What are ESG funds and how to invest in the best one?

Mutual fund investments come in various forms. You can pick equity funds for their potentially attractive returns or debt funds for their stability. If you want the best of both worlds, you can pick balanced funds that combine both equity and debt instruments.

Different funds, different characteristics. Each of these funds helps in fulfilling the different investment needs of the investors.

More and more investors have started investing in a more sustainable manner. Sustainable investing can be done in three ways – socially responsible investing, impact investing, and ESG investing.

know more about the first two categories, read our article on Impact Investing Vs Socially Responsible Investing on the Teji Mandi blog. As for ESG investing, let us get into its details here.

ESG investing involves ESG funds, which are a type of mutual fund scheme that follows the ESG investment theme. Let’s elaborate.

ESG Theme – the concept

ESG stands for Environmental, Social and Governance. The ESG theme encompasses companies whose activities and operations are conducive to the ESG trinity. Here’s how it works–

E as in Environmental

Companies whose activities do not harm the environment qualify under this category. Such companies take measures to reduce their carbon footprint, minimise pollution caused by their production or operations, have a good waste disposal system and also preserve natural resources like water.

S as in Social

Companies that contribute to the development of society, as well as their employees, qualify in this category. Such companies take measures to create gender equality, have pay parity between their male and female employees, provide employee wellness and benefit programs and also contribute to social causes.

G as in Governance

Corporate governance measures whether companies follow the regulatory framework of the industry that they operate in. Companies that have strong compliance measures, follow the regulations, conduct themselves ethically, have a strong whistleblower policy and take strict actions against internal wrongdoings are said to follow good governance. Such companies, then, qualify under the Governance parameter of the ESG trinity.

How are companies measured or ranked on ESG?

Organizations like Morningstar, MSCI, Sustainalytics judge companies on ESG standards. They allocate grades or scores to companies on their ESG practices. These grades and scores measure if the company is ESG compliant or not.

For example, as per MSCI grading, companies are graded as follows – 

AA or AAA – Leader

A, BBB or BB – Average

B or CCC – Laggard

Needless to say, companies in the AA or AAA category are stronger on the ESG parameters than companies in the lower parameters.

Morningstar, on the other hand, scores companies from 1 to 50 where 50 denotes the highest risk and 1 denotes the lowest.

What are ESG Funds?

ESG funds are thematic mutual funds that invest in companies that are ESG compliant. They are equity-oriented mutual fund schemes which invest at least 65% of their portfolio in the stock of ESG compliant companies. The fund, thus, invests in sustainable and socially compliant companies across all market capitalisations.

Features of ESG funds

Some of the salient features of ESG funds are as follows –

These funds are exposed to volatility risks since they are equity-oriented. However, for the risks that you take, the return potential is also high.

You can invest in ESG funds in a lump sum or take the SIP route, wherein you can invest in installments. If you choose the SIP option, the minimum amount of each instalment might start from Rs.500.

ESG funds come in both dividend and growth options. While the dividend option pays regular dividends, the growth option reinvests the profit earned by the portfolio for higher returns.

ESG Funds attract equity taxation. Short-term capital gains earned on redemption within 12 months are taxed at 15%. Long-term capital gains, however, earned on redemption after 12 months are tax-free up to Rs.1 lakh. If the returns exceed this limit, only the excess is taxable at a rate of 10%

Benefits of investing in ESG funds

Some of the benefits of investing in ESG funds include the following –

Doing your bit for the environment and

If you are a strong advocate for environmental or social causes or you want to do your bit for the society at large, ESG funds can be a good choice. By investing in companies that resonate with your sentiments, you can take a step towards supporting the causes that you believe in.

Potential for good

According to a Survey conducted by the CFA Institute across institutional and retail investors, 60% of the Indian investors said that they invested in ESG funds for higher risk-adjusted returns.

Being equity-oriented schemes, ESG funds can give you attractive returns over the long-term period. Moreover, since the companies follow stringent norms, they are less likely to wind up the business. As such, you can enjoy the potential for higher risk-adjusted returns. 

The returns are also inflation-adjusted so that your corpus keeps pace with the increasing economy. This can help you create a corpus for your financial goals and meet them. Read more about ESG FUNDS