What you need to know about the new ESG equity funds

ESG stands for Environmental, Social, and Governance. ESG funds essentially apply these non-financial factors as part of their investment framework to identify material risks as well as growth opportunities in a company.

The year gone by might be remembered for the pandemic, but it was also the year when climate and sustainability issues got the necessary voice thereby bringing ESG funds into the limelight. Globally, the assets of ESG funds have grown rapidly. In India, it is still at a nascent stage with eight fund houses having an ESG equity fund; six of which were launched in 2020.

What are ESG funds?

ESG stands for Environmental, Social, and Governance. ESG funds essentially apply these non-financial factors as part of their investment framework to identify material risks as well as growth opportunities in a company. ESG funds can be in the equity or the debt space. But, as of now, all ESG funds in India invest only in stocks.

Typically, ESG risk scores are assigned to companies based on their environmental, social, and governance standards. For instance, in the environmental space, efficient disposal of waste or conservation of energy reduces environmental risk scores, while poor working conditions or labor standards increases Social risk score.

What’s the formula?

ESG score is Total exposure to ESG Risk minus Managed Risk.

The higher the ESG score, the greater is the ESG risk of a company. Any risk score which is about 30 is considered high and is usually avoided by ESG funds.

Is it any different from erstwhile ethical funds?

ESG might have evolved from socially responsible or ethical funds (which have been there for a while) but it’s different in its approach. Earlier, fund managers used value judgments and negative screening to arrive at companies to invest in. In ESG screening and analysis, it’s more specific as the fund managers incorporate the ESR risks while arriving at company valuations instead of just supporting a set of values or avoiding certain stocks.

How does it work?

Many ESG funds in India are benchmarked to the Nifty 100 ESG index which filters out companies that are high on ESG risk scores or controversy levels from the Nifty 100 list of stocks. These risk scores are assigned by Sustainalytics which is incorporated by NSE. Currently, there are 88 stocks that make the cut.

While ESG funds pick stocks from the Nifty 100 ESG stock universe, some also have a mandate to invest in midcap stocks.

Does the ESG factor compromise on returns?

In the traditional portfolio theory, the trade-off is between risk and returns in portfolio construction. However, this two-dimensional framework doesn’t incorporate information on the social and environmental characteristics of the optimal portfolio.

What would the ideal ESG portfolio be, if the ESG parameters were incorporated? More importantly, would it compromise on returns? Interestingly, a 2020 paper titled ‘Does the ESG Index effect Stock Return?’ found otherwise. Its authors studied Euro Stoxx 50 stocks and found evidence that companies scoring high on ESG factors reported excess returns and lower volatility. But it applied to a few companies from sectors like energy or utilities.

Since there is an insufficient track record of ESG fund performance in India, let’s look at the relative performance of local indices. Past performance indicates that NSE 100 ESG (TRI) has outperformed NSE 100 across time horizons – 1, 3, 5, and (nearly) 10 years. In the last 10 years, NSE 100 TRI has given an annualized return of 11.4% as against 12.9% for NSE 100 ESG.

However, it is difficult to say if the outperformance is only because of ESG factors. In fact, it is likely that market agents are only using ESG as a good proxy for gauging the firm’s financial soundness. Nevertheless, some top active large-cap equity funds have managed to outperform both these indices by a wide margin over the long term.

Data issues

In Europe, the regulator wants fund managers to provide more information about how ESG factors are affecting their investment strategies. In the US, driven by a powerful green lobby as well as huge ESG fund flows, companies are voluntarily making ESG disclosures and trying to reduce ESG risk.

ESG scores are only as good as the disclosures made. In India, ESG metrics are not yet part of mandatory financial reporting though some proactive companies are making standalone disclosures in their annual sustainability report. Moreover, poor regulations as regards data disclosures as well as lack of standardization make it difficult to make a meaningful comparison.

Should you invest?

With a lack of sufficient history of ESG fund performance, it is best to adopt a wait-and-watch approach. While many are predicting ESG to be the future way of investing it is still unclear how things will pan out. Perhaps till then, one is better off raising the climate and sustainability voice through alternate means.

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