The Mutual Fund Show: Looking To Invest In An ESG Fund? Here’s What You Need To Know
MSCI India ESG Leaders Index has been outperforming MSCI Index Index since 2008.
A breed of conscientious investors has put focus on the environment, social and governance behavior of companies, creating a different category of investments.
Called ESG funds, they invest in companies that, among other things, focus on environmental sustainability, treat suppliers, employees and customers responsibly and are transparent in accounting and other business practices.
While India’s market regulator hasn’t defined ESG funds, they have been classified as thematic funds whose returns might be more sustainable on ESG parameters compared to others, said Jimmy Patel, managing director & chief executive officer at Quantum Asset Management Company—which has an ESG fund.
The concept is evolving, according to Chirag Mehta, senior fund manager of alternative strategies at Quantum. 500 Indian companies have been mandated for business responsibility reporting and the count would double to 1,000 by 2021, he said.
Such funds deliver returns, according to Mehta. It’s a cliché that if you try to do good, you cannot make money, said Mehta. MSCI India ESG Leaders Index has been outperforming MSCI Index Index since 2008, tracking superior returns of similar indices in U.S. and China.
MSCI India ESG Leaders is a capitalisation weighted index that provides exposure to large- and mid-cap companies with high environmental, social and governance performance than sectoral peers.
According to Suresh Sadagopan, founder of Ladder7 Financial Advisors, ESG funds make total business sense as they reduce regulatory risks by investing in companies that set high governance standards and are doing all the right things.
Want to know more about ESG funds? Watch the full show here...
Here are the edited excerpts from the interview...
When you guys decided to launch this fund, what was your thought process? Was it about adding one more feather in the cap because a fund should have all of those or do you believe that over the course of the next few years, ESG funds could actually give disproportionate or better returns and, therefore, would attract a larger part of the money flows? What is the thought process?
CHIRAG MEHTA: So, if you see right since the 1990s when we as a group have been investing in equity markets, governance has been at the forefront of an important pillar when we look at investments. For global investors, environmental and social risks are increasing significantly and therefore becoming more important in the investment process. So, we started this process of having a team and looking at ESG aspects five years back when no one was even talking about it. So, we think that these are important traits for companies and therefore having that in the investment process and making those companies truly sustainable is important. Therefore, we have that. It’s not a feather in the cap, but I think sustainability is a better way to drive the long-term performance of companies and therefore we have ESG as a fund and we think it’s very important.
How different would such a fund be, or the components of such a fund be from components of any other large-cap fund in which I presume, all of these factors would be anyway playing a very important part. So, what differentiates these funds from some of the others? I believe that there’s no SEBI-defined mandate about what an ESG fund can or cannot have.
JIMMY PATEL: If you were to look from SEBI’s perspective, it is more in the nature of a thematic fund. So, being a thematic fund, the components or the characteristics one would look at while building the portfolio would obviously as you rightly mentioned, cover the environmental, social, and corporate governance aspect.
The returns may not be commensurate with the returns of a normal fund because these returns are more in the nature of (if we were to use the word) ‘sustainable returns,’ because a company may be doing extremely well, but then what does it take to protect its stakeholders (including the shareholders, customers, creditors, and the staff); what are the parameters the company uses to protect the environment in which it operates, etc.?
So, it is not necessarily that each and every company doing well would be taking care of everything. They may be taking care of a few source pointers but not necessarily everything and that’s where the differentiation lies. Having stated that, the whole world has, as my colleague Chirag pointed out, is moving to sustainable returns and two companies who take care of these three parameters. So, it’s a question of time where India will also move. The Indian companies will also show more respect for all these three parameters.
So, would you reckon that, from where we are right now on the ESG parameters for the companies at large and therefore the options available for an ESG fund, those options would only increase over a period of time? I mean because right now I presume that the investible universe of companies which comply with all of the three parameters in the strictest of senses would be a bit narrow. It’s a relatively new concept in India so to say.
CHIRAG MEHTA: Yes, it is relatively new, and if you see, the leads have been taken by the top groups in India so far, but the regulations are unfolding. BRR (business responsibility report) has been made mandatory for 500 companies and 1,000 companies next year, which is not very detailed but it’s moving towards that. Many companies have been proactive in terms of publishing a sustainable report based on GRA framework. So, there is a lot of information now being available for us to evaluate. So, if you see the sustainability report, which is very detailed, we have about 800 companies which have published sustainable reports. So, the universe is growing and that will mandate companies to at least go about and measure, verify, and publish information which is not happening today. So, over a period of time, I think the universe is about to grow.
So, what kind of investors should actually look at investing in two ESG funds? I mean it sounds great but let’s work with this hypothesis that as much as an investor wants to invest in companies that are taking care of all of the factors that ESG companies normally would, the first principle for any investment is the kind of returns. I believe there are five or six offerings, including one from your stable.
JIMMY PATEL: Investors I would say should look at responsible investment because ultimately, in a growing economy, the investments that are made ultimately go into making investments in companies which help turn around the economy. So, if you’re looking from an economic growth (point of view), acknowledging the fact that we are not isolated from the world at large, then yes, ESG parameters have to play an upper hand for any investor who would like to make investments.
Now yes, institutional investors should not ignore these kinds of parameters because from an institutional investment perspective, they can’t say they are only bothered about returns. A retail investor, if you were to say that, probably we can pardon. This is because for a retail investor who is just making an entry into mutual funds, he would first like to understand what a mutual fund is. Then, he would understand their returns and finally go into a concept of an ESG. But if we were to look at a HNIs—the institution segment, which is huge, that segment has to look at the ESG funds at large.
Which is fine because the HNIs would always be more informed and for more evolved investors. But I’m talking from a perspective of a retail investor who is parking in an SIP, some Rs 2,000, Rs 5,000 or Rs 10,000 a month, let’s say. What portion of such money should flow into an ESG fund and what kind of returns can people anticipate because hitherto whenever advice comes in when you look at past performance or even otherwise, we’ve seen that India has been a growth market, so an ESG fund would not necessarily outperform. So, I’m just trying to get a sense from you guys as you would have looked at global parameters as well. What should one do?
CHIRAG MEHTA: So, it’s I think it’s a cliché and a misunderstanding that if you try to do good, you cannot make money. I think both are complementary in nature rather than be opposed to each other. For example, if you see the ESG indices, MSCI India index- ESG with MSCI a market-cap weighted index, the ESG weighted index has outperformed over the long-term and the gap has widened over a period of time. Even if you see the Nifty ESG index vis-a-vis the Nifty Index, the ESG index has outperformed. That’s not only true for India it’s true for most of the global indices, which says that ESG does work. Therefore, it’s not that you cannot make money, or you cannot generate returns or sustainable returns. Rather, I hear that the returns are more sustainable in nature because the companies are good. They have value in terms of all areas protected and therefore they tend to make much better returns compared to the other indexes.
So, when you compare these returns that ESG-led indices in India would have done and in the recent past I presume compared to the global parameters, is there a sustainable track record for us to be able to predict that this would happen? Because I reckon at some point of time, the returns would not be a factor of a company following the ESG practices alone but the nature of the business as well. A non-ESG fund will not be bound by the limitations of investing in companies that necessarily follow ESG parameters. That fund manager would be able to take a bet on a company where the rate of growth is arguably going to be faster and therefore the returns would be faster.
JIMMY PATEL: If you were to look at all the three components of an ESG, one is environmental, social and corporate governance. Let’s look at corporate governance. Now, any fund manager or any investor when he decides to make an investment, can he ignore corporate governance? Probably not. So, that parameter is a must, irrespective of the kind of scheme or the kind of investments that you do. The next comes is your social. Now, what is social? Social means that how could you take care of your stakeholders, which means that, starting from your employees and to your shareholders, creditors, regulators and the people at large; in terms of quality of information, in terms of the welfare measures, etc.
Again, no company can in isolation tend to not take care of his employees or shareholders or creditors or stakeholders and now there are regulations that govern what you should give, what information should be disclosed. So, again it is there. You cannot ignore. The last point, which is currently loose in a sense, not well regulated in an Indian environment is environment. So, in an environment, there are many industries that are not impacting the environment, while there are industries who impact the environment. Now, industries who affect the environment can perform better if they show respect for the environment and have measures taken to ensure that the pollution is under control for example, or the pollutants that are discharged, are recycled or some alternative means of energy for are used. The government or regulators also taking efforts to ensure that all the three parameters are taken care of and the industries or the management of the industries do respect and take care and ensure that the environment is not polluted, the staff are not unduly put under pressure and that adequate disclosures are being made from a corporate governance perspective.
CHIRAG MEHTA: Also, the risk from these factors is increasing significantly, right? India has not caused the climate issue, but it has to be part of a solution because the by-product of growth is going to be carbon emissions. Therefore, there is significant pressure from global peers to ensure that India also adheres to certain norms. That is why India committed to the SDG goals and reducing carbon emissions at the country level.
So, are you actually making a case? I am just trying to figure out that with tightening regulations, more awareness, etc these are things that all firms eventually will have to do. Therefore, the ones which are better prepared, currently will essentially not have to go through a steeper learning curve and therefore their performance or a period will be better than the others. Is that the case you guys are making?
CHIRAG MEHTA: Yes, that’s the case that we’re making and not only from a risk mitigation perspective. If you see these companies even after following environmental social and governance criteria, they are very innovative and are leaders in the industry when it comes to these things. They are much ahead of the curve in terms of ensuring or forcing regulations. Therefore, they are better prepared and they are likely to do well in the future because when regulations unfold, they will not have to run around and get their house in order. They will be prepared for it and therefore will be able to focus on their business.
So, the last two questions. First, let me try and rephrase because I’m still trying to search for that answer. Jimmy, in one of the answers you mentioned that investors are looking for sustainable long-term returns who invest here. I’m trying to ask you, when I was an investor, I’m looking at your fund house and trying to choose whether I should invest in A, which is an ESG fund versus a fund B, versus a fund C.
What kind of returns can I expect from an ESG fund versus some of the others? I know it’s not possible to predict returns, but I’m just trying to ask you that if I’m trying to choose between funds, would I expect steady-state but slightly lower returns as a hypothesis compared to maybe a mid-cap fund compared to maybe multi-cap fund. How should I approach my investment thesis?
JIMMY PATEL: As I mentioned earlier, corporate governance is a given across funds- whichever a fund maybe, it may be a mid-cap fund, small-cap fund, a growth fund, a value fund or even an ESG fund. So, no fund manager or for example, our fund house- it can ignore corporate governance and make an investment in a company.
It can happen by mistake?
JIMMY PATEL: Yes, errors can still happen because corporate governance is also a factor of the disclosure. If you don’t get the right disclosure, you are prone to making errors but then you have to rectify the error. So, the first given is corporate governance. The regulators also say that corporate governance is a must in terms of right from a proxy voting to how the companies behave in terms of regulatory respect, etc. So, the first parameter is a given across funds. The second parameter depends on what kind of investments you are taking. For example, in an ESG environment, if you’re taking more exposure to finance or software, these follow all the three parameters.
It is not necessary that in a growth fund or a value fund or a finance company or a software company may fit for a parameter in the criteria that classifies that company into small or big. But then, the first parameter having achieved, coming to the second parameter; environment. The environment would be more on the manufacturing side and manufacturing companies would typically be across. So, if you are having a sectoral fund that is investing in a particular manufacturing team, or if you are having a wider-based fund, you will again pick up a company that is respecting the environment because you don’t want your effort to go wrong.
The last thing, when it comes to your social responsibility, so if a company is paying more heat to social responsibility, again from a performance perspective, the stakeholders will respect that company and the performance is bound to improve. So, from a short-term perspective, while you may have a certain fabulous return which is being given by a company that is not respecting the three criteria, but in the long term, the three criteria will ultimately pay.
So, you are saying in the long term, ESG funds will give better returns than normal ones?
JIMMY PATEL: Yes, and to support what my colleague Chirag also mentioned, if you look at the returns given by the indices MSCI and Nifty, they are much better than the other active indices.
What about the fund offering that you have? What kind of investors with what mindset should invest in this fund, what is this fund all about? I’m guessing an ESG fund, but can you just give us some details about this?
CHIRAG MEHTA: So, all those investors who are looking at banking on sustainability as a long-term driver of returns, I think we all should look at it. Because if you see how the millennial generation is much into the workforce and now becoming a big part of the investment pool, all those believe that their value system reconciles with what ESG funds offer. So, all those who think that their value or belief system is having responsibility also as an important pillar, they all should look at ESG funds. From a return perspective, I think ESG funds have showcased that they do better. So, hopefully, that trend stays in the future as well and therefore it caters to both the needs: one is making sustainable returns and at the same time, be a responsible investor.
The Quantum AMC team before you came was of the opinion that ESG funds naturally, have done really well and for steady sustained returns, these could do well. There is no SEBI mandated formula, so therefore when you look at the portfolios of the three or four funds which are there in India- which are ESG funds, do they reveal something about a particular style of investing that these funds have and what kind of investors should approach ESG funds?
SURESH SADAGOPAN: As far as ESG as a theme is concerned today in India, it is a fairly new concept and new theme. Investors themselves have to warm up to this particular thing but I am really hoping that the investors will warm up to this because it actually sets the standards at a much higher level and it is all good from the investor’s point of view. Because if you are looking at the environmental standards going up and they’re getting a better score or from the corporate governance point of view or from the social point of view if they’re scoring higher, probably it makes the company a much better one apart from the financial parameters on which mostly the fund managers evaluate. So, these companies are less prone to regulatory problems. They generally tend to do very well on the corporate governance parameters because they do all the right things which a good company is expected to do, that is why they scored well.
Environmental issues are subject today. So, I mean if a company is going well above what they are mandated to do, for example, if the company is let us say carbon positive, or if the company is water positive using lesser water then they are able to give back- so these are all positive things and it can actually be an advertising point for companies. So, in my opinion, currently, we have made a small beginning today with the ESG funds which have been launched today by quantum access and SBI. In my opinion, energy funds currently we are looking at it like a theme. In my opinion, this is this is a major thought process shift. So, apart from the financial parameters, this should be very much incorporated and should be a part and parcel of our selection process itself.
Are you talking about investors investing in companies?
SURESH SADAGOPAN: I’m saying that the fund managers should look at the ESG parameters and some of the parameters based on which they evaluate companies are to be taken into any fund.
Then we won’t have a need for an ESG fund?
SURESH SADAGOPAN: Eventually, but I mean these are fundamentally good parameters is what I’m trying to say.
No, that point is well-taken. The only question that I have is, that I think lay investors would wonder that almost all fund managers would speak on their stock-picking abilities or another. So, why would they anyway buy companies which are very low on the ESG score? But notwithstanding, because we know that short-term returns may not necessarily come only from buying ESG compliant companies but at times buying companies in which they could be an earnings traction.
My question is when somebody is looking at these ESG funds currently as an investor, what should be a return expectation vis-à-vis some of the other categories? The reason I’m largely restricting this conversation to maybe the large-cap or the multi-cap category because we know that the mid-caps and the small-caps might have a company here there which is not comparable. Therefore, let’s leave them out.
SURESH SADAGOPAN: So, currently the index that we have is only for large caps. So, we are probably not going to go beyond the top 100 companies as far as it’s on the ESG funds. In a sense, the ESG funds are currently in the market, they will be large-cap oriented. So, what was your question?
If I’m an investor and let’s say I’m looking at one single AMC, say Quantum AMC, hypothetically presuming that they have a multi-cap fund, a large-cap fund and then, they have an ESG fund. What kind of return expectations should I have for the next five years from each of these categories? Would the ESG funds be steady return funds but maybe lower-return funds?
SURESH SADAGOPAN: So, let us look at what has happened globally as far as ESG funds are concerned. I’m going back to the same theme that ESG is a good theme to follow inherently and because of that worldwide, if you look at whether it is the U.S. or Europe or the emerging market; emerging markets have done wonderfully well, much above the typical index. Even the U.S. has done better. Europe is kind of hugging the general index so that is what we have seen. So, there is nowhere in the world where the companies chosen on ESG parameters have underperformed the larger index.
As far as India is concerned, we don’t have any data currently because both the funds are comparatively new. Over a period of maybe next three or five years, I think in my opinion it will again bear out what has happened across the world because ESG, as I would want to repeat, is, they’re good parameters to have in any well-run company. Because of that, I will not be surprised at all if the Indian ESG funds also do well. So, coming to the point of view of whether the investor should consider an ESG fund, I would say absolutely yes. I mean today it is a thematic fund unfortunately and I’m not really, I mean looking for a thematic fund. I’m saying that this parameter should be incorporated across categories, but if you are looking for a large-cap fund and probably instead of a large-cap fund, you can probably look at the ESG fund because it’s a large-cap fund but with one more layer, one more factor applied over them.
Which is choosing companies with the highest ESG scores as well arguably the highest ESG scores?
SURESH SADAGOPAN: Correct.
So, you are saying that for investors looking at large-cap funds, this might be a better alternative. What about investors who- and strictly from an investment gain perspective are looking at multi-cap mid-cap funds because those ones might give higher returns. ESG funds are outperforming the benchmark indices. Do you reckon that in a country like India over a 5, 7-10-year period they might even outperform multi-cap and mid-cap and small-cap categories? Is this possible?
SURESH SADAGOPAN: See, whether a large-cap oriented fund can never outperform a mid-cap or a small-cap fund, it is a matter of conjecture; the point is I really don’t know nobody can predict.
But when you are telling your clients to invest in to say at times of multi-cap fund versus at times a large-cap fund, I’m guessing you give them some estimate or based on some idea that the client gives you about the kind of returns that he or she wants right?
SURESH SADAGOPAN: Largely, we also understand that there are mid-cap funds, there is a higher risk-reward equation. While we’re actually constructing a portfolio, we will have a certain level of large-caps, a certain level of mid-caps. If it is warranted, we may also have certain small-cap funds, if at all it is warranted. What I would say is that, as far as a large-cap is concerned, I’m willing to consider an ESG fund. As far as mid-caps and small-caps are concerned, we don’t have too much data as far as the ESG compliance is concerned as of now.
But between a mid-cap fund which is a vanilla mid-cap fund, and between a mid-cap fund which also is selected on an ESG parameter, I would definitely look at the funds which also are ESG-compliant because they are better-governed companies. So, as and when this comes, probably this may take maybe 3-5 years and every company probably I’m hoping that will have an ESG score. So, then obviously I’ll be looking at companies that have better ESG scores as opposed to other companies; other funds which have companies that are invested in the lower or no ESG scores.
So, the funds that are on offer in India and I think the Axis House has this ESG equity fund the, Quantum has the regular plan, Magnum has. Do you like these funds as a category? What individual investors do with the percentages it’s completely their prerogative depending on how much they want to, but do you like these funds, these two or three that I am asking you?
SURESH SADAGOPAN: So, I think from whatever they have talked now I think, I have shown my love for these funds and this category. As far as these particular funds are concerned, currently, we don’t have too much information on these. I mean both of them have not even completed one full year of performance.
So, to that extent, it becomes a kind of a problem in terms of recommending today but we’re definitely going to look at it. We are definitely going to recommend these kinds of the fund going forward in the future because the ESG as a parameter is something which is very appealing. Those funds which have been molded around that parameter obviously is a candidate which we want to recommend at some point.
Any other point do you want to make about these funds?
SURESH SADAGOPAN: So, there are several things that are going around ESG. A lot of times, we confuse ESG with let’s say, a religion-based investing. So, ethical funds, for example, is confused with an ESG thing. It is somewhat close; it will have certain maybe some themes of ESG. It is not exactly the same that is the thought I would want to leave with the investor. I’ll just take one example: an ethical fund that works on the Islamic principles.
It may not want to invest in a financial company that is giving interest and that is from the religious point of view for a person who wants to be religiously compliant in a Shariah fund. This may be attractive for him, but from an ESG perspective, this is not a parameter that an ESG fund would want to incorporate. There are going to be points which both an ESG fund and a Shariah fund or a Christian fund may follow. For example, both an ESG fund and the Shariah fund, for example, may avoid companies that are dealing in gambling, tobacco, alcohol and so on. It also depends on who is developing the ESG theme. But largely there will be concurrence between the people who are developing ESG. It will not be way different.