What are ESG funds and how to invest in the best one?

What are ESG funds

Mutual fund investments come in various forms. You can pick equity funds for their potentially attractive returns or debt funds for their stability. If you want the best of both worlds, you can pick balanced funds that combine both equity and debt instruments.

Different funds, different characteristics. Each of these funds helps in fulfilling the different investment needs of the investors.

More and more investors have started investing in a more sustainable manner. Sustainable investing can be done in three ways – socially responsible investing, impact investing, and ESG investing.

know more about the first two categories, read our article on impact investing vs socially responsible investing on the Teji Mandi blog. As for ESG investing, let us get into its details here.

ESG investing involves ESG funds, which are a type of mutual fund scheme that follows the ESG investment theme. Let’s elaborate.

ESG Theme – the concept

ESG stands for Environmental, Social and Governance. The ESG theme encompasses companies whose activities and operations are conducive to the ESG trinity. Here’s how it works–

  • E as in Environmental

Companies whose activities do not harm the environment qualify under this category. Such companies take measures to reduce their carbon footprint, minimise pollution caused by their production or operations, have a good waste disposal system and also preserve natural resources like water.

  • S as in Social

Companies that contribute to the development of society, as well as their employees, qualify in this category. Such companies take measures to create gender equality, have pay parity between their male and female employees, provide employee wellness and benefit programs and also contribute to social causes.

  • G as in Governance

Corporate governance measures whether companies follow the regulatory framework of the industry that they operate in. Companies that have strong compliance measures, follow the regulations, conduct themselves ethically, have a strong whistleblower policy and take strict actions against internal wrongdoings are said to follow good governance. Such companies, then, qualify under the Governance parameter of the ESG trinity.

How are companies measured or ranked on ESG?

Organizations like Morningstar, MSCI, Sustainalytics judge companies on ESG standards. They allocate grades or scores to companies on their ESG practices. These grades and scores measure if the company is ESG compliant or not.

For example, as per MSCI grading, companies are graded as follows –

  • AA or AAA – Leader
  • A, BBB or BB – Average
  • B or CCC – Laggard

Needless to say, companies in the AA or AAA category are stronger on the ESG parameters than companies in the lower parameters.

Morningstar, on the other hand, scores companies from 1 to 50 where 50 denotes the highest risk and 1 denotes the lowest.

What are ESG Funds?

ESG funds are thematic mutual funds that invest in companies that are ESG compliant. They are equity-oriented mutual fund schemes which invest at least 65% of their portfolio in the stock of ESG compliant companies. The fund, thus, invests in sustainable and socially compliant companies across all market capitalisations.

Features of ESG funds

Some of the salient features of ESG funds are as follows –

  • These funds are exposed to volatility risks since they are equity-oriented. However, for the risks that you take, the return potential is also high.
  • You can invest in ESG funds in a lump sum or take the SIP route, wherein you can invest in installments. If you choose the SIP option, the minimum amount of each instalment might start from Rs.500.
  • ESG funds come in both dividend and growth options. While the dividend option pays regular dividends, the growth option reinvests the profit earned by the portfolio for higher returns.
  • ESG Funds attract equity taxation. Short-term capital gains earned on redemption within 12 months are taxed at 15%. Long-term capital gains, however, earned on redemption after 12 months are tax-free up to Rs.1 lakh. If the returns exceed this limit, only the excess is taxable at a rate of 10%

Benefits of investing in ESG funds

Some of the benefits of investing in ESG funds include the following –

  • Doing your bit for the environment and society
    If you are a strong advocate for environmental or social causes or you want to do your bit for the society at large, ESG funds can be a good choice. By investing in companies that resonate with your sentiments, you can take a step towards supporting the causes that you believe in.
  • Potential for good returns
    According to a survey conducted by the CFA Institute across institutional and retail investors, 60% of the Indian investors said that they invested in ESG funds for higher risk-adjusted returns.

Being equity-oriented schemes, ESG funds can give you attractive returns over the long-term period. Moreover, since the companies follow stringent norms, they are less likely to wind up the business. As such, you can enjoy the potential for higher risk-adjusted returns.

The returns are also inflation-adjusted so that your corpus keeps pace with the increasing economy. This can help you create a corpus for your financial goals and meet them.

  • Potential to capitalise on changing preferences

Consumer preference is slowly changing as millennials are becoming more aware of the environment, social causes and good governance. As such, they back organisations that are in sync with their perceptions.

Moreover, the preference for investing in ESG compliant companies is increasing globally. As per a report by Bloomberg Intelligence, ESG assets are expected to exceed the USD 35 trillion mark by the year 2025.

So, as preferences are changing, investors are likely to add ESG stocks to their portfolios which would drive up the market price of such stocks. When you invest in ESG funds, you can thus capitalise on the popularity of ESG stocks and gain on your investment.

  • Professionally managed portfolios

Like all mutual fund schemes, ESG funds also offer a professionally managed portfolio wherein the stocks are picked and managed by experienced fund managers. The fund is actively managed to capitalise on stock market opportunities.

  • Tax effective

You can enjoy tax-free returns from your investment if you hold the fund for at least 12 months, and your return is up to Rs. 1 lakh. Even if the returns exceed Rs.1 lakh, the tax rate is marginal at 10%. You can, thus, save taxes on long-term gains and get attractive tax-adjusted returns.

  • Affordable investing

Lastly, by choosing the SIP mode of investment, you can invest in ESG funds in small and affordable amounts and build up your corpus.

How to invest in the best ESG Fund?

As ESG funds are gaining traction, many investors are adding them to their portfolios. If you also want to explore these funds and invest in them, here are some tips for picking the best one –

  • Historical performance

Investors look for returns when comparing ESG funds. Since the funds are equity-oriented, the returns are not guaranteed. However, the past performance of the fund can give you a good idea of what to expect.

Compare the funds on their past returns. Funds with the most consistent returns would be a better alternative. Though past returns do not guarantee future performance, they can show how the fund was managed and how the portfolio grew.

  • Sustainability factor

When investing in ESG funds, you need to check the sustainability factor of the underlying stocks. Check how the companies are rated in terms of their ESG compliance. Pick a fund that has the best-rated companies in its portfolio.

  • Portfolio composition

Besides checking the sustainability factor, also check for portfolio diversification. Being a thematic fund, ESG funds have limited exposure to stocks. As such, funds that have the maximum diversification would be better as they would help in risk mitigation. Choose a fund that has companies across all market caps for better returns at lower risks.

To learn more about portfolio diversification, read our article on stock investing in India – what is diversification of portfolio on the Teji Mandi blog.

  • Expense ratio

Lastly, check the expense ratio of the fund. The fund’s expenses eat into the portfolio returns, which, in turn, reduces the returns that you might get. Funds with lower expense ratios are better as they would give better returns on investments.

The key to finding the best ESG fund is comparison. With more than a dozen mutual fund houses operating in the market, there are too many choices available for you. You, thus, have to sift through the choices on the basis of the aforementioned parameters to find the best fund. This would help you earn the maximum possible returns and also diversify your portfolio with the addition of a unique theme.

Things to remember

When investing in ESG funds, here are a few points to remember –

  • ESG funds are risky by virtue of their thematic exposure. Have a suitable risk appetite when investing in them.
  • Investing with a short-term horizon might not yield the returns that you expect. Try to invest with a long-term perspective.
  • ESG funds have limited options when it comes to investments. Their portfolios, thus, might be a little restricted.
  • If you choose the dividend option, the dividends would be taxed at your slab rates.
  • There is no restriction on redeeming your investment. However, keep the tax implications in mind when you redeem.

The bottom line

ESG funds give you thematic investment. If you want to add the ESG theme to your portfolio, you can pick ESG funds for a diversified basket of stocks managed by experts. Know how to choose the best ESG fund for investment so that you can get the maximum bang for your buck.

Let TejiMandi guide you with active advice on portfolio management. The experts help you diversify your portfolio in a way that you are able to attain your financial goals by minimising your risk and maximising returns. Reach out to us on our website to get started!

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