What Are ESG Funds and How Do They Work?

The latest buzzword in the markets is ESG funds, a form of green investments. In simple terms, ESG funds can be defined as open-ended thematic mutual funds whose portfolio consists of equities and bonds of the companies assessed on environmental, social, governance factors. In 2020 alone, India witnessed 6 new ESG funds launch, and the new inflow to ESG funds shot up from a meager INR 68 crore to INR 678 crore in March 2021.

At the heart of ESG funds lies the desire to be socially responsible while investing. ESG funds are popular as they promote a sustainable style of investing — while the financials of a company are essential, they are not the sole criterion for certain investors for making a decision. They are also keen to assess the company’s environmental, social, and governance or ESG practices.  Companies that score higher on these parameters are likely to be more transparent about their accounts and have a good debt-to-equity ratio.

How ESG funds work is straightforward: shares and bonds of the companies ranking higher when evaluated based on sustainability and consciousness about the environment, sound corporate governance practices, and a commitment towards creating positive social impact through products and practices are given preference. This is especially true for the younger generation of investors who are more concerned about the impact of their decisions on society.

Before we delve into the benefits of ESG investing, let’s examine each parameter and how it is measured:

Environmental: This involves assessing the impact of a company’s activities on the environment. For instance, if a company uses natural resources sustainably for generating electricity on its premises, it will rank high on the environmental parameter.

Social: This involves evaluating how the company’s activities impact the lives of people and communities. Therefore, a company that makes significant efforts to ensure diversity in its workforce through equal employment opportunities will be considered to be socially responsible.

Governance: This pertains to the decisions taken by the company’s leadership for the day-to-day management of affairs of the company. For example, whether the management is receptive to the shareholders’ concerns would be one of the ways to assess its governance style.

How does ESG investing help the investors?

While the returns offered by ESG funds may not be astronomically higher when compared to regular mutual funds, there are still a host of advantages of making such investments:

Better risk management: As the company is already complying with the highest standards of ESG, you can protect yourself from inherently risky investments, which may ultimately erode your returns. For instance, the chances of investing in a company that may be ordered to shut down by the regulator due to its practices that negatively impact the environment are very low.

Niche investment filter to align investments to your values: You get an opportunity to align the investment with your value system as ESG funds only invest in such companies that demonstrate excellent environmental, social, and governance practices.

Have a high-quality portfolio: ESG mutual funds are not merely jargon. It is a great way to add assets to your portfolio that will truly pay off in the long run. In fact, a quick Google search will tell you that the companies involved in the biggest scandals across the world were those who paid little to no attention to their ESG parameters.

Are ESG mutual funds suitable for you?

In the world of investments, there’s no one-size-fits-all approach. The same holds for ESG funds as well.

If you see yourself as part of an environmentally and socially responsible pool of investors but finds it daunting to monitor the ESG parameters of each company individually, ESG mutual funds are a great option. Similarly, if making a social impact through investments is on top of your wish list and looking for capital appreciation over the long-term period, investing in ESG mutual funds is an excellent avenue. SIPs for most ESG mutual funds start as low as INR 1000, and you can enjoy 30 percent annualized returns.

However, bear in mind that standard practices and procedures for evaluating the individual parameters are still in their formative stages. Therefore, there is no litmus test to tell you whether the company is fully ESG compliant.

If you’d like to find about different ESG mutual funds you can consider adding to your portfolio, get in touch with our team of advisors at Moneyfront.