ESG Funds - What Is Meaning, How It Works and Types (2024)

ESG (Environmental, Social, and Governance) mutual funds are gaining popularity among investors who want to align their investments with their values. These funds invest in companies that meet certain criteria related to environmental sustainability, social responsibility, and corporate governance. In this article, we will give you a basic overview of what ESG mutual funds are and how they work.

What are ESG mutual funds?

ESG mutual funds are a recent trend in India’s investment landscape. ESG stands for Environmental, Social, and Governance. These funds invest in companies that meet specific criteria in these three areas.

• The Environmental aspect considers a company’s impact on the environment, including its carbon emissions and waste management practice.
• The Social factor focuses on employee welfare, gender equality, and contributions to social causes.
• The Governance component emphasizes regulatory compliance, ethical conduct, and strong internal controls.

While ESG investing aligns with sustainable practices and societal impact, it’s important to note that most ESG funds in India do not have a long-term track record yet. Therefore, investors should carefully consider their personal investment goals and risk tolerance before investing in these mutual funds.

How does ESG investing work?

ESG investing in India involves considering a company’s environmental, social, and governance performance alongside traditional financial metrics. ESG-compliant companies focus on sustainable practices, employee welfare, gender equality, pay parity, and strong internal controls against wrongdoings.
The level of ESG compliance is determined by an ESG score allotted by research organizations. TheSecurities and Exchange Board of India (SEBI) has introduced guidelines requiring the top 150 listed companies to disclose their ESG-related activities (FY 2023-24). This has enhanced transparency and encouraged companies to improve their ESG practices. ESG investing presents significant business opportunities for companies in India. By adopting sustainable practices and focusing on ESG factors, businesses can enhance their operational efficiency, reduce risks, attract capital from responsible investors, and gain a competitive advantage in the market.

Types of ESG funds

In India, the Securities and Exchange Board of India (SEBI) has proposed five new categories under the ESG scheme.

1. Exclusions: This category excludes companies that do not meet certain ESG criteria. For instance, companies involved in activities that have a negative impact on the environment or those with poor governance practices may be excluded.
2. Integration: In this category, ESG factors are integrated into the traditional investment process. This means that along with financial performance, ESG factors are also considered while making investment decisions.
3. Best-in-class and positive screening: This category involves investing in companies that are leaders in their respective industries in terms of ESG performance. Positive screening involves selecting companies that not only meet basic ESG criteria but also demonstrate superior ESG performance compared to their peers.
4. Impact investing: Impact investing refers to investments made into companies, organisations, and funds with the intention to generate a measurable, beneficial social or environmental impact alongside a financial return.
5. Sustainable objectives: This category includes funds that invest in projects or initiatives that are aimed at achieving specific sustainable development goals.
6. Transition or transition related investments

Each of these sub categories offers a different approach to ESG investing, allowing investors to choose the one that best aligns with their personal values and investment goals.
Minimum 80% of the total assets under management (AUM) of ESG schemes shall be invested in equity & equity related instruments of that particular strategy of the scheme (as per the above specified sub-strategies).

How are ESG scores calculated?

ESG (Environmental, Social, and Governance) scores are used to evaluate a company’s ethical practices and sustainability. In India, this involves analysing over 1000 pieces of data, which form more than 500 indicators.
Each piece of data and indicator is scored, with importance assigned to each indicator. The company’s risk management framework is also scored. These scores are then combined to form the overall score.
The scores are divided into three categories: Environmental, Social, and Governance. These categories are further split into 19 main themes and 35 key issues. The final ESG rating shows a company’s sustainability, potential for growth, and future performance.

Benefits of investing in ESG funds

Here are some advantages they offer:

• Sustainable investing: ESG funds put money into businesses that care about the environment, the well-being of their employees and society, and good business practices.
• Risk reduction: ESG funds can reduce risks by choosing to invest in good quality companies that are expected to grow sustainably. For instance, a company with good business practices is less likely to get into legal trouble that could lower its stock price.
• Diversification: ESG funds help spread out investments because they consider different factors - Environmental, Social, and Governance. This can lead to a better spread of investments.
• Long-term performance: Over time, ESG funds usually do better than traditional funds.
• Social and environmental benefits: When you invest in companies that meet ESG standards, you’re indirectly helping the environment and social causes.

How and where do ESG funds invest?

ESG Mutual Funds, a subset of Thematic Mutual Funds, focus on investing in socially responsible companies. These funds evaluate potential investments based on environmental (E), social (S), and governance (G) factors. By aligning with companies that adhere to ESG principles, these funds seek to promote sustainable growth while considering the broader impact on society and the environment.

Moreover, ESG Mutual Funds aim to generate long-term wealth for investors by selecting companies with robust business models capable of meeting sustainability criteria. Depending on the fund's strategy, investments may span various market capitalisations and even include overseas stocks that comply with ESG standards, offering investors a diversified approach to responsible investing.

Taxation on ESG funds

ESG mutual funds are taxed as mentioned below:

• Capital gains from ESG funds are taxed like any otherequity mutual fund.
• Short-term capital gains tax (STCG) applies if you hold the fund for less than 12 months, taxed at 15%.
• Long-term capital gains tax (LTCG) applies if you hold the fund for over 12 months, taxed at 10%.
• TheLTCG tax comes with a Grandfathering clause for gains above Rs. 1 lakh, exempting gains made before January 31st, 2018, from taxation.

Who should invest in ESG funds

Given the evolving nature of ESG funds in India, only a minority of investors currently feel confident incorporating them into their portfolios. The following types of investors may find ESG funds suitable:

1. Investors knowledgeable about the advantages and limitations of ESG fund investments.
2. Investors with a high tolerance for risk.
3. Investors with long-term investment goals.

How to choose the right ESG fund

Before choosing an ESG fund, carefully consider these factors:

1. Investment thesis: Understand the fund’s investment strategy and how it aligns with your financial goals.
2. Portfolio composition: Look at the types of investments and sector weightings in the fund, and whether they fit into your overall portfolio.
3. Total expense: Consider the cost of the fund, including management fees.
4. ESG factors: Evaluate how the security wise ESG score of the fund .
5. Performance and research: Review the fund’s past performance and any available articles or sources on its ESG features.

Also read:What is total expense ratio

Things to consider before investing in ESG mutual funds

ESG (Environmental, Social, and Governance) investing is gaining momentum in India, reflecting a growing interest in sustainability and ethical practices among investors. When selecting an ESG mutual fund for investment, several factors need consideration:

• Historical performance and sustainability: While past performance does not guarantee future success, analysing an ESG fund's track record against benchmarks and peers provides insights. ESG funds prioritise sustainability, investing in companies that adhere to ESG norms and contribute positively to society.Read more about, What is mutual fund history in India.
• Investment objective: ESG investing prioritises environmental, social, and governance criteria alongside financial metrics. Investors increasingly consider the societal impact of their investments, making ESG funds appealing due to their focus on ethical and socially responsible businesses.
• Investment horizon: ESG mutual funds typically require a long-term investment horizon due to potential short-term volatility. Investors should align their investment duration with the ESG theme, recognising its potential for significant returns over time.
• Suitability: ESG funds are suited for aggressive investors seeking sustainable and ethical investment opportunities. However, investors must assess whether the theme and fund align with their portfolio goals, risk tolerance, and investment horizon.
• Asset allocation: Diversification remains essential in investment strategies. ESG funds, while focusing on specific themes, aim for well-diversified portfolios.Fund managers may select stocks from various market capitalisations, with a preference for large-cap companies known for ESG compliance.

Disadvantages of ESG funds

Here are some disadvantages of ESG funds in India:

• Decreasing interest: Even with regulations promoting them and more knowledge about green economy and climate dangers, investors’ interest in ESG-focused funds is reducing over time.
  
• Money outflow: ESG-focused funds are seeing a consistent outflow of money, lessening the assets under management (AUM).
• High fees: Many of these carry high charges, which can eat into returns over time.
• Limited choices: It can be challenging, if not impossible, to find fully “green” companies to invest in, as most companies have some level of exposure to environmental or social issues.
• Less diversification: ESG can lead to less diversification of investments.
• Dependent performance: The performance of ESG funds is highly dependent on the underlying companies and industries in which they invest, which can make them volatile.

Risk associated with investing in ESG funds

• Risk in performance: ESG funds place emphasis on companies demonstrating a strong commitment to environmental, social, and governance factors, fostering long-term benefits. Yet, these funds might not exhibit short-term performance similar to regular funds. It's important to note that companies embracing sustainable practices often yield superior performance in the long run.
• Diversification challenges: ESG funds may display concentration in specific industries, like renewable energy, potentially impacting returns due to a lack of diversification. Returns could be affected if a particular sector or industry encounters challenges.
• Impact of regulatory shifts: ESG criteria are shaped by government regulations. Consequently, any alterations in governmental rules and regulations have the potential to influence thefund's performance. Understanding and navigating these risks are crucial for investors venturing into the ESG landscape.

Remember, the goal is to find a balance between your investment objectives and your values.ESG funds allow you to invest in companies committed to sustainable practices, contributing positively to society while also seeking financial returns.

Difference between ESG Funds and traditional Funds

Here's a summary of the key differences between ESG Funds and Traditional Funds according to the webpage you linked:

• Investment criteria: ESG Funds prioritise companies with strong Environmental, Social, and Governance (ESG) practices. Traditional Funds focus on a company's profitability, past performance, and growth potential.
• Risk management: ESG Funds consider a company's ESG practices as a way to manage risk. Traditional Funds use a variety of methods for risk management.
• Financial performance: ESG Funds may prioritise factors like sustainability over short-term returns. Traditional Funds focus on maximising financial returns for investors.
• Societal impact: ESG Funds aim to create a positive social and environmental impact through their investments. The societal impact of Traditional Funds depends on the specific companies they invest in.

Conclusion: Should you invest in ESG funds?

While traditional funds focus solely on financial returns, ESG funds offer the potential to align your investments with your values. By prioritising companies with strong environmental, social, and governance practices, ESG funds can contribute to a more sustainable future. There's no guarantee of superior returns, but ESG investing can provide a sense of satisfaction alongside the potential for competitive growth. Carefully consider your investment goals and risk tolerance before choosing an ESG fund. Consulting a financial advisor can help you navigate the options and determine if ESG investing aligns with your financial plan.

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