ESG mutual funds are thematic mutual funds that focus on the theme – environmental, social and governance. Typically, a company or a fund is assessed based on its historical performance, business model, annual reports, etc. However, recently, investors have been considering additional factors such as environmental, social, and governance. These three factors come together to generate ESG funds, a new type of mutual fund. Therefore, ESG funds invest primarily in stocks and bonds of firms that have been reviewed for environmental, social, and governance parameters. Environmental factors include the organization’s greenhouse gas emissions, business model sustainability, and utilization of renewable resources, among other things. Similarly, social factors might include how they treat their employees, attitude towards work-life balance, equal opportunity for everyone of all genders and religions, etc. Finally, the governance aspect considers the company’s leadership diversity as well as its sensitivity to shareholders. SEBI regulates ESG funds to invest at least 80% of their assets in securities that comply with the ESG theme. However, the remaining 20% cannot be invested in securities that are starkly in contrast to the core philosophy of the ESG theme. For instance, a fund house decides not to invest in ‘sin goods’ companies, i.e., commodities harmful to society such as alcohol, tobacco, and so on. The fund should avoid investing in any FMCG company that deals in the tobacco business as one of its verticals. Similarly, if a fund’s theme is to refrain from investing in companies that pollute the environment, it should avoid companies dealing in petrochemicals and pesticides.
According to a research report, ESG theme mutual fund assets grew 4.7 times between November 2019 and November 2021. As of November 2021, the total AUM was INR 12,320 crore across ten funds. Furthermore, they are on track to grow even more as more similar schemes are created. Currently, there are eight actively managed equity schemes, one ETF and one fund of fund (FoF). Post the COVID pandemic, the ESG theme has gained traction, and the future looks bright for the theme. Indians are starting to look for sustainable alternatives for numerous reasons. Strict regulatory constraints have pushed companies to be more ESG compliant. In reality, companies have shut down, failing to comply with the rules. As a result, most companies started being more ESG compliant, seeing the fate of the failed companies. Apart from regulatory obligations, the interest of foreign investors is another factor that is encouraging companies to take ESG norms more seriously. Companies that are sustainable and ESG compliant are gaining the attention of foreign investors.
Stringent Regulations: SEBI has recently mandated fund houses on various ESG theme norms. All funds have to clearly name the scheme, investment objective, investment policy and investment strategy (as per the norms). Moreover, mutual fund schemes must monitor and analyze the long-term performance of the companies in which they invest. Furthermore, the regulator proposes ESG funds to disclose the positive environmental changes that investors may expect. Also, the funds must provide links to Business Responsibility and Sustainability Report (BRSR) disclosures for every company held in the fund portfolio. Fund houses should disclose the source of ESG information of underlying investments, investment processes and philosophy. Additionally, the key ESG factors to be considered in decision making, due diligence methodology and its limitations. And also, the engagement policies, including stewardship, monitoring of investments and evaluation. The capital market regulator has noted dissimilarities in the terminologies and meanings of ESG. As a result, the Association of Mutual Funds in India (AMFI) is responsible for ensuring that the industry participants must use common, finance-related words and definitions that are compliant with global norms. Furthermore, AMFI will be responsible for promoting financial and investor education programmes relating to the ESG theme.
Increasing Acceptance: ESG funds have got a remarkable response from investors over the past couple of years. Investors have started looking for parameters beyond financial statements, business models, and historical performance. Sustainability and governance have started to take an important role in choosing a company for investment.
New Funds: The ESG theme is fairly new to the Indian markets in comparison to the global markets. With the increasing demand and better regulatory framework, there is a good scope for more ESG based theme funds. As of November 2021, the ESG theme AUM was barely 0.3% of the total INR 38.45 lakh crore mutual fund industry. Currently, there are only eight actively managed equity schemes, one ETF and one fund of fund (FoF).
Advantages of Investing in ESG Mutual Funds
Good Potential: The theme of environmental, social, and governance (ESG) is well-known around the world. However, in India, it is gaining importance. Thus it has the potential to deliver reasonable gains in the long term.
Long Term Capital Appreciation: ESG funds identify companies that have long-term growth potential and, at the same time, adhere to the ESG parameters. ESG funds invest in companies with strong financials, as well as decent governance procedures and viable business strategies. This has a good potential to generate significant returns while also having a favorable long-term societal impact.
Risk Management: ESG funds invest in companies that comply with the ESG norms. Such companies have a low risk of going out of business. Therefore, ESG funds focus on risk mitigation and pick only high-quality stocks that score well on the ESG metrics.
Capitalize on Opportunities: ESG funds have the ability to capitalize on new economic opportunities created by modern-day customer preferences.
Professional Management: If you are interested in investing in ESG themes, it can often be difficult to identify stocks and invest in them. ESG mutual funds are a good alternative. Since the fund manager focuses on selecting ESG stocks, you can leverage his expertise and invest in the fund.
Who Should Invest in ESG Mutual Funds?
Consider investing in ESG Funds if you are a person who wishes to positively impact the world by being socially, ethically and environmentally responsible. Investing in ESG schemes is beyond financial benefit. The ESG fund’s objective is sustainability. Therefore, you cannot select funds based on just financial performance. You will have to analyze the portfolio and see how sustainable it is.
ESG funds are equity mutual funds. Therefore, a long-term investment horizon is a must. These thematic funds are highly volatile in the short term. Though the funds invest in high-quality stocks that comply with the ESG norm, the inherent market risk still prevails. Hence, these funds are highly volatile and invest only if you are comfortable with the risk levels. Furthermore, since ESG funds focus on one single theme, exposure of more than 10% to your portfolio is not advisable.
Things to Consider Before Investing in ESG Mutual Funds
The ESG theme is trending in India; however, you should be careful while choosing a scheme to invest in. Following are some parameters that will help you select the best ESG mutual fund for investment:
Historical Performance and Sustainability Factor: The historical performance of an ESG fund doesn’t guarantee future returns. However, analyzing the ESG fund’s returns against its benchmark and peers will help you understand its performance. Funds that have consistently outperformed their benchmark and peers are good investment options. Furthermore, ESG funds are beyond profitability. Sustainability is a major parameter for these funds. ESG funds invest in companies that comply well with the ESG norms. ESG funds give an opportunity to invest in sustainable businesses that work towards the betterment of society.
Investment Objective: ESG investing is synonymous with sustainable, ethically and socially responsible investing. An ESG fund shortlists companies that score well on environmental, social responsibility, and corporate governance before looking at financial criteria when choosing a company to invest in. Currently, investors are re-evaluating their strategies and are considering the impact of their decisions on the planet. Resonating with the investor thought process, ESG funds are creating portfolios that focus on ethical and social impact. Also, the funds adopt good risk mitigating techniques to generate returns for investors.
Investment Horizon: ESG mutual funds are equity schemes and therefore require a long-term investment duration to generate significant returns. ESG schemes can be highly volatile in the short term. Consider investing in an ESG fund only if you have a long-term investment horizon, support and believe in the theme.
Suitability: ESG mutual funds are ideal for aggressive investors who have a good wish to invest in sustainable, ethical and environmentally friendly businesses. These funds offer good diversification to your portfolio. However, it requires you to stay invested for a long time. Therefore, assess the suitability of the theme and the funds to your investment portfolio, goals and horizon.
Asset Allocation: Diversification should always be the goal of your investment. A well-diversified investment will help you average out the market’s volatility. Since ESG funds follow a theme, the choice of stocks narrows. Since large-cap companies are known for complying with the ESG norms, they are often the preferred picks. However, the fund manager has the liberty to pick stocks from mid-cap and small-cap categories as well. Look for ESG funds whose asset allocation is well diversified.
Even though the ESG theme is in the nascent stage and gaining importance, its growth may not be permanent. ESG funds are highly susceptible to market pressures. Therefore, if you are an investor who understands the theme in-depth and is willing to undertake the volatility, you can consider investing in ESG mutual funds.