January 2004

by Jon Entine

Jon Entine investigates the investment of American state pensions in SRI funds.

Should state and local pension funds in the United States ­ which collectively hold more than US$3 trillion in assets ­ invest the assets of their hard-working current and future retirees based on which companies support and practice "progressive" social and environmental policies?

Not surprisingly, "socially responsible" investing advocates say this idea is a no-brainer. As stock prices have been obliterated by blowups and bankruptcies at ethically-challenged companies, SRI proponents claim to offer a way out of the wilderness. "There's a huge overlap in the universes of high-quality companies and socially screened investments," claims Dan Boone, who runs the Social Investment Fund Equity Portfolio for the Calvert Group in Washington, DC.

For years, few pension funds incorporated social screens because of a slew of studies showing the comparative underperformance of socially invested portfolios. Because equity markets are relatively efficient over time, money managers forced to draw from a shallower pool of stocks invariably lagged the major indices. Investing using social screens risked violating rules mandating fiduciary responsibility. To circumvent this criticism, SRI advocates have been pounding the bushes in recent years claiming that stocks that pass social screens regularly beat the overall market. "The argument that social investing outperforms has incredible leverage because it puts Wall Street in total contradiction with itself," suggests Peter Camejo, a former trustee of the US$3 billion public employees pension fund for Contra Costa County, California.

Politicisation

The SRI mantra has certainly caught the ear of ambitious politicians, especially in California. Camejo himself used that argument to convince his home county to exclude so-called environmental underperformers from its pension fund, a first for a state or local government. Shortly before the county's portfolio tanked, Camejo left the Contra Costa board to run for governor in the recent recall election won by Arnold Schwarzenegger (Camejo received less than three percent of the vote).

California State Treasurer Philip Angelides has used social investing as his calling card for years. Angelides directly controls US$45 billion in taxpayer funds held by the state government and more than 3,000 California municipalities and is an influential member of the boards of the California Public Employees Retirement System (CalPERS) and the California State Teachers Retirement System (CalSTRS), which together hold more than US$300 billion in assets. In late 1999, he helped persuade the boards to sell their US$800 million in tobacco shares.

"I feel strongly that we wouldn't be living up to our fiduciary responsibility if we didn't look at these broader social issue," says Angelides. "I think shareholders need to start stepping up and asserting their rights as owners of corporations. And this includes states and their pension funds."

As in Contra Costa, social investing has not quite worked out as advertised. Since Angelides began his crusade, the American Stock Exchange Tobacco Index has outperformed the S&P 500 by more than 250 percent and the Nasdaq by more than 500 percent. That decision alone has cost California pensioners more than a billion dollars. Should we boycott buying stocks in tobacco companies even though the boycott has zero impact on the operations or profits of these companies but devastates the returns of pensioners who often have little say in what's being done in their name?

Underperformance

California's socially responsible misadventure is not the only recent investment fiasco. Since the puncture of the market and technology bubble, most social funds, including those managed by Calvert, Citizens and Domini Investments, have significantly underperformed the market and mainstream competitors. The stocks and bonds of every corporation beset by scandal or accusations of financial or ethical impropriety ­ including Enron, WorldCom, HealthSouth, Global Crossing, Adelphia, Quest, Tyco, Citigroup, Verizon, JP Morgan/Chase and Microsoft ­ were sprinkled throughout the portfolios of leading "social investment" mutual funds. Some, like Enron, were stars. Others, like Microsoft, Verizon and Citigroup, around which ethical and legal actions and accusations still swirl, remain prominently featured in SRI portfolios.

It's now clear that the competitive performance of SRI funds during the 1990s ­ the justification for the bragging by Camejo and other SRI promoters ­ is almost entirely explained by the large sector bet placed on high technology, communications and financial stocks ­ the epicentre of the corporate scandals.

The underperformance of pension funds using trendy social litmus tests is hardly news. In a study of 50 state pension plans over the period 1985 to 1989, Roberta Romano of Yale University concluded, "Public pension funds are subject to political pressures to tailor their investments to local needs, such as increasing state employment, and to engage in other socially desirable investing." She noted pointedly that investment dollars were directed not just toward "social investing" but also toward companies with lobbying clout.

Olivia Mitchell of the University of Pennsylvania reviewed the performance of 200 state and local pension plans during the period 1968 and 1986 and found "public pension plans earn[ed] rates of return substantially below those of other pooled funds and often below leading market indexes."

Roots of SRI

The SRI phenomenon took wing in the early 1980s amid an activist campaign to encourage pension funds to withdraw investments from corporations doing business in South Africa. According to social investing mythology, the boycott wrought economic havoc on corporations that stayed in South Africa and eventually brought "apartheid to its knees". The campaign turned into a movement in 1998 when a Labor Department letter made clear that socially screened funds could be included in qualified retirement plans.

Although the boycott certainly had public relations value ­ it put pressure on politicians around the world to withdraw political support of the racist regime ­ the claims of economic input don't hold water. The definitive study on the boycott, "The Effect of Socially Activist Investment Policies on the Financial Markets: Evidence from the South African Boycott," published in the Journal of Business in 1999 by Siew Hong Teo of the University of Michigan, Ivo Welch, then at the University of California, Los Angeles, and C. Paul Wazzan of the Law and Economics Consulting Group concluded that "despite the prominence and publicity of the boycott and the multitude of divesting companies, the financial markets' valuation of targeted companies or even the South African financial markets themselves were not easily visibly effected."

Research by Prakash Sethi, the university distinguished professor of management and the academic director of executive programs for the Zicklin School of Business at Baruch College in New York also found that companies that remained in South Africa became the leaders in introducing social reforms and today remain among the most admired companies in that country.

Despite their limited impact and tepid performance record, social screens are being adopted by an increasing number of pension systems. A study by James Love at the liberal Center for Study of Responsive Law in Washington found 23 percent of state and local government-employee pension systems have prohibitions against investment in specific types of companies, including restrictions on investment in companies that fail to meet the MacBride Principles for doing business in Northern Ireland; in companies that are accused of pollution, of unfair labour practices or of failing to meet equal opportunity guidelines; in the alcohol, tobacco and defence industries; and even in companies that market infant formula to Third World countries.

Entering the mainstream

With the all-important California beachhead secure, social investing advocates have launched a full-scale assault on the mainstream pension fund world by trying to conflate the ideologically tainted "touchy-feely" world of social investing with the admirable goal of raising corporate ethical standards and transparency. "Corporate irresponsibility did for social investing what Watergate did for politics," states Cliff Feigenbaum, editor of Green Money Journal, an SRI public relations magazine.

"Where ten or 12 years ago, institutional investors were very careful to say, ŚWe pay attention to corporate governance but not social investing,' now there's no distinction," agrees Peter Kinder, president of KLD Research Analytics, the US leader in left-leaning social research. "The trend is strongly toward incorporating the issues that social investors have been concerned about for 30 years into mainstream securities analysis."

In a white paper on the future goals of SRI, Steve Lydenberg of Domini says pension funds are prime territory to spread the gospel of so-called mission-based investing. "Institutional investors should initiate ongoing dialogue among themselves on social and environmental issues, as they have begun to do on corporate governance issues," he writes. "As this occurs, the artificial distinction between corporate governance and corporate social responsibility will begin to blur."

The reality, of course, is that the distinction between corporate governance and corporate social responsibility is the very antithesis of arbitrary. With the introduction of patently political criteria, SRI advocates are releasing the genie of unintended ideological consequences. Generally, it's pretty easy to agree on broad-brush social principles: let's support companies that do good things and avoid the bad guys. But once you move from the abstract to the specific, all hell breaks loose.

"Subsidising destruction"

Consider the debate over Walt Disney, a favourite equity in many liberal SRI portfolios. The Texas legislature passed an appropriations bill in 1998 prohibiting state agencies from investing in companies that own ten percent or more of a business that records or produces music glamorising or advocating violent criminal acts, illegal drug use or perverse activities. The conservative American Family Association of Texas immediately targeted the state's US$27.5 million holdings in Disney. "We believe investing in a company like this is bad public policy," said Wyatt Roberts, executive director of the Family Association. "I don't think that the citizens of Texas like the idea of subsidising the destruction of their own children through the Disney Corporation."

Although Disney had already netted the fund a healthy 35 percent return when the controversy ensued, some board members were more animated by their personal ideological convictions than their fiduciary responsibility to pensioners. "I think we should be setting a good example for the children of Texas," proclaimed Dr. Richard Neill, a state board member from Fort Worth.

Invoking the South Africa boycott, a number of activists are arguing for a boycott of Israel. A Berkeley group calling itself "Students for Justice in Palestine" has collected more than 220 faculty signatures in support of disinvestment from Israel "until Israel ceases its ongoing violations of international laws". Green Party candidates around the United States cite social investment principles to target Israel. Howie Hawkins, the defeated Green Party candidate for state comptroller in New York in 2002, said dumping Israeli bonds is not only good politics but also sound economics. His documentation?­­a thin gruel of propaganda, The SRI Advantage: Why Socially Responsible Investing Has Outperformed Financially, written by none other than Peter Camejo.

Even the policy of "targeted investments" ­ the "double bottom line" investment strategy touted by Angelides ­ raises serious concerns. CalPERS and CalSTRS have committed US$7 billion to a programme called Smart Investments to support "environmentally responsible" growth patterns and invest in struggling communities. Another Angelides initiative is a programme to screen developing countries for such criteria as a free press, an independent judiciary and an active labour movement. While economically targeted investments are a worthy cause for legislatures, whose representatives are subject to the vote of constituents, they've periodically proved disastrous for public pension funds, which don't submit such decisions to public vote. Consider these examples highlighted in a study by Competitive Enterprise Institute scholar Cassandra Chrones Moore:

• In 1980 the Alaska public employees and teachers retirement funds loaned US$165 million, 35 percent of total assets, to make mortgages in Alaska. When oil prices fell in 1987, so did home prices. Forty percent of the loans became delinquent or resulted in foreclosures.

• In 1989, in what may well have been an election-year bailout of a failing firm, the State of Connecticut Trust Funds invested US$25 million in Colt's Manufacturing Co. after a lobbying effort to save jobs; the company filed for bankruptcy three years later, endangering the trust funds' 47 percent stake.

• The Kansas Public Employees Retirement System (KPERS) invested US$65 million in the Home Savings Association, an investment that became worthless when federal regulators seized the thrift in the 1980s. All told, KPERS has written off upwards of US$200 million in economically targeted investments.

Prescription for chaos

In the late 1980s, before financial disaster struck, KPERS was being held up as a model programme to stimulate the economy. Allowing short-term political concerns to drive investment decisions is clearly a prescription for chaos. In an attempt to create jobs in the state, activists in the Ohio legislature are currently trying to force the Ohio State Teachers Retirement System to invest not less than 70 percent of equity and fixed-income trades with approved Ohio-based brokers and no less than an additional ten percent with minority business firms. Even the bills supporters don't believe there is enough investing expertise among brokers in the state to responsibly handle multi-billion dollar portfolios.

Wall Street has long preached that making social judgements in the investment process has no effect on corporations, especially large ones. It has also firmly maintained the belief that making social judgements limits return to investors. Despite the claims of social investment acolytes, those two adages remain firmly in place. Although social investing has demonstrated that it can be an effective brand marketing strategy, it does not promote systematic investment in "good" companies nor necessarily "do good" as Angelides and its advocates claim.

The irony in California is that the foray into social investing by CalPERS and CalSTRS has coincided with a multi-year slide in returns. And despite a reputation as the world's corporate governance bulldog, Angelides has been beset by conflict-of-interest controversies. CalPERS committed more than US$760 million in 2001 and 2002 to two funds created by Los Angeles billionaire Ronald Burkle, who, with his wife, contributed to Angelides' run for state treasurer.

The hard-edged left and right are clearly energised by the politicisation of the pension funds. But as the ill-timed investments in California show, this is risky business. Pension funds are heading into treacherous waters where political grandstanding or moral righteousness threatens clear financial mandates. By implicitly encouraging the belief that the intentions of a business can be judged distinct from its economic impact, social investing often promotes corporate behaviour that is neither socially progressive nor ethical and may certainly result in adverse consequences to stakeholders ­ including pensioners. Politicians should set only the broadest investment guidelines for state funds and no more. It's time to stop gambling with other people's money in support of ideological vanity.

Jon Entine is scholar-in-residence at Miami University (Ohio) and adjunct fellow with the American Enterprise Institute in Washington, DC. Jon is also an award-winning freelance journalist.