Is It Worth Considering The ESG Theme?
ESG captures number of environmental, social and governance issues. Further, all these factors are non-financial in nature but are likely to have a great financial impact on the businesses. This article elaborates on whether investors should consider the ESG theme while investing
When it comes to investing in a company there are a lot of factors that a fund manager considers before doing so. There are different schools of thoughts: one believes in growth investing and the other believes in value investing. Also, some believe in having a concentrated portfolio and others believe in having a diversified portfolio. Even every fund house has its own investment philosophy, which they prefer to adhere with. Furthermore, there are funds that are quant-based with minimal human intervention in decisionmaking. In all these, there is a niche investment idea called ESG that takes a host of factors into consideration before investing in a particular company. ESG stands for environmental, social and governance.
Lately, we have witnessed that fund houses are busy launching ESG schemes. Aditya Birla Sun Life ESG Fund and Kotak ESG Opportunities Fund are the most recent ones. Further, in the month of November 2020, Mirae Asset ESG Sector Leaders Fund of Funds (FoF) and Quant ESG Equity Fund were launched. This said, eight out of 10 funds available in the domestic market with ESG theme were launched in the year 2020. In this article, we would understand what ESG theme is and whether it makes sense to include this in your investment portfolio.
Defining the ESG
Theme ESG is an acronym for ‘environmental, social and governance’. Here, to comply with the theme, the company’s performance on environmental, social and governance parameters is considered, besides other financial aspects. An important premise in this theme is that the companies that adhere to ESG principles carry the potential of delivering sustainable earnings growth in the future. Further, it also considers the company’s risk management, which means, how the company manages its operations in order to minimise the negative impact of ESG risk factors.
As we can see the above image, ESG captures number of environmental, social and governance issues. Further, you may have noticed that all these factors are non-financial in nature, but are likely to have a great financial impact on the businesses. Stakeholders, including investors, customers, suppliers and regulators, are getting more sensitive to issues like climatic changes, sustainable farming, sustainable mining, data protection and privacy, greater regulatory scrutiny and lifestyle changes, to name a few. And it is believed that weak ESG practices have the potential of increased business risk.
In years to come, there is a possibility that companies scoring high on sustainability front based on ESG parameters are likely to thrive and survive. Around 2,750 asset management companies (AMCs) representing over USD 100 trillion of assets under management (AUM) had signed the United Nations Principles for Responsible Investing (UNPRI) as on April 2020. It considers integrating ESG principles in investments among its most fundamental priorities. Even most of the foreign institutional investors (FII) use ESG principles while making investment decisions in Indian equities. That said, ESG principles are not just limited to equity investments but are also considered while investing in fixed income securities. Therefore, companies posting negative ESG may find it difficult to raise capital, which may raise their cost of borrowing and hence compromise their financial health along with investors’ returns in the medium to long term.
Ethical Funds and ESG Funds: What’s the Difference?
Overall, ethical funds and ESG funds might look identical, but they are indeed not the same. Ethical funds essentially are ‘Shariah’ (principles of Islam)-compliant. We might see some similarities between the principles of Shariah and ESG factors. Though, the ‘e’ and ‘g’ factors are more visible in Shariahcompliant funds owing to the presence of green sukuk and an additional layer of governance in Shariah, the ‘s’ factor has historically been less visible in ethical funds. The industry is slowly moving into this direction and ESG funds will have an edge over ethical funds.
Performance Matters for Investors
The things discussed above are fine, but do they hold true even in terms of performance? At the end of it all, non-performance of investment is the cost that no investor desires to pay. Therefore, in this section of the article we would be viewing how this theme holds in terms of performance. As there is limited net asset value (NAV) data available for ESG funds, we would be comparing the Nifty 100 ESG index with that of Nifty 100. The data for Nifty 100 ESG index is available from April 2011. Also, we would review the performance of two of the oldest ESG funds i.e. SBI Magnum Equity ESG Fund and Quantum India ESG Equity Fund. Though you might see the inception date of SBI Magnum Equity ESG Fund to be 1991, it would be baseless to take NAV data from there as in the year 2018 SBI Mutual Fund converted its SBI Magnum Equity Fund into an ESG fund. Therefore, it makes more sense to take its data from 2018.
As can be seen from the above graph, till the year 2018, Nifty 100 ESG index performed in-line with the Nifty 100 index. However, post that it started performing better than the Nifty 100 index.
Even looking at one-year, three-year and five-year average rolling returns, the ESG theme does better than Nifty 100 index. As such, it would be more interesting to see how SBI Magnum Equity ESG Fund and Quantum India ESG Equity Fund perform as against Nifty 100 index.
The above graph clearly shows that SBI Magnum Equity ESG Fund almost tracks Nifty 100 ESG index and also performed better than Nifty 100 index. Though it is quite early to comment on the long-term performance sustainability of ESG funds, the theme indeed looks promising purely based on returns. Even on risk measured through standard deviation, the fund is less volatile than its benchmark, albeit marginally.
Conclusion
ESG theme is quite popular in developed nations. However, it is yet to gain traction in India. Looking at the number of new funds launched with ESG theme, it would eventually attract investors’ attention in the near future. Presently, there are only two funds that have NAV history of more than a year. Therefore, it becomes too difficult to quantify and compare the performance of the theme with sound statistical robustness. Nevertheless, we do have the price history of Nifty 100 ESG index available since April 2011. Therefore, we have used the same for gauging the performance of the ESG theme. In our analysis, we compared the Nifty 100 ESG index with that of Nifty 100 index. Though the outperformance margin is not too high, it shows that in long term it certainly beats Nifty 100 index.
Now the big question is whether it makes sense to invest in ESG funds? We believe that the ESG concept is still new in India. Therefore, new investors or investors adhering to a financial plan should certainly avoid ESG funds. However, those who are seeking to create wealth in the long-term but don’t want to take high risk can consider investing in the same. Also, those who wish to further diversify their investment portfolio can have ESG fund in their portfolio. From a sustainability viewpoint the companies in ESG funds are certainly better off in managing the non-financial risks.