Will Anti-ESG Forces Undermine What Made American Mutual Funds Great?

It was only a matter of time until the tidal wave of concern over environmental, social, and governance investing triggered a backlash, but it has surely come with a vengeance. Notably, however, the revolt hasn’t come primarily from business interests angered about being asked to alter their practices. The business community in many cases has embraced ESG, recognizing the importance attached to these concerns by the communities they serve and the young talent they want to attract to their businesses. Rather, the opposition has come largely from politicians seeking to position themselves as “anti-woke” candidates in their election bids. This is not the usual business versus politics squabble, with the business community gathered on one side and the politicians on the other. Instead, this battle, like the abortion debate in the United States, has pivoted to a state-by-state quarrel, with red interests dominating in some states and blue ones in others.

This divide-and-conquer strategy by anti-ESG forces is a clever, if nefarious, move. Given the overall embrace of ESG among investors globally, trying to bar ESG in total would be a fruitless fight. By shifting the debate to smaller, often more partisan districts, the chances of winning at least some of the time go up. But there is much collateral damage in the process. American investors and the U.S. asset-management industry stand to suffer greatly, as the scale advantage that made American mutual funds the model for the rest of the world may be unintentionally undermined by these warring parties. While scale does not always translate into higher quality (which is why consolidation among asset managers generally benefits shareholders of the asset manager over shareholders of their funds), scale is correlated with lower cost, more choice, and generally higher transparency, all of which clearly benefit investors. It’s likely that we are going down a path that’s bad for asset managers and unfortunate for investors.

When I joined Morningstar in the 1980s, U.S. mutual funds were still largely mom-and-pop businesses. You had some larger family businesses like the East Coast and the West Coast Johnson families, but much of the industry was small local firms, often regional concerns that set up a fund to solve the “brother-in-law problem.” These private wealth managers often served high-net-worth clients who asked them to take on a smaller account of a friend or relative. A mutual fund allowed such firms to consolidate those smaller accounts. Most of their clients were local, and the fund groups often only registered their funds for sale in that state or in a few contiguous ones. Only the bigger shops registered funds in all states. That soon changed, however, as the fund business matured and these firms became national presences.

When Morningstar started covering funds in other parts of the world, I realized what a significant advantage a large playing field gave U.S. money managers. Not burdened by lots of differing local regulations the way, say, European managers were, U.S. funds had huge scale advantages, many of which translated into better investment experiences for American investors. Indeed, ever since we launched our Global Investor Experience studies, the U.S. fund market has ranked as having among the lowest cost, greatest choice, and best disclosure in the world. Investors in other markets began demanding similar treatment, and the asset-management industry responded with more funds that could be sold across borders to replicate the scale advantage American investors already enjoyed, a trend that culminated in the creation of exchange-traded funds. While there has been occasional backsliding—Switzerland is currently requiring asset managers to jump through registration hoops specific to that country—the trend has been against local regulation and toward a greater embrace of national or pan-national standards.

Until recently. The ESG debate has thrown this long-term trend a twist, but oddly, it’s twisting in opposite directions in different parts of the world. In Germany, the government is pushing for higher ESG standards than those embraced by the wider European community, a stance that could force asset managers to manage separate funds for the German market, likely increasing cost and limiting choice for German investors. In the United States, the opposite concern is in play. Here, far-right politicians are campaigning against what they term “woke capitalism” in general and more specifically against ESG concerns being used in the management of state pension funds. All investors should have the right to embrace ESG concerns if they wish. By the same principle, people should have the right not to focus on them if they so choose. Obviously, this gets complex when you must decide for a whole state where many citizens will be on both sides. Forcing the issue like this at the state level, however, where it’s all or nothing will have the unfortunate result of further dividing us into competing red and blue parts of the nation, further testing Abraham Lincoln’s ominous counsel that a house divided cannot stand.

The current political posturing suggests that this conflict may escalate to something even more divisive. Some state officials have gone beyond rejecting ESG-oriented funds for state pensions and have proposed punitive actions against asset managers that manage any ESG mandates anywhere. Some states have threatened to sanction financial firms that opt to avoid fossil fuel exposure. Firms like BlackRock BLK, Goldman Sachs GS, and JPMorgan Chase JPM have been cited as among those that could face local penalties because they have embraced ESG. The notion that we not only divide into red and blue states, but that we may also have to have red and blue service providers for different states would largely undermine the scale advantage that made America a global leader in asset management—and specifically in asset management for the middle class, as represented by mutual funds.

That the undermining of this competitive business advantage comes from supposedly pro-business and pro-middle-class Republicans is an irony that seems to be lost on these politicians. The ability of local politicians to damage the American investment landscape for their own short-term political advantage should not be ignored. Individual investors and asset managers need to band together to combat this growing threat. Exchanging long-term structural advantages that empower millions of investors for the short-term benefit of a handful of politicians is a losing trade.

This column was first published in the Q4 2022 issue of Morningstar magazine.