A funny thing happened recently in the left-leaning Golden State. In a board election last month, members of the California Public Employees’ Retirement System, or Calpers, the biggest pension fund in the nation, threw out their president and gave ESG investing a bloody nose.
ESG is the increasingly popular asset-management style that applies environmental, social, and governance standards to screen potential investments. Following this approach, an investor might avoid certain stocks or push shareholder proposals to modify corporate behavior. Unfortunately, they often favor hard-to-define social objectives rather than the narrower goal of maximizing shareholder returns.
In the vote, Jason Perez, a sergeant in the Corona, Calif., police department, upset board member Priya Mathur, a 15-year Calpers veteran, who was also board president and a champion of Calpers’ focus on ESG investing. The pension fund runs $351 billion for its 1.9 million members. Because of its size and stature, Calpers is among the most influential institutional investors in the U.S., and its policies are often adopted by other state pension funds.
Perez, who received 57% of the vote to Mathur’s 43%, ran a campaign that criticized her support for Calpers’ use of ESG, which goes back to at least 2012. Perez’s victory didn’t come as a surprise to those who bothered to look at Calpers’ mediocre recent returns. And that’s exactly what members seemed to have done.
Over the past five and 10 years ended on June 30, the close of Calpers’ fiscal year, the fund returned 8.1% and 5.6%, respectively, in one of the strongest bull markets in history. In the same periods, the S&P 500 index returned 13.4% and 10.2%. In fairness, the fund’s portfolio slightly topped its benchmark over the five years ended on Dec. 31, but underperformed over 10 years.
In an interview with Barron’s, Perez credits his win to a growing belief among members that ESG wasn’t doing them any favors. “Calpers’ social investment focus and lack of returns received a lot of attention of labor up and down the state….Everyone noticed the performance and [Calpers’] desire to concentrate on social issues.”
Perez is straightforward about his plans: The mission of the fund is primarily to provide benefits to members and reduce the burden on contracting agencies like the municipalities that hire state workers, he says. “We have a fiduciary duty, and I intend to hold them [Calpers] to that.”
The Calpers board has its work cut out. As of the most recent fiscal year, it was just 71% funded. That’s a small improvement from the previous year, when it was 68% funded with a $138.5 billion unfunded liability. That’s the shortfall between retirement benefits promised and the current funding available to meet those obligations. It’s hard to see how it will get fully funded on its own anytime soon.
Short of strong future performance, employees and taxpayers will have to make up that deficit. Perez notes that the upcoming state elections include numerous municipal ballots about tax increases, in some cases partly as a result of underfunded pensions.
Calpers isn’t the only seriously underfunded public plan. In a report from the Pew Charitable Trusts, the funding gap in 2016, the latest year for which comprehensive data were available, was put at $1.4 trillion, up $300 billion from 2015.
Proponents of ESG point to studies suggesting that its methods can often attain portfolio returns that are no worse, or even better, than conventional methods. Opponents produce other studies that suggest using social litmus tests for investing can lead to worse returns, particularly through a lack of sector diversification. I would point to Calpers’ own study on the matter: Its exit from some tobacco stocks in 2000 reduced portfolio returns by $3 billion from 2001 to 2014.
There’s another basic problem with ESG: no standard legal definition. Each fund approaches it in its own way, which can mean varying degrees of emphasis on the environmental or social good or governance. In my experience, better governance and transparency are shareholder friendly and worthwhile. How hard is ESG to define? On Oct. 1, a group of securities lawyers and dozens of institutions, including Calpers, petitioned the Securities and Exchange Commission to standardize rules on ESG. I doubt the SEC knows any better.
And still, ESG shareholder proposals keep coming. According to Institutional Shareholder Services, the majority of shareholder proposals submitted to U.S. companies during the 2018 proxy season was related to environmental and social concerns. Two funds have filed a shareholder proposal requesting
to “explain what it is doing to address content that threatens democracy, human rights, and freedom of expression.”
“We are reaching a crescendo of bad fund management meeting unfunded liabilities,” says Christopher Burnham, president of the Institute for Pension Fund Integrity. “Calpers members recognize this and reject those who are playing politics instead of getting the highest rate of return at a reasonable risk.”
While the jury is still out, why are active fund managers tripping over themselves to produce new ESG funds? Could this be their response to the competitive landscape, after having lost huge amounts of investor money to passive strategies like exchange-traded funds? Yes, probably.
“It’s too early to tell if this election will have ramifications beyond Calpers,” says Paul Atkins, CEO of Patomak Global Partners and a Republican SEC commissioner from 2002 to 2008. “But a lot of funds are already using ESG, and investors don’t know to what extent they are using it.”
With ESG so popular, the election of Perez could be just a blip in its ascent. But if ESG investing doesn’t produce demonstrable proof of its efficacy on long-term shareholder returns, it could be the first tremor before an earthquake.
Write to Vito J. Racanelli at firstname.lastname@example.org