All you wanted to know about ESG funds

Global pension funds and other large investors are moving money to ESG (Environmental, Social and Governance) investing. The Indian mutual fund industry, always quick to capitalise on such themes, has rolled out new funds for investors based on ESG investing too.

Currently, there are three funds — SBI Magnum Equity ESG, Quantum India ESG Equity and Axis ESG — following the ESG investment strategy in India. Fund houses such as ICICI Pru, DSP, Aditya Birla, Kotak and BNP have also filed draft offer documents with SEBI and are awaiting approval.

The ESG strategy revolves around investing in companies that score high on three non-financial parameters — environment friendliness, social responsibility, and governance. They focus is on companies that adopt environment-friendly practices, produce products or services that influence society positively and conduct their business ethically.

While there are no strict norms on what constitutes ESG companies, each fund house follows different parameters to assign scores to companies on ESG to short-list stocks. Most funds though exclude sectors that are deemed harmful from a social perspective such as tobacco, liquor and gambling. On the environmental side, they check for a company’s carbon footprint, emission norms, water consumption, waste recycling and energy practices. They also avoid firms with poor governance which have had regulatory issues.

ESG investing is based on the idea that only pressure from large investors can force the corporate world to behave responsibly from a social, environmental and governance perspective. Secondly, factors such as climate change, shifts in societal preferences and governance issues do pose risks to corporate earnings and thus to investors in stocks. Companies that are aligned with ESG norms usually have lower risk of losses due to these factors. Thus, investing in firms with a high ESG score in believed to translate into enhanced value for investors in the long run.

The Nifty 100 ESG Index, which was designed to reflect the performance of companies within Nifty 100 index based on the ESG score, has outperformed its parent index Nifty 100 across various timeframes.

The Nifty 100 ESG Index has delivered a compounded annual return (CAGR) of 4.6, 9.3 and 7 per cent in the last one-, three- and five years while the Nifty 100 index posted 4.5, 7.8 and 6.4 per cent respectively. As on January 2020, the Nifty 100 ESG had 88 companies spread across 16 sectors. Fours sectors — financial services, IT, consumer goods and energy — accounted for 74 per cent of the index.

Globally about $2.96 trillion has been invested in funds that are managed with an ESG focus, according to Morningstar. In India though, the concept is as yet nascent. As the data available on ESG firms is limited, fund houses have devised their own methodologies to screen for ESG and procure data. The challenge is that only the top 100-150 companies by market capitalisation share a lot of data related to ESG.

Currently, given their investment mandate and limited investment universe, the ESG-compliant funds may be similar to existing ethical funds or those that follow Shariah principles to exclude sectors such as liquor and tobacco.

However, SEBI recently mandated that the top 1,000 listed companies prepare an annual business responsibility report (BRR) starting this year. A BRR has extensive disclosures about the adoption of responsible business practices by a listed company. This may eventually expand the investment universe for ESG funds.

You may invest in ESG funds for the ethics of it. For returns though, you’ll have to wait for a longer track record.

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