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Tata Capital > Blog > Wealth Services > What Are ESG Funds: Meaning, How They Work, and Types

Wealth Services

What Are ESG Funds: Meaning, How They Work, and Types

What Are ESG Funds: Meaning, How They Work, and Types

Summary: ESG funds allow investors to take a more holistic approach through broader through considerations beyond their financial performance. Their approaches may vary, from exclusions and peer based selection to thematic funds. To gain a clearer view of what’s actually behind each ESG fund investment, you should analyse the funds objectives, portfolios, screening techniques, public disclosures, costs, and historical performance of the fund.

Environmental, Social, and Governance (ESG) investing has emerged as a topic of discussion among investors who not only look at their profits but also align their money with their values. ESG funds are mutual funds that evaluate companies based on ESG standards apart from the financial factors that have been traditionally followed.

They apply ESG factors alongside financial analysis to build their portfolios. You should understand the meaning of ESG, how these ESG-fund investments differ from conventional funds, and the ESG strategies to make the right investment decision.

What Are ESG Funds? Meaning

ESG funds refer to the mutual funds, which consider a company’s performance across Environmental, Social, and Governance (ESG) aspects while choosing securities for the portfolio. These factors are considered along with the conventional financial measures such as revenue, valuation and overall business performance.

The three components of ESG include:

  • Environmental: This dimension reflects the ways in which a company affects the environment, including areas such as the climate related practices, carbon emissions, energy use, pollution and waste management.
  • Social: This refers to the company’s management practices and its supervision. It includes the areas such as workplaces practices, employee welfare, diversity, gender equality and community impact.
  • Governance: ESG mutual funds incorporate not only financial measures but also social and environmental factors when assessing companies within their wider range of criteria. The specific factors and their relative significance depend on the fund’s stated investment strategy and approach.

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How Do ESG Funds Work?

ESG mutual funds evaluations are based on annual reports, corporate sustainability disclosures, board structure, and compensation practices. The ESG rating agencies may assign the scores through these aspects.

The fund managers use these scores to build portfolios by eliminating the weaker-performers or favoring companies with stronger ESG scores. SEBI’s requirements for ESG mutual fund schemes in India outline the investment and disclosure criteria that need to be met. Based on the applicable system, an ESG fund has to allocate at least 65% of its assets (AUM) in companies, subject to the defined BRSR and BRSR Core-related provisions.

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Types of ESG Funds

ESG mutual funds can follow different approaches when incorporating environmental, social and governance factors. The main types include:

  • Exclusionary or Negative Screening Funds: Exclusionary funds exclude the companies, activities and industries that do not fulfil the specified ESG criteria. Based on the strategy, sectors such as weapons, tobacco or fossil fuels may be excluded. It can prevent exposure to businesses that lie outside the fund’s defined ESG parameters.
  • Best-in-Class Funds: Best in class funds choose the companies with stronger ESG performance with respective industries. Instead of excluding an entire sector, this approach compares the companies against their peers.
  • ESG Integration Strategy Funds: ESG integration means considering the factors of environment, social and governance and the traditional financial aspects in company analysis. Under this approach, ESG information is not necessarily used to impose strict exclusions.
  • Thematic ESG Funds: Thematic ESG funds include environmental themes, such as clean technology, renewable energy, resource efficiency or other sustainability-related areas. Because of the specific type of themes in these funds, they may have greater exposure to companies connected to those areas.
  • Impact Funds: Impact funds can generate measurable beneficial environmental or social results apart from financial returns.

The specific impact objectives and methods used to measure them are based on the fund strategy. Investors should examine the fund’s stated objectives and disclosures to understand how impact is assessed and defined.

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Benefits of Investing in ESG Funds

ESG funds merge the conventional investments with social, environmental, and governance (ESG) considerations. Here are some possible advantages of investing in ESG funds:

  • Alignment With Personal Values: ESG investing offers investors an option to incorporate their views on a company’s environmental, social and ethical practices with a company’s financial performance.
  • Consideration of ESG-Related Risks: Social, governance and poor environmental practices may expose the companies to regulatory action, operational challenges, litigation or reputational concerns. Considering these factors give additional perspectives to investors to assess the companies.
  • Encouraging Capital Flow: The capital allocation towards companies that fulfil defined ESG standards can support more attention to social practices, environmental responsibility and corporate governance.
  • Diversified Exposure: ESG funds provide exposure to companies across different market capitalisations and sectors. The extent of diversification varies between the individual funds.
  • Growing Attention to ESG: Environmental, social, and governance (ESG) considerations gain the attention from investors, companies and regulators in India. These developments make the ESG-linked investment approaches more recognised.

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Risks and Limitations of ESG Funds

ESG mutual funds in India also have the limitations you should be aware of. India’s ESG funds have limited historical track record. It makes long-term performance comparisons more difficult.

Excluding certain industries or companies may reduce the range of securities available to a fund. For example, avoiding particular energy-related businesses or other sectors affect the portfolio diversification and affect returns.

ESB ratings may vary from one rating agency to another. The same company may receive different ESG assessments based on the methodology used.

The ESG label alone does not describe how a fund operates. The fund’s stated strategy, portfolio composition, screening methodology and disclosures provides more details about this approach.

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How to Invest in ESG Funds in India

The process of investing in ESG funds generally involves several steps. The exact process may vary based on the platform or intermediary used.

  • Complete KYC Formalities: Investors need to satisfy the relevant KYC requirements before investing in ESG mutual funds in India. It includes submission of the ID and address verification details and other documentation. If the KYC has already been completed and valid currently, it may not need to be repeated for each mutual fund transaction.
  • Understand the ESG Strategy: Review the fund specific strategy to understand how ESG criteria aligns to your portfolio. It helps you to understand how ESG supports fund administration. It also determines the type of companies you need to consider.
  • Compare Fund Disclosures: Fund documents and disclosures can be reviewed to understand the ESG screen applied, the portfolio holdings, expense ratio and the performance history available. Comparing these details can show the way in which the individual ESG mutual funds in India apply their stated strategy and how the portfolio comparison may vary from other ESG focused funds.
  • Choose SIP and Lump-Sum Options: A Systematic Investment Plan (SIP) involves making the investments at regular intervals, while a lump-sum investment involves making a one-time allocation. These are different methods to invest in mutual funds. The right investment route may depend on the nature of investment arrangements.
  • Invest via an Available AMC App: Once the required criteria are met, any mutual fund transaction can be made through the asset management company’s (AMC) website or app, broker, or mutual fund distributor. The available process, documentation and transaction facilities may vary depending on each platform and the specified ESG funds in India.

Conclusion

ESG funds provide a method to consider the social, environmental and governance factors along with financial considerations while evaluating companies. However, the ESG label alone does not describe each fund’s approach. Understanding the fund-specific strategy, screening criteria, portfolio composition, and track record is important to get better context when assessing ESG mutual funds.

Tata Capital Wealth helps you to find more details about the ESG-type investment strategies. It also keeps you updated on every aspect that affects wealth management.

Mutual Fund Disclaimer: Mutual fund investment comes with some market risk. Make sure you understand the associated risk factors by thoroughly verifying the scheme-related documents before investing.

Note: SEBI’s ESG fund framework and disclosure requirements may evolve with time. Refer to the latest applicable regulations and guidance from SEBI or AMFI before acting on specific regulatory requirements.

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FAQs

What are ESG funds?

ESG funds are investment portfolios that select companies based on financial performance and Environmental, Social, and Governance (ESG) factors.

What does ESG stand for?

ESG stands for the Environmental, Social, and Governance. Environmental factors include the emissions, climate impact, and waste. Social factors include employee welfare and community impact. The governance factor includes the company governance structure, compliance, transparency, and ethical corporate practices.

What are the different types of ESG funds?

The common types of ESG funds include exclusionary or negative screening, ESG integration, thematic strategies, best-in-class selection and impact investing. Each type applies social, environmental and governance considerations, so the fund's stated methods and disclosures must be reviewed to understand the investment process.

Are ESG funds available in India?

Yes, there are many ESG mutual funds in India. The funds are governed by the regulations and disclosure framework. Varying ESG strategies may be adopted by the funds. Screening criteria and methods of portfolio construction may vary from one to another. So, it is suggested to check the latest SEBI requirements and scheme documents to obtain updated information.

Are ESG funds a good long-term investment?

ESG funds can not be described as suitable or unsuitable for all investors. Their performance and risk characteristics may vary based on the portfolio, strategy and market conditions. ESG funds have a limited long-term track record in India, so it is suggested to consider the individual strategy and disclosures before investment.

What is SEBI's ESG fund framework?

SEBI's ESG specifies the requirements on how mutual funds using ESG strategies (mutual funds mainly) operate and disclose the information. The framework may change over time, so you should check the current requirements through SEBI's latest regulations and related disclosures before acting on the specific provisions.

How do I choose an ESG fund to invest in?

You should align your fund specific strategy, holdings and fees with values to invest in suitable ESG funds. Also verify whether the fund's strategy involves exclusions, best-in-class selection, ESG integration, thematic investing or another method before investment.
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