What Are ESG Funds and How Do They Work?

The main motive behind the emergence of these funds is to encourage companies to give importance to environmental considerations, follow ethical business practices and also fulfil social responsibilities. There are three components in an ESG fund, i.e., environmental, social and governance. Let’s consider in detail each of these aspects:

The environmental component involves the carbon footprint of the company and sustainable practices taken by the company to reduce its carbon emissions. Apart from this, it factors in efficient solid waste disposal mechanisms and water and energy conservation practices. In simple words, we can say this factor gives weightage to efforts taken by the company towards a green and clean environment.

The social component gives emphasis on the welfare of the company’s employees and the overall society. These companies pay special attention to employee welfare, equal pay for equal work and actively participate in different social causes.

The governance component focuses on ethical corporate governance policies. A company shall become a part of the ESG portfolio if it diligently follows all regulatory compliances, has an effective grievance redress mechanism and a robust whistle-blower policy. From the above discussion, there is greater clarity regarding what ESG funds are, now it's time to venture into other dimensions of these investment plans .

Here are some things that one should consider before investing in ESG funds:

• Investing in ESG funds that consider factors beyond just potential does not necessarily imply low returns, i.e., it does not mean that if you are investing in responsible companies, they will give low returns.
• Some sectors like alcohol and tobacco companies, due to their inherent nature, may not be included in these types of funds. On the other hand, there may be some sectors which have a disproportionately high representation in the portfolio.
• This type of mutual fund was launched in India recently in 2020. Hence there is very little concrete historical data to carry out a thorough analysis of their returns.
• There are 4 key techniques that ESG Funds use to select their investments. These are exclusionary screening, positive selection, ESG integration and impact investment.
• Investments are primarily selected on the basis of ESG score assigned to companies based on computation carried out by research companies like Morningstar, MSCI, Sustainalytics, etc.

Some benefits of investing in ESG funds are as follows:

• These funds allow investors to synchronise their investments in line with the values and ideas they believe in.
• The ESG funds can serve as a balancing investment which enables individuals to diversify their portfolio and thereby mitigate overall investment risks.
• Investing in companies that pay special attention to the society and the environment will encourage other companies to pay equal attention to them and hence will bring a positive change in the way businesses conduct themselves.

Now, let’s shift our focus towards the limitations of ESG funds. Some of the drawbacks are discussed below:

• Management fees levied on these funds can be high. This ultimately has an impact on the net returns of the investors.
• These funds have a very narrow company base. In such a situation, these funds can have significant concentration risk.
• These are not completely green investments as every company will have some impact on the environment.
• As these have come into the Indian markets recently, it is difficult to predict the accurate performance of these funds in the long-term because of the lack of concrete historical data about their functioning.

As already discussed the ESG funds shall invest in companies which exhibit a high level of environmental and social consciousness. These mutual fund schemes have distinct scrutinising methods and weighting methods. On the other hand, a traditional mutual fund does not give due importance to environmental, social or corporate governance norms. These funds are only interested in generating high returns and in doing so may overlook the company’s environment and social exposure.

An ESG fund aims to bring about a positive change in the corporate world by focusing on companies which have a low carbon footprint and it gives investors an opportunity to align their investments with their values. Whereas conventional funds do not shy away from investing in sectors that might have adverse environmental or social impact like tobacco, alcohol, petroleum, mining, etc.