Mitigate accounting, disclosure and governance risks with ESG funds

Environmental, Social and Governance (ESG) investing has gained significant traction as sustainable investing practices take centre stage. ESG-focused investing has been present in India for a while. WhiteOak Capital Mutual Fund recently launched the ESG Best-in-class Strategy Fund for subscription.

“ESG is a structured and superior method for measuring the sustainability of companies by identifying risks hidden in a company’s operations. It has a material impact on a firm’s valuation,” says Chirag Mehta, chief investment officer, Quantum Mutual Fund.

On September 30, 10 ESG schemes managed assets worth Rs 12,079 crore. Of these, Mirae Asset, Nifty 100, ESG Sector Leaders, Exchange-Traded Fund (ETF) and its fund of funds (FOF) are passively managed schemes.

The sustainability pitch

Globally, regulators, rating agencies, and institutional investors have led the charge in promoting ESG investing.

“There are six subsets of ESG strategy suggested by the regulator, including exclusion, integration, best-in-class and positive screening, impact investing, sustainable objectives, and transition or transition-related investments. Asset Management Companies (AMCs) must invest at least 80 per cent of a scheme’s net assets in one of these strategies, while the remainder must align with the selected ESG strategy,” says Manuj Jain, director, head of strategy, WhiteOak Capital Mutual Fund.

ESG exclusions

ESG strategies first exclude businesses like gambling, tobacco, weapons of mass destruction, liquor, and intoxicating objects due to their detrimental impact on society. The remaining businesses are then ranked on ESG parameters.

Why choose ESG investing?

ESG investing mitigates risks such as questionable accounting, lack of disclosures, poor governance, and environmental damage.

“ESG investing leads to reduced regulatory risk, exposure to well-governed companies, a diversified equity portfolio, and potential for better risk-adjusted returns. It also aligns investments with personal values,” says Mehta.

Companies with high ESG scores are often large, established firms that are likely to create long-term wealth.

“Firms with strong governance and robust environmental and people policies and practices tend to have lower cost of capital. They tend to demonstrate better and sturdy long-term performance, profitability, and efficiency,” says Siddharth Srivastava, head of ETF product and fund manager, Mirae Asset Investment Managers (India).

Potential drawbacks

ESG investors can miss out when the excluded companies perform well.

“ESG funds may underperform in certain market cycles due to sector biases that arise from ESG-specific exclusion criteria. For instance, in recent times when energy, metal, and industrial sectors did well in India, the ESG theme lagged behind the broader market,” says Srivastava.

ESG investing is typically biased toward large-cap companies, which may show slower growth.

“ESG tends to be more biased towards large-cap stocks. Investors seeking pure mid- or small-cap exposure may avoid these funds. However, given current valuations, large-cap stocks look less expensive compared to their mid- and small-cap peers,” says Mehta.

Long-term allocation required

Investors looking to lower risks in their equity portfolios can consider allocating a portion to ESG funds.

“A 20 per cent equity allocation to ESG funds is a good start. As more evidence on ESG performance builds, investors may increase allocations. Sustainability drives performance over the long run, hence a time horizon of 5-10 years would be ideal,” says Mehta.

“Sector-agnostic ESG funds can be part of an investor’s core portfolio, particularly if they are large-cap or flexi-cap oriented. The investment horizon should typically exceed five years,” says Srivastava.

Invest through a systematic investment plan in these funds.