What are ESG Funds and How to Invest in ESG Funds

What are ESG funds?

The process of investing involves vetting the fund or company based on factors like business model, historical performance, annual reports, and so on. However, in this day and age, investors have started considering some additional fundamentals, namely Environmental, Social, and Governance. These three aspects combined form the basis of a new class of mutual funds called ESG funds.

ESG mutual fund focuses not only on a company's financial performance but on how it functions as a part of society. ESG-compliant companies include those that are performing well not only in terms of finance, but also in the environment, society, and governance.

Types of ESG Mutual Funds

Exclusionary Funds

These funds include companies that do not meet the ESG criteria and are involved in services/products that are harmful.

Best-in-Class Funds

These are the funds that invest in companies with the best ESG ratings in their respective industry.

Thematic Funds

In these types of funds, the companies are bucketed into a similar type of purpose they are resolving under ESG.

Impact Funds

Investments are made in these types of funds to gain financial return along with generating measurable and beneficial environment and social return.

What are the Benefits of Investing in ESG Funds?

Benefits of investing in ESG funds are:

• Portfolio diversification by investing in ESG purpose-driven companies which reduces traditional risks
• Contributing towards the betterment of the world by investing in ESG-led companies
• Long-term gains in terms of the high growth potential of ESG-compliant companies

Difference between ESG Funds and traditional Funds

What is an ESG score, and how is it calculated?

Many agencies rate companies on each of the ESG parameters and give an individual and overall score based on their assessments. Dun & Bradstreet, Sustainalytics from Morningstar, and ESG data from the likes of MSCI, S&P and MSCI are sources of scores on companies based on their ESG metrics.

In India, a company called SES (Stakeholders Empowerment Services) rates the top 100 companies based usually on publicly available data on ESG parameters. It gives the rating on each of the ESG parameters and ranks them based on the overall scores.

Standard-setting bodies such as the IOSCO and FSB are still working on exact frameworks and disclosures on the ESG front.

Closer home, SEBI (securities and Exchange Board of India) has mandated the top 1000 listed companies by market capitalization to come out with a business responsibility and sustainability (BRSR) report every year, which includes ESG reporting as well. It has floated a consultation paper as well on evolving a rigorous ESG reporting framework for companies.

However, despite many agencies and regulators insisting on ESG scoring, there is no universally or even locally agreed common parameters followed by all companies. Definitions of environmental, social, and governance parameters vary quite widely across rating agencies, countries, and even within industries.

ESG Funds: How and where do they invest?

ESG funds evaluate their potential investment based on the ESG scores of various companies. Once the company is evaluated, these funds invest in them and promote the idea of sustainable growth with a broader focus on environmental and social impact.

For investors, these funds help in generating long-term gains and diversifying their portfolio with responsible investing.

Pros & Cons of Investing in ESG Funds

Advantages of ESG Funds

• Aligning investments with individual values
• Provides risk-adjusted returns
• Portfolio Diversification

Disadvantages of ESG Funds

• Performance pressure in companies under their industry
• High fees of ESG funds
• Finding 100% ESG compliant fund is a difficult task
• Reduced asset diversification
• Increased money outflow for maintaining the ESG standards

Factors to Consider before Investing in ESG Funds

Now that you're all caught up on finding out more about an ESG fund, you might wonder if it’s a good idea to invest in it. Before you decide, here are a few things you should consider:

1. Profitability

Ideally, you would want the company you invest in to have some, if not all, the abovementioned attributes, you also want to ensure that it is profitable. Contrary to popular belief, an ESG fund is not the same as a charity. It's like any other mutual fund – that is, focused heavily on returns along with sustainability. According to Value Research, the Nifty 100 ESG Index has generated average returns of 10.9% since inception, and the figure is only expanding.

2. Sustainability

Climate change has been one of the most-talked-about subjects of the decade around the world. We live in a time when companies must think about sustainable business models, and investors must carefully consider the kind of organizations they support. By helping the growth of ethical companies that follow practices that favor sustainability, you make a difference in the planet's future. This is what an ESG mutual fund measures. It’s an opportunity to work towards the betterment of society at large without compromising on your financial goals.

3. Diversification

One of the thumb rules of investment is diversifying your portfolio because it helps in navigating the market’s volatility. However, when it comes to ESG funds, this rule is difficult to abide by.

ESG companies have generally been large-cap stocks, which means you might miss the opportunity to invest in mid-cap and small-cap stocks. The funds, by nature, also exclude several large sectors with great earnings potential. So, your choice while selecting funds narrows and exposes you to greater risk than a diversified portfolio does.

Additional Read: 7 Reasons to Invest in Mutual Funds

Conclusion

It's worth noting that ESG mutual funds are a relatively new concept, and there isn’t enough data to offer accurate assessments of their performance over time in the Indian markets. However, the human conscience plays a critical role in the decision to invest in an ESG fund. There’s no doubt that socially responsible enterprises are the future and investing in them is an ethical alternative, but how these funds perform in the long run is yet to be seen.