SEBI has introduced 6 new ESG flavours, but is there a case for investing in such funds?

SEBI requires ESG funds to invest primarily in those companies that have comprehensive Business Responsibility and Sustainability Reporting (BRSR) disclosures.

A few weeks back, SEBI allowed asset management companies (AMCs) to launch up to six different types of funds under the ESG category of mutual funds. With this expansion in scope of the environmental, social, and governance (ESG) category, it seems the regulator wants to support the increasing need for green finance by channeling more and more mutual fund investments towards ESG-complaint companies.

However, this will lead to further confusion for the end-investor, who is anyway overwhelmed with the multitude of fund categories and schemes that are on offer.

As a category, ESG funds never quite took off, and they have just over Rs 10,000 crore in combined AUM (assets under management) across a handful of schemes.

Six new ESG sub-categories

As explained in this article, ESG funds now come in the following six flavours: i) ESG-exclusion, ii) ESG-integration, iii) ESG-best-in-class & positive screening, iv) ESG-impact investing, v) ESG-sustainable objectives, and vi) ESG-transition or transition-related.

Per SEBI-defined investment criteria, at least 80 percent of the scheme’s assets needs to be invested in equity instruments relevant to that particular scheme.

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Now, while the intention behind this move may be fine, there are bound to be some practical difficulties. ESG fund managers, who are best placed to judge this development, feel that these new sub-categories will limit the number of companies to choose from in each bucket.

There is another issue here. SEBI requires ESG funds to invest primarily in those companies that have comprehensive Business Responsibility and Sustainability Reporting (BRSR) disclosures. Now, the BRSR data is mostly available for larger companies (read largecaps). So, till the time smaller companies have this, chances are that the pool of firms available for investment will have a largecap bias.

Is there a case for ESG investing?

ESG investing can offer a ‘feel-good’ factor as you may believe that you are, in a manner of speaking, contributing to environmental or social causes. But if we were to set aside this emotional angle, and look at it purely as an investment, then does it make any sense?

I have said earlier that ESG funds aren’t unique when you look under the hood. And since the pool of companies for all fund categories are the same, there’s bound to be some overlap between ESG funds and other category funds.

For example, the largest ESG fund in India currently, SBI Magnum Equity ESG Fund, has an AUM of Rs 4,999 crore. If you compare it with Nifty50, then it has a 47 percent overlap. And if you compare it with the flexicap fund of the same AMC, then the overlap is around 39 percent. Similarly, the second largest ESG fund in the market, the Axis ESG Equity Fund (AUM Rs 1,483 crore), has almost a 30 percent overlap with Nifty50 and about 43 percent overlap with the flexicap fund of the same AMC.

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This effectively means that if you just have a largecap index fund (Nifty50-based) and complement it with a good flexicap fund, then chances are that the combined underlying portfolio will anyways have a large allocation to companies that are part of ESG funds.

This factor alone is sufficient, in my view, to avoid investing in ESG funds.

While it is still early days, I can safely say that most investors wouldn’t understand too much about the differences in sub-categories like exclusion, integration, best-in-class & positive screening, impact investing, etc. It is too confusing for the layman.

For most investors, it is better to continue avoiding ESG funds, even after the new changes, and just stick with well-diversified fund categories like passive largecap, flexicap, midcap, etc. There is no need to have a standalone ESG fund in your portfolio unless you really want to ‘feel-good’ about some cause / company which the fund is investing in.

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Interestingly, noted finance professor Aswath Damodaran, in a paper titled ‘Valuing ESG: Doing Good or Sounding Good,’ which he co-authored, says, ``the hype regarding ESG has vastly outrun the reality of both what it is and what it can deliver. The potential to make money on ESG for consultants, bankers and investment managers has made them cheerleaders for the concept, with claims of the payoffs based on research that is ambiguous and inconclusive, if not outright inconsistent with some of the claims.’’

Strong words, but nevertheless, something to keep in mind given that its coming from an expert.