There are several types of mutual funds to invest in, one such popular fund is ESG or Environmental, social and governance fund. These are the types of funds that invest in companies or specific sectors that comply with ESG parameters and are also focused on sustainable growth such as healthcare, technology, renewable energy etc.
Let’s understand the types, benefits, risks and other crucial aspects of ESG funds.
What is ESG?
ESG stands for Environmental, Social, and Governance, and is a set of standards used to measure how an organization impacts the environment and society. ESG is a type of mutual fund that invests in companies that meet 3 particular criteria, i.e., companies that are committed to environmental conservation, social responsibility, and corporate governance practices.
Investing in ESG refers to sustainable investing since you invest in companies that take out their business activities through a sustainable and holistic approach. The aim should be to provide financial returns but also impact the environment positively only.
ESG Full Form
E, S and G stands for 3 different components of ESG mutual funds. Let’s understand the meaning of each alphabet separately.
- E (Environment): Focuses on safeguarding the environment by reducing carbon emissions, efficient waste disposal, and promoting energy and water conservation to support a greener environment.
- S (Social): Emphasizes on social factors like employee well-being, gender equality, pay parity, and contributions to social causes, ensuring a positive impact on both employees and society.
- G (Governance): Dealing with corporate governance with a focus on regulatory compliance, effective grievance handling, ethical conduct, whistleblower protections, and robust internal controls.
Why is ESG important?
Below are the points that shows the importance of ESG funds:
- Risk Management: ESG practices help companies identify and manage risks, potentially reducing costs and preventing future problems by addressing environmental, social, and governance issues.
- Sustainability: ESG strategies enhance long-term sustainability, contributing to a more sustainable future.
- Reputation Building: Implementing ESG principles can improve a company’s reputation and attract investors who value ethical and sustainable practices.
- Social Responsibility: ESG initiatives promote social responsibility, helping companies contribute positively to society and address social issues effectively.
- Investor Value: ESG investments can protect and enhance long-term value, aligning investor interests with sustainable and ethical growth.
- Innovation: ESG encourages innovation, particularly in sectors like energy, by driving the development of new, sustainable technologies and practices.
Types of ESG Funds
Following are the 4 types of ESG funds:
- Thematic funds: Investment is only made if the company is dedicated to sustainability themes like clean energy, gender diversity, or water conservation.
- Impact funds: Companies that generate strong and positive social impact and meanwhile provide higher returns to the investors are targeted here.
- Exclusionary funds: As the name suggests, these funds exclude some particular sectors including fossil fuels, weapons, tobacco etc.
- Best-in-class funds: These funds only invest in companies if the ESG ratings of that company is the best in their particular industry.
Advantages of Investing in ESG Funds
Investors gain several benefits if they invest in ESG funds, some of them are:
- Diversified portfolio: ESG investments consider environmental, social, and governance factors, reducing exposure to traditional risks and enhancing diversification.
- Long-term performance: In comparison to traditional funds, ESG funds have superior long-term performance since they focus on companies with high growth potential and robust ESG practices
- Sustainable investing: Investing in ESG funds supports social and environmental improvements by funding companies with strong ESG ratings who are sustainable.
- Reduced risk: The risk here is reduced as ESG invests in high quality companies that have a potential to grow in future years.
ESG Funds Vs Traditional Funds
| Basis | ESG Funds | Traditional Funds |
|---|---|---|
| Company investment | ESG funds invest in companies that have high ESG ratings and aims for sustainable growth | Mutual funds invest in companies’ profitability and growth. |
| Risk management | Companies that follow strong ESG practices are targeted for lower risks | Each fund has a different risk management strategy |
| Financial performance | Prioritizes sustainability over short term gains | Focus remains on high long-term returns |
| Societal impact | Creates a positive and social impact | Impact varies depending on the nature of investment |
ESG Score: Meaning & Calculation
Research organizations such as CRISIL, MSCI, Sustainalytics, and Morningstar allots an ESG score to companies which determines the level of compliance to ESG standards. Every research organization allots a score to a company and mutual funds depending on their own assessment and methodologies.
The scores keep on changing due to various factors such as changes in regulations, standards/norms, and the company’s own initiatives and many more aspects. However, an ESG score is not mandatory for companies, but it is a good-to-have metric.
How and Where do ESG Funds Invest?
ESG Mutual Funds are a type of thematic mutual fund that focuses on socially responsible investing. These funds assess companies based on their environmental (E), social (S), and governance (G) practices, targeting those that follow high ESG standards. By investing in ESG-compliant organizations, these funds promote sustainable growth and aim to generate long-term wealth for the investors.
ESG Funds may invest across various market capitalizations and sometimes include international stocks that meet ESG criteria. This strategy aligns with sustainability goals and targets companies with resilient business models that can adapt to evolving sustainability standards.
ESG Funds & Taxation
Following points show the taxation of ESG mutual funds:
- Similar to equity mutual funds, capital gains from ESG funds are also taxed.
- Short- term capital gains tax is taxed at 15% if you hold them for less than 12 months.
- Long- term capital gains tax is taxed at 10% if you hold them for more than 12 months.
- If your long-term capital gain is ₹1 lakh or more and includes a Grandfathering clause, this provision exempts gains accrued before January 31, 2018, from any tax.
Risks of Investing in ESG Funds
- Performance risk: ESG funds target companies with strong environmental, social, and governance practices, which may benefit long-term performance. However, they might underperform compared to traditional funds in the short term.
- Limited diversification: ESG funds do not target specific sectors such as renewable energy, which may reduce returns if those sectors face challenges.
- Regulatory changes: Changes in the government rules could impact ESG performance since its criteria is based on government regulations.
Points to Consider Before Choosing an ESG Fund
Following are a few points that should be considered before making a decision and choosing an ESG fund:
- Understand the strategy of the fund. Make sure you match that with your financial goals to gain returns.
- Compare the fund and its sector weightage with your portfolio. Choose a fund whose weighing fits right into your portfolio.
- Always consider the overall cost of the fund including aspects like management fees etc.
- Go through the past performance of funds and try to understand the features
