What are ESG funds and how they work

ESG (Environmental, Social, and Governance) funds are a category of mutual funds that invest in companies meeting certain environmental, social, and corporate governance standards. ESG funds aim to generate long-term returns by investing in sustainable and responsible companies.

The ESG fund category is relatively new in India but has seen rapid growth recently. As investors become more aware of sustainability issues, demand for investments that reflect environmental and social values is rising.

• Table of contents

• ESG mutual funds - An overview
• The workings of ESG investing
• Types of ESG funds
• Calculating ESG scores
• Advantages of investing in ESG funds
• How and where ESG funds invest
• Should you invest in ESG funds?
• Things to consider before investing in ESG funds

ESG mutual funds - An overview

ESG mutual funds invest primarily in companies that score high on environmental, social, and governance parameters. They avoid companies engaged in business activities deemed detrimental to the environment and society.

The criteria used by ESG funds to evaluate companies include -

Environmental criteria: Companies’ efforts towards reducing pollution, optimising resource use, utilising clean energy, managing waste responsibly, and maintaining ecological sustainability.

Social criteria: Companies’ record on data privacy, labour practices, diversity policies, community engagement, and product safety.

Governance criteria: Companies’ management quality, executive compensation, board independence, shareholder rights, transparency, and business ethics.

The workings of ESG investing

ESG funds integrate analysis of companies’ ESG performance along with financial analysis to construct a portfolio. The process involves the below,

• Identifying the ESG criteria material to the fund’s theme: Funds establish criteria vital to their specific objective, like gender diversity or carbon footprint.
• Researching companies’ ESG metrics: Public disclosures, third-party data, and direct company engagement provide insight into ESG practices.
• Scoring companies on ESG factors: Companies are rated based on relevant metrics like greenhouse gas emissions, board diversity, etc.
• Constructing a portfolio favouring higher ESG scorers: Companies with better ESG scores are preferred, without compromising on financial robustness.
• Monitoring and engaging with portfolio companies: Funds continue assessing ESG risks and encouraging improvement through proxy voting and corporate engagement.

Types of ESG funds

• Environmental funds: Concentrate on companies with minimal environmental footprint and resource use. They favour renewable energy companies, electric vehicle manufacturers, wastewater treatment providers, etc.
• Ethical funds: Avoid industries like tobacco, alcohol, gambling, and weapons based on values or religious views.
• Sustainability funds: Invest in companies providing solutions for sustainability challenges like clean water, healthcare, education, etc.
• Impact funds: Seek measurable positive social and environmental impact alongside financial return.
• ESG integration funds: Incorporate analysis of material ESG factors into investment decisions across sectors.
• Low carbon funds: Focus on companies with lower carbon emissions than industry peers.
• Gender lens funds: Invest in companies with gender-diverse leadership and equal employment policies.
• Green bonds funds: Invest primarily in green bonds financing climate change mitigation and adaptation projects.

Calculating ESG scores

Since there are no universal standards for ESG measurement, funds rely on specialised research agencies to rate companies on ESG criteria. Some leading ESG research providers include:

• MSCI ESG Research
• Sustainalytics
• ISS ESG
• S&P Global Corporate Sustainability Assessment

These agencies analyse publicly disclosed company information, questionnaires, proprietary models, and news sources to evaluate ESG performance. The analysis may cover criteria like -

• Greenhouse gas emissions
• Energy efficiency
• Water use
• Biodiversity impact
• Toxic waste
• Renewable energy use
• Employee diversity
• Labour relations
• Data privacy
• Product safety
• Business ethics
• Anti-corruption policies
• Executive compensation
• Board independence
• Audit practices
• Shareholder rights

Based on such analyses, companies receive an overall ESG score as well as sub-scores on each aspect. Fund managers use these scores to identify and compare companies on material ESG risks and opportunities.

Advantages of investing in ESG funds

• Values alignment: ESG funds allow investors to put money towards companies reflecting their environmental and social values.
• Reduced risk: Companies with poor ESG track records may face regulatory action, litigation, and reputational damage - ESG analysis helps spot and avoid such risks.
• Future readiness: Leading companies on ESG factors seem better positioned for emerging sustainability challenges.
• Investment stability: Research suggests portfolios integrating ESG factors may offer more stable returns over the long term.
• Positive impact: ESG funds create an incentive for businesses to improve their ESG performance.

However, ESG funds have a relatively short track record in India. The benefits will become more evident only as funds mature over a full market cycle.

How and where ESG funds invest

Equity: ESG funds predominantly invest in stocks of ESG-compliant companies across market capitalisation levels.

Fixed income: They also invest significantly in highly rated corporate bonds and debt issued by sustainable companies.

Government securities: A portion is allocated to sovereign bonds.

Money market instruments: Liquid funds, commercial paper, certificates of deposit etc. enable liquidity management.

ESG funds largely invest in domestic securities. However, some funds also allocate up to 20-35% towards global securities like foreign ESG ETFs to diversify geographical risk. Exposure across sectors depends on availability of suitable ESG-compliant companies.

Should you invest in ESG funds?

ESG funds may appeal to

• Investors seeking portfolios well-aligned with their environmental and social values.
• Those wanting to incentivise and benefit from sustainable corporate practices.
• Long-term investors attracted by potential stability and risk reduction from ESG integration.
• Millennial investors favoring conscientious investing.

However, investors must have realistic return expectations as ESG funds exclude certain high-performing sectors. These funds are suitable for investors willing to sacrifice some returns for sustainability.

Things to consider before investing in ESG funds

• Fund’s ESG investment strategy: Assess the comprehensiveness of ESG criteria used and rigor of ESG analysis conducted.
• Portfolio composition: Scan portfolio holdings to check alignment with fund’s ESG focus.
• Performance record: Evaluate historical returns compared to category average and benchmarks.
• Costs: Check expense ratio and other costs impacting returns.
• Fund manager expertise: Examine manager experience in ESG investing.

While costs of ESG funds are coming down, they remain slightly higher than traditional funds. Investors should compare costs against expected benefits before investing.

Conclusion

ESG mutual funds allow investors to put money into companies adhering to environmental, social, and governance best practices. Though a relatively new category in India, these funds aim to offer the prospect of competitive returns from conscientious investments in sustainable businesses.

However, ESG investing entails some limitations in terms of higher costs and availability of suitable assets currently. Investors must set realistic expectations regarding returns and portfolio composition. As ESG data quality, disclosures, and assets expand in future, these funds hold strong potential for investors preferring their money to reflect their values. Those believing in the investment merits of sustainability can consider allocating a portion of their portfolio towards ESG funds.

FAQs:

What does ESG fund mean?

ESG stands for environmental, social, and governance. ESG funds are mutual funds that invest in companies that score high on environmental, social, and governance factors. They integrate analysis of these sustainability factors along with financial metrics for stock selection.

Are ESG funds a suitable investment?

ESG funds allow investors to put money into companies reflecting their values. Research suggests portfolios integrating ESG factors may offer more stable long-term returns by reducing risks related to sustainability challenges. However, ESG funds have limited history in India. Investors must set realistic return expectations as these funds exclude certain high-performing sectors.

Are ESG funds more risky?

Integration of ESG analysis is intended to reduce portfolio risk by avoiding companies with poor sustainability standards who may face litigation, reputation loss and regulatory action. However, limitations in availability of companies meeting ESG criteria can restrict portfolio diversification and impact returns. Investors should evaluate funds' investment strategy and portfolio composition to assess risks.

Why are ESG funds expensive?

ESG funds tend to have slightly higher expense ratios than conventional funds primarily because of the costs of specialised ESG research and data required for analysing companies. As ESG investing gains scale, costs are coming down gradually. Investors should compare the costs against expected benefits before investing in ESG funds.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.

This document should not be treated as endorsement of the views/opinions or as investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.