Due Diligence . Why you should look closer at ESG funds

Ethical investing, one that gives you good returns while aligning with your values, has always been popular.

Environment, Social and Governance (ESG) is one of the ethical investment strategies that is growing popular by the day.

The reason why investors need to take note of ESG investment is that these funds have delivered decent returns in comparison with the large-cap equity fund category.

Also, Indian fund houses have begun launching funds based on this theme of late. Quantum India ESG Equity Fund and Axis ESG Equity Fund were launched in the last 13 months and SBI Magnum Equity ESG Fund changed its mandate to cater to the ESG theme.

Other fund houses such as ICICI Prudential, DSP, Aditya Birla Sun Life, Kotak and BNP are also in the queue.

What is it about?

ESG funds invest in stocks that are socially responsible, environment-friendly and follow good governance practices.

The companies that are involved in controversies involving the three tenets are excluded. Companies involved with the manufacture of tobacco, alcohol, controversial weapons or gambling operations do not form a part of the strategy.

Broadly, the selection is based on evaluation of companies’ performance on a set of indicators that measure their ESG score.

Indicators include use of renewable energy, carbon intensity trend, waste management, working conditions policy, discrimination policy, health and safety management of employees, presence of whistleblower policy, board diversity and responsible investment policy.

The trouble in India is that there aren’t too many listed companies that score high on the above parameters.

A white paper published by NSE shows that the average ESG score of Nifty 100 companies was only 58, on a scale of 1 to 100.

Seventy per cent of the companies had scores between 50 and 80.

IT companies had the highest score of around 72, followed by cement (61) and consumer goods and industrial manufacturing (58). Pharma companies, telecom and financial services had lower scores between 49 and 50.

How is it different?

In its earlier form, Socially Responsible Investing (SRI), the focus was not on making returns, but on making the investment morally satisfying.

But the ESG theme has proved to be much better than its predecessor in delivering returns on par with other equity funds. If we compare the annual performance of the MSCI World ESG Universal Index with MSCI World Index between 2010 and 2019, the difference between the two was less than 1 percentage point in nine years.

The Nifty 100 ESG Index’s correlation with the Nifty 50 over a one-year period is 1 and over five-year period, it is 0.99.

This shows that the return of ESG investing has been comparable with large-cap equities. What’s more, the Nifty 100 ESG TRI has delivered superior returns than the Nifty 50 as well as Nifty 100 TRI over all time-frames (see table).

The popularity of the ESG theme is also because it is broader, catering to a larger investor base compared with the earlier funds, which catered to specific needs such as clean energy, or ethical investing or funds based on religious tenets such as Shariah investing.

ESG funds in India

There are no exchange-traded funds (ETFs) based on NSE’s ESG indices yet. If an ETF is launched, it would be the best vehicle to participate in this theme since the index is constructed in such a way that it captures the best companies on the ESG score.

Of the ESG funds currently available, Axis ESG Equity was launched in February this year, and hence does not have sufficient history. SBI Magnum Equity ESG is lagging the benchmark (Nifty 100 ESG TRI) returns by around 6 percentage points on a year-to-date (YTD) basis as well as on a one-year basis. The holding of 32 per cent of its AUM (assets under managment) in financial services sector appears to have dragged returns.

Quantum India ESG Equity, a relatively smaller fund, has managed to deliver good returns since its inception in July 2019. It has delivered 8.7 per cent over a one-year time period and 0.9 per cent YTD.

Its higher holding in IT and cement sectors, with financial services making only 4.2 per cent of the AUM, seems to have helped returns. A relatively lower expense ratio of 1.4 per cent is also a positive in this fund. The top five holdings are TCS, Infosys, Wipro and the HDFC twins.

Suitability

ESG funds fall in the thematic funds category. But this does not make them riskier than large-cap equity funds. This is because the stocks for ESG are selected from the large-cap-oriented Nifty 100 index and the fund-holding is likely to be quite diversified since stocks with high ESG scores can be found across sectors.

More importantly, the focus on governance in stock selection can help the funds better the large-cap indices. With poor governance practices being the main problem with the majority of stocks in India, leading to sudden stock price crashes, filtering out such stocks puts these funds in a more secure position. Also, companies that devote attention to ethical practices in their operations are more likely to be run by a management team that can also deliver strong earnings growth over the long term.

Investors can, therefore, consider investing a part of their equity portfolio in these funds through SIPs (systematic investment plans). Taxability of gains is in line with other equity mutual funds.