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 & CalSTRs) have made environmental, social and governance (ESG) issues a major theme of 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 mainstream and profitable.

Billions of Social Dollars

Combined, the California Public Employees' Retirement System (CalPERs) and the California State Teachers' Retirement System (CalSTRs) have over $502 billion under management as of 2017; 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 socially 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.

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. In 2013, the company adopted a set of 10 Investment Beliefs that, according to its website, "weave the sustainability theme throughout. The Beliefs guide our decision making, facilitate the management of our complex portfolio, and enhance consistency." CalPERs requires that all managers receiving capital allocations employ ESG principles into their investment process. CalSTRs has a similar approach.

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.

Betting directly on stocks that CalPERS and other ESG-focused funds invest in could be one way to benefit; however, a better way to participate 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 120 different firms and over $533 million in assets as of May 2017. The ETF could be 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 0.22% expense ratio. The ESG metrics employed by the fund has allowed it to nearly match the S&P 500 over the past five years, generating roughly 14.43% annualized returns vs. 14.66% for the S&P 500 between 2012-2016.

The Bottom Line

With two of the country’s largest pension funds moving now firmly committed to ESG investing, regular retail investors may want to get in on the act. While regular investors lack the size and scope of CalPERs and CalSTRs, 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.

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