Conservative investors with long-term goals may opt for ESG funds

Their recent underperformance vis-a-vis multi- and flexi-cap funds was due to predominantly large-cap exposure

Though the Environmental, Social, and Governance (ESG) fund category has given a reasonably decent category average return of 32.4 per cent for the year ended February 28, 2024, it has underperformed diversified equity categories. Flexicap schemes have given 36.9 per cent while multicap schemes have given 44.7 per cent over the same period. Should investors avoid these funds after this recent spell of underperformance?

As of January 3, 2024, 10 ESG schemes across various fund houses were managing assets worth Rs 10,946 crore. One of these schemes — Mirae Asset Nifty100 ESG Sector Leaders Exchange Traded Fund (ETF) — is passively managed.
 

Where do they invest?
 

ESG-based investing aims to identify businesses that score high on sustain-ability. Businesses such as liquor, tobacco, and gambling are excluded.
 

“ESG portfolios generally tend to have companies with robust corporate governance and are conscious of the social and environ-mental impact of their manu-facturing or business pract-ices,” says Mittul Kalawadia, senior fund manager, ICICI Prudential Mutual Fund.
 

Reasons for underperformance  
 

These schemes invest predominantly in largecap companies, which partly explains their underperformance compared to diversified peers. “Flexicap and multicap funds have done better than ESG funds as they have a higher allocation to small and midcap stocks, which have outperformed large caps,” says Siddharth Srivastava, head-ETF product & fund manager, Mirae Asset Investment Managers (India). Most ESG funds have invested around 70 per cent in largecaps.
 

Positive outlook
 

ESG schemes are expected to gain prominence as the global focus shifts towards environmental sustainability. “The outlook for ESG schemes remains constructive. As the world and India begin to focus more on clean energy and clean technology, with more stringent requirements pertaining to climate change, emission, people policies, ESG-compliant companies could possibly benefit more than others,” says Srivastava.
 

The largecap space, which has underperformed vis-a-vis mid and smallcap, could do better in the future, providing a fillip to ESG funds. “Valuations of growth companies, espec-ially in the largecap space, are in the attractive zone. Hence these funds could perform well in the medium term. Their long-term outlook remains good,” says S Sridharan, founder & chief executive officer (CEO), Wallet Wealth.
 

Restrictive mandate  
 

ESG schemes face the volatility risk associated with all equity funds. “Just because you are entering into an ESG scheme that focuses on the 3Ps, i.e., people, planet, and profit, it doesn’t mean your principal is safeguarded from volatility,” says Srivastava.
 

Also, the mandate of these funds ties up the fund manager’s hands. “The ESG theme could be restrictive in terms of the companies the fund can invest in. As a result, an ESG fund may miss out on certain themes in the market which may be doing well at a certain point in time,” says Kalawadia. Srivastava adds that depending on the selection or exclusion process, certain ESG funds may be biased against certain sectors which may bring additional risk of cyclicality.
 

Beware of ‘greenwashing’
 

There is no predefined definition of how to assess a company on ESG metrics. “Some funds may claim a company to be ESG compliant while other asset managers may not. Investors also need to be aware of ‘greenwashing’ where a company or a fund may claim to be ESG compliant but is not,” says Srivastava.
 

Who should invest?
 

An allocation to ESG theme funds can bring down the overall risk of an equity portfolio. Investors with long-term financial goals, such as retirement, should not ignore sustainable investing. “Conservative investors can choose ESG funds as they provide superior risk-adjusted returns,” says Sridharan.
 

Investors looking for largecap allocation may also consider ESG schemes. “ESG funds that are sector agnostic and are tilted towards large caps can potentially form part of an investor’s core portfolio,” says Srivastava.
 

Investors should only invest in an ESG fund after understanding its selection process, which should align with their investment objectives. Enter these funds through a systematic investment plan (SIP) or a systematic transfer plan (STP).