Mutual Funds: Balancing ethics with performance

Mutual Funds: Balancing ethics with performance

India’s first socially responsible investing (SRI) mutual fund (MF) scheme, Fortis Sustainable Development Fund (FSDF), completed three years in April. Targeted at investors-with-a-conscience, the fund was launched with much fanfare, but has failed to enthuse investors.

FSDF returned 4.82% in the past three years. As per data provided by mutual fund tracker, Morningstar India, large-cap funds (the category in which it places FSDF) returned 9.42% over the same time period. At present, its corpus is Rs6.78 crore, down from Rs58 crore it collected when it launched its new fund offer in April 2007. So, what went wrong?

The concept entails investing in companies without compromising on values. MFs that follow SRI principles look at financial parameters and key ratios before investing in companies, but also consider their values and morals.

Some SRI funds avoid investing in companies that pollute the environment, while others avoid companies that are known to be inhospitable to, say, gay and lesbian employees or ignore minority employees. There are other parameters, too. Some SRI funds avoid tobacco and liquor companies, while others target investors of specific religious community like Christianity and Islam.

According to a report by the US-based Social Investment Forum, between 2005 and 2007, social investing grew by 18%, increasing from $2.29 trillion in 2005. The report adds that nearly $1 out of $9 under professional management in the US goes into socially responsible investing. As of 2007, there were 260 socially screened MF schemes in the US, with assets of $201.8 billion, up from just 55 SRI funds in 1995 with $12 billion in assets.

Socially responsible investing: Here, typically, fund houses run several filters to check a company’s responsibility quotient, chiefly towards society at large or towards environment.

Says Sunil Sinha, head and senior economist, Crisil Ltd: “Factors such as environment, social and corporate governance are impartial to the top-line (sales) and bottomline (profits after expenses) of companies. There are large numbers of investors who are not just satisfied with the financial performance of companies." Sinha also says that a company’s future financial performance can sometimes depend on how well they manage their risks and also environment, social and corporate governance (ESG) issues. Here’s where FSDF broadly fits in.

Ethical investing: Another branch of SRI investing—albeit not straying too far from it—is ethical investing. There’s actually a thin line between ethical investing from SRI investing. For instance, India’s first ESG index, the Standard & Poor ESG index, consists ICICI Bank Ltd which came under fire for using unconventional methods for debt recovery. Later, the Reserve Bank of India (RBI) came down heavily on banks using coercive methods to recover dues.

“All companies undergo a stringent two-stage process. The first stage involving 197 parameters screens on transparency on information available. The second stage screens them on their conduct based on whatever news, information or reports are available in the public domain, which if it reports any negativity, adversely impacts a company’s overall rating. If a company has scored high on the basis of its disclosure practices at the first stage but its conduct is less than perfect then it is penalized at the second stage to arrive at the final score. However, despite being penalized for its ESG conduct at the second stage if a company still makes it to the final list we do not impose any biases and let it be part of the index. This ensures that the S&P Crisil methodology is based on objective criteria and not subjective factors," says Sinha. Further, ICICI Bank’s initiatives in microfinance lending as well as achieving penetration in banking services scored for the bank.

Shariah investing: The third branch of ethical investing is Shariah investing guided by Islamic laws. Muslims are required to follow strict do’s and don’ts as part of their lifestyle. Liquor and tobacco firms are forbidden, for example. “Even on earnings, there are strict rules. You can’t earn by doing anything that’s prohibited under Islam, such as gambling and such means," says Zafar Sareshwala, managing director, Parsoli Corp., a brokerage house specializing in Shariah investing.

Shariah-specific MFs invest in companies that conform to the Shariah norms and are shortlisted by Shariah advisory firms such as Parsoli. At present, there are two Shariah funds in India—Taurus Ethical Fund (TEF; actively managed) and Benchmark Shariah BeES (SB; passively managed). Tata Select Equity Fund is also said to be investing in Shariah-approved sectors.

Shariah laws prohibit investments in companies whose debt to market capitalization ratio is less than 33%.

A company whose net receivables (the money that is due to the company) is at least 45% of its gross net worth is also avoided. Large infrastructure companies, therefore, typically, get weeded out.

The fund leans on rating agency Crisil’s methodology to filter out companies that don’t meet their ESG criteria. Crisil rates the top 500 companies by market capitalization. Among these companies, FSDF looks at only the top 300 companies and further those with a market capitalization of Rs200 crore or more.

Crisil’s exercise was a result of winning a competition put out by the International Finance Corp.—part of the World Bank—in 2007 to frame guidelines on evaluating companies based on their ESG quotient and offering them to international investors with a conscience investing in India. Subir Gokarn, now RBI’s deputy governor, headed this project then when he was with Crisil; Sinha was a member of this team. Around the same time, Fortis Investments (erstwhile ABN Amro Asset Management Co. Ltd) launched FSDF and joined hands with Crisil for the ESG filters.

Now Crisil’s ESG evaluation is an annual exercise. Using its own methodology, Crisil and its parent company Standard and Poor’s devised the S&P ESG India index of 50 companies. The components of this index change once a year when Crisil runs its ESG parameters.

It seems like ages back when, in front of a packed press conference, Nikhil Johri, CEO, Fortis Investments, announced the merits of sensitizing ourselves to a company’s social and environmental behaviour before investing in it. Three years down the line, Johri admits “the product is ahead of its time in India".

Sinha said that in the wake of increased shareholder activism and also by non-governmental organizations (NGOs), regulations also catch up and force companies to look inwards. “Companies that toe this line make profits with a motive, to make a difference," adds Sinha. He cites the recent activism against British mining company, Vedanta Resources Plc, whose Indian subsidiary was denied final clearance to mine the Niyamgiri hills of Orissa for bauxite.

There’s no harm in being ethical about investing, but, at the end of the day, if your investments do not match your expectations, there’s bound to be disappointment.

Fortis’s performance in most of its other equity funds also are not inspiring. Except for Fortis Dividend Yield Fund, which has a five-star rating by Morningstar India, all its other equity funds are out of the top Morningstar quartiles.