ESG Funds: Meaning & How They Work

ESG funds are part of the thematic mutual fund segment based on the themes of Environmental, Social, and Governance. By fulfilling ESG compliances, companies receive cooperation from both society and the government, providing them with an environment conducive to sustenance and growth. As a result, investments in such companies have the potential to provide stable returns.
 

How They Work?
Apart from running their businesses to earn profits, ESG-compliant companies also focus on the following aspects:
 

Environmental: The letter ‘E’ in ESG stands for Environment. ESG-compliant companies are considered environment-friendly as they either work in sectors with very low carbon footprints or take up green initiatives to minimize or eliminate environmental pollution. For example, a power-generation company producing renewable energy works in an environment-friendly atmosphere. Conversely, a power-generation company producing thermal power must take initiatives to minimize carbon emissions. Similarly, a company producing cotton cloth needs to treat the chemically polluted water from its coloring or bleaching units before releasing it into a water body or the surroundings.
 

Companies emphasizing clean or renewable energy, reducing pollution, having good waste management systems, focusing on preserving natural resources, and engaging in animal welfare activities may be included in ESG funds.
 

Social: The letter ‘S’ in ESG stands for Social. ESG-compliant companies are expected to produce things that are good or not hazardous for society and take up initiatives that benefit the neighbors and their employees. For example, a company producing tobacco products or any other product harmful to human health may not be considered good for society. On the other hand, a company producing non-hazardous products involved in employee welfare and spending a lot on CSR (Corporate Social Responsibility) activities would be a good fit for the “Social” tag in ESG.
 

Companies emphasizing promoting human rights, preventing child and forced labor, spending on health and safety, engaging in community activities, and maintaining good stakeholder and employee relations may be included in ESG funds.
 

Governance: The letter ‘G’ in ESG stands for Governance. ESG-compliant companies are expected to have a sound corporate governance mechanism, follow regulatory compliances, implement ethical conduct, prevent wrongdoing through stringent internal controls, and have effective grievance redressal mechanisms.
Companies emphasizing improving management quality, ensuring Board independence, upholding shareholder rights, and ensuring transparency of conduct may be included in ESG funds.
Hence, apart from financial factors like revenue growth, cash flow, and profitability, ESG funds focus on non-financial factors such as positive effects on the environment, social responsibilities, and good governance in a shift towards a sustainable business model.
 

Performance
The question, however, is: will returns take a hit if the focus shifts from financial factors to non-financial factors?
 

As ESG funds are in an early stage in India, long-term historical data is not available to predict if ESG investment is really sustainable. However, from the medium-term data of three years of the existence of most ESG funds in India, it can be predicted that the cost of adopting the ESG theme may not be very high compared to the performance of other fund categories.
 

From September 29, 2020, to September 29, 2023, ESG funds provided a 19.38% annual return, while their benchmark Nifty ESG 100 gave 20.32% and Nifty 50 gave 21.96% returns in the same period. Although the actively managed ESG funds couldn’t beat their benchmark (Nifty ESG 100) and Nifty 50, the performance over a longer term may clear the picture, provided the investors are willing to stay invested further.
 

Issues Related to ESG Funds
Apart from the short period of existence of ESG funds in India, there are other issues as well that impact them.
 

Lack of Guidelines: In the absence of proper guidelines, determining the right composition of ESG funds becomes difficult. As a result, fund houses face difficulties in constituting the portfolio of an ESG-themed fund, and investors face dilemmas in deciding which ESG fund is ideal to invest in. To overcome this, fund houses rely on ESG ratings given by private agencies, which depend on the criteria set by the agencies themselves. Some companies may also falsely project themselves as ESG-compliant to attract ESG-oriented investments. So, a few companies not fulfilling the ESG criteria may also get into an ESG fund.
 

Limited Choice: Fund managers may find it difficult to pick companies for their ESG funds as not many companies meet the criteria. This may hamper the diversification of the portfolio of an ESG fund, enhancing the risk. To mitigate the risk, a fund manager may have to include a few companies in the portfolio that are not strictly following the ESG criteria.
 

ESG Investment
ESG funds are relatively new in India. While the 3-year annual return (from September 2020 to September 2023) was above 19%, the Nifty ESG 100 benchmark and Nifty 50 outperformed the returns generated by the actively managed ESG funds. At present, not many companies are meeting the ESG criteria, and the lack of set guidelines makes it difficult for fund managers to choose the right picks.
 

Long-term data on the performance of the ESG funds are not available yet, and the market regulator SEBI is trying to set guidelines for this segment. meeting ESG criteria, which can affect fund composition and diversification.