McGrew runs the Focus List at California Public Employees' Retirement System, or CalPERS. CalPERS' global equity portfolio has assets of about $75 billion spread over internal indexing and external managers. He spoke with writer Elizabeth Wine about exacting changes to corporate practices.

1. What academic or sell-side research influenced CalPERS to invest in companies based on their corporate governance practices?

We developed principles for good corporate governance and adopted it without real performance data to back it up. CalPERs believed that good corporate governance defined by this set of principles would lead to better performance. And now, 20 years later, you're beginning to see empirical evidence that supports this small subset of specific principles. Lucian Bebchuk, [a professor of law, economics and finance at Harvard] did a study of anti-takeover defenses [including staggered boards and poison-pills, golden parachutes for executives and supermajority requirements] and found that if a company has three to four of these practices, it will underperform the market. So here we are today, many years later and a lot of these studies and practices in the marketplace are starting to support it. It takes time.

2. What is your Focus List, and how do you come up with it?

The Public Focus List started in 1992, and we look at the 2,000-plus U.S. securities we own in our index funds-we're going to own them regardless. However, CalPERS' perspective was: Let's identify those companies that are most underperforming in terms of share price on an absolute and relative basis by looking at financial performance-return on invested capital-and corporate governance practices. This screen shakes out most underperforming companies. The CalPERS board directs the staff to engage the boards of those companies, behind the scenes at first, to communicate changes to corporate governance practices we'd like to see.

3. How do you do that?

We'll say, 'We see you have a classified board structure. Has that changed? We ask you to declassify your board. We'll work with you over the next 12 months to get that done. If you choose not to do that, then we'll elevate your company to the Public Focus List, letting the market know that you're an underperforming company.' The board has Wilshire Associates do an independent study. In the five-year period looking ahead, after CalPERS engaged them, those Focus List companies outperformed the S&P 500. The CalPERS effect is launching public notification because we're engaging them to affect change. [CalPERS engages 15 to 25 companies a year. If a company makes the changes, it is not placed on the Public Focus List. The number of companies that make it to the Public List each year ranges from three to 11.]

4. What if you meet up with a company that doesn't want to cooperate, even with the specter of public shaming? Many investors advocate voting with their feet, and selling the stock of any company whose practices they don't like, so why do you keep companies in your non-index portfolios if they won't cooperate?

It's a big philosophical debate. If CalPERS or any investor says, 'This company is not going to do anything today, let's sell,' that removes your voice. There's nothing you can do to influence the company position [at that point]. It's a case for engagement as a route to change.

5. But aren't you expending resources on something in which you're not going to see a result?

CalPERS is the eternal optimist in that we are a permanent long-term owner of the company. Over time we can influence change with a company. There's a whole lot of patience involved. Say I ask a company to declassify their board, they tell me no. In the United States, I can put it to a vote of all the shareholders and wait 12 months until the next annual meeting. If a majority or more of the shareholders support the proposal, it passes. It's a piece-by-piece effort over time.