The Virtue of CalPERS' Emerging Equity Markets Principles

Research article

The virtue of CalPERS’ Emerging Equity Markets PrinciplesGabriel A. Huppé* and Tessa HebbCarleton Centre for Community Innovation, Carleton University, Ottawa, Canada

This article argues that CalPERS’ new principles-based approach to investing in emerging markets stands at the midpoint betweenits previous alpha-generation policy of complete country-level divestment and its beta enhancement associated with universalinvesting in its domestic and developed markets. Although CalPERS’ previous policy addressed macro-level standards at a countrylevel by negatively screening out companies in restricted countries, it precluded CalPERS’ normal practice of corporate engage-ment to raise environmental, social and governance (ESG) standards at the company level in these markets. We argue that thenew policy brings CalPERS’ emerging market portfolio more closely in line with its policies of engagement. We describe this policyas ‘enhanced alpha generation’. We use CalPERS’ emerging market portfolio holdings data and cross-reference these companyholdings with KLD data to contract extra-financial merits of the new policy. We further examine the share prices of these firmsagainst standard industry benchmarks to determine the policy’s material impact on CalPERS’ portfolio. We conduct interviewswith CalPERS’ investment managers – both internal and external – to determine how the new emerging market investment prin-ciples are incorporated in investment processes. This allows us to identify two approaches to the implementation of the Principles: a‘hard-fast’ screening approach, and a ‘value tradeoff’ approach. One of which entailed significant opportunity costs. These find-ings, when assessed in the context of various trends in the investment environment, and issues brought fourth in our interviews –with related investment practitioners, CalPERS’ trustees, and leading ESG experts at KLD and Verité – sheds light on the future stateof ESG investing in emerging markets.

Keywords: activism; alpha generation; CalPERS; corporate engagement; corporate social responsibility; economic development;emerging markets; ESG investing; extra-financial standards; pension funds; universal ownership

1. IntroductionThe California Public Employee Retirement System(CalPERS) is one of the largest pension funds in theUnited States. It is renowned for its trailblazing insti-tutional activism resulting in superior portfolio financialperformance and yielding global ancillary economic andsocial benefits. In demonstration of the power of activeshare ownership, each spring since 1987 CalPERS hasused a quantitative and qualitative process to review itsUS equity holdings according to governance and finan-cial performance criteria. Companies with low govern-ance and financial scores are analysed to determinewhether discussions with the board and company man-agement could potentially add value and, if a companydoes not respond to CalPERS’ attempts at engagement,then CalPERS may decide to place the company onthe Corporate Governance Focus List (Mercer, 2006).CalPERS’ focus list of American companies to beengaged on financial and corporate governance concernshas generated substantial returns to the economy andsociety at large (Barber, 2005). CalPERS’ ownership

practices have historically set the example for other insti-tutional investors to follow. It was an early signatory tothe UN PRI and is a leading member of the CERES-ledUS-based Investor Network on Climate Risk. CalPERS’leadership activities in the area of responsible investmentprocesses and responsible ownership practices are a goodindicator of future industry developments.

CalPERS’ active share ownership has historically beenlimited to developed markets. However, the evolution ofCalPERS’ investment philosophy in emerging marketssuggests the emergence of an approach to investmentprocesses and ownership practices that could potentiallygenerate similar returns to the economy and society atlarge from emerging markets.

Beginning in 2002, CalPERS’ emerging market equityinvestments were restricted by a Permissible EmergingMarkets Policy. According to this policy, fund managerswere disallowed from investing in countries that fellshort of an environmental, social and governance (ESG)threshold based on factors such as political stability,

*Corresponding author: E-mail: [email protected]

Journal of Sustainable Finance and Investment 1 | 2011 | 62–76doi:10.3763/jsfi.2010.0007 © 2010 Earthscan ISSN: 2043-0795 (print), 2043-0809 (online) www.earthscan.co.uk/journals/jsfi

transparency and labour practices. By conditionallyexcluding these countries from their portfolio, CalPERSeffectively influenced governments to adopt a moreinvestor-friendly macro-environment as an impetus toattract capital inflow. Despite the Permissible EmergingMarkets Policy’s merits, the policy’s restrictive nature dis-allowed fund managers from investing in booming equitymarkets such as Russia andChina – countries that consist-ently failed to meet the minimal threshold of permissibil-ity. In 2006, this restriction imposed 2.6% in annualforegone return on CalPERS’ emerging market equitiesportfolio and forced management to reconsider its emer-ging market investment strategy (Wilshire Associates,2007).

In late 2007, CalPERS was motivated to capitalize onRussian and Chinese equities. Feeling that the best wayto influence change in policies and practices was ‘nolonger at the government level but at the corporate level’(CalPERS’ CEO Anne Stausboll as quoted in Eccles andSesia, 2009, p.4), CalPERS adopted a new principles-basedapproach to equity screening at the company level, therebypermitting investments in all countries listed in the FTSEAll Emerging Index (CalPERS, 2007).

This article argues that CalPERS’ new principles-basedapproach to investing in emerging markets stands atthe midpoint between its previous alpha-generationpolicy of complete country-level divestment and itsbeta-enhancement associated with universal investing inits domestic and developed markets. Although CalPERS’previous policy addressed macro-level standards at acountry level by negatively screening out companies inrestricted countries, it precludedCalPERS’ normal practiceof corporate engagement to raise ESG standards at thecompany level in these markets. We argue that the newpolicy brings CalPERS’ emerging market portfolio moreclosely in line with its policies of engagement. We furtherargue that the financial returns on these emerging marketinvestments are more in line with emerging market bench-mark returns, while the raised ESG standards allow for riskreduction in the portfolio over time.

The article extends the pension fund active share own-ership argument (Hawley andWilliams, 2000; Clark andHebb, 2004; Lydenberg, 2007; Hebb, 2008) to emer-ging markets by proposing a new approach to emergingmarket investing. By, first, screening companies basedon extra-financial (ESG) factors and, second, engagingthese to raise corporate standards, CalPERS wouldreduce risk in its emerging market equities portfolio fora given return and thereby achieve a better risk/returntrade-off than that of the market investor. We termthis approach ‘enhanced alpha generation’. We addresshow investor initiatives contribute to redressing systema-tic issues derived from market failures. More specifically,we build on the management literature of ‘voice’ and‘exit’ through the exploration of alpha, beta andenhanced alpha investment strategies. We delineate thefinancial and extra-financial motivations behind these

strategies and the preconditions for their application.We focus on enhanced alpha investment strategies inthe context of foreign institutional investment in emer-ging markets.

We use data fromCalPERS on their portfolio holdings inemerging markets and cross reference these company hold-ings with KLD1 Research and Analytics Inc. (KLD) data toexamine CalPERS’ impact on ESG standards in the compa-nies of interest. We look at these companies’ standardsbefore, during and after CalPERS’ investment. SinceCalPERS seeks to reduce risk in its emergingmarket portfo-lio by taking into consideration the ESG standards of firms,we further examine the share prices of these firms againststandard industry benchmarks to determine the approach’smaterial financial impact on CalPERS’ portfolio. Weconduct interviews with CalPERS’ investment managersto determine how the emerging market investment prin-ciples are incorporated in the emerging market investmentprocess. We also interview leading experts at KLD andVerité on the current and future state of ESG standards inand engagement with emerging market companies.

The article is structured as follows. Section 2 reviews theliterature and explores our theoretical contribution. Section3 studies the history and purpose of CalPERS’ EmergingEquityMarkets Principles. Section4 describes ourmethod-ology. Section 5 discusses our data. Here we examine thefinancial data that relate to the companies added toCalPERS’ portfolio. In Section 6, we draw on a set of semi-structured interviews with CalPERS’ senior management,trustees and external fundmanagement, and extra-financialanalysts and data providers. This exercise provides a quali-tative analysis from their perspective and allows us to deter-mine how CalPERS’ emerging market investmentprinciples are incorporated in the emerging market invest-ment process. These interviews provide a good basis tounmask the current and future state of ESG standards inand engagement with emerging market companies. InSection 7 we discuss our findings and their implications.We conclude the article with some final thoughts on limit-ations and future research.

2. Literature and our theoretical contribution

The attractiveness of emerging market investmentsEmerging markets are in the process of rapid industrializ-ation and dynamic economic development. In contrast tomost developed countries, where limited business growthopportunities have dampened investment returns, emer-ging markets offer exceptional investment opportunities.

Near the end of the millennium’s first decade, aspension funds encountered increased difficulty to meettheir liabilities (Watson Wyatt, 2009) because of thefinancial crisis and the enlarging funding gap (The Econ-omist, 2009), emerging markets became an attractivesource of yield pickup (Chan-Lau, 2005). It is thereforeexpected that large pension funds such as CalPERS will

Virtue of CalPERS’ Emerging Equity Markets Principles 63

Journal of Sustainable Finance and Investment

continue to increase the proportion of their equity port-folio allocated to emerging markets. CalPERS’ emergingmarket equities portfolio represented 12.3% of its inter-national equity investments and 5.1% of its total equityinvestments as of June 2009.

But despite being a potential source of superior finan-cial returns and yield pickup, emerging market invest-ments, as opposed to their developed marketcounterparts, are generally associated with a higher levelof political, financial and economic risks (Harvey, 2004).2

These emerging market risks are mainly attributed torelatively poor public administrative governance and therudimentary state of legal and regulatory frameworkscoupled with poor enforcement and oversight by auth-orities (La Porta et al., 1997). Compliance with corporatestandards required by legal and regulatory frameworks istherefore a plaguing problem in emerging markets. Evenwhen compliance is achieved, the typically low demandsof compliance put companies at risk of competitive dis-parity (Barrett, 2006). In some regions, rapidly changingregulations could put environmental and social laggardsat a competitive disadvantage or expose them to litigationrisk (Grossman and Krueger, 1995; McWilliams et al.,2002). And even in the case of no real imminentchanges in the regulatory environment, these still runthe risk of reputational damage.3 Such risks affect theattractiveness of emerging market investments.

To compensate for discrepancies between corporatestandards that investors expect and those minimallyrequired or enforced by nation-states, voluntary ‘civil regu-lations’ have emerged as a relatively new dimension ofglobal business regulation that governs the social andenvironmental impact of global firms (Haufler, 2001;Vogel, 2008). ‘Civil regulations’ involve product or produ-cer certification andusually take the formof codes governedby non-governmental organizations. By voluntarily sub-scribing to these regulatory standards, emerging marketcompanies pledge to comply with certain levels of extra-financial commitments that are usually above those mini-mally required at the local and national levels. These com-mitments can vary by industry and product. They typicallyconcern labour or environmental practices and addressissues such as human rights, natural resources managementand waste disposal. For example, the International LaborOrganization (ILO) Core Labour Standards aim toimprove worker conditions by addressing human rightsissues in developing countries and theGlobal Sullivan Prin-ciples of Corporate Social Responsibility establish environ-mental and social responsibility standards. These voluntary‘civil-regulations’ are the object of CalPERS’ EmergingEquity Markets Principles three and four, respectively(refer to Appendix 1).

Many emerging market companies subscribe to thesestandards in response to pressure from activist groups’public protests or boycotts from consumers, whileothers subscribe in response to their environmentallyand socially sensitive corporate clients’ demand that

suppliers adopt such standards in an effort to mitigatethe risk of potential reputational damage arising fromsupply chain procurement activities (Murray and Monta-nari, 1986). Increasingly, however, other companiesdecide on their own to adopt voluntary standardsbecause it makes good business sense (Dowell et al.,2000; Christmann and Taylor, 2002).

Besides averting external pressure and reputationaldamage, there is an actual business case for heightenedcorporate standards (Hart, 1995; Menon and Menon,1997; McWilliams et al., 2002; Porter and Kramer,2006). For instance: becoming more eco-efficient canreduce business costs (Porter and Van der Linde, 1995;Shrivastava, 1995); labelling products as socially respon-sible (e.g. fair trade coffee) or eco-friendly (e.g. green pro-ducts, low-emission cars) can appeal to niche markets(Reinhart, 1998; Blomqvist and Posner, 2004; Lintonet al., 2004); anticipating changes in the regulatoryenvironment can lead to a competitive advantage(Roome, 1994); integrating social responsibility can leadto the development of competitively valuable capabilities(Starik and Rands, 1995); and better labour practices canlead to improved employee productivity and retentionrates (Moskowitz, 1972; Romm, 1994); etc. Moreover,an emerging market company that has heightened socialand environmental standards is at a comparative advan-tage when it comes to growing its business abroad(Gugler and Shi, 2008).4

Deeper to the heart of the subject, there exists compel-ling evidence that ‘superior human capital practices are notonly correlated with financial returns, [but] are, in fact, aleading indicator of increased shareholder value’ (WatsonWyatt, 2002, p.1).5 This stream of literature recognizesthat people lend their human capital to employers andthat companies must then provide an environment inwhich these people can create value to stakeholders inthe organization (Mayo, 2001). Yet, especially in emergingmarkets, many executives still regard – and manage –employees as costs even though, for many companies,people are an important source of long-term competitiveadvantage (Bassi and McMurrer, 2007). Therefore, ‘com-panies that fail to invest in employees jeopardize their ownsuccess and even survival’ (Bassi and McMurrer, 2007,p.1). Thus it is important that companies put in placeresponsible worker policies (Edvinsson, 1997; Sveiby,1997), and it is equally important that investors takecare to address such extra-financial standards in theirinvestment processes (Royal and O’Donnell, 2008).6

The above-mentionedmotives are all strategically impor-tant reasons for emergingmarket companies to subscribe toheightened corporate standards. As such, subscription cantranslate into material financial benefits for shareholders.7

There are three ways in which investors can factor thecorporate standards of investments into their investmentselection and management processes: alpha generation,beta enhancement and enhanced alpha generation.Short-term investors can seek to generate alpha, excess

64 Huppé and Hebb


risk-adjusted returns, by conditionally allocating capitalto companies that can temporarily externalize costs tosociety and thereby deliver attractive return on invest-ments for its investors at the longer-term expense ofthe rest of the economy and society at large. Similarly,the investor can also screen out companies whoseirresponsible behaviour is seen as a significant source ofdownside market risk and thereby achieve a morefavourable level of risk in its portfolio. This latter strategywas the aim of CalPERS’ Permissible Emerging MarketsPolicy. Longer-term investors, however, have an incen-tive to redress systematic issues derived from marketfailures. This is known as the universal owner hypothesis,and is key to understanding responsible investing broadlyand the shift to enhanced alpha generation detailed inthis article.

Next, we delineate the financial and extra-financialmotivations behind these strategies and the preconditionsfor their application. We first explore beta-enhancementstrategies (see the ‘CalPERS’ active investment in devel-oped markets’ section) and then focus on alpha andenhanced-alpha investment strategies in the context offoreign institutional investment in emerging markets (seethe ‘CalPERS’ investment in emerging markets’ section).

3. History and purpose of CalPERS’ Emerging EquityMarkets Principles

CalPERS’ active investment in developed marketsTo understand the evolution of CalPERS’ approach inemerging equity markets, it is useful to first consider itsperspective as a universal owner in developed markets.

The theoretical underpinnings of the universal ownerhypothesis (Hawley and Williams, 2000) address prob-lems associated with the efficient markets hypothesis(Fama, 1965; Samuelson, 1965) and modern portfoliotheory (MPT) (Markowitz, 1952). These two theoriesrest on the notion that the market is efficient and thatall information about the firm is known and factoredinto its stock price. The capital asset pricing model(CAPM) (Sharpe, 1964), used as the basis for pricingequities, is built on the rationality of these two under-lying theories. However, vocal critics of the efficientmarkets hypothesis, MPT and, by extension, CAPMargue against the assumption of a rational and informa-tionally efficient market. This critique has led to a rela-tively new field of behavioural finance. Increasedcriticism of MPT has arisen in light of the financialcrisis of 2008/2009 (Bogle, 2008; Taleb, 2008; Fox,2009). Behavioural finance argues against a rationalmarket (Schleifer, 2000; Shiller, 2000; Lo, 2005)rather than for an efficient market as assumed byMPT. For instance, many finance theorists have foundthat information asymmetries in financial markets arethe norm (e.g. Akerlof, 1970; Stiglitz, 1976).

Responsible investing and the universal ownerhypothesis build on the critique of the efficient marketshypothesis and MPT, recognizing that ESG factors area source of information asymmetry in financialmarkets. Traditionally, ESG factors have been viewedas externalities of the firm and therefore not consideredin its value (UNEP, 2001; Hebb, 2008; Kiernan,2009). Yet taking ESG into consideration can reducerisk for investors and add value over time (Porter andVan der Linde, 1995; Gompers et al., 2003). Buildingon the critique of efficient markets, Hawley and Wil-liams’ universal owners hypothesis (2000) posits thatbecause large institutional owners effectively own thewhole market, what may be externalized costs for onecompany in the portfolio have direct and often costlyimpacts on another holding. Because of their sheer size,these large institutional owners cannot divest from devel-oped market companies without eroding share price onexit (Monks, 2001). As a result, today’s institutionalinvestors must be concerned about the ESG standardsof the firms they hold in their portfolio.

Critics of the universal owner hypothesis suggest thatlarge institutional investors with their focus on quarterlyreturns and their need to benchmark performance tend todrive myopic behaviour in the market rather than mitigateit (Jarrell et al., 1985; Bushee, 1998; Karpoff, 2001; Gillanand Starks, 2007). The drive to short-termism in themarkethas been well documented with annual turn-over rates ofthe New York Stock Exchange increasing from 25% inthe 1960s (Bogle, 2005) to over 100% in 2002 (Drew,2009). Such short-term, opportunistic behaviour standsin sharp contrast to the role of institutional investorsassumed by the universal owner hypothesis (Grahamet al., 2005; Gjessing and Syse, 2007; Drew, 2009).

The normative definition of universal investing should,however, be adapted to reflect the entrenched nature ofthe individuals that, together, compose the pension (andother institutional investors’) value chain. These individ-uals, who are normally incentivized to behave accordingto personal and short-term economic goals, usually donot behave in the way prescribed by the universal ownerhypothesis. Thus, in the absence of external control mech-anisms, beta-enhancement-type activities are expected tobe absent from the agenda. CalPERS, as we know, doesbehave, at least to some degree, in the manner prescribedby the theory, and it was and has remained one of theleaders in the area. In the case of CalPERS, the externalcontrol mechanism that gives rise to beta-enhancementbehaviour is its sheer exposure to criticism by its relativelylarge number of progressively minded beneficiaries andstakeholders that are especially predisposed to engage inactions that could potentially result in reputational harmand litigation cases against CalPERS and its trustees –thus creating an incentive for responsible behaviour thatis, to some extent, in line with the universal hypothesis.

We argue that the increasing size of these universalowners,8 their use of passive index funds that discourage



exit, and the impact of both the financial crisis andmarket downturns of 2000–2002 have increased theirsensitivity to ESG risks and returns in their portfolio(Derwall et al., 2005; Clark and Hebb, 2005; Hebb,2008). A testament to the increased sensitivity to theseissues is the Principles for Responsible Investing, aglobal body of signatories with assets under managementof $20 trillion (as of September 2010). According to uni-versal investing theory, pension funds should seek theoptimal economic performance that is achievable bythe use of the power of their collective share ownershipthrough collaborative frameworks, and bring aboutchanges in corporate practices in the companies theyown (Bauer et al., 2005; Clark and Hebb, 2005;Hawley and Williams, 2003; Lydenberg, 2007; Hebb,2008).9 By using ‘voice’ rather than ‘exit’ through theexploration of beta-enhancement and enhanced alpha-generation investment strategies, these funds can influ-ence portfolio companies to adopt more socially, envir-onmentally and, often as a result, financially sustainablecorporate practices. Barber (2005) showed thatCalPERS’ activism generated as much as $89.5 billionfrom 1992 to 2005.

Beta enhancement increases absolute market return. Itincreases the financial return on a market portfolio –composed of a properly weighted allocation of all trad-able assets in the investment universe – to generate abetter financial return for a given level of market risk.In contrast, alpha generation seeks to exploit market inef-ficiencies by investing in a selection of assets that areexpected to deliver a financial return greater than whatis commensurate with its given level of perceivedmarket risk over a certain time horizon. Beta enhance-ment has a long-term positive effect on the market, theeconomy and long-term universal owners’ investmentportfolios whereas alpha generation has a short-livedpositive effect on non-universal investment portfoliosand potentially long-term negative effects on themarket and the economy (Lydenberg, 2009). Enhancedalpha generation stands at the midpoint between thesetwo philosophies.

CalPERS’ investment in emerging marketsHistorically, in contrast to their position in developedmarkets, pension funds such as CalPERS had little incen-tive to behave as active long-term universal investors inemerging markets (Soederberg, 2007). Pension fundholdings in emerging market companies were not impor-tant enough to deter ‘exit’ (divestment) strategies or towield enough power to influence practices and corporatestandards in a way that would outweigh the extra costs ofthat engagement. Moreover, engaging emerging marketcompanies was difficult because high levels of familyand/or government ownership rendered companiesunreceptive to foreign pension fund and internationalinvestor concerns (Peng and Heath, 1996; Yeung,2006); local shareholders often acted in concert

without pension funds’ knowledge (Young et al.,2008); and there was a lack of coordinated actionamong institutional investors (Hagart and Knoepfel,2007). For these reasons, there was little perceivedopportunity for beta-enhancement-centred corporateengagement as there had been in developed markets.These emerging market investment conditions inducedCalPERS to pursue an alpha-generation strategy (Hebband Wójick, 2005).

According to the alpha-generation strategy, CalPERSwould conditionally invest in companies that werethought to provide a financial return greater than thatrequired for its given level of perceived market risk (Lo,2005). It was CalPERS’ belief that market risk in emergingmarkets was closely related to a country’s ‘housekeeping’(macro-policies, political economy, local financialmarkets, corporate governance, etc.) and ‘plumbing’(legal and regulatory framework, settlement proficiency,taxes, etc.).10 As a result, in 2002 CalPERS decided topursue an alpha-generation strategy guided by a newlyinstated Permissible Emerging Market Policy. The Per-missible Emerging Market Policy mandated screeningout the equities of entire countries that did not meet aminimal threshold of permissibility based on factorssuch as political stability, transparency and labour prac-tices. By prescribing to screen out companies accordingto the geopolitical properties of countries, the PermissibleEmerging Market Policy affirmed CalPERS’ status as ashort-term investor in emerging market companies.

CalPERS would use ‘exit’ (disinvestment) rather than‘voice’ to engage relevant agents. CalPERS also believedthat countries that did not meet the minimal thresholdof permissibility were too risky for investment; financialreturns in these countries did not adequately compensateinvestors for the given level of investment risks. CalPERSthus claimed to be able to generate alpha by screening outthe companies based in these countries and thereby gen-erate a better financial return for a given level of marketrisk prevalent in the emerging market equities universe.The policy also sent a clear message to nation-states:CalPERS would disengage with emerging market compa-nies and engage with governments, believing that it couldeffectively influence governments to improve the invest-ment macro-environment in emerging markets that wereexcluded from CalPERS’ permissible emerging marketslist.11,12

Unfortunately for CalPERS, although country-levelscreening may have reduced risk in its portfolio, it hadeffectively screened out the most promising and lucrativeequity markets in the world, among others, Russia andChina, and by late 2006, CalPERS’ emerging marketportfolio had been subject to 2.6% in annual opportu-nity cost of foregone return, totalling over $400million in losses from the time of the policy’s inceptionin 2002 until late 2006 (Wilshire Associates, 2007).

So the merits of the permissible emerging market policyeventually came into question. Therefore, in late 2006,

66 Huppé and Hebb


CalPERS finally decided to permit stock purchases inselected companies in China and other developingcountries. CalPERS required that external managers whowished to invest in a company in a non-permissiblemarket address country and market factors where the com-pany’s home country scored below threshold, and explainwhy the company would meet threshold standards(CalPERS, 2006). Later in 2007, CalPERS formalizedthe new strategy, calling it the Emerging Equity MarketsPrinciples approach – a principles-based approach toguide external managers who invest in emerging inter-national markets (CalPERS, 2007). This approachenabled external managers to take advantage of marketopportunities in all developing countries listed in theFTSE All Emerging Index, including China, Colombia,Egypt, Pakistan and Russia (CCEPR), five countrieswhere investment was previously prohibited.

The virtue of CalPERS’ Emerging Equity Markets PrinciplesJust as CalPERS’ 2002 decision to screen at the country-level signalled disengagement with companies, its newprinciples-based approach signalled a new era of emer-ging market investing: a move towards CalPERS’typical corporate engagement style. CalPERS wouldinvest in select emerging market companies that areexpected to provide excess risk-adjusted return andengage these through dialogue and shareholder activismon specific ESG issues in order to raise corporate stan-dards, achieve an even more favourable level of risk andcontribute to more sustainable corporate practices. Butwhereas the argument for corporate engagement in devel-oped markets is framed around beta-enhancement strat-egies in answer to CalPERS’ position as a long-termuniversal investor, the argument for corporate engage-ment in emerging markets is framed around theconcept of alpha generation over the longer term.

CalPERS is not a universal investor in emergingmarkets and therefore has no incentive to behave as suchthrough beta-enhancement strategies. Instead, CalPERSwould, first, screen companies based on extra-financial(ESG) factors and, second, engage these to raise corporatestandards and thereby reduce risk in its emerging marketequity portfolio and remove the ESG discount, resultingin a better risk/return trade-off than that of the marketinvestor. We refer to this investment strategy in emergingmarkets as enhanced alpha generation.

Enhanced alpha generation is different from betaenhancement in that, for a given level of market risk,beta enhancement seeks to amplify financial returns gen-erated by the whole investment universe whereasenhanced alpha generation seeks to amplify returns of aselect, screened number of investments for a given levelof market risk. Enhanced alpha generation is differentfrom alpha generation in that the latter is a simple screen-ing activity whereas the former incorporates a longerterm investment horizon and engagement activities toinfluence heightened corporate standards in portfolio

companies. By raising corporate standards through theenhanced alpha-generation strategy, CalPERS promotesmore sustainable corporate practices and therefore, inthe long term, more competitive companies, marketsand industries in the developing world.

4. MethodsWe use holdings data from CalPERS’ emerging marketsinvestment portfolio to identify all CCEPR holdingsadded to CalPERS’ portfolio as a result of the investmentpolicy change to the new principles-based approach fromyears 2007 to 2009. We cross-reference these holdings’Stock Exchange Daily Official List (SEDOL) codes totime-series ESG rating data obtained from KLD. TheseESG rating data assess a company’s ESG practices andinvolvement in controversies concerning employeehealth and safety, labour relations, bribery and corrup-tion, discrimination, community relations, humanrights and environmental impact.

KLD Emerging Market Research ESG ratings are usedby CalPERS’ internal fund management and two of itsemerging market equities portfolio external fund man-agers (Alliance Bernstein and Dimensional) to assessemerging market companies’ corporate standards asthey relate to CalPERS’ Emerging Equities Market Prin-ciples Three (Productive Labour Practices) and Four(Corporate Social Responsibility and Long-term Sustain-ability) (see Appendix 1).13 The KLD data rank thecompanies using three ratings: ‘pass’, ‘watch list’ and‘red flag’. A ‘red flag’ rating signifies egregious corporatebehaviour with regard to CalPERS’ Principles Three andFour. A ‘watch list’ rating signifies suspected oranticipated egregious corporate behaviour with regardto the same principles.

Ratings are collected for the years 2005–2009. Thistime period allows us to look at these companies’ stan-dards before, during and after CalPERS’ investment.We examine KLD ratings of CCEPR holdings to deter-mine whether and in what direction corporate ESG stan-dards changed during CalPERS’ investment. This allowsus to draw conclusions on the extra-financial (ESG)impact of CalPERS’ new principles-based approach.We classify companies of interest under three categoriesaccording to their ESG performance ratings over theyears under examination: (1) improving ESG perform-ance, (2) declining ESG performance and (3) recent orconsistent ESG underperformance.

We collect benchmark financial return data on thesecompanies based on business type and country of oper-ation. We also collect MSCI Barra CCEPR country-specific financial return data. We use these financialdata to determine the Emerging Equities Market Prin-ciples approach’s material financial effect on CalPERS’portfolio. Using these methods, we draw conclusionson the policy’s financial and extra-financial impacts and



their implications for CalPERS and emerging marketcompanies.

We also conduct semi-structured interviews withCalPERS’ senior management, trustees and externalfund managers to determine how the emerging marketinvestment principles are incorporated in the emergingmarket investment selection and management processand gain insight into the importance attached to ESGfactors for emerging market investments. We draw onYin (2003) in our case study method. We use these inter-views to uncover responses to companies’ consistent ESGunderperformance and declining ESG performance. Wealso interview leading experts at KLD and Verité on thecurrent and future state of ESG standards in and engage-ment with emerging market companies.

5. ESG standards in CalPERS’ CCEPR portfolioIn 2008, 105 out of 151 rated CCEPR companies wererated ‘pass’ by KLD Emerging Markets Research; 38were rated ‘watch list’ and eight were rated ‘red flag’.In 2009, 125 out of 180 rated companies were rated‘pass’; 43 companies were rated ‘watch list’ and 12were rated ‘red flag’. Three of the ‘red flag’ rated compa-nies were previously unrated companies and included theChina Mengiu Dairy company that was involved in theChinese tainted milk scandal.

In summary, four companies saw their ESG ratingimprove over the years under examination; five compa-nies saw their ESG rating decline; nine companies main-tained a consistently poor rating; and three previouslyunrated companies were rated ‘red flag’.

We matched the average return of companies in eachof these categories to their respective standard industrybenchmark.

Companies with improving ESG ratings were ChineseandRussian companies in thefinance and process-industriessectors. These companies outperformed their standardindustry benchmark by an equal weighted average 3.3%per year, delivering −10.4% annually over the years 2008and 2009.

Companies with declining ESG ratings were Chinese,Egyptian and Pakistani companies in the non-energyminerals, transportation, industrial services andfinance sectors. These companies underperformed theirbenchmark by an equal weighted average −7.3% peryear, delivering −32.9% annually over the years 2008and 2009.

Companies that were in conflict with CalPERS’ Prin-ciples Three and Four were Chinese and Russian compa-nies in the energy minerals, non-energy minerals,consumer non-durables, consumer durables, transpor-tation, utilities and communications sectors. These com-panies outperformed their benchmark by an equalweighted average 10.3% per year, delivering −19.7%annually over the years 2008 and 2009.

Over the years 2008 and 2009, CalPERS’ emergingmarket equity portfolio returned −6.4% annually – areturn that is on par with the all-emerging market equitybenchmark. It is interesting to note that the equalweighted average return of CCEPR broad country bench-marks was −16.7% per year over the same time period,underperforming the emerging market equity universeby 10% annually. In 2008, CCEPR broad country bench-marks returned −57.5% on an equal weighted averagebasis, faring much worse than the rest of the emergingmarket benchmark country components.

6. Understanding enhanced alpha strategiesTo gain a deeper understanding of CalPERS’ new Emer-ging Market Principles, we conducted five intensivesemi-structured interviews with representatives ofCalPERS (both staff and trustees), the provider of ESGinformation, KLD Research & Analytics Inc. (KLD),one of CalPERS’ external emerging market fund manage-ment companies and research firm Verité that monitorsemerging market company performance.

It was clear from the interviews that emerging marketsare becoming increasingly important. Most mentionedthe growing role that emerging markets are playing as apercentage of total global equity. CalPERS’ Global Equi-ties manager Eric Baggesen and trustee Priya Mathurnoted a shift in CalPERS’ portfolio since 2007 infavour of emerging markets:

In, 2007, the [Global Equity] team brought a rec-ommendation to the CalPERS Investment Commit-tee to restructure the benchmark used to guide theallocation of these assets due to a significant homemarket bias. The recommendation was to adopt amarket capitalization weighted benchmark that wasapproximately equally split between the U.S. andinternational. Since that point in time, the benchmarkand portfolio weightings have evolved to about 40%U.S. and 60% international, with emerging marketsexposure more than doubling (Baggesen 2010).

At CalPERS, there is a question as to whether amarket capitalization based asset allocation strategyadequately reflects the growth rate in some of theemerging market countries and whether that reallypositions CalPERS to be able to take advantage ofthe economic activity in some of these countries. SoCalPERS has been talking about taking GDPweighted approach. The feeling is that CalPERSwants to invest more rather than less (Mathur 2010).

CalPERS’ previous Permissible Emerging Markets Policyexcluded such countries as China and Russia, resulting ina significant underperformance compared to benchmark(as detailed earlier in this article). Interviewees suggestedthat the current returns on the portfolio since the policy

68 Huppé and Hebb


change to the Emerging Equities Markets Principlesapproach were now more closely aligned with benchmarkperformance (the benchmark for this portfolio is theFTSE All Emerging Index).

But it was not simply financial performance that wasan issue with the permissible markets policy. It was feltthat while the policy had some effect on the governmentsof small emerging market countries (such as the Philip-pines), it had very limited impact on larger countriesexcluded from CalPERS’ portfolio.

It was a blunt instrument that didn’t effectively delivera message to companies in Emerging Markets as muchof the factors dealt with national policy, such asfreedom of the press, rather than issues that compa-nies have direct control over.

Nor did it

create an opportunity for companies that behaved welland that were not involved with the human rights,ethical, corporate governance issues to be rewardedor to set up support models for appropriate behaviouron a company basis in these emerging countries.Divestment says your company is not an attractiveinvestment. It doesn’t say for what reason. It justdoesn’t send a clear message that is consistent withwhy we would be divesting (Mathur 2010).

CalPERS’ internal fund management uses KLD data onemerging market companies as a screen or filter in itsactive management of its own portfolio. UnlikeCalPERS’ domestic portfolios, there is limited directengagement between CalPERS and emerging market com-panies as CalPERS lacks the capacity to engage companiesin its internally managed emerging market portfolio; theyhave a limited bandwidth to internally generate a valuedetermination on these companies’ ESG standards. Pres-ently, if a company receives a ‘red flag’ from KLD this isusually enough to warrant removal of the company fromthe internally managed portfolio, while companies on the‘watch list’ are monitored but neither removed norengaged.

Global Equities manager Baggesen suggests that hewould prefer that greater positive engagement takeplace with these companies and that progress on ESGstandards be directly tied to the weighting of the stockin the portfolio, a carrot and stick approach to raisingstandards in these companies that ensures the fund hasa seat at the table and incentivizes the company toimprove ESG standards in accordance with issuesraised in CalPERS’ corporate engagement.

External emerging market managers are free to takethe steps they feel necessary to integrate ESG in theirinvestment decisions. ‘They make those value tradeoffsbetween the economic opportunity and the potentialrisks attached to these aspects of the Principles (Baggesen

2010)’. Similarly, CalPERS trustee Priya Mathursuggests that

if there is an opportunity so incredible that it out-weighs these risk factors then we are willing to con-sider that investment possibility. It is not that wewould eschew fiduciary duty; we are trying to under-stand the importance of all these risk factors as theyrelate to fiduciary duty, sustainable financial returns.

An external emerging market portfolio fund manager forCalPERS suggests that

ESG standards should be used to analyze whether acompany’s business model is sustainable. Whendeciding to purchase stock in a company, the priceof the asset is the primary driver but you need toknow that over time the company will be sustainable.If it mistreats its workers, suppliers and communitiesit will not be sustainable in the long run no matterwhat you paid for it.

This external fund manager seldom divests from compa-nies but rather uses the KLD and other ESG data in thedecision-making process before investment occurs. Inter-estingly, all CCEPR companies that were subject to aKLD ESG downgrading as a result of ‘unforeseen’ egre-gious behaviour with regard to CalPERS’ Principles hadbeen identified as unattractive investments before theoccurrence of any such egregious behaviour or down-grading from KLD and had therefore not been allocatedcapital by this manager. On the other hand,

if a stock looks attractively priced but is the object of anegative KLD ESG rating [that signals potential risksfrom suspected, anticipated or evident ESG underper-formance], our staff will engage with the company(Baggesen 2010).

The fund manager has the internal capacity to make thevalue trade-offs on these ESG issues. It engages someemerging market companies it invests in. One exampleis an engagement with a South African company onthe issue of sub-standard housing for its workers. Theissues were resolved. In another instance, when concernswere raised about the treatment of workers by a consist-ently ‘red flag’ rated CCEPR company in the apparelindustry, Yue Yuen Industrial Holdings, it engaged thesupply chain and customers of the company and wasable to satisfy itself that the standards of the companywere satisfactory and did not represent an excessivelevel of investment risk that would violate the spirit ofCalPERS’ Principles.

There are challenges to the new approach thatCalPERS has taken with the Emerging Market EquitiesPrinciples. A certain amount of tension exists as to howmuch companies can influence, address and mitigate



the large country-level risks identified in the CalPERS’Principles. In particular, trustee Priya Mathur suggeststhat ‘it does not address some of the bigger, macro, pol-itical issues that CalPERS wanted to target’. The policyremains limited to CalPERS’ public equities emergingmarket portfolio. It does not extend to emergingmarket private equity investment, infrastructure, or cor-porate or government bonds in emerging markets. HereCalPERS is working towards mainstreaming ESG factorsinto all areas of its portfolio.

As trustee Mathur suggests,

ESG factors have long been important but how weprioritize the ESG factors has changed over time.One of the things we are talking about now is howwe are trying to mainstream the approach, how dowe mainstream that assessment across all asset classeswithin the portfolio.

Similarly, Michelle Lapolla Friedman at KLD pointedout that ‘PRI signatories such as CalPERS should worktowards having an ESG philosophy that is consistentacross all asset classes, including emerging markets’. Sheadds that

the PRI requirements on disclosure of how the Prin-ciples are being incorporated into the investmentdecision making process will encourage institutionalinvestors to pursue the integration of the principleswithin all asset classes and product lines, leading toincreased attention on ESG issues in emerging markets.

As more institutional investors pay attention to ESGissues in these markets, we are prone to see more collab-oration on redressing ESG issues in emerging marketcompanies. As trustee Mathur notes,

on a company basis we have not been as engaged [inemerging markets] particularly because there havenot been investment talent in the area that hasfocused on these issues. It’s not like we have internalstaff that is on the ground in emerging markets thatcan really engage there and we have to rely on externalmanagers for that. It really matters who our invest-ment partner is in any given country. It is crucialbecause we don’t have access to the informationnecessary to adequately evaluate risk.

7. Implications and discussionGiven the Emerging Equity Markets Principles’ emphasison sustainable financial returns, it is not surprising to seethat the portfolio’s consistently ‘red flag’ rated CCEPRcompanies outperformed their benchmark in the periodunder analysis. CalPERS’ Board believes that there is alink between the ESG concepts outlined in the Principles

and the ultimate sustainability of the companies theyinvest in. In the case of CalPERS’ ‘red flag’ CCEPR hold-ings, it was correctly determined that the ESG risks posedby these investments did not outweigh the investments’attractive ability to generate returns over the long term.It is also not surprising to see that companies withimproving ESG ratings also outperformed their bench-mark while those with declining ESG ratings underper-formed their benchmark.

These findings take a more interesting context whenwe contrast them against two identified approaches toenhanced alpha generation: a ‘hard–fast screen’ approachand a ‘value trade-off’ approach. As previously stated,although the Principles and their complementary KLDESG ratings are not meant to be used as ‘hard–fastscreens’, CalPERS’ internal fund management, becauseit lacks the internal capacity to make the value trade-offsbetween the ESG performance of firms and sustainablefinancial returns, uses KLD ratings as ‘hard–fastscreens’, meaning that it invariably screens out ordivests from ‘red flag’ rated companies. CalPERS’internal fund management thereby encountered twosources of opportunity costs: (1) it was unable to capit-alize on the attractive returns of the consistently ‘redflag’ rated portfolio companies (these companies aremanaged externally), and (2) it was subject to the nega-tive returns generated by the companies that were down-graded by KLD following ‘unforeseen’ egregious ESGbehaviour. Moreover, CalPERS’ internal fund manage-ment has yet to engage with CCEPR companiesbecause it has a ‘limited bandwidth’ to do so.

Alternatively, some external fund managers use thePrinciples to analyse whether a company’s businessmodel is sustainable and include a spending programmeto improve conditions in emerging markets. This strategydoes not employ a ‘hard–fast screen’ approach against ‘redflag’ rated companies, but rather employs an approach thatuses KLD ratings as one of the several inputs into the ESGinvestment selection and management process. If a ‘redflag’ rated company looks attractive, this fund managerengages with the company instead of ‘not investing’.Moreover, this manager’s financial sustainability-centredapproach to investment selection enabled the screeningout of companies that, according to their KLD rating,were perceived to be in line with CalPERS’ Principlesbut that were later downgraded by KLD following‘unforeseen’ egregious ESG behaviour.

With this take on alpha generation, the fund managerwas able to generate greater alpha by benefiting fromsuperior returns from sustainable ‘red flag’ rated compa-nies and by pre-emptively effectively screening out thecompanies that underperformed the benchmark follow-ing egregious ESG behaviour and subsequent KLDdowngrading. As a result, engagement with some ofthese companies enhances this alpha and contributes tolower investment risk and more sustainable companiesand financial returns. This contributes to promoting

70 Huppé and Hebb


best practices in emerging market companies, potentiallyyielding scalable economic development with positiveeconomic and social impact in emerging markets at large.

Industry consensus and our findings indicate that itremains difficult and expensive to engage emergingmarket companies. For this reason, we find that engage-ment is limited in scope and carried out at the discretionof external portfolio managers. This is reflected in thelimited ESG improvement we see in CCEPR companiesin CalPERS’ portfolio over time; raising standardsbeyond screens and filters remains a narrow and nicheactivity that is quite rudimentary in contrast toCalPERS’ normal engagement policies and activities inits domestic and developed market investments. It isinteresting to note that, since the large majority ofCCEPR equities were acquired following CalPERS’policy change at the end of 2007, shortly before the econ-omic downturn, CalPERS’ emerging market equitiesportfolio would have fared much better had it refrainedfrom changing its country-level screening policy andthereby effectively eliminated the high downside riskposed by CCEPR investments. It is reasonable toassume that CalPERS would have generated alpha hadit kept with the old policy. CCEPR underperformancerelative to the all emerging market equity universe isemblematic of the additional country-level macro-levelrisks posed by these investments.

Despite the bad timing of the policy change, we dofind that the Principles approach is more in line withCalPERS’ spirit of corporate engagement and closer tounleashing the latent potential to generate greaterrisk-adjusted return, if not greater absolute emergingmarket portfolio returns, by engaging at the companylevel. We also find that the preconditions for greater cor-porate engagement, and ‘focus list’-style beta enhance-ment, in emerging markets are rapidly developing.CalPERS and other institutional investors are presentlymainstreaming their responsible investment approach‘across all asset classes’ and, as the PRI requires the dis-closure of how responsible investment principles arebeing incorporated into the investment selection andmanagement process, more investors are paying attentionto ESG issues in emerging markets. With more investorsfactoring ESG issues into their investment processes,there is greater opportunity to collaborate on ESGengagement opportunities. Collaboration will makeengagement activity more feasible as it enables thesharing of valuable information to identify ESG risksand inefficiencies, and it also enables the sharing of thecosts of engagement to redress these ESG issues in away that the benefits of redressing the issues outweighthe costs of the engagement process (Guyatt, 2008).

With these preconditions in place, it will be easier forinvestors such as CalPERS to contribute to more sustain-able and more socially and environmentally responsiblecorporate practices in the developing world. Moreover,it might even make sense for CalPERS to engage in

beta-enhancement targeted active share ownership inemerging markets. In our interviews, CalPERS’ GlobalEquities manager Eric Baggeson suggested thatCalPERS adopt a ‘carrot–stick’ approach with emergingmarket companies. Notable in this approach, CalPERSwould invest, if only a small stake, in companies thatare ‘distasteful’ from an ESG perspective only to have aseat at the table and engage, possibly in collaborationwith other investors, the company to improve its ESGstandards. According to this approach, CalPERS wouldshift portfolio weights and acquire a greater stake in thecompany as target management complies with requestsbrought up in this corporate engagement. Such anapproach could deliver substantial returns to theeconomy and society at large just as CalPERS’ universalownership motivated corporate engagement has done indeveloped markets. As it moves towards a more inclusiveapproach, the application of the Emerging EquityMarkets Principles with its enhanced alpha generationstands at the midpoint between its alpha-generatingpolicy of complete country-level divestment and thebeta enhancement associated with universal investing.

8. ConclusionsCalPERS’ Emerging Equity Markets Principles posed thepotential to generate enhanced alpha in its emergingmarket portfolio. Despite the bad timing of the policychange, we find that CalPERS’ emerging market portfo-lio returns are now closer to the benchmark. By cross-referencing KLD ESG ratings to CalPERS’ emergingmarket portfolio company holdings based in the newlypermissible equity markets of CCEPR, we find that con-sistently ‘red flag’ rated CCEPR companies and compa-nies with improving ESG ratings outperformed theirbenchmark while companies with declining ESGratings underperformed their benchmark.

Our interviews revealed two investment philosophiestowards the Principles and their complementary KLDratings. The first, a ‘hard–fast screen’ approach, presentstwo sources of opportunity costs: the foregone ability tobenefit from the financial performance of sustainable ‘redflag’ rated companies, and the failure to pre-emptivelyscreen out companies that would later engage in egre-gious ESG behaviour and create negative alpha. Thesecond, a ‘value trade-off’ approach, is sustainabilitycentred and enables greater alpha generation by allowingthe realization of superior returns from sustainable ‘redflag’ rated companies and by pre-emptively effectivelyscreening out the companies that underperformed thebenchmark following egregious ESG behaviour. This‘value trade-off’ approach also includes an engagementprogramme to enhance this alpha and encourage moresustainable corporate practices in emerging markets.

Our findings indicate that it remains difficult andexpensive to engage emerging market companies. For



this reason, we find that engagement is limited in scopeand carried out at the discretion of external portfoliomanagers. This is reflected in the limited ESG improve-ment we see in CCEPR companies in CalPERS’ portfolioover time; raising standards beyond screens and filtersremains a narrow and niche activity that is quite rudi-mentary in contrast to CalPERS’ normal engagementpolicies and activities in its domestic and developedmarket investments.

We also find that emerging markets are becoming moreimportant to institutional investors, CalPERS included.CalPERS is investing a larger portion of its portfolios inthese regions. Most interviewees spoke to the increasinglyimportant role of ESG investing in emerging markets. Itwas suggested that CalPERS employ an investment philos-ophy whereby it would invest, if only a small stake, incompanies that are distasteful from an ESG perspectiveonly to have a seat at the table and engage the companyto improve its ESG standards. According to this strategy,the company would be incentivized to implement ESGrecommendations in order to attract more capital fromsimilar ESG-minded long-term institutional investors.

Because CalPERS’ policy change occurred in late2007, our study is limited by a short evaluation period.Corporate behaviour does not improve overnight and itcan take time for heightened corporate standards toaffect positive financial returns. The returns againstbenchmark were calculated for a two-year time period,during which there was the occurrence of a sharp econ-omic downturn, which might have compromised thegeneralizability of our findings.

Future research is needed on the financial materialityof environmental and social externalities in emergingmarkets. In emerging markets, what environmental andsocial behaviour leads to superior financial performancefor what companies? What are the financial implicationsof corporate externalities on other emerging market com-panies’ profitability? And, how can institutional investorsbest address systemic issues in emerging markets?

Our current research suggests that responsible invest-ment is going through a mainstreaming phase thatshould lead to greater collaboration on ESG corporateengagement initiatives in emerging markets. This devel-opment has the potential to yield scalable economicgrowth with positive economic and social impact inemerging markets at large. Such investor behaviour inemerging markets could deliver, by fiduciary duty,beta-enhancement type returns to the economy andsociety similar to those motivated by universal ownershipin developed markets.

AcknowledgementsWe thank Michelle Lapolla Friedman and Celeste Coleat KLD for their assistance with ESG data collectionand interpretation. We are grateful to Charles Fitzpatrick

at CalPERS for providing us with the data needed toperform our analysis and to Anne Stausboll for support-ing our research. We are indebted to Eric Baggesen ofCalPERS and CalPERS’ trustee Priya Mathur, andDan Viederman of Verité, and other confidential inter-viewees for the enlightening discussions that shapedour understanding of and enthusiasm for the subject.We acknowledge the support of this research by theSocial Sciences and Humanities Research Council ofCanada. We also thank participants at the 2010 UNPRI Academic Conference at Copenhagen BusinessSchool, Benjamin Richardson, Matthew Haigh and ananonymous referee for their helpful comments on anearlier draft of this article, and Laura Webb for her edi-torial assistance.

Notes1. At the time of writing, KLD was part of the Risk-

Metrics Group.2. See Political Risk Services’ International Country Risk

Guide (ICRG).3. Reputational risk often affects emerging market com-

panies and their investors. Reputational damage canhave an important effect on a company’s profitability.Among others, it can lead to lost revenue from sociallyand environmentally conscious customers (Klein et al.,2004) and degraded employee morale (Romm, 1994),which can affect workforce productivity. Investors inemerging market equities therefore have importantincentives to be concerned with firms’ level of socialand environmental standards that lie beyond thoserequired by compliance or by enforcement and over-sight by local actors.

4. Emerging market companies wanting to expand oper-ations abroad to more developed countries mustusually meet standards above those locally and nation-ally required in order to meet the expectations of newstakeholders such as host nation-states, corporate part-ners, clients and customers upon which the financialsuccess of expansion depends. Heightened corporatestandards are therefore an especially important con-sideration if one expects the company to continuebeing an attractive investment opportunity as itexhausts national and regional opportunities of growth.

5. We thank an anonymous referee for recommending amore elaborate discussion on the contemporary under-standing of change management and human capital.

6. In the case of CalPERS’ current policy, these standardsare taken from the ILO Core Labour Standards and theGlobal Sullivan Principles for CSR.

7. See ‘Demystifying Responsible Investment Perform-ance’ (October, 2007) by UNEP Finance Initiative& Mercer for a review of key research on the financialimplications of extra-financial (ESG) factors.

72 Huppé and Hebb


8. There continues to be only a handful of ‘universalowners’, and these are primarily the world’s largestpension funds and sovereign wealth funds –CalPERS, CalSTRS, NYCERS, The GovernmentPension Fund of Norway, USS, etc. Our case studyof CalPERS’ emerging markets investments providesan opportunity to test the universal owner hypothesiswith one of the world’s largest pension funds.

9. Examples of collaborative frameworks: The InternationalCorporate Governance Network (www.icgn.org/), ofwhich member institutional investors represent about$10 trillion in assets under management, and the Insti-tutional Investors Group on Climate Change (www.iigcc.org/).

10. See Ladekarl and Zervos (2004) for a detailed discus-sion of the implications of ‘housekeeping’ and ‘plumb-ing’ as they affect investing.

11. Only 13 out of 27 emerging countries met CalPERS’minimal threshold for investment that year. For ineligiblecountries, failure to meet CalPERS’ threshold led tocapital drain due to the divestment of CalPERS andother investors that saw CalPERS’ disapproval of thesemarkets as an information signal that these regimes wereparticularly risky for investment (McKinsey, 2004).Obtaining CalPERS’ ‘seal of approval’ became a specialconcern for those many nation-states wanting to attractforeign direct investment (Hebb and Wójick, 2005).

CalPERS’ engagement with these governments influ-enced many countries to meet the challenge for a moreinvestor-friendly environment. By year, 2006, 20 emer-ging markets met CalPERS’ investment threshold.

12. Here we note that CalPERS enhanced beta in theexcluded countries by influencing them to improve theirinvestor macro-environment. Enhancing beta in thesecountries was directly corollary to the particular alpha-generation strategy. CalPERS’ emerging market equitiesportfolio did not benefit from this beta enhancementsince it was not invested in the countries prior to orduring their reform to meet the minimal threshold of per-missibility.Other investorsmight have benefited from thisbeta enhancement. The Permissible Emerging MarketPolicy thereby delivered greater benefits to the economyand society at large in addition to its promises to generatealpha in CalPERS’ portfolio.

13. Principle Three targets ‘Productive Labor Practices’ bydisallowing harmful labour practices or use of childlabour and requiring compliance, or moving towardscompliance, with the ILO Declaration on the Funda-mental Principles and Rights at Work. Principle Fourtargets ‘Corporate Social Responsibility and Long-termSustainability’. It includes environmental sustainabilityand requires compliance, or moving towards compli-ance, with the Global Sullivan Principles of CorporateSocial Responsibility.

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Appendix 1: CalPERS’ Emerging Equity MarketsPrinciplesCalPERS’ emerging markets managers shall evaluatetheir investment in emerging markets according to thefollowing Emerging Equity Market Principles:

Principle One: Political Stability – Progress towards thedevelopment of basic democratic institutions and prin-ciples, including such things as: (1) a strong and impartiallegal system; and (2) respect and enforcement of propertyand shareowner rights. Political stability encompasses:political risk (including external conflicts and law andorder) civil liberties (including freedom of expression,and human and economic rights) and independent judi-ciary and legal protection (including the extent to whichthere is a trusted legal framework that honours contracts,clearly delineates ownership and protects financial assets.

Principle Two: Transparency – Financial transparency,including elements of a free press necessary for investorsto have truthful, accurate and relevant information.Transparency encompasses: freedom of the press, monet-ary and fiscal transparency, stock exchange listingrequirements and accounting standards.

Principle Three: Productive Labor Practices – Noharmful labour practices or use of child labour. In com-pliance, or moving towards compliance, with the ILODeclaration on the Fundamental Principles and Rightsat work. Productive Labor Practices encompasses: ILOratification, quality of enabling legislation, institutionalcapacity to enforce ILO standards and evidence thatenforcement procedures exist and are working effectively.

Principle Four: Corporate Social Responsibility andLong-term Sustainability – Includes environmental

sustainability. In compliance, or moving towards compli-ance, with the Global Sullivan Principles of CorporateSocial Responsibility.

Principle Five: Market Regulation and Liquidity – Little tono repatriation risk. Potential market and currency volatilityare adequately rewarded. Market regulation and liquidityencompasses: market capitalization, change in market capi-talization, average monthly trading volume, growth in listedcompanies, market volatility as measured by standard devi-ation and return/risk ratio.

Principle Six: Capital Market Openness – Free marketpolicies, openness to foreign investors and legal protec-tion for foreign investors. Capital market opennessencompasses: foreign investment (including the degreeto which there are restrictions on foreign ownership oflocal assets, repatriation restrictions or un-equal treat-ment of foreigners and locals under the law), tradepolicy: degree to which there are deterrents to freetrade such as trade barriers and punitive tariffs), andbanking and finance (including the degree of governmentownership of banks and allocation of credit and protec-tionist banking regulations against foreigners).

Principle Seven: Settlement Proficiency/TransactionCosts – Reasonable trading and settlement proficiencyand reasonable transaction costs. Settlement profi-ciency/transaction costs encompasses: trading and settle-ment proficiency (including the degree to which acountry’s trading and settlement is automated and thesuccess of the market in settling transactions in atimely, efficient manner) and transaction costs (includingthe costs associated with trading in a particular marketand the amount of taxes).

Principle Eight: Appropriate Disclosure – On environ-mental, social, and corporate governance issues.

Appendix 2: Country distribution of CalPERS’ CCEPRcompany holdings on fiscal year-end 30 June 2009



Appendix 3: CCEPR companies of interest

SEDOL Name FactSet Sector Country 2009 2008 2007 2006 2005

6559335 CHINA TELECOM CORP Communications CHINA WL WL WL WL WL

B0B8Z18 CHINA COSCO HLDGS Transportation CHINA WL WL WL WL N/A

6142780 HUADIAN POWER INTL Utilities CHINA WL WL N/A WL WL

B00LYN3 SBERBANK ROSSII Finance RUSSIA WL WL WL WL RF

6797458 SINOPEC S/PETROCHE Process industries CHINA WL WL RF RF RF

B00G0S5 CNOOC LTD Energy minerals HONG KONG RF RF RF RF RF

5140989 GAZPROM Energy minerals RUSSIA RF RF RF RF RF

368287207 GAZPROM O A O Energy minerals RUSSIA RF RF RF RF RF

2768243 JSC MMC NORILSK NICK Non-energy minerals USA RF RF RF RF RF

3189876 LUKOIL OIL COMPANY Energy minerals RUSSIA RF RF RF RF RF

B114RK6 MMC NORILSK NICKEL Non-energy minerals RUSSIA RF RF RF RF RF

2537432 OIL CO LUKOIL Energy minerals RUSSIA RF RF RF RF RF

B0PH5N3 DONGFENG MOTOR GRO Consumer durables CHINA RF RF N/A N/A N/A

B0N7G09 EVRAZ GROUP S A Non-energy minerals LUXEMBOURG RF N/A N/A N/A N/A

6586537 YUE YUEN INDL HLDG Cons. non-durables HONG KONG RF N/A N/A N/A N/A

B01B1L9 CHINA MENGNIU DAIRY Cons. non-durables HONG KONG RF N/A N/A N/A N/A

6725299 ZIJIN MINING GROUP C Non-energy minerals CHINA RF WL N/A N/A N/A

6208422 BEIJING CAPITAL IN Transportation CHINA WL Pass N/A N/A N/A

B2PFVH7 CHINA RAILWAY CONS Industrial services CHINA WL Pass N/A N/A N/A

6162614 EL EZZ STEEL REBAR Non-energy minerals EGYPT WL Pass N/A N/A N/A

6419332 NATIONAL BK OF PAK Finance PAKISTAN WL Pass N/A N/A N/A

2196963 CHINA LIFE INS CO LT Finance CHINA Pass WL N/A N/A N/A

6718976 CHINA LIFE INSURANCE Finance CHINA Pass WL N/A N/A N/A

76 Huppé and Hebb


Documents

The Virtue of CalPERS' Emerging Equity Markets Principles