Thematic funds and sector funds invest only in a defined part of the equity market focusing on specified sectors and types of companies. The latest in this selection is ESG. ESG stands for environment, social and governance.  Funds which apply these standards to portfolio construction are known as ESG funds. 

Over the last few years, this standard of investing has gained significant popularity in developed capital markets and is slowly finding favour in India too. As a theme, ESG brings the appeal of moral investing without compromising returns. Although there is no empirical evidence of relative out-performance of ESG only funds, there is also no evidence to the contrary. 

Just like ESG, there are several thematic funds already in the market, these could be sector based like banking, technology, pharmaceutical funds or themes like energy, consumption, infrastructure, dividend yield and so on. 

The question is do these funds make for a good investment?

What’s in a theme

Whether the thematic fund delivers return or not depends on the theme itself and on the timing too. Often sector funds have periods where they do very well, like technology and pharmaceutical funds now and periods where they underperform diversified funds, like PSU and banking sector funds currently. 

This cyclicality makes sector funds very unsuitable for long term allocation and wealth creation. 

Some argue that theme-based funds are wider in their scope of investment as compared to sector funds and hence, make for better long-term allocation. There is no empirical data to support this hypothesis. 

The infrastructure theme, for example, started with a bang about 15 years ago and after the first few years has failed to deliver outperformance when compared with simple diversified equity funds. Same is the case with dividend yield based funds or funds investing in PSUs. The last ten years returns will show that these themes do not make for good long-term investments and which is best left up to diversified equity funds. 

ESG is a lasting theme

The consciousness that socially fair and relevant companies and those which take environmental issues seriously are the ones which will be long term earnings producers can’t be argued away. One only has to see the fate of listed equity of certain large energy producers globally or refer to the famous Volkswagen emissions standards blunder to understand that ESG factors do have critical importance in defining stock returns. 

However, the returns from an ESG fund will also depend on the proportion of the scheme that is dedicated to this theme. It is not yet clear that the ESG theme itself is the biggest return generator or whether it is simple active stock selection. 

For example, one of the largest global funds which have integrated the ESG theme in this portfolio construction process, Morgan Stanley Global Opportunity Fund, is beating benchmark returns by a large margin.

However, this could very well get attributed to the huge overweight in the fund to IT sector stocks, which are the ones leading the rally in the last 2-3 years. One may argue that those IT companies are ESG compliant.

In a sense, ESG as a theme is also highly diversified. However, prioritizing the theme is not an assurance of long-term wealth creation. Moreover, every asset manager has a different ESG framework and the validity of assumptions and process around this will determine the outcome.

Lastly, nothing stops an ordinary diversified equity fund from integrating ESG standards; a diversified fund portfolio can look very similar to its ESG counterpart.