What does CalPERS’ hedge fund decision mean for ETFs?

560968_fire_exitLast week, the hedge fund industry took a hit from the biggest public pension fund in the U.S.—the California Public Employees’ Retirement System (CalPERS). The US$300-billion fund nixed its US$4-billion hedge fund program—known internally as the Absolute Return Strategies Program (ARS Program)—in an effort to “reduce complexity and costs in its investment program,” as the CalPERS press release put it. All told, the program invested in 24 hedge funds and six hedge fund of funds.

As CalPERS’ interim chief investment officer, Ted Eliopoulos, put it: “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’ size, the ARS Program is no longer warranted.”

Bottom line: the costs outweighed the benefits. Also, for a pension fund as committed to transparency as CalPERS is, explaining the performance and value of 30-some hedge fund products on its balance sheet proved too challenging.

When a pension fund the size of CalPERS makes this kind of decision, you can’t help but wonder what this means for other institutional investors. A decade ago, for example, plan sponsors were all over absolute return strategies—who wouldn’t want an investment that promised to deliver solid returns during the good times and downside protection during the bad?

Post-2008, the focus has become more basic—low cost, decent transparency and all-important liquidity. The ideal investment right now is relatively simple to explain and offers an easy exit when you want to leave.

And it is this exact trifecta of characteristics that explains the rise of exchange-traded funds (ETFs) in institutional portfolios. ETFs have traditionally been marketed to do-it-yourself investors who don’t want their returns eroded by mutual fund fees. Lo and behold, however, a combination of volatility and low returns now has institutional investors looking for the same things retail investors have always wanted.

Just look at the latest report on institutional ETF use by Greenwich Associates. It shows that some of the largest investors in Canada (with $5 billion or more in assets) are now making good use of ETFs in their portfolios—40% of Canadian institutions using ETFs plan to increase their allocations by 5% or more within the next year. The other 60% are planning to hold their ETF allocations steady. Moreover, the largest investors in Canada are also the greatest fans of ETFs—27% of them are using ETFs compared with just one in 10 among other institutional investors.

And, with an increasing menu of cheap and liquid options—including hedge funds—the expanding ETF universe has a lot to offer sophisticated investors seeking cheaper, liquid investments.

By focusing on costs and simplicity, pension funds are indeed taking some lessons from small investors—and, in the end, it could mean a further shakeup across the investment industry. Retail meets institutional—it’s an interesting story.