Investing With Purpose: Unlocking The Potential of ESG Investing

The purpose of every investment has to be the returns garnered, irrespective of its timeframe. But for today’s responsible investors, certain environmental, social and governance parameters are critical to park their funds. Vardan Pandhare underscores the practice of investing with purpose in this special report
 

In the realm of contemporary investing, conscientious investors are actively seeking out companies that prioritise sustainability as a core principle. They have a strong desire to comprehend the diverse facets that contribute to the stability and enduring success of the companies they choose to invest in. There is a growing demand for businesses that possess the ability to withstand the profound impacts of any crisis and consistently integrate environmental, social and governance (ESG) factors into their day-to-day functioning.[EasyDNNnews:PaidContentStart]
 

In fact, ESG investing is gaining significant traction on a global scale and India is also witnessing a surge in awareness and interest regarding sustainable and responsible investment practices. Presently, there are about 12 mutual fund schemes in India that are centred on the theme of ESG. In this special report, we will delve into a detailed exploration of ESG funds investing and provide valuable insights into what investors should know about this innovative investment format.
 

Development of ESG Investing

The evolution of ESG investing can be traced back to the 1960s when it was initially known as socially responsible investing. At that time, investors began avoiding investments in stocks or industries associated with activities such as tobacco production or supporting the South African apartheid regime. Although ESG investing is still in its early stages for Indian investors, the global landscape offers a wide array of nearly 3,000 ESG schemes for investment. In recent years, a range of sustainability challenges has emerged, including flood risks, rising sea levels, privacy threats, data security issues, demographic shifts, regulatory changes, and more.

These challenges have introduced new risk factors that investors must take into account. As businesses faced growing complexities on a global scale, investors started re-evaluating traditional investment approaches, leading to the rise of ESG investing. Over time, companies worldwide have increasingly prioritised their ESG disclosures, leading to the proliferation of numerous third-party ESG data and rating providers. ESG disclosures are reports that comprehensively assess a company’s long-term strengths and weaknesses related to ESG risks. Evaluating a company’s long-term financial health by assessing potential risks is an important step in screening stocks and building risk-appropriate portfolios.

Working of ESG Funds

ESG funds refer to mutual funds that belong to the thematic fund category. The investment philosophy of ESG funds can take various forms. One approach involves excluding ‘sin’ stocks, such as companies involved in the production of tobacco, alcohol, weapons, etc. Another approach emphasises impact investing, which aims to generate not only financial returns but also incentivize positive environmental or social change. In essence, impact investing involves deploying capital to address broad societal concerns. These funds revolve around the theme of investing in the equity of companies that demonstrate the following:

■ Environmental-friendly business practices
■ Positive social impact through their products or practices
■ Strong corporate governance and ethical standards.

ESG funds employ their own methodologies to assign ESG scores to companies and determine which companies qualify for inclusion in the fund. Typically, these funds prioritise sectors such as technology, financial services and consumer goods while avoiding energy, mining and utilities. While there are no specific sector exposure norms governing ESG funds, most of them place importance on a company’s carbon footprint, adherence to emission norms, efficient resource utilisation and sound governance practices.
 

ESG Funds Performance




■ Currently, there are 12 mutual fund schemes in India that focus on ESG as their thematic approach.

■ ESG-focused mutual funds, which are still in the early stages of development in India, have experienced a decline in their asset base by ₹2,020 crore during the fiscal year 2022-23. But, industry experts remain hopeful that these funds will garner increased attention in the forthcoming years.

■ Data compiled by Morningstar India reveals that as of March 2023, the combined assets under management (AUM) of the 12 ESG funds amounted to ₹10,427 crore. This figure represents a decrease of ₹2,000 crore or 16 per cent compared to the previous year’s AUM of ₹12,447 crore.

■ In comparison, the AUM of ESG funds in March 2021 stood at ₹10,998 crore and in the fiscal year 2019-2020 it was ₹3,605 crore.
 

Concerns Surrounding ESG Investing

Some of the concerns include:

■ Obtaining comprehensive data to thoroughly assess a company’s ESG practices is not easily attainable. There is a cost associated with gathering such data, which poses a challenge in accurately evaluating a company’s ESG performance. It requires extensive reporting from the company itself and thorough research from analysts.
■ The methodology used to determine ESG scores for companies is highly subjective. Without a standardised framework and established norms, there is ongoing debate and uncertainty regarding the credibility of a stock being considered a good fit for ESG investing.
■ Some companies may engage in ‘green-washing’ or superficially presenting themselves as ESG-compliant without making substantial changes. Detecting and filtering out such companies relies heavily on the competence of fund managers and the availability of reliable information.
■ Many ESG-focused funds may not have a well-established track record of performance. As a result, investors need to rely on their market insights and personal investment preferences when making decisions.
■ In India, there are a relatively limited number of funds specifically dedicated to ESG investing. However, investment managers and individuals can still integrate ESG factors into their investment strategies.
 

Myths Surrounding ESG Investing

While ESG investing may imply a simple strategy in itself, there are certain myths that need to be clarified:

1) ESG is Negative Screening — ESG investing is often mistakenly associated with negative screening where certain stocks are excluded based on ethical considerations. However, ESG investing takes a broader approach. It involves assessing and incorporating environmental, social and governance factors into investment decisions, aiming to identify companies with sustainable practices and positive impact.

2) ESG is Just Value — While values and ethics play a role in ESG investing, it is not limited to subjective judgments. ESG investing is rooted in the recognition that companies’ environmental, social and governance practices can significantly impact their long-term performance and risk profile. It goes beyond personal values to include an objective analysis of these factors.

3) ESG is a Jargon — ESG investing is far from being a mere buzzword or public relations exercise. The significant increase in global inflows into ESG funds in recent years demonstrates the growing commitment of investors to incorporate sustainability into their investment strategies. It reflects a shift towards aligning financial goals with positive environmental and social outcomes.

4) ESG Means Missing Good Returns — Critics argue that ESG investing sacrifices financial returns. However, numerous studies have indicated that integrating ESG factors into investment decisions can lead to competitive risk-adjusted returns. By considering sustainability factors, investors can gain insights into a company’s resilience, efficiency and long-term prospects.
 

ESG-oriented funds offer diversification across sectors and can be an integral part of a well-rounded investment portfolio. As ESG investing continues to evolve, risk-averse investors may opt to wait for more options to emerge. In India, the market is eagerly anticipating the introduction of passively managed ESG-oriented funds, which would further enhance risk management and promote sustainable wealth creation.
 

Investing in ESG Funds

Given the evolving nature of ESG funds in India, only a limited number of investors currently feel at ease incorporating them into their portfolios. Here are the types of investors who may find ESG funds suitable:
1. Investors who possess an awareness of the advantages and limitations associated with investing in ESG funds.
2. Investors with a high-risk tolerance who are willing to embrace the potential fluctuations that may arise from investing in ESG-focused assets.
3. Investors who have a long-term investment horizon and seek to align their portfolios with sustainable and responsible investment principles.
 

ESG Funds In Numbers

■ The number of stocks in existing ESG portfolios ranges from 38 to 52, whereas a diversified equity portfolio consists of 70 to 100 stocks.
■ The major sectors represented in the index are Financial Services, accounting for 29.37 per cent, Information Technology at 23.05 per cent and Automobile and Auto Components at 10.76 per cent.
■ Over the past year, the category has experienced an average return of -5.09 per cent. In three years, the category has yielded returns of 21.79 per cent, while over a fiveyear period, the returns are 11.01 per cent. 
 

Path Ahead for ESG in India

As regulatory bodies strengthen their oversight, the expectations for companies to achieve ESG compliance will intensify in the future. This will encompass a wider range of environmental norms and social impact considerations. Non-compliant organisations can anticipate rigorous penalties as regulators take a firm stance. ESG-compliant companies gain a significant advantage by being ahead of the curve. When more stringent regulations are introduced, they will already have established practices in place, making it easier to adapt and meet the new requirements. In contrast, non-compliant companies will face greater challenges as they strive to align with the evolving standards.

Furthermore, ESG-compliant companies are poised to seize significant market opportunities. As their non-compliant counterparts struggle to meet the emerging ESG norms, compliant companies can consolidate their market presence and capture the trust of investors. By prioritising sustainability, these companies enhance their credibility and reputation, further attracting investors who value long-term viability and responsible practices. In summary, the future of ESG in India entails a stricter regulatory landscape and increasing differentiation between compliant and non-compliant companies. Embracing ESG principles not only ensures regulatory compliance but also positions companies to thrive in an environment where sustainability, credibility and attracting investment converge. 

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