4 min read.Updated: 27 Jan 2020, 10:59 PM ISTRenu Yadav
ESG funds invest in firms that are committed towards the environment and society and have lower risk of facing regulatory punishments, which in turn can boost returns. However, ESG funds may have limited investing options. Renu Yadav asks experts if it makes sense to invest in ESG funds
There has been flurry of environmental, social and governance (ESG) funds recently. Axis Mutual Fund launched an ESG fund on 22 January, Quantum Mutual Fund came out with one in July 2019, and SBI Mutual Fund rechristened its equity fund to ESG fund in 2018. ESG funds invest in companies that are committed towards the environment and society and have lower risk of facing regulatory punishments or environmental controversies, which in turn can boost returns. However, ESG funds may have limited investing options. Renu Yadav asks experts if it makes sense to invest in ESG funds:
Chirag Mehta, Senior fund manager, alternative investments, Quantum Mutual Fund
ESG investing replaces the question: “How much return?" with “How much sustainable return?" Claims that you have to surrender returns to engage in sustainable investing are flawed. Evidence suggests it often boosts the risk-adjusted rate of return.
The impact of E, S, G factors (response to climate change, waste management, fair labour policies, ethical supply chains and so on) on a firm’s long-term financial prospects is often underestimated. But these risks can have an impact on the firm’s earnings over the long term, making them important considerations for investors. The importance of actively managing risks related to environmental and social trends, along with rising expectations for better accountability and corporate governance, presents challenges with far-reaching financial consequences.
Excellent ESG standards indicate a company’s overall quality of management. Investing in such companies is a time-tested way of wealth creation. ESG investing is intuitively appealing but is still evolving. One can allocate about 20% of their equity allocation to ESG funds as of now.
Investors usually want three benefits from a financial product—utilitarian benefits (returns), expressive benefits (their values, tastes and status to others) and emotional benefits. While rationality would suggest that investors should only target utilitarian benefits, investors often want expressive and emotional benefits as well. The ESG funds cater to the emotional benefits and, to a certain extent, the expressive benefits.
These funds don’t have any particular advantage over a regular well-diversified equity fund in terms of potential returns, but are more about alignment with investors’ value systems.For some investors, ESG investing is about investing responsibly in companies that engage in positive environment, social or corporate governance practices.
These funds will naturally have a “high quality" orientation and, hence, valuations will need to be taken into context. This is a new category and there is subjectivity involved in stock-picking as there is no clear definition of ESG. At this juncture, we will prefer to wait and evaluate the category over the next few years to derive conviction.
ESG funds limit investing universe of fund managers
Gifting vouchers is becoming popular. But the problem with them is they take money that can be used anywhere and convert it into money that can be used only at one retailer. My issue with thematic funds in general and, in this instance, ESG funds, is similar. You take money that can be invested into any company the fund manager believes will generate superior returns and force it into only a smaller set of companies that pass through a particular filter.
It is sensible for companies to focus on ESG issues as they develop strategies to run their businesses in the future. Companies that conduct themselves in line with sound ESG principles are likely to navigate the future minefields better. An MSCI report showed that companies with improving ESG credentials have, on average, outperformed by 14.4% in emerging markets and 5.2% in developed markets over a five-year period.
We are wary of fund houses launching ESG funds in a desire to not miss the latest investment wave. We would be happier if ESG factors became a part of the decision-making process for all investments alongside financial factors.
Jinesh Gopani, Head, equity, Axis Mutual Fund
ESG to become a core part of equity allocation
Long-term decisions in businesses have historically factored only the tangible costs of their processes. Investors have also used the same yardstick as the trade-off between financial risk and return. Sustainability is another factor which brings a holistic approach to investments. Incorporating the ESG thought process is no longer a luxury but a necessity. This change is a result of company stakeholders addressing sustainability challenges. Going forward, to make credible long-term assessment of sustainable growth potential of any business, assessing the impact through the ESG lens is imperative. This approach will give investors a better understanding of the company’s business.
There are intangible impact costs that the company invariably bears for not being ESG-compliant—be it costs associated with environmental damage or governance factors around management integrity. This, in turn, impacts investors’ returns. Considering all these factors, we expect ESG to become a core part of investors’ long-term equity allocation. We believe investors should add ESG fund.
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