ESG Funds – The Change That’s Going To Last

Our kids bring in sweeping changes to the way we live, consume, and invest. In this case, One of my regular clients posed a unique dilemma he was facing, during his annual financial health check-up.

His 11-year old daughter, Nainika, saw a show about plastics and electronic waste, undisposed PPEs, and oil spills affecting marine life and oceanic ecosystems. She knew that he is a stock investor in big-big companies, and those companies made everything from her noodles to the car they have.

So, she asked him a pointed question – “Dad, do you have shares of companies that do these dirty things with sea and sea animals?”. Then she went on to add, “I know my dad is so smart that he will never have them!”

As a loving father he wanted to tell her that he only has shares in companies that are responsible and eco-friendly, but like most people, didn’t know which companies followed sustainable practices and which did not.

ESG Funds

ESG Funds: What are they?

ESG mutual funds, just like any other thematic fund, have different criteria to let any company enter their universe. The fund managers identify and invest in, corporates showing responsible behavior and actions taken to sustain the environment, support society, and maintain the highest corporate governance standards.

In addition to the usual financial metrics, ESG funds‘ portfolios integrate environmental, social, and governance factors into their investment process. It means, if the fund manager is very particular, then stocks and bonds in the fund may make up what you can call a green fund or a rainbow fund.

The UN Principles for Responsible Investment, launched in 2006, provided the framework for launching ESG funds and socially responsible investing. ESG funds are growing in popularity among investors for their impact and return.

Vocal for Global

ESG investment philosophy gained currency globally over the past few years as people become more aware of many global issues – climate change, undemocratic and autocratic regimes, companies with poor governance records, or discriminatory policies against a section of society.

Ideally, an ESG fund can hold in the portfolio only stocks and bonds issued by the corporate or government with a high sustainability score from Morning Star, MSCI, and other leading indices.

These funds would exclude corporations who are defaulters in pollution cases, have had poor labor relations, have less than desirable transparency, or poor management practices. An ESG fund would, desirably, also keep away from government bonds of countries with poor records on any of these.

Research shows that applying the ESG filter led to thorough scrutiny and better investment decisions. Better risk management resulted in avoiding potential duds earlier than the market and better returns for the investors.

As of Nov 2020, a third of all US financial assets were controlled by ESG funds totaling USD 17.1 trillion, a 42% increase over 2018 (Click Here).

As per the KPMG European Responsible Investing Fund market 2019 report, there were EUR 496 billion in assets under management, with a 12% y-o-y growth.

According to another report, ESG funds are expected to manage EUR 7.6 trillion across Europe with a market share of 57% in 2025.

ESG Funds in India

ESG funds were first introduced in India in 2018 when in 2018, SBI AMC reclassified its SBI Magnum Equity fund (both direct and regular plans) as an ESG fund. The first proper launch of an ESG fund was by the Quantum MF in July 2019 with its Quantum India ESG Equity fund.

The year 2020 saw ESG funds launched by six fund houses viz. Axis, ICICI, Quant, Mirae Asset, Kotak, and Aditya Birla Sun Life.

The ESG theme not only has an emotional value for some investors, on many counts, but it is also a more practical and rewarding theme. Environmentally sustainable companies have a lower risk of regulatory sanctions and societal ire, resulting in steady growth with less volatility in share prices.

Similarly, companies having low standards of corporate governance are the potential bankruptcies of tomorrow. Investors and mutual funds who had shares of Satyam, Kingfisher, and DHFL in recent years would have saved many heartburns had they followed ESG investing style.

And like Warren buffet has said, “First Golden rule of investment is not to lose money” and “the Second Golden rule is never to forget the first rule”, ESG investing can help you avoid the losers, so that your winners can take care of themselves.

Also Read: How to identify Companies which Dupe Investors.

ESG Funds in india

ESG Funds – Is it the new fad?

The core idea behind the ESG funds that what is right for humanity, must be suitable for investors. But in India, ESG funds are in a nascent stage and have yet to take fancy of retail investors.

For a country obsessed with cars’ mileage, the performance record is a necessary condition to attract interest.

In western economies, the ESG theme is strong, as many endowments and pension funds with big purse strings mandate a responsible investing style. As their asset managers form the bulk of foreign portfolio investors in the Indian markets, the ESG style of stock picking is already affecting us.

The FPI shun the companies having a low score on the ESG scale maintained by Morning Star, MSCI, or companies, not on India’s own Nifty 100 ESG or S&P BSE 100 ESG indices.

It makes the significant FPI inflows not going to companies with a low ESG score, and as their stocks do not give spectacular returns, they eventually go out of favor. The FPI inflows would undoubtedly provide the necessary tailwinds to ESG funds, and when they deliver, investors will jump in.

So, Indian investors may gradually move towards ESG funds, more due to dwindling returns in non-ESG funds than anything else.

ESG Criteria – Inclusive or Exclusive!

ESG funds can take multiple approaches to build their portfolio – inclusive, exclusive, mimicking.

Some proactive ESG funds work on actively promoting the principles and helping individual businesses achieve pre-defined goals. For example, a company manufacturing organic herbicides/pesticides would have more ESG funds willing to buy its stocks and bonds.

Other ESG funds may define an exclusionary criterion – corporations engaged in individual businesses would not make it to their portfolio, ever. Some of the most common exclusions may include companies in tobacco, gambling, alcohol, fossil fuels, controversial weapons, or acting as state agents of oppressive regimes.

Finally, many passive funds may follow an ESG index maintained by a bourse or a reputed rating/index agency and add stocks to their portfolio according to their normalized ESG scores.

Performance of ESG Funds in India

The Nifty ESG Index has outperformed the Nifty50 in one and five-year periods. As of October 30, 2020, the Nifty ESG Index delivered a five-year return of 10.80%, while the Nifty50 gave only 8.99%, both CAGR.

For the one year, the Nifty ESG Index returned 5.42% and Nifty 50 a negative return of -0.98%, a gap of close to 6.5%!

As per AMFI, ESG funds in India have an AUM of INR 45 billion, and it would grow further with increased awareness and better returns. The positive side effect would be that many companies may start cleaning their backyards, follow better governance standards, and safeguard the environment.

To compare the five-year ESG funds performance of the S&P BSE 100 ESG index with its other thematic categories, glance at the chart below (Source: BSE):

ESG Funds

In India, like elsewhere, ESG funds have delivered higher returns over 1 and 5-year periods. It was possible because by filtering out firms with issues or controversies, you can save yourself from losers.

Two funds may consider the same index as a benchmark but still deliver different results. It may be because of many factors, like portfolio building methodology, time of the funds’ entry, or simply because one of their stocks didn’t pay off.

So, what is the advice to Nainika’s father?

To contribute to building a sustainable future for our kids like Nainika, companies, and countries with good ESG scores are likely to be a fair employer and a positive impact on society.

Compliance ensures that risks and threats to the local climate can be managed, mitigated, or avoided. Foreign investors look closely at ESG metrics very seriously. If India wishes to continue to attract its FPI investors, it has to take ESG seriously.

In the end, Nainika’s father must thank his little champ, who forced him to ask questions. He could now not only say proudly that he contributes towards a better tomorrow. And he would go laughing to the bank, doing so.

Hope you got a good idea about ESG mutual funds in India – if you still have any questions add them in the comment section.