All you need to know about ESG funds

7 MinsJuly 12, 2022

Socially responsible investing means ethical, green and clean investing. In other words, you need to be looking at three key factors: Environment, Social, and Governance (ESG) when you make investments. 

Everything You Need to Know About ESG Funds

ESG investing is gaining a lot of importance all around the world. In India, too, many mutual fund houses now offer ESG Funds. The total AUM of the ESG Funds in India is at Rs 10,810.93 crore as of May 2022 compared to Rs 2,390.92 crore in May 2019. 

What is an ESG Fund?
An ESG Fund is classified as thematic and is required to invest at least 80% of its total assets in securities that are consistent with the ESG (Environment, Social and Governance) theme, as per the existing regulations. Given that, an ESG Fund is also classified as a ‘sustainable mutual fund’.

The investments are predominantly in equity and equity-related instruments of companies that meet the ESG criteria. The main focus is on investing in businesses or companies whose operations are in the direction of protecting the environment and potentially honouring social responsibility (following best labour practices, considering stakeholders' opposition on vital issues, looking at privacy and data security closely, etc.) and, in general, following good transparent, fair, and good governance practices. 

So, typically, companies engaged in the business of tobacco, alcohol, controversial weapons, and gambling operations, or funds that focus merely on their growth by indulging in unfair and unethical practices and/or do not have a fair executive compensation policy, or whose independent board function is compromised, do not make the cut to the portfolio of an ESG Fund. 

Similarly, coal mining companies, thermal power producers, and companies manufacturing environmentally hazardous chemicals may trade at cheaper valuations but may not make it on the ESG investing parameters.  

The fund manager of an ESG Fund may follow a combination of ‘top-down’ and ‘bottom-up’ approaches. Plus, the investment style could be growth, value, or a combination of the two. And as regards market capitalisation, since bigger companies usually make the cut on the ESG parameters, most ESG Funds hold a predominant portion of their portfolio in large-cap companies.  

[Also ReadInclude a mix of asset classes in your investment portfolio]

That said, every fund house has its process to select securities based on the ESG criteria. The capital market regulator, SEBI has introduced a consultation paper intending to standardise ESG ratings, which can be used by fund houses to select securities with the ESG framework. This will bring uniformity to the entire ESG selection process.   

The capital market regulator has also proposed that ESG schemes should periodically disclose positive environmental changes that investors might expect. Better disclosures will make ESG investing more transparent. And for the investor, monitoring the real-world impact of ESG investing will become possible. 

What is the investment objective of an ESG Fund?
The investment objective of an ESG Fund is broadly to provide long-term capital appreciation with active portfolio management by following the ESG criteria. 

How does an ESG Fund benchmark its performance?
Most ESG Funds track their performance against the Nifty 100 ESG TRI (Total Return Index), incepted on March 27, 2018. This index is designed to reflect the performance of companies within the Nifty 100 index based on the Environmental, Social, and Governance (ESG) risk score. The weight of each constituent in the index is tilted based on the ESG risk score assigned to the company, i.e., the constituent weight is derived from its free-float market capitalisation and modified ESG risk score.

Since its inception (27th March 2018), the Nifty 100 ESG TRI has clocked a decent CAGR of 12.70% as per its factsheet of May 31, 2022.  

What are the benefits of investing in an ESG Fund?

The five key benefits of investing in an ESG Fund are:

  • Facilitates diversification with, Environment, Social, and Governance aspects being the focal points.
  • Offers an avenue for better investment allocation.
  • Mitigates the risk involved to an extent by exposure to quality companies with sustainable growth.
  • Ensures liquidity and an opportunity to earn positive real returns (also known as inflation-adjusted returns) over the long-term.
  • Helps you become a socially responsible investor.

Who should consider investing in an ESG Fund?
If you have a high-risk profile, your broader investment objective is capital appreciation and you have an investment horizon of 5 years, the ESG Fund may be a worthy addition to the portfolio. That said, remember that a sustainable future won’t automatically safeguard you from the risks associated with equity markets and ESG investing, and that’s why your scheme selection matters.

Disclaimer: This article has been authored by PersonalFN, a Mumbai-based Financial Planning and Mutual Fund research firm. Axis Bank doesn't influence any views of the author in any way. Axis Bank & PersonalFN shall not be responsible for any direct / indirect loss or liability incurred by the reader for taking any financial decisions based on the contents and information. Please consult your financial advisor before making any financial decision

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