ESG mutual funds: Why these MFs may not be the right choice for investors (2024)

The bull market rally that began after the Covid lows proved to be a turning point for ESG (environment, social, and governance) investing. Investors shifted their focus from how much money companies make to how they make it. In response, fund houses in India, like their global counterparts, launched a raft of ESG thematic offerings to capture the trend. However, three years down the line, most ESG funds have failed to generate superlative returns despite filling up portfolios with the so-called ‘do-gooders’ of the corporate terra firma. The category has struggled to beat one-year and three-year returns of simpler products, such as large-cap funds and flexi-cap funds.

ESG investing is built on the way investee company treats the planet, cares about people, and is being governed. ESG-focused funds primarily invest in companies that are selected on ESG criteria as defined by their proprietary investment framework. The ESG theme garnered popularity in the post-Covid era, coinciding with the phase when investors sought a new plank to justify premium valuations of certain stocks. Between 2020 and 2021, eight new ESG funds were launched. In total, there are 10 ESG schemes today (eight actively managed and two passively managed) managing about Rs.11,000 crore investor assets.

Active funds employ sector-level and stock-level screening to identify ESG-compliant companies. Companies are included in ESG portfolios based on strength in one or two ESG parameters, not necessarily all three. While ESG scores/risk scores are an integral part of the investment research process, funds are not restrained by them. In July 2023, market regulator Sebi allowed AMCs to launch multiple ESG schemes with different sub-strategies like exclusion, integration, best-in-class and positive screening, impact investing, sustainable objectives, and transition or transition-related investments. ESG funds are required to allocate a minimum 80% of total assets to equities, following their specified strategy.

Following this, two ESG funds from ABSL and Axis specified that they would employ integration strategy, while two from ICICI Pru and Kotak said they would use exclusion strategy. In integration strategy, the fund considers ESG factors, along with financial ones, while deciding where to invest. On the other hand, those with exclusion strategy build portfolios by avoiding investments tied to certain ESG activities, business practices, or segments.

Average performance

ESG strategy is like a lion without claws as it has failed to boost the returns of ESG funds. Among the 20 equity fund categories, the ESG category with 33% absolute gain is ranked 16th in one-year time frame, while its 17.1% CAGR places it in a similar rank in the three-year time frame.

In the one-year period, six out of eight actively managed ESG funds have lagged the benchmark Nifty 100 ESG Total Return Index. In the three-year period, four out of eight have shown underperformance. ESG funds from Quant and ICICI Pru have been notable exceptions to the category trend, but overall, the ESG fund category has underperformed simpler equity fund categories such as large-cap and flexi-cap baskets.

From a portfolio standpoint, ESG funds are biased towards large-caps (55-79%). Except for Quant ESG’s concentrated portfolio (19 stocks), most funds have 40-55 stocks. The most frequently held stocks across ESG fund portfolios are ICICI Bank, Infosys, HDFC Bank, Axis Bank, Maruti Suzuki, TCS, Kotak Mahindra Bank, Bharti Airtel, Bajaj Finance, RIL, HUL, and HCL Tech.

ESG funds lagged largecap funds in past 3 years

Experts say generating high returns from ESG portfolios could be a tough task in India if one were to stick to large caps. While US markets have hundreds of large caps, in India there are 100 large caps. “ESG funds add another layer of selection to choose ESG stocks as per their framework. This could leave them with a much smaller universe. In this situation, it’s all about assigning accurate weights to get outperformance,” says Vikas Gupta, CEO and Chief Investment Strategist, OmniScience Capital.

Other experts say the ESG theme could struggle due to premium valuations. “Themes such as ESG may find it difficult to beat broad market indices in some markets as the emphasis on ‘quality’ might mean holding stocks with a slightly premium valuation that can curtail the upside,” notes Vidya Bala, Co-Founder, PrimeInvestor.in.

Due to portfolio positioning, most ESG funds haven’t been able to capture the market upsides in the last one- and three-year periods. However, the downside capture has been less than the market, staying true to expectations that firms scoring high in ESG offer a better cushion during declines.

Investors should understand ESG data’s challenges and reporting. ESG scores aren’t mandatory and there’s no standardisation for formal disclosures. This gives rise to greenwashing examples, where some companies selectively disclose positive ESG practices while concealing negative aspects. This makes it challenging to gauge firms’ actual impact on ESG criteria and select them for fund portfolios. Hence, ESG theme investing is not for every investor, especially if your sole aim is high returns. Consider your goals, preferences and risk tolerance before going for ESG funds as they are yet to see a full market cycle.