It didn’t sound like much, even at the time. In April 2002 the California Public Employees’ Retirement System invested a total of $50 million with five hedge fund firms. For the then-$235.7 billion CalPERS, the largest state pension plan in the U.S., writing $50 million in checks was hardly a noticeable occurrence. But as the first step in an initial $1 billion allocation, the investment was a monumental moment for the hedge fund industry. It marked one of the first significant commitments by a public pension fund to a program of investing with hedge fund managers, a group that the pension community and its advisers had previously shunned as too risky and secretive. And in ways that are only now starting to become completely clear, it would dramatically change how public pensions invest.

CalPERS had good reasons for wanting to get into hedge funds. By 2002 the U.S. stock market, which had overheated during the late 1990s as the mania for technology and telecommunications stocks generated trillions of dollars in paper wealth for individuals and institutions, was plunging in a bear market rout. Like most U.S. public pensions, CalPERS had heavily invested in such securities as part of an outsize allocation to large-cap equities that had made the plan rich during the boom years but hurt on the way down. The fund lost $12.3 billion in the fiscal year ended June 30, 2001, and $9.7 billion the next year. CalPERS had gone from having 110 percent of the assets it needed to meet its future pension liabilities in fiscal 2000 to being underfunded, with a 95.2 percent — and falling — funding ratio.

One person who saw the writing on the whiteboard was Mark Anson. A lawyer with a Ph.D. in finance, Anson had been recruited to CalPERS from OppenheimerFunds in New York in 1999 to head up its alternative investments. By the time he became CIO in December 2001, he was seriously worried.

“I could see the dot-com bubble popping and the impact it would have,” Anson tells Institutional Investor. “I was concerned that our asset growth would not be faster than what I could see on the liabilities side.”

Anson believed that hedge fund investing would help protect CalPERS during times of market stress. For Anson, hedge funds are their own asset class and a valuable tool for diversifying a portfolio beyond traditional bonds and equities. In The Handbook of Alternative Assets, which Anson wrote while at CalPERS and published in 2002, he devoted more than 150 pages to hedge funds, including sections on how to set up an investment program and handle risk management. Unfortunately, by the time CalPERS began seriously investing in hedge funds, it was too late to prevent the carnage from the 2000–’02 bear market, but Anson remained convinced that the asset class would help the retirement plan in the future.

He was not alone. In New Jersey newly elected governor Jim McGreevey in 2002 appointed hedge fund manager Orin Kramer to the board of the New Jersey State Investment Council, which oversaw management of the Garden State’s then-$62 billion retirement system. Like CalPERS, the New Jersey fund had been badly scarred by the bear market; it was also laboring under a debt burden in the form of $2.75 billion in pension obligation bonds. Kramer started pushing for the system to invest in alternatives, stressing the diversification and risk management benefits. But the politically charged environment made change difficult.

In Pennsylvania, Peter Gilbert was having more luck. As CIO of the Pennsylvania State Employees’ Retirement System, Gilbert had gotten permission from his board in 1998 to start investing in hedge funds. After a failed attempt at “going direct” by investing in four long-short equity managers, he says, the then-$23 billion in assets PennSERS in 2002 hired Blackstone Alternative Asset Management (BAAM), the hedge fund arm of New York–based private equity firm Blackstone Group. Gilbert was one of the early public fund adopters of “portable alpha,” the strategy of taking the alpha, or above-market returns, of an active manager — often a hedge fund — and transporting it to the more traditional parts of the portfolio (large-cap U.S. equities, in the case of the Pennsylvania retirement system).

Between 2002 and 2006 other large state pension funds began investing in hedge funds, with varying levels of sophistication. They included New York, Missouri, Massachusetts, Texas, Utah and finally New Jersey. By May 2006, Marina del Rey, California–based investment consulting firm Cliffwater, itself a product of the growing interest by institutional investors, found that 21 U.S. state retirement systems were using hedge funds, with a total investment commitment of $28 billion. But there were also funds that held back, like the Public Employee Retirement System of Idaho and the Washington State Investment Board. Some were legally prohibited from making investments; others were not convinced hedge funds were right for public plans. Hedge fund investing remained controversial.

The hedge fund experiment was put to the test in 2008, when, under the pressure of too much bad debt, the U.S. housing and mortgage markets collapsed. That was soon followed by the near-failure of the banking system, the credit markets and the entire global financial system. State pension plans lost, on average, 25 percent in 2008, according to Santa Monica, California–based Wilshire Associates’ Trust Universe Comparison Service. That was better than the broad U.S. stock market — the Standard & Poor’s 500 index plummeted 38.5 percent in 2008, its third-worst year ever — but it lagged the performance of the typical hedge fund, which was down 19 percent, according to Chicago-based Hedge Fund Research.

Hedge fund managers often like to tell investors they’ll be able to deliver positive absolute returns regardless of what happens to the market, but in 2008 most managers didn’t live up to those expectations. Hedge funds did, however, cushion their investors against the near-record drop in the stock market and proved their value  as portfolio diversifiers. Now, a decade after the first generation of public pension plans started to invest in hedge funds, more and more are looking to do so. In fact, today some of the biggest holdouts from the past decade are beginning to embrace hedge funds, including the $153 billion California State Teachers’ Retirement System, the $152.5 billion Florida State Board of Administration and the $74.5 billion State of Wisconsin Investment Board.

If things looked bad for defined benefit pension plans in 2002, they look a whole lot worse today. The 126 public pension systems tracked by Wilshire Associates had, on average, a funding ratio for the 2009 fiscal year of 65 percent — meaning they had only 65 percent of the assets needed to pay for the current and future retirement benefits of the firefighters, police officers, schoolteachers and other public workers covered by their plans. The situation has been exacerbated in states like Connecticut and Illinois, which in the intervening decade decided to increase benefits without increasing their contributions to pay for them.

“The pension benefit promises that have been made to unions by politicians have been in many respects unrealizable,” says Alan Dorsey, head of investment strategy and risk at New York–based asset management firm Neuberger Berman.

To make up for the shortfall, public pension plans have few places to turn. In the current economic environment, it is political suicide to even broach the topic of raising taxes. And despite calls from some high-ranking officials, like New Jersey Governor Chris Christie, to reduce health care and retirement benefits for public workers, getting state legislators to approve such cuts won’t be easy. For beleaguered public pension officers, the best and perhaps only solution is to try to figure out a way to generate better investment returns.

“Hedge funds start looking attractive because of their superior liquidity relative to private equity and real estate, and superior risk-adjusted returns relative to the overall market,” says Daniel Celeghin, a partner with investment management consulting firm Casey, Quirk & Associates, who wrote a seminal paper on the future of hedge fund investing in the aftermath of the 2008 crisis.

That is, of course, assuming that hedge funds continue to put up superior risk-adjusted returns. Capturing alpha — skill-based, non-market-driven investment returns — is, at the end of the day, the whole point of putting money in hedge funds. Although hedge funds as a group didn’t produce the same amount of alpha in the past few years as they did early last decade, it appears that they added some.

The ability to generate alpha enables hedge funds to justify their high fees. Managers typically charge “2 and 20”: a management fee of 2 percent of assets and a performance fee of 20 percent of profits. It’s been harder for funds of hedge funds to make the case for their management and performance fees — typically 1 and 10 — which investors must pay on top of the fees of the underlying managers. As a result, many fee-conscious pension plans that initially invested through funds of funds are now electing to go direct. That approach, however, can make hedge fund investing much more challenging, especially for pension plans with small investment staffs.

Hedge funds are not like traditional money managers, says former PennSERS investment chief Gilbert, now CIO of Lehigh University, responsible for managing the Pennsylvania school’s $1 billion endowment. Hedge fund managers require more due diligence and constant monitoring because in their search for alpha they operate with few if any constraints. “You really have to know what to expect from each particular hedge fund manager and how you are going to use them,” Gilbert says. Most investment consultants, the group that public plans typically rely on to help with manager selection — which can step in to take over the role of a fund of funds at a lower cost — are still grappling with advising on hedge funds.

Public pension plans, for their part, with their billions of dollars and stringent investment requirements, are changing the parameters of the hedge fund experiment. In a January 2011 report, consulting firm Cliffwater found that 52 of the 96 state pension plans it surveyed had a total of $63 billion invested in hedge funds as of the end of fiscal 2010, more than double the amount from four years earlier. “Public pension funds are the investment group that is going to shape the hedge fund industry,” says Scott Carter, head of global prime finance sales and capital introduction in the U.S. for Deutsche Bank, as well as co-head of hedge fund consulting.

Christopher Kojima, global head of the alternative investments and manager selection group at Goldman Sachs Asset Management in New York, would agree with Carter’s assessment. “The debate we are seeing at public plans today is much less about whether hedge funds are a sensible contributor to their objectives,” Kojima says. “The question we encounter much more is how to invest with hedge funds.” Pension funds are looking at how to identify and monitor top managers, think about risk management and connect hedge funds to their broader portfolios. “Are hedge funds even a separate asset class?” Kojima asks. More and more, the answer is no.