What should you know about the sub-category in ESG Mutual Funds?

Currently, the investor community is likely acquainted with the concept of “ESG investing,” a practice that incorporates non-financial criteria such as environmental sustainability, social responsibility, and sound corporate governance in the process of investing in companies. In December 2023, Kotak Mutual Fund renamed Kotak ESG Opportunities Fund to Kotak ESG Exclusionary Strategy Fund. Other asset management companies (AMCs) including ICICI Prudential, Aditya Birla SL, Axis, and Quantum, too, have also renamed their ESG thematic funds. This was prompted by the SEBI circular in July 2023 explicitly mandating AMCs to incorporate details of their specific ESG strategy in the scheme name. The delay in execution can be attributed to operational aspects such as AMCs getting clarity of ESG sub-categories before finalising the strategy. So here’s what MF investors should know.

New ESG sub-categories

Before the issuance of the July 2023 SEBI framework, “ESG” constituted a single category within thematic equity mutual funds. This resulted in funds positioning themselves as ESG-focused without adhering to specific criteria or ensuring transparency. In response to these concerns, SEBI introduced a comprehensive framework that delineates six distinct sub-categories under ESG, mandating clear disclosure of the chosen strategy in the scheme name. These categories are exclusion, integration, best-in-class & positive screening, impact investing, sustainable objectives, and transition or transition-related investments.

The ‘exclusion’ strategy, also known as negative screening, involves constructing a portfolio of companies while deliberately excluding those that do not align with ESG core values. This exclusion may be based on environmental factors (like fossil fuels), social issues (for example, tobacco, weapons), or governance practices (bribery, corruption). However, it should be noted that excluding entire sectors/companies may increase portfolio concentration risk. Currently, Kotak MF and ICICI Prudential MF have adopted this strategy for their respective ESG schemes.

For those who prefer not to exclude companies solely based on their business model, the ‘integration’ strategy becomes relevant. This approach integrates qualitative and quantitative ESG factors into financial analysis to evaluate a company’s overall risk and performance. For instance, considerations may include a company’s greenhouse gas emissions, reported in tonnes of carbon dioxide equivalent (tCO2e), posing a potential threat to the environment. Aditya Birla MF and Axis MF have currently embraced this strategy in their ESG schemes.

The ‘Best-in-Class’ strategy, implemented by Quantum MF, involves selecting companies based on their superior performance in ESG factors compared with industry peers, thereby widening the stock investment universe. Despite minor differences, the ‘impact investing’ strategy is oriented toward generating a positive social and environmental impact, whereas the ‘sustainable practices’ strategy is designed to harness long-term benefits from companies that have good ESG practices. Finally, the ‘transition-related’ investment strategy focuses on supporting companies in their journey towards sustainable practices, aiming to navigate and adapt to ESG considerations efficiently.

To sum it up, among the existing 10 ESG-oriented funds (two of which are passively managed), those managed by SBI, Quant, and Invesco are yet to be renamed. However, SBI MF and Quant MF investment strategies suggest a likelihood of following the exclusion strategy.

Tracking risk and returns

During the one-year timeframe, five out of eight actively managed funds demonstrated outperformance relative to the Nifty 100 ESG TRI benchmark, with returns ranging from 0.03-13.5 percentage points. However, over the three years, only three out of seven funds (excluding the Invesco ESG fund, given its less than three-year tenure) have surpassed the benchmark index. Notably, the Quant ESG MF stands out as the sole fund generating alpha in both periods, albeit with the caveat of exhibiting the highest standard deviation among all funds, signifying heightened volatility in returns.

It is imperative to highlight that the SBI Magnum Equity ESG fund boasts a substantial track record, though not originally launched as an ESG fund; it transitioned to this focus in May 2018. Despite its longer history, this fund, too, fell short of outperforming its benchmark over the one-year and five-year periods.

Investors takeaways

Currently, a majority of ESG funds allocate significant investments to well-established sectors such as banking and IT, resulting in limited exposure to emerging businesses within the green economy. However, the implementation of SEBI’s sustainability disclosure norms, specifically the Business Responsibility and Sustainability Reporting (BRSR) guidelines for listed companies, along with the introduction of new sub-categories, will help foster a more sophisticated and diverse investment universe for ESG funds in India. Usually, when there is a modification in the investment strategy of mutual funds, an exit option would be extended to investors, allowing them to sell without incurring an exit load fee. However, the existing ESG funds haven’t provided any such exit option implying that there is no major fundamental attribute change with their strategies.