The Golden State's not-so-golden goose

By Christopher Palmeri

updated 2:59 p.m. ET July 16, 2008

In March 2000, California state Treasurer Philip Angelides announced a bold new initiative. Angelides felt the Golden State could do good for both the citizens of the world and its retirees by taking state pension fund money out of two asset classes that were performing horribly at the time, tobacco stocks and emerging markets, and reinvesting in something with a social benefit — businesses and real estate in low-income neighborhoods in his home state. Angelides called the initiative the "Double Bottom Line," because it would produce both a social return and strong investment results.

Eight years later, Angelides is gone, but the state's two big pension funds are still wrestling with the fallout of the initiative. A recent report from the California State Teachers' Retirement System (CalSTRS), revealed that the $170 billion fund, the nation's third-largest, would have been $1 billion richer if it had stayed in tobacco stocks. Meanwhile, investments in California real estate are proving particularly painful for the nation's largest fund, the $230 billion California Public Employees' Retirement System (CalPERS). Among other bad deals, it faces a loss of nearly $1 billion on one land investment alone.

The performance of the Double Bottom Line plan illustrates the potential drawbacks of socially responsible investing. While it's fine for individual investors to vote their conscience by putting money into the growing number of socially responsible mutual funds, they should know that it could lead to weaker investment performance. Although the most closely watched index of socially responsible companies, the Domini 400, has slightly outperformed the S&P 500 since its inception in 1990, it has underperformed in the past 10-, 5-, and 1-year time periods. Like it or not, people do gamble, smoke, and buy expensive nuclear-powered war machines.

Consequences take years to show up
The Double Bottom Line saga also provides a cautionary tale for all public funds that let investment decisions be made by politicians, rather than by the investment professionals hired to do so in the first place. Politicians on the campaign trail can generate fast headlines by announcing bold investment initiatives, but the bottom-line consequences of such actions take years to show up. Angelides has since left public office, having lost his bid to replace Arnold Schwarzenegger as California's governor in 2006.

A spokesman for the former treasurer notes that many CalPERS investments in California real estate "either predated his involvement, occurred after he left, were decided upon by staff or were unrelated to Phil's policy initiatives." In an e-mail response to BusinessWeek.com, Angelides said: "I am extraordinarily proud that during my tenure as State Treasurer, California's pension funds set new standards for responsible investing, posted record returns and boosted pension fund assets from $244 billion to $386 billion. I am particularly proud of our successful efforts to invest in urban, inner-city neighborhoods, where CalPERS has earned annual returns of more than 20% while creating jobs and hope in communities too often left behind."

The first part of the Double Bottom Line to unravel was the push to reduce investments in emerging markets. Angelides proposed, and CalPERS approved, a method for screening foreign countries based on such criteria as whether they had a free press and laws in place to protect workers. The program was a diplomatic disaster for CalPERS after countries such as Indonesia, Malaysia, the Philippines and Thailand got dropped from the list of approved investments.

Excluding some angry countries
The Thai stock market fell 7 percent in just two days after the list came out. Representatives of the dropped countries howled and bused local citizens to CalPERS' Sacramento headquarters to protest. It proved particularly embarrassing when the data used to exclude the Philippines turned out to be old and the country was reinstated.

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An even bigger problem was that CalPERS was excluded from investing in such economic powerhouses as China, India and Russia. A 2007 CalPERS report found that the fund's emerging-market investments underperformed an index without the same screening process by 2.6 percent a year, costing the fund some $400 million in lost gains. In August of last year, the fund changed its policy after declaring victory over the social ills it had targeted.

"Year by year, scores are improving, and many countries have responded to our standards for investing," Rob Feckner, president of the CalPERS board, said in a press release announcing that the fund had repealed the screening policy.

Can't quit smoking
Next to be reinstated may be tobacco. In a June 4 report, CalSTRS revealed that excluding tobacco stocks had cost the fund more than $1 billion in lost gains over seven years. After all, shares of tobacco giants Altria (MO) and Reynolds American (RAI) had shot up threefold and sixfold, respectively, this decade. The CalSTRS staff found that the potential costs of lawsuits and increased regulation of tobacco companies were no longer as dire as they were and that a movement among state pension funds to divest themselves of tobacco stocks had waned. The report said the fund "could no longer justify" excluding the stocks on a financial basis and recommended repealing the policy. 

In general the professional money managers who run the California pension funds have opposed restrictions on what they can invest in. Exiting an asset class typically costs the funds millions of dollars in transaction fees, capital gains taxes, and fees to consultants to both justify the divestiture and monitor the ongoing performance. The CalSTRS board is expected to consider reinvesting in tobacco stocks at a meeting in September.

Then there's real estate. Based to a large degree on the Angelides push, CalPERS and CalSTRS invested heavily in real estate in their home state. One big beneficiary was Victor MacFarlane, a San Francisco money manager who invested CalPERS money in low income urban areas in partnership with basketball great Earvin "Magic" Johnson starting in 1996.

At a conference on California investing co-sponsored by CalPERS and CalSTRS last September, MacFarlane noted that the definition of urban investing had since expanded to include not just investments in poor neighborhoods but luxury high-rise condos and suburban master-planned communities. He said he had earned CalPERS returns of 33 percent a year. "The bottom line — or the double bottom line — is that urban real estate investments can help revitalize downtrodden neighborhoods and spur economic growth," MacFarlane said. "Pension funds and others are proving you can do well by doing good."

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