-adjusted return goals," Ted Eliopoulos, interim chief investment officer for the nearly $300 billion pension fund, said in a statement. "Hedge funds are certainly a viable strategy for some, but at the end of the day, when judged against their complexity, cost, and the lack of ability to scale at Calpers’s size, the ARS program is no longer warranted.”

The pension fund reports that in February of this year its board adopted a new asset allocation mix seeking to reduce the risk in the portfolio, while still aiming to meet its annual return goal of 7.5%. Calpers says it earned 18.4% during the 2013-14 fiscal year and has averaged a 12.5% return for the past five years -- and an 8.4% return for the past 20 years.

Hedge funds are generally more expensive than traditional mutual funds and are often exempt from some of the regulatory oversight of mutual funds. Managers frequently employ short-selling and leverage – the process of borrowing against assets to multiply investment exposure – in order to take aggressive positions.

Fees are generally stout, too. Hedge funds often charge an annual management fee of 1% to 2% as well as performance fees of 20% of a fund’s profit.

But for high-net-worth investors and institutions, hedge funds remain a popular investment choice. In an annual survey considering the assets of 159 institutionally oriented, single and multi-strategy hedge fund managers, Pensions and Investments found holdings increased 15.4% to $1.5 trillion for the 12-month period ending June 30.

What does this all mean for the typical investor? First, in order to qualify to invest in a hedge fund, you must be generally be an “accredited investor.” That means a net worth of $1 million or more, excluding your primary residence, or an annual income of $200,000 – or joint income including your spouse of $300,000. Once those hurdles are cleared, the question is: If “smart money” like the Calpers pension fund is bailing on hedge funds, why would you invest in them? And if you already have hedge fund positions, should you hit the exit as well?

In research published last year by the Federal Reserve Bank of Chicago, vice president and senior research advisor Ed Nosal, along with Dan Bernhardt from the department of economics at the University of Illinois at Urbana-Champaign, analyzed hedge fund performance and came to a plain-spoken conclusion: “We show that the longer is an investor’s horizon, the lower is the expected return of the hedge funds in which he invests.”

The researchers also noted:

  • More established hedge funds deliver less volatile returns and have a more predictable performance
  • Hedge fund failure rates are initially very high, but fall sharply with hedge fund manager experience. More than 20% of hedge funds fail in their second year, though that statistic may be understated, as many funds don’t survive long enough to be entered into hedge fund data bases.
  • A hedge fund’s returns tend to fall over time. The researchers believe this is because hedge fund managers initially take “risky gambles,” but take less risk once the hedge fund succeeds.

--Written by Hal M. Bundrick for MainStreet