Ethical investment has gained traction, especially post-COVID when it has become all the more evident that disregarding nature eventually harms social and financial well-being of humans. Investors are increasingly making a case for financing clean and green companies as we start to recover from the pandemic. ESG funds cater to this need as they put higher emphasis on Environmental, Social and Governance (ESG) factors while picking the companies for investment. Not only has there been a rapid rise in global net flows in ESG funds, in India also ESG-focussed mutual funds have attracted capital. These funds have delivered strong returns as well.
Among six ESG funds in India, barring one, rest have added up to 27 per cent assets under management (AUM) in the June quarter itself. Taking into account fund performance, Nippon India ETF Shariah BeES returned 46 per cent since March 23, when the benchmark Nifty50 had hit its lowest in 2020. SBI Magnum Equity ESG Fund and Quantum India ESG Equity jumped 40 per cent and 38 per cent, respectively. Meanwhile, NSE's ESG-focussed index - Nifty100 ESG Sector Leaders Index- rallied 49 per cent during the same period. As per NSE Indices data, Nifty100 ESG index has outperformed Nifty100 since inception in 2014 with a 10 per cent CAGR against 8.7 per cent for Nifty100.
More ESG funds in fray
The global shift towards ESG investment is nudging corporates to adopt sustainable business practices. In fact, more fund houses are planning to launch their own ESG funds. "DSP Mutual Fund, Aditya Birla Mutual Fund, Kotak Mutual Fund, ICICI Prudential Mutual Fund, and BNP Paribas Mutual Fund have already filed their offer documents with SEBI for approval. Additionally, AMCs like SBI Mutual Fund are integrating the ESG research into their core investment process and this trend is expected to grow over the period of time," says Deepak Khurana, Performance Director for Fund Ratings and Distribution for Asia Pacific region at Refinitiv, a financial market data provider.
Globally, ESG investment that started in Europe is much more advanced and moving beyond equities in terms of ESG-compliant products. "The ESG funds are not limited to equity funds, even ESG thematic bond funds which are investing in green bonds are increasingly launched in overseas market. The overall ESG practice in key offshore locations, more so in Europe are much more evolved. The disclosure practices from the companies on ESG parameters and ESG investment practices of AMCs are much more evolved," Khurana of Refinitiv says.
How ESG compliant firms are chosen
The process starts with negative screening. So, companies engaged in tobacco, alcohol, gambling and controversial weapons etc are excluded. Further, their ESG risk and controversy scores are looked into. Companies with greater ESG risk score than that of their global sub-industry peers are excluded. Similarly, companies with higher ESG controversy scores are also set aside. Finally, among ESG compliant firms, those with strong fundamentals are chosen.
"By negative screening of some of the companies, we avoid ESG risk factors. For example, many companies have recorded huge fall in stocks due to issues like labour protests, judicial actions, related party transactions, auditor resignation and corporate plants being shut etc. So, non-ESG compliant firms do hold risk to their financial capital," says Navneet Munot, Chief Investment Officer at SBI Mutual Fund.
"As a fund house we focus on constructive engagement with management of these companies and nudge them towards scoring better on ESG factors. We sensitise them with ESG disclosures. So, we proactively vote on resolutions on reducing carbon emission and improving overall energy consumption etc," he adds.
ESG funds are well-diversified
Although ESG funds, as per Sebi rules, have been categorised under thematic funds, these are not narrowly concentrated thematic funds like other funds in the same category. Essentially, ESG funds are well-diversified largecap equity-oriented funds. "From the perspective of Sebi classification, ESG funds do go into thematic category, but ours is a diversified largecap equity fund with an overlay of ESG," says Munot.
ESG tool to reduce long-term risks
As per a report from Edelweiss Securities, in recent months, investors sold off fixed income, held onto equities in part, and gulped money markets instruments, while ESG funds continued to grow, particularly in equities. "Not only have they outperformed underlying benchmarks, but also on a sector-adjusted basis. Importantly, companies that fit the ESG bill have suffered lower earnings cuts. The main driver of ESG-compliant companies' outperformance in the face of the crisis is that sustainable businesses are quality investments. They have a corporate culture of compliance, integrity, and transparency in business reporting. Such companies tend to be more resilient and recover quicker from crises," says the report.
As per a study by SBI Mutual Fund, top 20 companies with low ESG risk score recorded 19.5 per cent average fall in their stocks between January 1 and May 28 compared to 36.07 per cent average stock fall for the bottom 20 companies with high ESG risk score.
So, it's safe to say that ESG compliant investment no longer means sacrificing on returns. In fact, this could be a tool to earn better risk-adjusted returns in the long term. "The focus on triple Ps - people, planet and profit -- ultimately delivers better shareholder value in longer time," says Munot. So, unless you have a low-cost index fund in the ESG category, instead of choosing other active funds, one of existing ESG funds could be a good option.