(Bloomberg) -- The California Public Employees' RetirementSystem recently opened a new chapter in sociallyresponsible investing (aka environment, social, and governance, orESG, investing) when its investment committee decided to startrequiring that the boards of the companies it invests in includeclimate change experts.

With this move, CalPERS is attempting to turnESG investing on its head. Rather thandivest from companies it deems undesirable, it will engage thosecompanies and attempt to improve them from the inside.

Which begs the question: What’s causing CalPERS to rethinkthe traditional levers of ESG investing?

ESG investing is intuitively appealing from an ethicalperspective, and also from a financial perspective.

Some companies are clearly better citizens than others, and it’sreasonable to assume that our collective well-being would beimproved by having more of the good ones and less of the bad ones.(Though the standards and metrics around deciding what's "good" or"bad" can be a decidedly subjective affair, of course.)

It’s also reasonable to assume that companies that are seriousabout corporate governance and environmental and social impact areless likely to encounter costly surprises that inevitably drag downstock prices (for what can go horribly, horribly wrong, see BP'sDeepwater Horizon oil spill).

There’s just one small fly in the ointment: Companies withstellar ESG ratings have underperformed the broader market, andexposed investors to higher risk to boot.

The MSCI World ESG Index returned 9.8 percent annually from May2009 to February 2016, with a standard deviation of 14.5 percent(the longest period for which data is available; those returnsinclude dividends). By comparison, the MSCI World Index returned11.3 percent annually over the same period, with a standarddeviation of 14.4 percent. (Standard deviation reflects theperformance volatility of an investment; a lower standard deviationindicates a less bumpy ride.)

To see whether the ESG Index’s performance is indicative ofinvestors’ experience with ESG investing more broadly, I gatheredperformance data for every equity mutual fund with a MorningstarESG rating. I then sorted the funds into five groups based on theirpercent of assets under management with high ESG scores, asreported by Morningstar.

It turns out that mutual fund managers have had no more successwith ESG investing than the ESG Index. The group with the highestESG exposure returned an average of 1.1 percent annually over thelast five years and 2.3 percent annually over the last tenyears.

The group with the lowest ESG exposure, on the other hand,returned an average of 7.3 percent annually over the last fiveyears and 5.6 percent annually over the last ten years. The middlethree groups fell in line -- as their ESG exposure increased, theiraverage return decreased.

ESG investing is still in its infancy, so we shouldn’t make toomuch of its short history.

But what if turns out, contrary to CalPERS’ belief and ourintuition about ESG investing, that ESG investing is no free lunch?In other words, that the cost of an ESG-friendly portfolio is lowernot higher investment returns. There are two appealing hypothesesthat suggest that this may be the case.

First, ESG investing expands the available pool of capital forcompanies with high ESG ratings, and contracts the available poolof capital for companies with low ESG ratings. It stands to reasonthat, in order to compete for capital, companies with low ESGratings must hold out the promise of higher expected returns --similar, for example, to the way that investors expect a higherreturn from junk bonds versus investment grade bonds, or from valuestocks versus growth stocks. Inversely, high ESG ratings would beassociated with lower expected returns.

Also, companies attempting to raise their ESG ratings may exitfrowned upon businesses such as alcohol, tobacco, or gambling --you know, all the fun stuff. This would, of course, reducecompetition in those businesses and thereby increase profitabilityfor the remaining players. The likely result for the remainingplayers is lower ESG ratings but higher stock prices.

As a fiduciary, CalPERS must considerwhether ESG investing is likely to be a drag on investmentperformance, and ESG investing’s wobbly start may explainwhy CalPERS is attempting to promote good ESG policies throughactivism rather than divestment.

But if it turns out that the cost of ESG investing is subparreturns, it’s not at all clear that activism is the antidote. Byimproving the ESG practices of the companies in its portfolio,Calpers may unintentionally compromise its investment returns overtime.

None of this is to say that companies’ ESG practices areunimportant. On the contrary, it is in our collective interest topromote the most ethical corporate behavior. But if there is aprice to pay for ESG investing, CalPERS may have to findanother way to demand the best of its portfolio companies.

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