By: Tavaga Research
What does ESG in investing stand for?
ESG stands for Environmental, Social, and Governance.
ESG investing is an up and coming style of sustainable investing in the markets. Sustainable investing means constructing a portfolio of stocks that stand out in terms of environmental, social, and governance factors.
Financial risks and non-financial risks pose a threat to the company’s bottom line. ESG investing aims to mitigate the forms of non-financial risk which are significant in the long-term. Companies are going-concern entities, and the companies that acknowledge the long-term impact on their surroundings are more likely to stay equipped for any uncertainty that may arise in the future. Therefore, ESG investing aims to take advantage of superior returns from such selected companies.
Why is ESG investing trending?
With every passing year, the globe has been setting records of causing adverse climate change. Global warming is actively contributing to melting glaciers, and the corporations are directly related to the emission of harmful gases into the environment. Australia had to deal with an adverse eventuality of wildfires that lasted for six months due to extreme heat. Indonesia witnessed the wrath of rising sea levels during the Indonesian floods. The cities closer to the coast are facing the everlasting threat of getting submerged. The cities away from the coast are dealing with drought and extinguishing groundwater levels.
As the emerging economies consume more resources to achieve new levels of growth, ensuring sustainable growth is of utmost priority. ESG investing strives to recognize companies with good practices toward their physical and social environment.
After all, how does one expect a company to last if the ecosystem enabling the company vanishes into thin air?
Practices prevalent in capital markets follow the money. Therefore, the idea of ESG investing is to reward sustainable business decisions. As more institutional investors and sovereign funds focus on stocks with high ESG scores, more companies are likely to welcome the trend.
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What are the ESG funds?
- Environmental-friendly business practices
- Positive social impact by the company products or practices
- Discipline in corporate governance and company ethics
Investment philosophy for ESG funds may be multi-faceted. One approach may be to directly exclude the ‘sin’ stocks, for example, stocks of companies marketing tobacco, alcohol, weapons, etc. Another approach is to place importance on impact investing. Impact investing is not only about generating financial returns but also about incentivizing positive environmental or social change. In essence, impact investing means providing capital to address widespread concerns that affect society as a whole.
ESG funds have self-developed methodologies of assigning ESG scores to companies and deciding which company qualifies to be a part of the fund. Typically, ESG funds prioritize technology, financial services, and consumer sectors and avoid energy, mining, and utility sectors. There are no norms for sector exposures governing such funds. However, most ESG funds place importance on a company’s carbon footprint, emission norms, resource utilization, and governance.
How is the global market for ESG funds?
The year 2020 has been groundbreaking for ESG funds globally. According to a report from Morningstar, both the number of funds and assets under management of such funds have doubled in the past three years. As of the second quarter of 2020, the funds guided by sustainable investing are managing approximately $250 billion. The US has followed in the footsteps of Europe and currently represents around 20 percent of the global AUM for ESG funds.
Investors across the globe have exercised caution by adopting the socially responsible way of investing. It is only poetic justice that ESG funds find their break whilst the pandemic grips the globe.
Which are the ESG funds in India?
The ESG fund market for India is still in its nascent stage. Indian market presently offers the following funds based on ESG considerations:
- SBI Magnum Equity ESG (Growth-oriented stocks with a large-cap bias)
The fund is the oldest ESG-based fund in India that was established on 01 January 2013. The AUM of the fund is Rs 2,173 crores as of 30 September 2020. The expense ratio for the fund is 1.36 percent. Return since inception for the fund is 11.73 percent.
Quantum India ESG Equity (Blended stocks with a large-cap bias)
The fund was established on 12 July 2019. The AUM of the fund is Rs 18 crores as of 31 August 2020. The expense ratio is 0.90 percent. Return since inception for the fund is 9.56 percent.
- Axis ESG Equity Fund (Growth-oriented stocks with a large-cap bias)
Having launched on 12 February 2020, the fund is the most recently listed ESG-based thematic fund. The AUM for the fund is Rs 1,755 crores as of 31 August 2020. The fund demands an expense ratio of 0.40 percent. The fund has yielded a return of 10 percent since inception.
The Axis ESG Equity Fund has outperformed the other funds, including the benchmark S&P BSE 500. The SBI Magnum ESG fund has been unable to beat the index mainly due to the high expense ratio of the fund. It is important to consider that the performance of the Axis ESG equity fund is recent and lacks a track record.
ICICI Prudential closed the issue of their ESG fund on Oct 05 and is waiting to be listed, which will make it the fourth ESG-based fund in India. Other fund houses such as DSP, Aditya Birla, Kotak, and BNP are awaiting approval from the market regulator on their draft filings for new fund offer.
Switzerland-based bank J. Safra Sarasin launched an ESG-focused fund in partnership with UTI Asset Management. The fund is named JSS Responsible Equity India fund and employs a bias towards growth stocks with high quality.
Another positive development in the arena of sustainable investing is the SEBI regulation in 2019 mandating the top 1000 listed companies to prepare an annual business responsibility report (BRR). Such an extent of the disclosure will make ESG assessment more robust and transparent.
ESG funds in India consider NIFTY 100 ESG TRI as their benchmark. Essentially, actively managed ESG funds make it their objective to outperform NIFTY 100 ESG TRI. The index presently has 88 constituents spread across 16 sectors.
The index gives weightage to stocks based on their ESG scores and free-float market capitalization. As per NSE, for a stock to form a part of the NIFTY 100 ESG index, the following eligibility criteria must be met:
- Stocks should form part of NIFTY 100
- Companies should have an ESG score
- Companies with a higher controversy score 4 and 5 (on the scale of 1-5) will be excluded
- Companies engaged in the business of tobacco, alcohol, controversial weapons, and gambling operations shall be excluded
Each constituent within a particular sector is capped at 10 percent. The index is reconstituted on a semi-annual basis.
What are the concerns underlying ESG investing?
- The data to holistically assess a company’s ESG footprint is not easily attainable. There is a cost associated with mining such data. Therefore, to accurately judge a company in terms of ESG parameters, there has to be extensive reporting on the company’s part and thorough research on the analyst’s part
- The method to determine the ESG scores for a company is highly subjective. In the absence of a streamlined framework and established norms, the validity of a stock being an ESG fit will always remain under question
- Few companies may indulge in window-dressing of results to be considered an ESG-compliant firm. Filtering through such companies will depend on the fund manager’s competence
- Most of the funds will not have a track record of performance. Therefore, the decisions of the investor will have to be based solely on the market view and personal investment preferences
- There are limited funds in India pursuing ESG-based investing. However, investment managers and individuals may still integrate ESG parameters within their investment strategies. Research companies, such as Morningstar, assign sustainability ratings to assess how the stock ranks relative to other portfolio holdings
Busting myths surrounding ESG Investing
‘ESG means negative screening’
ESG investing is often confused with ethical investing. Both investing styles are separated by a fine line. Ethical screening employs negative screening, which clearly states the stocks that the fund will not invest in. ESG investing involves positive screening adopting an inclusive approach.
‘ESG means values’
ESG investing is more than just values and ethics. ESG investing is a way of risk mitigation for the portfolio. Historically, companies that made the headlines for the biggest scandals were the ones that did not prioritize ESG parameters.
‘ESG is just a jargon’
ESG investing is more than just a public relations project. The global ESG funds have witnessed major inflows over the past years that goes to show that investors are putting money where their mouths are.
‘ESG means foregoing superior returns’
ESG investing is carried out with a long-term view. Critics of ESG investing dismiss the recent outperformance of sustainable funds calling it premature. However, ample research across the globe points to better risk-adjusted returns for ESG strategies.
ESG-oriented funds are well-diversified across sectors and certainly qualify to form a part of an investor’s portfolio. Given the evolving nature of ESG investing, a risk-averse investor may decide to wait out the transitionary phase and enter the market when enough alternatives are available. The Indian markets are still looking forward to passively managed ESG-oriented funds, that will lower the risk level and promote sustainable wealth creation.