It was only a matter of time until the wave of stress on environmental, social and governance investment brought a reaction, but it has certainly come with a vengeance. Notably, however, the revolt was not primarily motivated by business interests, who resented being asked to change their practices. The business community has embraced ESG on many fronts, recognizing these concerns in the communities they serve and the young talent they want to attract to their businesses. Instead, opposition comes from politicians who want to present themselves as “anti-tattoo” candidates in their election campaigns. This is not a normal business, where the business community is pitted against politicians on the other side. Instead, this war, like the American abortion debate, has created a conflict between states with red interests dominating in some states and blue interests in others.
If this strategy of divide and conquer by anti-ESG forces is smart, if cunning, move. Given the general acceptance of ESG among global investors, trying to ban ESG altogether is a fruitless struggle. By shifting the debate to smaller, often divisive districts, the chances of winning at least some of the time increase. But there is a lot of collateral damage in the process. American investors and the American asset management industry are suffering because the large-scale benefits that American mutual funds have modeled for the rest of the world could be unwittingly undermined by these warring factions. While scale does not always translate to higher quality (which is why consolidation among asset managers generally benefits asset managers over their fund shareholders), scale is associated with lower costs, greater choice and overall greater transparency, all of which clearly benefit investors. We are probably headed down a path that is bad for asset managers and unfortunate for investors.
When I joined Morningstar in the 1980s, American mutual funds were still largely mom-and-pop businesses. You had some big family businesses, like the East Coast and West Coast Johnson families, but most of the industry was small local companies, often with regional concerns setting up funds to solve the “brother-in-law problem.” These private wealth managers often served high-net-worth clients who asked to take over a friend’s or relative’s small account. Mutual funds have enabled such organizations to consolidate smaller accounts. Most of their clients were domestic, and the fund groups often only registered their funds in that state or a few following. Only large stores are cash registers in all states. That soon changed, however, as the fund business grew and these companies became a national presence.
When Morningstar started covering funds in other parts of the world, I realized how much a bigger playing field it gave US money managers. According to European managers, US funds have had significant advantages, many of which have translated into a better investment experience for US investors. In fact, since we began our global investor experience surveys, the US fund market has ranked among the lowest-cost, best-selected and best-disclosed in the world. Investors in other markets began to demand similar treatment, and the asset management industry responded with more funds that could be sold across borders to replicate the benefits US investors had previously enjoyed, a trend that led to the creation of exchange-traded funds. While there has been occasional pushback—Switzerland currently requires asset managers to be able to bypass registrations specific to that country—the trend has been to go against local regulation and adopt national or country-wide standards.
Until recently. The ESG debate has put this long-term trend in a dilemma, but unfortunately, it is twisting in opposite directions in different parts of the world. In Germany, the government is pushing ESG standards higher than those accepted by the wider European community, a stance that could force asset managers to manage funds specifically for the German market, potentially increasing costs and limiting choice for German investors. In the United States, the opposite threat is in play. Here, far-right politicians are campaigning against what they call “active capitalism” in general, and ESG issues in particular in the management of public pension funds. All investors should have the right to accept ESG risks if they wish. By the same principle, people should have the right not to focus on them if they choose. Obviously, this gets complicated when you have to decide on a whole territory where there are many citizens from both sides. But forcing the issue so much at the state level would have the tragic result of dividing us into an all-or-nothing national race, red and blue, further testing Abraham Lincoln’s ominous admonition that a house cannot stand divided.
The current political situation suggests that this conflict could lead to a more divisive one. In addition to rejecting ESG-oriented funds for state pensions, some state authorities have proposed punitive measures against asset managers who manage any ESG mandates anywhere. Some states have threatened to fine financial firms that choose to avoid fossil fuel exposure. Firms such as BlackRock BLK, Goldman Sachs GS and JPMorgan Chase JPM have been cited among those who could face environmental fines for embracing ESG. The idea that we can not only be divided into red and blue states, but that we can have red and blue service providers for different states, seriously undermines the importance that has made America a world leader in asset management, especially in asset management. Represented by mutual funds for the middle class.
The undermining of this competitive business advantage is an irony that seems lost on these politicians, who are supposedly pro-business and pro-middle-class Republicans. The ability of domestic politicians to harm the US investment climate for their own short-term political gain should not be overlooked. Individual investors and asset managers must come together to combat this growing threat. Exchanging long-term structural benefits that encourage millions of investors is a trade-off for short-term gains for a few politicians.
This column was originally published by Q4 2022 issue. of Morningstar Magazine.