The California Public Employees' Retirement System has quietly started a program aimed at doubling down and reaping more profit from public companies it is engaging on environmental, social and governance issues.
Anne Simpson, senior portfolio manager and director, corporate governance, of the $253.2 billion Sacramento-based pension fund, said the initiative involves buying additional shares of stock of companies in which CalPERS already invests through its internally managed indexed equity portfolio.
The additional shares will be actively managed by CalPERS' investment staff in a concentrated portfolio.
“It's an important signal to the market that we believe in this, we have conviction,” said Ms. Simpson, referring to officials' belief that they can earn additional returns through stock picking among the companies CalPERS engages.
Lev Janashvili, managing director of corporate governance research firm GMI Ratings in New York, said he believes CalPERS is the first pension fund to build a separate portfolio — beyond indexed positions — of companies it has engaged.
“We have not seen anything like this with a public face,” Mr. Janashvili said. “It seems pretty simple and pretty sensible.”
Ms. Simpson would not disclose specific positions CalPERS has taken or how much money CalPERS has allocated to the program, saying that information is market sensitive. The program was approved by the pension fund's investment committee behind closed doors in August. It was publicly disclosed at a CalPERS board meeting in November.
She said CalPERS expects its engagement to drive up stock prices. “We call this monetizing our company focus list,” she said.
A CalPERS official, familiar with the program but who did not want his name used, said the fund plans to allocate $50 million a year indefinitely to the concentrated portfolio, dividing the money among five to 10 companies each year.
The source said the CalPERS board and staff would review the program periodically and if it is successful could increase the annual allocation to $100 million or more. The source said it was not inconceivable the portfolio could grow to $1 billion or more over time.
“We view it as a deep-value portfolio, buying shares of stock of underperforming companies that can grow under our engagement,” he said.
Forcing governance change
Ms. Simpson said CalPERS does not normally disclose the names of companies it is engaging, but makes exceptions when it files shareholder resolutions to force governance changes, as it did successfully last year in the case of Chesapeake Energy Corp. and Nabors Industries Inc. She said CalPERS has about 10 other companies also under engagement.
The CalPERS source said other companies on the list (usually determined each June) include Adobe Systems Inc., Staples Inc. and Steel Dynamics Inc. It is unclear whether CalPERS has bought more shares in any of them beyond its index positions.
Ms. Simpson said expectations that CalPERS will reap profit from the program are based on past performance. She said a CalPERS study found that the 155 companies the retirement system put on its focus lists to engage between 1998 and 2008 generated on average, after three years of engagement, a total cumulative excess return of 15.8% above their respective benchmarks.
“I think what's going on is what's well known, which is observation changes behavior,” she said. “So, the fact that shareholders come into a boardroom when a company's failing and ask questions, want to know who's on the board, what's the strategy, that changes the company's behavior.”
She said key to increasing stock price is that CalPERS' involvement is sustained. Engagements usually last five years, ensuring that governance, risk management and safety and environmental issues that could be holding the price of stocks back are resolved over the long term.
“We are not a quick in-and-out; we are a sustained engagement,” she said of CalPERS.
While there are ample studies that efforts by investors to change corporate governance practices can change a company's behavior and improve share price, the research is also still in the “nascent” stages, said GMI Ratings' Mr. Janashvili.
He said many investors in the broader investment community still reject ESG factors as having a material impact on share price. “They would maintain it's still a marginal thing,” he said.
Engaging on ESG
The CalPERS corporate governance portfolio will be watched closely by executives at other pension funds because it will test the concept of whether a pension fund can successfully manage a concentrated portfolio of companies it is engaging on ESG issues, said Michael McCauley, senior officer, investment programs and governance of the $162.3 billion Florida State Board of Administration, Tallahassee.
“Any time you concentrate the portfolio, you are taking on more risk,” he said. “The higher the risk level, the higher potential there is for volatility and underperformance.”
Mr. McCauley said the difficulty of managing such a portfolio is that it's hard to quantify which engagement strategies work in driving the share price upward.
“There is no smoking gun,” he said of the various studies that have examined ESG's influence on stock performance.
Ms. Simpson conceded that more research needs to be done to quantify the impact of ESG, but said she is confident about the results of CalPERS' study.
“Our evidence is we've got 10 years (of) data that (show that)the companies that we engage have gone from underperformance to outperformance,” she said. “And now, the board has agreed that we put our money where our mouth is, and we have capitalized that strategy.”
CalPERS board member J.J. Jelincic said the new strategy is logical because it gives CalPERS the ability to benefit from its investments in engaging companies.
“We have been paying all the costs of our social engagement, but the benefits have been socialized,” he said. “All investors have been benefiting by higher stock prices. By having a concentrated portfolio, we are capturing a bigger portion of the profits for ourselves.”
CalSTRS to follow
California's other jumbo public pension fund, the $157.8 billion California State Teachers' Retirement System, West Sacramento, expects to launch its own actively managed concentrated portfolio, buying additional stock of companies it is engaging whose shares now are only held in index funds, said Anne Sheehan, director of corporate governance.
“It's a natural evolution of the governance movement,” she said.
Ms. Sheehan said no timetable has been set to start the portfolio. She said the pension system must first complete a process to expand its in-house investment capabilities before introducing new internal mandates.
She said the expanded approach will benefit not only CalSTRS but also the companies that are engaged.
“Engagement benefits the company in the long term because an improved governance structure positions them for long-running performance,” she said. “It also benefits us because supplemental investment will yield supplemental value over the long haul, which makes money for the benefit of our members.”
Mr. Janashvili said he believes the CalPERS experiment with a concentrated ESG portfolio has the potential to be embraced by many asset owners if it is successful.
He said someone had to be first in testing the waters with the actively managed portfolio.
“I say God bless them for doing it,” he said.
This article originally appeared in the March 4, 2013 print issue as, "CalPERS puts money where mouth is".