Mega-sized endowments, pension funds and hedge funds have the ability to move the markets and change investing trends. So when two of the largest begin moving into a style or sector, it can be fruitful for us regular retail investors to pay attention.

In this case, two of California’s largest pension funds (CalPERs & CalSTERs) have recently made environmental, social and governance (ESG) issues a major theme to their investment process. While ESG investing has been generally disappointing in the returns department over the last decade or so, the pension fund's shift into the portfolio style certainly could bring better prospects in the years ahead. Overall, California’s decision could be the catalyst to make ESG investing more main stream and profitable.

Billions of Social Dollars
Combined, the California Public Employees' Retirement System (CalPERs) and the California State Teachers' Retirement System (CalSTERs) have nearly $413 billion under management; so when they throw their combined weight around an idea, it usually turns out to be a good one. This time the initiative is to incorporate environmental, social and governance ideas into their investment processes.

ESG or social responsible investing basically adds a “filter” to stock selection by only choosing firms that meet certain social or environmental standards. These ESG screens can include everything from resource management and pollution prevention to labor and human rights issues. The basic idea is to only engage in firms that have desirable social or ethical practices. By applying these screens to their research, the two pension plans hope to achieve added returns for their investors as well as change the world for the better.

SEE: What is socially responsible investing?

There is some evidence that applying ESG metrics after initial financial research does produce better returns. According to Goldman Sachs, companies that are considered leaders in ESG policies are also leading the pack in stock performance by an average of 25% over the long term. This echoes similar research by RCM, which found that between 2006 and 2010, investors could have added an additional 1.6% a year to their investment returns by allocating to portfolios that invest in companies with above-average ESG ratings.

However, CalPERs is taking things a bit further aside from avoiding sin and weapons stocks. The pension fund plans on shifting roughly $50 million a year, indefinitely, into a concentrated portfolio. The focus of this is to buy shares of stocks that are underperforming and directly benefit from CalPERs ESG influences. The role of the portfolio is not to interfere with the running of the company, but to hold the board accountable and for the board to oversee the management strategy. Recent wins for the pension include shareholder resolutions to force governance changes at Chesapeake Energy (NYSE:CHK) and driller Nabors (NYSE:NBR).

CalSTERs expects to launch its own actively managed concentrated ESG portfolio by buying additional stock of the companies it is engaging later this year.

SEE: Introduction To Institutional Investing

How to Participate
Odds are the retail average investor doesn’t have enough capital to directly influence the board of a large corporation. However, there are ways to add a dose of ESG investing to their portfolio.

The magazine Pension & Investments highlights Adobe Systems (NASDAQ: ADBE) Staples (NASDAQ: SPLS) and Steel Dynamics (NASDAQ: STLD) as CalPERs latest ESG targets. Betting directly on them could prove prudent; however, a better way could be through an ESG exchange traded (ETF) or mutual fund.

The iShares MSCI USA ESG Select Index (NYSE: KLD) tracks U.S. large- and mid-cap stocks screened for positive environmental, social and governance characteristics. Currently, KLD holds 133 different firms and nearly $200 million in assets. The ETF could a good starting place for investors looking to add ESG screens to their portfolio.

Another solid choice could be the Vanguard FTSE Social Index Investing mutual fund (VFTSX). The fund focuses on similar ESG metrics like the iShares ETF, but charges a dirt cheap 0.29% expense ratio. The ESG metrics employed by the fund has allowed it to slightly outperformed the S&P 500 over the past five years, generating roughly 6% annualized returns.

The Bottom Line
With two of the country’s largest pension funds moving into the world of ESG investing, regular retail investors may want to get in on the act. While they lack the size and scope of CalPERs and CalSTERs, there are plenty of ways to add social and environment values to their portfolio. That could be a good thing in the return department as well.

SEE: Socially Reponsible Stocks: Do Good Deeds Punish Profits?

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