If you ever wondered how a handful (really, a handful) of big investment funds essentially run capitalism, the response is: they do it by setting up acceptance rules to invest in companies, when they acquire their bonds, stocks, derivatives, etc. Since they are the biggest investors in the world, NOBODY wants them to avoid investing in your company, and thus you accept these rules and standards so you are eligible to get their money, “investable” in the financial jargon.
Below, there’s part of June 25’s Money Stuff column by Bloomberg News’ Matt Levine, perhaps the world’s most astute financial writer, in which he explains how social justice concerns, normally disguised in the financial world as “ESG,” have become a growing part of the big funds’ agenda; and how the U.S. administration is pushing back.
This is easily the world’s most important news you never heard of. Definitely worth reading without me commenting:
My maximalist theory of environmental, social and governance (ESG) investing goes like this. There is a government of the U.S., consisting of a president and Congress and and so forth, chosen through more-or-less democratic processes, and it makes big collective decisions for society. There is another government, in the world, consisting of a handful of gigantic institutional asset managers—BlackRock, Vanguard, Fidelity, etc.—who own (on behalf of their customers) most of the stocks of most of the public companies, and can, in some loose sense, tell those companies how to behave. They are not chosen democratically, exactly, but they are representative; millions of people give their money to those institutions and trust them to make decisions for them.
Traditionally asset managers didn’t really tell companies what to do, or if they did, they mostly told them to do business-y things like buy back stock or increase profits or whatever. But now the biggest asset managers are so big and so diversified that they do not get much bang for their buck from analyzing companies and telling them to improve their businesses, and they are too important to just do nothing. So the asset managers tell companies to do things that they think are good for society as a whole, in part because doing things that are good for society tends to improve the long-run economic returns to owning all the stocks (as the big asset managers do), and in part because the asset managers are run by humans who live in society and want society to be good. And so the asset managers find themselves in the business of making big collective decisions about how society should be run, not just business decisions but also decisions about the environment and workers’ rights and racial inequality and other controversial political topics.
There is a lot of overlap between what the regular government does and what the government-by-asset-managers does. Not total overlap, of course—the U.S. government has an army, BlackRock does not, etc.—but in broad areas of business and business-adjacent conduct, the U.S. government, and state governments, and BlackRock all have overlapping legislative power. Should companies be allowed to dig up coal to provide power, when coal causes a lot of pollution? That is a complicated question involving individual freedom, externalities, efficiency, economic growth, jobs, etc., and different governments could come to different answers. The U.S. government, under Donald Trump, comes to the answer “yes coal is great, more coal please.” BlackRock Inc., under Larry Fink, recently came to the answer “no coal is bad, no more coal please.” Coal companies are allowed by federal law but banned by BlackRock.
Being banned by BlackRock is not as bad as being banned by federal law; if you dig up coal anyway, BlackRock can’t put you in prison. But in a world in which capital is mostly allocated by a handful of giant institutional asset managers, those managers’ quasi-regulatory decisions have a lot of weight, and companies will generally try to follow them. BlackRock makes big decisions on broad social and environmental issues, and then companies are somewhat compelled to do what BlackRock decides.
This is all kind of new, and weird, and exaggerated; what I wrote above is not so much true as it is in the process of becoming true. The role of institutional asset managers in making big collective decisions is still under-theorized. The asset managers would not describe any of it like this, all of this would make them uncomfortable, and they claim only a modest role for themselves: “We just help our clients make their own investment decisions, we don’t tell companies what to do, and we certainly don’t write environmental legislation.” While the U.S. government’s regulatory process is formalized and full of checks and balances, the institutional investors’ process is ad hoc and proprietary. We have talked before about John Coates’s description of this situation as the “Problem of Twelve,” referring to his estimate that “the majority of the 1,000 largest U.S. companies will be controlled by a dozen or fewer people over the next ten to twenty years.” Coates has suggested that maybe the big asset managers need to have more formal procedures—analogous to U.S. administrative law—to make their governance decisions more transparent and legitimate. If BlackRock is a government, it should act like it.
But another problem is that, you know, there already is a government, and it gets jealous. When Donald Trump says that there should be more coal mining, and BlackRock says that there should be less, that can feel like an intrusion on the U.S. government’s turf. Why does BlackRock get to decide that? And since the U.S. government really definitely is a government—it can put you in prison, etc.—it can try to regulate the institutional investors to take away their governance powers.
The U.S. Department of Labor sets the rules for retirement accounts in the U.S., both corporate defined-benefit pension funds and also defined-contribution 401(k) plans. On Tuesday it announced that it will ban ESG investments from retirement accounts. I mean, that is an overly dramatic simplification of the proposed rule; pension funds will still be allowed to consider ESG factors in their investments, and 401(k) plans will still be allowed to offer ESG funds on their menu of options. But the overall thrust of the DOL’s proposed rule is that retirement-fund fiduciaries have to consider only economic factors in offering retirement accounts. They can consider ESG factors “only if they present economic risks or opportunities that qualified investment professionals would treat as material economic considerations under generally accepted investment theories”; they can offer ESG funds in 401(k) plans only if they use “objective risk-return criteria, such as benchmarks, expense ratios, fund size, long-term investment returns, volatility measures, investment manager tenure, and mix of asset types … in selecting and monitoring all investment alternatives for the plan, including any ESG investment alternatives.” You can refuse to buy polluters if you think, and can document, that their factories will blow up and they’ll be fined a lot of money, because losing a lot of money is bad under, uh, “generally accepted investment theories”; you can’t refuse to buy polluters because you think that pollution is bad for the world. You can offer ESG funds if their performance meets the same standards as your other funds; you can’t sacrifice performance for social good. BlackRock has announced that ESG funds will become the default option in some of their fund menus; the DOL has announced that ESG funds can’t be the default option in a 401(k).
The explicit reason that the DOL is doing this is to protect retirement savers from losing money:
“Private employer-sponsored retirement plans are not vehicles for furthering social goals or policy objectives that are not in the financial interest of the plan,” said Secretary of Labor Eugene Scalia. “Rather, ERISA plans should be managed with unwavering focus on a single, very important social goal: providing for the retirement security of American workers.”
But it is pretty tempting to read it instead as a political statement about the separation of powers: No, says the government, we are in the business of furthering social goals and policy objectives. The people making environmental, social and governance decisions should be the government, says the government; the asset managers and pension funds had better stick to making money.