What Are ESG Mutual Funds: Types, Benefits, and How It Works

Discover the principles of Environmental, Social, and Governance investing to kickstart your sustainable investment portfolio.
ESG Mutual Funds
4 mins
17 Feb 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 they 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. The Securities 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 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.

Read Also: What Are High-Risk Mutual Funds

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.

Read Also: Short-Term vs. Long-Term Investments in Mutual Funds

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.

Read Also: How to Compare Mutual Funds

Risks 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 the fund'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.

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Frequently asked questions

How do ESG funds differ from traditional investment funds in terms of their criteria?

ESG (Environmental, Social, and Governance) funds in India differ from traditional investment funds in their selection criteria. Traditional funds primarily focus on financial metrics, while ESG funds consider a company’s environmental impact, social responsibility, and governance practices.
ESG funds in India must allocate a certain percentage of their fund to ESG-compliant companies. The ESG compliance level is determined by an ESG score assigned by research organisations. This holistic approach makes ESG funds a tool for risk management and long-term value maximisation.

What are the key factors that ESG funds consider when selecting investments?

When ESG funds in India choose where to invest, they look at a few important things:

  1. Environment (E): They check if the company is doing things to lessen pollution, manage waste properly, and save energy and water.
  2. Social (S): They see how the company treats its employees and the community. This includes fair treatment of workers, equal pay for men and women, and efforts to help society.
  3. Governance (G): They make sure the company follows laws, handles complaints well, has policies to catch and stop bad behaviour, and controls its operations properly.

To measure how well a company does these things, ESG funds use a score given by research groups like MSCI, Sustainalytics, and Morningstar. This score can change based on new laws, standards, or actions by the company.

Are ESG funds exclusively focused on sustainable and ethical investments?

ESG funds in India do prioritise sustainable and ethical investments, but they aren't limited to these. They also consider companies' environmental impact, social responsibility, and governance practices. So, while sustainability and ethics are key, ESG funds also look at other aspects of a company's operations.

Why consider ESG investments?

Investing in ESG (Environmental, Social, Governance) is gaining traction in India as it provides valuable insights into factors impacting a company's financial metrics. This enables investors to make informed decisions, fostering conscious investing.

Does a high ESG score indicate positive performance?

A company's ESG score increases with greater disclosure, emphasizing transparency's role in governance. The score reflects a commitment to ethical practices, making it a positive indicator for investors.

Are ESG funds a worthwhile investment?

ESG funds exhibit consistency in limiting downside risks compared to traditional counterparts. Despite being relatively new, these funds demonstrate strong performance and resilience globally, irrespective of market fluctuations.

How does ESG differ from CSR?

While Corporate Social Responsibility (CSR) focuses on softer ethical aspects, ESG factors are quantifiable, measuring a company's sustainability and social impact. ESG provides a more comprehensive and measurable approach to evaluating corporate behavior than CSR.

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