ESG mutual funds will take time to catch on; it's not a switch: Kunal Kapoor, CEO, Morningstar

Environment, Social and Governance (ESG) focused mutual fund schemes, more popularly known as ESG funds, haven’t taken off in India. There are just 10 funds out there with collective assets under management of Rs 10,803 crore. Why aren’t they popular here, as they are in Europe and also the US?
Europe has set the agenda for ESG movement. ESG funds are also getting popular in the US as well. This is a long-term investment.

But at the level of individual companies, we’re seeing a change. Companies have started to care. ESG is in different stages of development in different parts of the world. You cannot snap your fingers and suddenly think it's (ESG) going to show up. It's a long-term process. In India, people are still just getting familiar with the merits of long-term investing.

ESG funds were one of the worst-performing funds in 2022

Do you think poor returns by ESG could be a contributing factor? According to ACE MF, ESG funds have underperformed the broader large-cap and flexi-cap funds over the past 1-year and 2-year time periods. No. What we should be asking is: Will the decisions I make have an impact on society? When you look at ESG funds from the point of returns, it becomes very narrow. Return is one part of an equation. Risk is another part of an equation. Personal choice is another part of an equation. And then measuring impact is another part of the equation. If you choose to do something for a certain reason, you need to be able to measure the impact of that choice. And the tools to do that are only now starting to come out in the market more meaningfully.

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Morningstar has started rating companies based on ESG parameters and then applying them to mutual fund schemes to know their ESG scores. What are your biggest observations so far? Yes, we purchased a firm called Sustainalytics in 2020. Sustainalytics has ESG-related data on individual corporates, including 450 companies that are here in India. We take the risk ratings and information on individual corporates, and we then apply them at the (mutual fund) portfolio level.

Any big lessons? These are still early days. The level of engagement with fund houses and their seriousness is good and encouraging. I just came from a meeting with a fund manager, who was also wondering if ESG would become a material criterion. His fund house didn’t have an ESG fund, but when we got to talking about how he chooses the companies whose shares the fund buys, it appears they look at many ESG-specific filters. A lot of things that existing fund managers are doing already have ESG imprints on them, even though these are not ESG labelled funds.

For instance, a big part of ESG is Governance. It’s not new to see a lot of portfolio managers being mindful of the governance of companies in which they invest. Fund managers have begun investing in alternatives to the traditional oil and gas companies, such as wind and solar. If you don’t evaluate such factors, you are at a disadvantage. Certainly, there is momentum.

Kunal Kapoor, CEO of Morningstar invests a small portion of his portfolio in India through an ETF focussed towards India and also through emerging market and global funds that invest in India

Do you foresee a time when all existing schemes would have adopted ESG, and there wouldn’t be a need for a separate ESG fund? Easier for investors, too, isn’t it? I think you can do both. It’s like ‘risk’. Till 20-25 years back, when Morningstar really started to focus on ‘risk’ as a factor that investors should consider, people used to say, “Why bother about risk? It’s all about returns.”

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Today, everybody looks at risk. Over time, they just become factors. Unless, investors ask for personalised strategies, in which case a non-ESG strategy might still persist.

A lot of Indian investors invest in the US and specifically in technology funds. But the 2022 crash in the US tech sector has left many investors with a loss. Does the sector still hold merit if someone wants to invest there now? Technology sector returns have been good over the past decades. There has been 12 months of bad news. Stocks have gotten over-valued, but they have come back to reality as interest rates have gone up. Today, when our analysts look at the tech sector, we see that some of our best ideas today are in this sector. We think that many of the companies that have been beaten down in the last year or so are quite attractive and are among our most significantly undervalued today.

Investors must continue with their allocation towards US tech stocks and funds.

Coming back to India, the Indian MF industry has about 45 fund houses. But there are hardly any foreign fund houses in the top 10 or so — Indian-born fund houses dominate. How do you see the landscape? Yes, it has been tough for foreign fund houses in the Indian market. And I don't necessarily see that changing anytime soon.

There is a lot of localisation already. But fund houses also need to look beyond the larger Indian cities to be able to grow meaningfully. Perhaps there has been a lack of a strategy in that area.

Also, India has not provided the kind of scale that they can get elsewhere. That has been a challenge.

The role of mutual fund ratings came under a cloud when despite ratings, some fund houses went through a bad phase in Covid-19. Research firms such as Morningstar rate funds on the basis of publicly available information. But is it possible to go beyond, to catch the unknown that could affect your fund ratings, to avoid nasty surprises later on? What’s been your biggest lesson from the COVID crisis? The MF industry has done a pretty good job of being a caretaker of investors’ assets. You don't hear of big blow-ups like in the cryptocurrency space. Think about it on a relative basis.

The lesson for us has been to tighten our research more during tough periods where liquidity can become an issue in the midst of huge outflows. That’s the big takeaway for us.

Has your research evolved as a result? Research is always evolving. We're always trying to make it better. But I wouldn't say it has radically changed. Our ratings have been quite successful in predicting performance. We are always tinkering on the margins. But no need to rotate or change course.

Can we solely rely on ratings? What about the sudden time bombs, shocks? Investors should always use ratings as part of an overall evaluation. Start with understanding your own risk profile, why you wish to invest in a particular category or scheme, then look at things like ratings, dig into the fund portfolio and read the research that Morningstar puts out.

Ratings give you a quick snapshot, but you need to go deeper. Ratings are a great entry point to sort and think about things. Then you’ve got to go deeper.

Do you think ratings can replace investment advisors? No. Advisors play an important part. They help fill out all the other pieces. Advisors can add a lot of value.

Multi-asset funds are suddenly becoming popular in India. These funds invest across equity, fixed income and even gold. Do you recommend asset allocation through these funds or is it better to separately invest in different schemes and manage asset allocation ourselves? Multi-asset funds in India have not caught on the way that they've caught on elsewhere in the world. I think there's still a culture here of people wanting to trade, wanting to move in and out of things.

The wonderful thing about multi-asset funds is you set it and you forget it. Outside India, multi-asset funds are popular as retirement plans. So, if you wish to retire in, say, 2050, you can put your money in a target date 2050 fund. Just contribute your money to it every month; the fund manages your asset allocation. And it will be mindful about how your allocation should move as you near retirement. I think those are great investments, they tend to be pretty cheap.

And I think for those who don't want to spend their days and nights monitoring the markets, it's a really good way to invest.

My take is this: if you like to trade, put 5 percent of your portfolio and do crazy things in there. That’s fine. But invest the rest sensibly. And the great thing about allocation funds is you can set it, forget it with the bulk of your assets. I think you're better off in the long run by keeping things simple.

Do you invest in India? How much percentage of your investments have you allocated to India? I own an ETF focused on India. It is a small part of my overall portfolio. I also own emerging market and global funds that can and do invest in India.