As the largest U.S. retirement plan prepares to dump hedge funds for good, its peers aren’t rushing to follow.

Pension funds including those in New Mexico, Ohio and Illinois said they don’t plan to exit the asset class after the $298 billion California Public Employees’ Retirement said this week it will pull its entire $4 billion in hedge-fund investments. New Jersey’s $77 billion state pension fund in June said it had added $1.1 billion to hedge funds since the start of its 2014 fiscal year, to protect against risk after a six-year bull market in stocks.

“There are a lot of endowments and some public funds that have done it successfully for years, and they have done it with better economic outcomes than Calpers,” said Orin Kramer, the former chairman of New Jersey’s investment council, who was a proponent of investing in hedge funds. “I don’t think the funds that have been able to devote resources to hedge funds and have been doing it well will stop.”

Calpers’s exit highlights the challenges for public pension plans of investing in hedge funds, lightly regulated vehicles that trailed most other asset classes in the past three years and have drawn scrutiny from unions for their high fees and billionaire managers.

‘Pretty Abysmal’

One of the earliest public investors in hedge funds, Calpers helped pave the way for other pensions to put money into the asset class to help cover the growing cost of government retiree benefits. At the same time, the California pension was slow to build the program and picked funds that underperformed, making it hard to justify the fees. The largest U.S. pension fund produced a 4.8 percent annualized rate on its hedge-fund investments over the last 10 years.

“Those returns seem pretty abysmal,” John Paulson, head of the $22.8 billion Paulson & Co. hedge-fund firm, said in an interview yesterday at the New York Philharmonic’s opening night gala.

“Our hedge-fund allocation was quite small,” interim Chief Investment Officer Ted Eliopoulos said yesterday in a Bloomberg Television interview. “It did not offer us the ability or the promise to effectively diversify or hedge any meaningful portion of our total portfolio.”

Calpers will eliminate 24 hedge funds and six hedge fund- of-funds. The board hasn’t decided where to invest the money after the pullout, which will take about a year, he said. Calpers, which first invested in hedge funds in 2002, paid $135 million in fees in the fiscal year that ended June 30 for hedge fund investments that earned 7.1 percent.

Bain, Lansdowne

Eliopoulos said Calpers’s decision isn’t related to the performance of the program. The pension invests in funds run by Och-Ziff Capital Management Group LLC, Bain Capital LLC’s Brookside Capital, Lansdowne Partners LP and Canyon Partners LLC, according to a report from Calpers. Its fund-of-funds investments include funds run by Rock Creek Group LLC and Pacific Alternative Asset Management Co.

While still a relatively small part of their investments overall, hedge funds have been received a growing share of pension funds’ money. Pensions with more than $5 billion in assets had an average of 1.35 percent in hedge funds as of June, according to Wilshire Trust Universe Comparison Service, up from 0.85 percent in 2008.

Hedge funds, which are open to large investors able to judge and bear the associated risk, employ investment strategies such as betting on rising as well as falling asset prices, in an effort to gain even when markets stumble. They typically charge fees equal to 2 percent of the money they manage, and keep 20 percent of any investment profits.

Simplifying Investments

Some corporate plans and endowments have sought to simplify investments. Ford Motor Co., which boosted debt investments to about 70 percent of its U.S. plan assets last year from 55 percent in 2012, has said it’s seeking to boost that allocation to 80 percent. The Los Angeles Fire and Police fund decided to withdraw from pools that invest in hedge funds after they returned an annualized 4.4 percent for the five years ended October 2013.

Jeff Hooke, a former investment banker who performed a study for the Maryland Public Policy Institute that found that states didn’t get higher returns from high-fee investments, said that because of Calpers’s prominence, its decision carries greater importance.

’Queen Mary’

“The Calpers decision is a momentous one,” Hooke said. “When the Queen Mary of state pensions turns course on hedge funds, a lot of other pension plans will be watching, but not necessarily acting.”

Chief investment officers who made the commitment won’t want to acknowledge they may have made a mistake, he said.

Calpers’s hedge funds haven’t performed as well as those of other large plans, according to data compiled by Bloomberg. Florida’s $181 billion pension fund, one of the largest investors in the asset class among state plans, currently has about $8 billion in such investments. They returned an annualized 16 percent in the five years ended June 30. Texas County & District saw hedge-fund returns of 9 percent in the same period. Calpers’s program climbed 5.6 percent.

Funds that have done well say they will keep investing in hedge funds, particularly as the U.S. Federal Reserve withdraws stimulus that’s driven stocks to a record and juiced bond market returns.

Downside Protection

William Atwood, who oversees about $15 billion as executive director of the Illinois State Board of Investment, said he’s sticking with hedge funds, which make up about 10 percent of his holdings, because they are a good way to protect against market swings.

“The challenge is trying to find an asset class that gives downside protection, that yings when equity yangs,” Atwood said. “That’s the role for us that hedge funds play and I don’t know what the alternative is right now.”

The investment head of the New Mexico state fund, which cut its target allocation this year, also doesn’t plan to divest. Hedge-fund investments at the New Mexico pension returned an annualized 8.1 percent in the five years ending June 30. The target return for the whole pension plan is 7.75 percent.

“Hedge funds have worked for us,” said Jonathan Grabel, chief investment officer at the $14.6 billion Public Employees Retirement Association of New Mexico. “The problem with the megaplans is that capital becomes the enemy of returns. You’re so big that you potentially have much greater beta exposure,” he said, referring to performance that’s in line with benchmark indexes.

Diversify Risk

The retirement plan, which started investing in hedge funds in 2007 and has $1.1 billion invested in the strategy, in April decided to reduce its allocation to 4 percent from 7 percent to diversify its risks across other alternative assets such as private equity and real estate. Hedge funds might be used within other investment buckets alongside managers who wager on rising markets.

“We still recognize that there are good hedge fund managers out there,” Grabel said. “Our board has the flexibility to work with them in other strategies such as credit or distressed debt.”

Another long-time investor, Farouki Majeed, chief investment officer at the School Employees Retirement System of Ohio, said he, too, would keep money with hedge funds.

Ohio Plans

“Currently there are no plans to drop our hedge-fund allocation,” he said. “We think an appropriately structured hedge-fund program relative to the risks and costs can be beneficial going forward, particularly in light of the outlook for bonds,” which may fall as the Fed begins to raise rates.

The $12.7 billion plan has generated a 4.5 percent return from its multi-asset strategy, of which hedge funds make up 90 percent, between June 1, 2008 and June 30, 2014. The strategy had $1.6 billion as of June 30.

Michael Trotsky, the chief investment officer of the Massachusetts Pension Reserves Investment Management Board, said in an interview published in June that he’s happy to pay hedge- fund fees -- if the managers perform.

“We love to find skillful managers and we’re happy to pay fees for that,” said Trotsky, whose Boston-based pension plan seeks to add as many as eight more managers within two years. “We’re unwilling to pay for beta exposure or luck.”

The hedge fund industry’s trade group, Alternative Investment Management Association, said in a statement today that “sophisticated” investors don’t view their hedge fund investments as a way to outperform the Standard & Poor’s 500 Index.

“They recognise that the equities boom may not last forever and they want capital preservation, reduced volatility, heightened diversification and strong risk-adjusted returns,” the London-based organization said in a statement today.

--With assistance from Michael B. Marois in Sacramento and Martin Z. Braun and Amanda Gordon in New York.