CALPERs, the huge pension for California state employees, made news with its latest investment policy shift where it will completely divest its hedge fund exposure over the course of the next year. At almost $300 billion in AUM, CALPERs is big enough to potentially move markets and it certainly is big enough to engender interest in its investment decisions.

There have been various policy decisions made by CALPERs over the years. The WSJ notes that CALPERs first got into hedge funds about a decade ago and now of course they plan to get out.

This raises an interesting behavioral question. Why are they getting out? CALPERs has said they want to simplify and of course simple is good but why do they want to simplify? The WSJ says it is not because of performance but if their hedge funds were adding tremendous value to the results (tremendous value is intentionally vague) do you think they would be divesting? I would say no.

Why did they get into hedge funds in the first place? Reasonably speaking they were looking to enhance results (either seeking better risk adjusted returns or maybe better nominal returns).

For a long time I’ve been writing about the idea that an adequate savings rate combined with going along for the ride with stocks (good and bad) would get the job done for most people in terms of meeting long term goals but a crucial part of that equation is maintaining a suitable asset allocation. Maintaining means not becoming impatient with the asset class that is underperforming.

If you have exposure to multiple asset classes you do so for diversification and when you have multiple asset classes one must be the top performer and one must be the laggard. Giving the benefit of the for reasonable asset class selection, no single asset class can always outperform and no single asset class can always lag. Since no one can truly know which asset class will lead or lag you maintain exposure to many to get the desired long term result. But the key to that is maintaining that exposure.

One way to look at CALPERs foray into hedge funds is that ten years ago they were impatient with equity returns as the indexes floundered somewhat, so they moved into hedge funds. Now domestic equity indexes have rocketed higher and it could be argued that CALPERs has grown impatient with their choice of diversifier and so is moving out after the stock market has gone up 190%.

This post is not to defend hedge funds or opine as to whether they are suitable for anyone but the true purpose of a hedge fund, or more relevant to most readers here a fund that replicates hedge fund returns, is to offer an exposure that reduces a portfolio’s correlation to the stock market. The stock market goes up most of the time so having a large exposure to something that doesn’t look like the stock market is probably not a good idea but a small exposure can smooth out the ride over the duration of the stock market cycle.

After 66 months of a raging bull market it is logical to think that the thing you bought for a small slice of the portfolio to not look like equities will have fallen behind a broad equity index. But if a hedge fund is going to add value (and of course there is no guarantee) it will be during periods when the market is not rocketing higher.

You might read that last paragraph and think well, they didn’t work during 2008. Many of these types of things did not “work” in 2008 in part because markets stopped functioning for a time (although some strategies were indeed flawed) which distorted all sorts of asset classes, strategies and inter-market dynamics. It is extremely unlikely that markets will fail to function like that again. If that does not resonate with you then you probably should leave these sorts of products alone. I continue to believe in small exposures to diversifiers to smooth out the ride over the entire stock market cycle with no expectation that they will lead the portfolio higher in a bull market.