When the world’s 12th-largest economy makes a big decision about its finances, you tend to notice. That’s what California is, budget problems aside. Now its state employees retirement fund, CalPERS, is on its way toward quitting the active investing game.

Not quitting the markets. Just dropping all pretense that beating the market is a worthwhile goal and taking its tens of billions’ worth of retirement investments mostly, if not entirely, passive.

How big a deal is this? Well, we’re talking about nearly 1.7 million public employees and an investment portfolio of $258 billion as of June 30. On that date, 35% of the portfolio was in passive investments and 65% was actively managed.

On Sept. 16, the CalPERS board adopted a lengthy set of “investment beliefs,” from which I will quote here briefly, specifically from No. 7 of a total of 10 beliefs:

“CalPERS will take risk only where we have a strong belief we will be rewarded for it

  • An expectation of a return premium is required to take risk; CalPERS aims to maximize return for the risk taken
  • Markets are not perfectly efficient, but inefficiencies are difficult to exploit after costs
  • CalPERS will use index tracking strategies where we lack conviction or demonstrable evidence that we can add value through active management
  • CalPERS should measure its investment performance relative to a reference portfolio of public, passively managed assets to ensure that active risk is being compensated at the Total Fund level over the long-term”

That’s a lot to digest, and certainly it was the result of many hours of thoughtful discussion and chewing over years of numbers.

But the bottom line is simple enough. Expect the percentage of CalPERS assets held in indexed, passive investments to rise, and rise dramatically. Consequently, active investing of assets will decline.

It will probably take such a massive pension system months to make a move, but once it does the eventual goal is likely a flip to 65% passive and 35% active — maybe more, maybe less. It’s a hard row to hoe after decades of paying active investing managers, but CalPERS has clearly taken on a new direction.

You really should read the whole document. It’s crammed with best practices verbiage. They talk about matching liabilities to asset structure — very much a pension-fund approach — and the importance of controlling risk in light of the system’s fiduciary responsibility.

I will point out one other key argument in the “beliefs” statement from CalPERS, which is that “strategic asset allocation is the dominant determinant of portfolio risk and return.” Translation: It’s not about stock-picking. It’s about owning the market.

Unless you’re a pro, there’s a lot in the preceding paragraphs that might induce a snore. Here’s a more palatable breakdown of what’s really going on.

1. The sixth-largest pension fund in the world, second in the United States behind the federal employees plan, just endorsed passive investments — index funds — over paying active managers to attempt to “beat the market.”

2. Cost is the reason why. High active investing management fees greatly diminish the likelihood of beating the benchmarks.

3. CalPERS will start “marking to market” its managers’ performance against the benchmarks, so even in areas where it may choose to remain active there’s no more room for error. By implication, if active management isn’t working out, those managers are on notice.

For retirement savers, the takeaway is that the sales message of Wall Street — you can beat the market if you try — is getting harder and harder to swallow.

If a roomful of the brightest, best-trained pension managers in the world recognize this, it could be time for the rest of us to reconsider.

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