Should You Invest in ESG Funds

While there has been a lot of interest in environmental, social and governance (ESG) funds, a cause for concern is that in recent times the outflow has been more than the inflow, suggesting that investors do not find ESG funds a ‘profitable’ choice even though they may be high on the ‘social cause’ list. The article explores the reasons why ESG funds have failed to live up to expectations by comparing them to regular funds using certain tried and tested metrics. 

In recent years, environmental, social and governance (ESG) funds have garnered substantial attention both on a global scale and within India. This surge in interest mirrors the widespread global trend towards sustainable investing. However, the question of whether investing in ESG funds is a rational choice deserves a close examination, and we can turn to data to provide the answer. 

Performance of ESG
Funds Within the spectrum of different fund categories, ESG funds are a distinctive subset belonging to the thematic category. This thematic category also includes funds dedicated to energy, PSUs and MNCs, among others. To gauge the performance of ESG funds, we conducted a comparative analysis, pitting their returns against those of other funds within the same thematic category. Regrettably, the performance of ESG funds has not proven to be particularly robust when measured against the performance of other thematic fund categories. ESG, emphasising investments in companies that adhere to stringent environmental, social and governance criteria, has exhibited underwhelming results. 

This has been both in the short-term and over more extended timeframes. For example, ESG funds yielded a one-year return of merely 9.20 per cent, marking the lowest return when juxtaposed with the other thematic categories. Over a threeyear horizon, the ESG category demonstrated improved performance, generating return in the double digits at 16.17 per cent. However, it still trails behind most of its thematic peers. Its three-year performance fares better only when compared to the MNC sub-category, which achieved single-digit returns. Nifty 500 TRI that remains the benchmark for this category has generated better return in both one-year and three-year timeframes. Thus, purely from a return perspective, ESG fund do not score much. 

India currently hosts eight actively managed ESG-themed funds, excluding fund of funds or index funds. In contrast to the initial rush towards ESG mutual funds in 2020, these fund categories have faced a consistent outflow of investments, and the absence of new schemes has further diminished their assets under management (AUM). The last ESG fund was launched in 2021. Over the last 12 months, ESG-focused funds have consistently experienced net outflows, with the most substantial outflow of nearly ₹300 crore occurring in June. For the one-year period ending in June, ESG mutual funds witnessed a total loss of ₹1,684.84 crore, with a net outflow of ₹891.53 crore in 2023 alone. 

The disillusionment towards ESG funds can be attributed to the performance of funds. Since 2021, with the exception of the Quant ESG Equity Fund, all ESG funds have significantly underperformed their respective benchmarks. Notably, the Axis ESG Equity Fund has performed the poorest, delivering an annualised return in single digits in the last three years, thus falling significantly short of expectations. 

Below is the graph of the relative movement of the NAVs of the ESG funds. 

So, what does this mean for potential ESG investors? ESG funds are often chosen not solely for their potential to deliver the highest returns in the short term but for their alignment with the values and long-term goals of investors. Hence, ESG investments appeal to those who prioritise sustainability and responsible corporate practices. While one might observe lower one-year returns, the focus of ESG funds on risk mitigation, ethical governance and sustainable practices can provide a more stable and resilient portfolio over the long term and hence lower risk.
 
Risk Assessment
There are different ways in which the risk of an investment is measured. However, we will gauge the performance based on volatility in returns and drawdown of these investments. Standard deviation provides insights into a fund’s volatility or the degree to which its returns fluctuate over time. A higher standard deviation implies greater volatility and, therefore, higher risk. Investors can use standard deviation to gauge the consistency and predictability of returns. 

Funds with lower standard deviations are generally considered less risky, making them suitable for conservative investors. In terms of volatility measured by the standard deviation of a fund’s daily returns, we find that most of the funds have low volatility compared to the benchmark, Nifty 500 TRI with an exception of Quant ESG Equity Fund, which also happens to be best performing fund among this category. 

The next measure of risk is drawdown, which measures the peak-to-trough decline in the value of a mutual fund’s investment over a specific period. By examining drawdown, investors can understand how much a fund’s value can drop during challenging market conditions. A larger drawdown indicates a higher risk of significant losses, which is a crucial consideration for risk-averse investors or those with specific investment timeframes. When it comes to drawdown, we observe that most of the ESG funds have worse drawdown than the benchmark Nifty 500 TRI – the worst being ABSL ESG Fund, which saw a maximum drawdown of 26.21 per cent in the last three years. 

The following graph shows the drawdown of the ESGdedicated funds along with Nifty 500 TRI.
 

By considering both the above risk measures, investors can make more informed decisions based on their risk tolerance, investment horizon and financial goals. While some investors may be willing to accept short-term fluctuations in value (higher standard deviation), they may want to limit the potential for substantial losses (lower drawdown). On the other hand, more risk-tolerant investors may be comfortable with higher volatility and larger drawdown in exchange for the possibility of higher returns. Our analysis and comparison of these risk measures with the benchmark shows that though ESG funds are less volatile they tend to fall more than the benchmark. Hence, we do not find ESG funds providing any comfort in terms of risk management. As such, we will go one step further to analyse the risk-adjusted return for these funds. 

Risk-Adjusted Returns
We have taken three factors to calculate the risk-adjusted return. The first is Sharpe ratio, which measures the risk-adjusted return of a fund. A higher Sharpe ratio indicates better returns for the level of risk taken. It considers both upside and downside volatility. Among the funds, the Quant ESG Equity Direct Plan Growth Fund stands out with the highest Sharpe ratio, indicating strong risk-adjusted returns, while the Axis ESG Equity Fund lags behind, signalling weaker performance. What is worth noting is that all the funds have a positive Sharpe ratio. 

The Sortino ratio, similar to the Sharpe ratio but focusing exclusively on downside risk, is another valuable metric. Funds with higher Sortino ratios provide better returns per unit of downside risk, which is crucial for assessing their ability to protect against losses. In this context, once again Quant ESG Equity Fund exhibits strong downside risk management, outperforming all its peers, including the benchmark. 

Finally, the Calmar ratio, which gauges risk-adjusted returns by comparing average annual returns to maximum drawdown, highlights the funds’ ability to manage substantial downturns. Even in this measure, Quant ESG Equity Fund excels. These ratios provide a comprehensive view of a fund’s risk-adjusted returns and its ability to manage both upside potential and downside risk. Therefore, purely from a risk return perspective, only two funds look better placed – ICICI Prudential ESG Fund and Quant ESG Equity Fund. 

Fund Constituents and Concentration
From the above analysis it becomes clear that though there might be a moral reason for including ESG funds in your portfolio, there is hardly any reason for their inclusion in your portfolio except for a few if considered purely from a risk return perspective. To know the reason for such performance we checked the portfolio constituent of these funds. From the portfolio constituent of these funds at the end of September 2023, it seems that ESG funds have major exposure to the Large-Cap stocks. Funds like Kotak ESG Opportunity Fund have large exposure of 80.28 per cent, while Quant ESG Equity Fund and ICICI Prudential ESG Fund have exposure of less than 60 per cent in the large-cap stocks. 

Since ESG funds place major weight on large-cap stocks, we compared the performance of Nifty 100 ESG index, which is designed to reflect the performance of companies within Nifty 100 index based on ESG risk score with Nifty 100. There are 88 companies from NSE 100 that are part of Nifty 100 ESG. We compared these two indices with different parameters. Since they have a longer history, this gave us a better understanding of the performance of the ESG category. 

Nifty 100 ESG appears to be the better-performing index when compared to the standard Nifty 100. It has demonstrated higher total returns, better risk-adjusted metrics (Sharpe and Sortino ratios), a slightly higher CAGR and lower drawdown, as evidenced by the Calmar ratio. Even when we check the calendar year return, we see that Nifty 100 ESG performed better than NSE 100 most of the years. 

This suggests that in the longer period, ESG-focused investments have provided superior risk-adjusted performance. However, in the case of individual funds, the picture is not as clear since they have limited history. Besides, ESG-dedicated mutual funds might have a different set of constraints that might be leading to such a performance. 

Understanding ESG score This score ranges from 0 to 100 and evaluates performance based on three core factors: environment, society and governance. A high ESG score reflects commendable performance in these three areas, while a low score suggests inadequate action, potentially leading to losses due to regulatory penalties, environmental crises, and more. 

The Potential
The underperformance of funds can be attributed, in part, to the construction of ESG strategies in India. These strategies often employ an inclusion-by-exclusion approach, where certain sectors like coal and tobacco are excluded from investments, thereby narrowing the available investment universe. This approach appeals to investors with strong convictions against these sectors due to their adverse environmental and societal implications. As a result, most ESG funds in India tend to be heavily concentrated in holdings from sectors like banking, financial services, information technology and consumer staples, as companies in these industries typically score higher on the ESG criteria. 

For instance, a quick look at the table reveals a snapshot of companies held by these funds, and it is evident that many of them have significant holdings in companies like HDFC Bank, with seven out of eight funds also holding positions in ICICI Bank. This concentration within specific sectors can impact the diversification and performance of these ESG funds and underscores the importance of continuous monitoring and adaptation of ESG investment strategies to achieve a more balanced and effective approach.

 

However, as of July 2023, SEBI introduced new ESG metrics for mandatory disclosure through the BRSR Core (Business Responsibility and Sustainability Report) for specific listed companies in India. While SEBI has outlined a timeline for obligatory compliance under the BRSR Core, it has also mandated that ESG schemes invest a minimum of 65 per cent of their assets under management (AUM) in listed entities that have provided assurance on the BRSR Core. This requirement raises a fundamental concern about an overconcentration of funds in large-cap stocks, potentially sidelining Mid-Cap and Small-Cap stocks. 

Many mid-sized and small-sized Indian companies have yet to embrace ESG compliance, leading to a smaller and more concentrated pool of options for ESG schemes. Notably, the BRSR Core mandate will initially apply to 250 companies in FY25 and is expected to expand to encompass the top 1,000 listed companies by FY27. This broader coverage may offer fund managers a more extensive selection of stocks, potentially boosting the performance of ESG funds. In the long run, we believe that ESG funds may imitate the returns of their benchmark and are likely to perform. However, as of now, it is still some time before they really become attractive for investors.