Planning to invest in ESG funds? Start small, but hold for long term

They have the potential to create wealth by circumventing hidden risks, but have limited track record

Today is World Environment Day. If you have been asking yourself whether you can combine your concern for the environment with profitable investment, the answer is yes. Environmental, social and corporate governance (ESG) funds offered by mutual fund houses offer an avenue to do so. Nine such funds are available currently.  

Avoid hidden risks 

While selecting a stock, an ESG fund manager considers the impact of the company’s operations on the environment and the society. He also takes into account its corporate governance standards.

These funds don’t invest in corporates that pollute the atmosphere or follow exploitative practices towards their manpower. “Some of the parameters that are checked include how corporations respond to climate change, how good they are at water management, how effective their safety policies are against accidents, how they treat their workers, and so on,” says Chirag Mehta, senior fund manager, alternative investments, Quantum Asset Management.

Avoiding companies with poor ESG practices helps these funds avoid hidden risks that can blow up anytime. “Strong ESG companies are typically less exposed to tail risks such as environmental accidents or punishment from regulators,” says Mehta. In India, applying ESG parameters keeps out companies whose promoters are unfair to minority shareholders.

Limited track record

Most ESG funds have been launched in the past year or so, or were transferred from other categories after the regulator’s recategorisation norms kicked in in October 2017. “SBI Mutual Fund realigned one of its existing funds into the ESG category. All the other funds were launched during the past six months to one year. It is difficult to predict how they will fare,” says S Sridharan, founder, Wealth Ladder Direct. 

Paucity of quality data also makes ESG investing a challenge. “Though companies practise good sustainability practices, they don’t disclose adequate data on their activities,” adds Sridharan.

The AUMs of most schemes are low, and they are actively managed (barring Mirae Asset ESG Sector Leaders Fund), so their expense ratios tend to be high.

Small universe 

These funds can invest in a limited number of stocks. Old businesses that may be polluters and sin businesses (tobacco, alcohol, etc that can be profitable) get excluded. If their stocks perform better, ESG schemes could lag diversified equity funds.

Most ESG-compliant businesses are richly valued. “These stocks trade at a significant premium over normal stocks, so there is limited upside in the short term,” says Vishal Dhawan, chief financial planner, Plan Ahead Wealth Advisors. 

Start small

Only investors who understand the significance of ESG investing should enter these funds for the long term. “Invest for more than five years,” says Sridharan. Make a small allocation—of say 5 percent of your equity portfolio—initially. “Increase allocation as these funds develop a track record,” says Dhawan.