(FORTUNE Magazine) – To visit the unofficial world headquarters of shareholder activism, you have to fly to Sacramento and locate the government office building that is home to the 1,600 employees of the California Public Employees Retirement System, or Calpers, the nation's biggest pension fund. The Finance Minister of the Philippines made the trip to Calpers after the fund decided to divest its holdings in his country. So did top executives of JDS Uniphase, which Calpers accused of destroying shareholder value. When AIDS activists from Los Angeles wanted to pressure GlaxoSmithKline to lower the prices of drugs in Africa, they sought help from Calpers--and got it. "Calpers is the 800-pound gorilla," says Tom Myers, general counsel at the AIDS Healthcare Foundation.

With assets of $154 billion and a willingness to throw its weight around, Calpers is one of the world's most influential investors. Its ally in shareholder advocacy, the California State Teachers Retirement System, or Calstrs, has another $103 billion in assets. That concentrates a quarter of a trillion dollars of investing power in a state not known as business-friendly. How that power will be used by the trustees who run Calpers and Calstrs--all Democrats, many with close ties to unions--is an important question.

Traditionally, big pension funds led by Calpers have focused on board independence, executive pay, and other corporate governance issues. In its heyday in the early 1990s, Calpers joined with other big investors to help topple the CEOs of GM, American Express, and IBM because their companies were underperforming. "Calpers has been a consistent force for shareholders, and the most important one," says Robert A.G. Monks, a pioneering shareholder advocate.

Calpers is still raising hell over governance issues today. Once a year it publishes its Focus List of underperforming companies with governance problems. The fund hires outside managers to run actively managed "governance funds" that take big stakes in poorly managed firms and then try to turn them around. It files shareholder proposals. Most important, its governance staff of nine people works behind the scenes with corporate executives and boards. JDS Uniphase, for example, agreed under pressure to limit its use of options, stop repricing them, and link compensation more closely to long-term financial performance. Later this year Calpers will publish its first list of overpaid executives and ask compensation committees to explain, in detail, how they measure CEO effectiveness. "We want to cut down the universe of people who are well paid to those who are really performing," says Ted White, who runs Calpers's governance programs.

Recently, though, Calpers and Calstrs have gone beyond governance into social engineering. Needless to say, this is controversial. Over the objections of its professional staff, Calpers trustees voted to divest tobacco stocks. (The stocks subsequently outperformed the market.) Calpers has lobbied U.S. firms that reincorporated overseas to "come home to America" even if that means paying more taxes. The trustees have also steered investments to inner-city businesses and are taking a close look at "green investing."

Leading the funds down this new path is Phil Angelides, the state treasurer of California, who sits on the boards of both Calpers and Calstrs. Angelides is a 50-year-old Democrat who made a fortune as a real estate developer before he was elected treasurer in 1998. Brainy and engaging, he shrewdly sat out the California recall election and is now positioned to challenge Arnold Schwarzenegger, the new governor of California, whose job he covets. Think of him as a Left Coast version of Eliot Spitzer, ready to save capitalism from its worst excesses, and in so doing propel himself to higher office. "This is a time when questions need to be asked about what is the right responsibility, the right compass, for America's corporate and financial sector," Angelides declares. "We can't lose sight of what we've just come through: the largest sustained losses in the market since the Great Depression. The biggest wave of market manipulation since the 1920s. The most visible acts of corporate irresponsibility. You know how they have, in floods, a 100-year flood? This is the 100-year flood of corporate irresponsibility. This was about millions of Americans losing trillions of dollars."

Calpers itself has lost nearly $20 billion since 2000. "On WorldCom alone, we lost $850 million," Angelides laments. Longer term, the fund has done better. During the ten-year period ended June 30, 2002, Calpers gained an average of 8.2% a year, slightly trailing the 8.3% average annual gain of big public pension funds. Calpers is currently fully funded, which means that it pays retirement and health benefits out of its earnings without requiring government subsidies. California taxpayers, not state employees, would have to make up any future shortfalls.

The new social agenda at Calpers is a tricky business because if it does crimp returns, no one wants to have to dip into taxpayer dollars to pay pensions. Trustees are obliged by law to run the funds for the sole interest of beneficiaries. Some fund trustees worry that Angelides and his liberal allies, led by Sean Harrigan, a union leader who is president of the Calpers board, are overreaching. "We've got to keep our eye on the ball," says Bob Carlson, a retired lawyer who has served on the board for 32 years and voted against divesting tobacco. "The only social concern I have is safe and adequate benefits for retirees and future retirees."

California state controller Steve Westly, who sits on the Calpers and Calstrs boards, also says social policy should be made by legislatures, not pension funds. "Vote with your heart," Westly says. "Invest with your head."

When I met Phil Angelides, the first thing we did was take a 15-minute drive to a suburb of Sacramento called Laguna West. Angelides is a Sacramento native who went to Harvard, then returned home to work in politics and real estate. He developed Laguna West. It wasn't his most profitable project, but it's his favorite because the development was guided by New Urbanism. Laguna West has a town green, pocket parks, sidewalks, artificial waterways, and front porches. His company planted 13,000 trees there; Apple built a factory nearby. Home values have appreciated nicely.

We've come here because Angelides has several points to make. (He always seems to have several points to make. He is one of those fast-talking people whose mind outpaces his mouth.) Point No. 1: Doing good and doing well go together in business. His reputation for fair dealing, he said, helped him survive the California real estate bust that bankrupted other developers. Point No. 2: Think long term. Laguna West struggled at first, and people doubted its success. "The real judgment is, What will this community look like in 30 years?" he said. Point No. 3: Making money is fine, but the rewards should go to those who take risks and create value, not to an elite managerial class. "I'm a big believer in free enterprise. There's no other engine like it," he said. "Risk and reward. Pay for performance. What we don't want to see is the development of an economic plutocracy that feeds resentment in our society."

That is what got Angelides so ticked off about Dick Grasso. The former chairman of the New York Stock Exchange earned $139.5 million while running a regulatory agency during an era of scandal. He also collected a $5 million bonus for getting the exchange reopened after Sept. 11. At a news conference broadcast live on CNBC, Angelides called for Grasso to resign. "I'm not aware of one firefighter, one police officer, the mayor of New York, or anybody else having gotten a $5 million bonus for doing the right thing for America," Angelides declared. "This defies all rationality and fairness." The next day Grasso quit.

Despite his wealth and Ivy League pedigree, Angelides styles himself a populist. His grandparents were Greek immigrants. His father, an engineer who worked for the state of California, urged him to make money and give back. "In an immigrant family," Angelides says, "the notion that you could be involved in the leadership of your community was held up as a special privilege." He's been a prolific fundraiser for Democrats, especially Greek Americans. (Michael Dukakis and Paul Sarbanes are friends.) The Greeks gave us democracy, and Angelides wants to deliver nothing less to corporate America.

That's why he and other institutional investors are lobbying the SEC to give shareholders easier access to the process of nominating and electing directors. "Shareholders are owners of companies. Owners," Angelides says. "There ought to be a voting-rights act that allows owners some reasonable say. Not two years after problems manifest themselves. It's like telling a homeowner you can install an alarm after your home's been burgled."

All this talk of reform doesn't at all please the leaders of corporate America. (For the record, the Business Roundtable, an organization of CEOs, opposes the SEC's proposal to open up the proxy-voting process. It warns that giving too much power to shareholders could "stifle business innovation, decrease productivity, and stall economic growth," among other horrors.) But it actually makes sense for pension funds like Calpers and Calstrs to work on a grand--not to say grandiose--stage. These organizations invest differently from money managers who depend on active stock picking to drive returns. Calpers holds stocks in more than 1,600 U.S. companies, most through index funds. The funds are virtually permanent holders of a broad cross section of corporate America. "If they can't sell, they have got to care," explains James Hawley, a business professor at St. Mary's College of California and author, with Andrew Williams, of The Rise of Fiduciary Capitalism. The idea is that since their portfolios are so diversified, shareholder activism and its ripple effects ultimately pay off for Calpers and Calstrs.

The social agenda at Calpers and Calstrs is driven by this holistic view of their holdings. Angelides argues that social good generates economic returns for his funds because a healthier society means healthier companies. Calpers's inner-city investments, for instance, might generate not only direct returns (and they do, says Angelides) but also indirect benefits because they curb inequality, reduce the costs of poverty, and create new customers for other companies owned by the fund. Angelides calls this a "double bottom line"--financial returns and social good. If Calpers, through either its investments or shareholder activism, can support companies that contribute to the health of the economy--say, by educating their workforce or preventing pollution--and penalize those that are antisocial, the fund will ultimately benefit. "I don't think many companies can be successful in an unsuccessful economy," Angelides says. Nor can companies thrive, he says, in an economy plagued by environmental woes, health-care costs, or "great divisions between rich and poor that erupt into social tension."

This is an unorthodox approach to pension-fund investment, to say the least. Think about what it means for an issue like global warming. Calpers and Calstrs arguably have good reason to pressure automakers and utility companies to reduce their emissions of greenhouse gases because of the threat that global warming poses to the tourism and agriculture companies that are also part of their portfolios. (In November, Angelides, Harrigan, and Jack Ehnes of Calstrs participated in a "climate change summit" with other pension fund managers and environmental activists at the United Nations. "It's a threat that we need to be cognizant of," said Harrigan.)

The risks of pursuing this untested path, which Calpers and Calstrs are just now exploring, are obvious. Inner-city investments sound fine, but they could be turned into payback for campaign contributors. (Calpers has been tainted by pay-to-play scandals in the past.) And who is to decide which company's practices are social or antisocial, good or bad for the overall economy?

"Once you get off the traditional financial criteria, you're on a slippery slope," says Hawley, the St. Mary's professor. "It can easily get politicized." When I visited Calpers, Christianna Wood, the deputy chief investment officer, said she'd just gotten a letter asking the fund to sell its holdings in Take Two, a videogame company that allegedly makes a game that degrades women. "We can't go around divesting on every ad hoc issue," she said. "We would end up owning nothing." Calpers's staff tends to be more cautious than the trustees when it comes to defining the fund's mandate. "We lose effectiveness when we get away from arguments that carry weight with the financial community," says governance expert Ted White.

Nevertheless, Calpers did write to GlaxoSmithKline about the high prices of its AIDS drugs. Several weeks later--and this could be a coincidence--the company dropped its prices. Myers, the lawyer for the AIDS foundation, says Calpers should go after "rogue companies" like Glaxo because "companies that engage in irresponsible conduct don't perform well." (GSK says it has repeatedly dropped the prices for its AIDS drugs to make them more widely available, particularly in the developing world.) Of course, cutting drug prices could also cut profits and returns.

Angelides' activism makes some people around Calpers nervous. "I pray that Phil does not use the fund's capital to build up his own political capital," says a former staff member, who asked not to be identified. Others are impressed. "He's very smart, and he's doing his homework," says Richard Koppes, a former Calpers general counsel who now works on governance for the law firm Jones Day.

Whether Angelides' new brand of activism will pay off is an open question. The relationship, if any, between social responsibility and economic performance is complex and hard to measure. "You may say it's pretty fuzzy," Bob Monks says, "but life's pretty fuzzy." We'll just have to await the returns--from the stock market, not the ballot box--to see how this experiment plays out.

FEEDBACK mgunther@fortunemail.com