The California Public Employees’ Retirement System (CalPERS) recently dumped its $4 billion hedge fund portfolio citing difficulties in scaling, but one research firm said there are significant benefits to holding a larger allocation—if the price is right.

“One of our prime considerations in reviewing the program is whether we believe we could scale the program to a much more significant part of the overall portfolio,” said Ted Eliopoulos, CIO of CalPERS, last week. “Our analysis, after very careful review, was that mainly because of the complexity of the hedge fund portfolio and the cost we weren’t comfortable scaling the program to a much great size than it currently held.”

The Absolute Return Strategy program made up approximately 1.3% of the pension’s total assets of almost $300 billion.

Research firm Markov Processes International (MPI) used a hypothetical pension portfolio based on CalPERS’ policy benchmark as of July 1, 2011 to calculate risk and return with varying levels of hedge fund allocation.

Using fund of hedge funds with assets over $1 billion—and tested for both 3-year and 7-year periods—it found a 1% allocation barely moved the needle in the portfolio profile.

“Depending on the investor focus, a 1% or no allocation might make more sense if one is only looking at the recent return profile,” MPI said. “Otherwise, for a longer time horizon or under other measures mentioned above, a 5% or 10% allocation to hedge funds makes more sense.”

According to the firm’s calculations, adding a 10% allocation to the portfolio reduced its risk and upped the Sharpe ratio over the most recent 3-year period. Over the 7-year period, the allocation helped significantly lower volatility and increased the portfolio’s annualized return.

A 5% allocation to hedge funds also offered a consistently higher Sharpe ratio than a portfolio with no absolute return program over both 3-year and 7-year periods.

However, MPI argued CalPERS’ exit from hedge funds highlights the industry’s fee structure that “feeds so many mediocre strategies and allows the universe of managers to grow.” The pension plan stated it had paid $60.7 million in management fees and $55 million in performance fees for the 12 months ending June 2013.

“While selection at such an insignificant allocation does not have the ability to impact the total portfolio’s risk-return profile, CalPERS’ experience underscores how difficult it is to select superior funds,” the firm said.

Instead, hedge funds should be incentivized only for attaining specific performance and risk goals, the firm said, beyond capturing beta.

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