Good summary, Ted, but I think I'm with Simon. The evidence against hedge funds, now and in the future, is much stronger than I think you acknowledge, and I don't see the industry getting back on track without some pretty radical changes.
You suggest that "For institutions to follow CalPERS’s lead, hedge funds would likely need to experience a prolonged period of pronounced underperformance." CEM Benchmarking recently released a study (sponsored by NAREIT, and available at http://www.reit.com/investing/industry-data-research/research/cem-bench…) looking at the actual performance of investments by more than 300 U.S. pension plan sponsors over a 14-year period (1998-2011), with assets grouped into 12 asset classes. Hedge funds were the WORST asset class:
Listed Equity REITs 11.31%/year
Private Equity 11.10%
Real Assets other than private or listed real estate 9.85%
U.S. Long Fixed Income 8.97%
U.S. Small Cap Stock 8.25%
Non-U.S. Stock 8.23%
Non-U.S. Fixed Income 7.64%
Private Real Estate 7.61%
U.S. Broad Fixed Income 6.56%
U.S. Large Cap Stock 6.06%
U.S. Other Fixed Income 4.95%
Hedge Funds 4.77%
CEM Benchmarking also estimated that the average pension plan would have done BETTER by REDUCING its allocation to hedge funds: a one-percentage-point reduction in its hedge fund allocation would have improved overall performance by 2.1 basis points per year.
Notice that the 14-year historical period included the period of what you call "terrific performance by hedge funds amid market turmoil in 2000–2002" and "this golden era of hedge fund relative performance." Notice also that it included the liquidity crisis of 2008-2009. If the main selling point of hedge funds is that they provide downside protection during a crisis, then one legitimate conclusion is that institutions just don't want to be in hedge funds for more than a year or two, because their underperformance during all non-crisis periods completely overwhelms the limited periods of positive contribution.
Finally, investment costs of hedge funds were higher than for any other asset class except private equity, averaging 125 basis points per year, compared to just 17 bps/yr for U.S. Broad and U.S. Long Fixed Income. Clearly if you're willing to give up some return in favor of downside protection, a traditional bond portfolio was a much, much better choice.