ESG Funds: Investing With Environmental and Social Filters

Environmental: how a company affects nature, such as pollution, energy use, emissions and waste.

Social: how it treats workers, customers and communities, including safety, fairness and product responsibility.

Governance: how it is run, including board independence, transparency, accounting quality and treatment of minority shareholders.

Most of them start with a universe of companies, then use ESG scores to exclude some and favour others. Some simply avoid certain industries. Others pick the best-scoring companies within each sector.

The scores often come from specialised rating providers, and the fund house may add its own research. Because methods differ, two such funds can hold quite different companies.

ESG investing is newer in India than in some other markets. Company disclosures on environmental and social matters are improving, but they are not always complete or comparable.

That means ESG scores can depend heavily on the method and data used. It is one more reason to read how each fund builds its portfolio rather than relying on the label alone.

In India, they fall under the thematic category of equity funds. That means they follow a specific theme rather than covering the whole market.

Our page on sectoral and thematic funds explains why themed funds can behave differently from the broad market for long stretches.

For Indian investors, the governance part is often the most practical. Poor governance, such as weak accounting or unfair treatment of minority shareholders, has been behind several company collapses over the years.

A fund that avoids companies with weak governance may reduce the risk of such surprises. That benefit applies even if you care less about the environmental and social parts.

In practice, many of them lean towards large, well-established companies with good disclosure, often in sectors like IT, banking and consumer goods. They may hold less of heavy industries, mining or some energy companies.

So an ESG fund can overlap a lot with a regular large cap fund. Check the top holdings before adding one. Our page on portfolio overlap explains how.

There are two broad approaches. Exclusion means avoiding certain industries entirely, such as tobacco or some forms of mining. Best-in-class means holding the better-scoring companies within every sector, including heavy industries.

The two approaches can lead to very different portfolios. The scheme documents usually explain which one a fund follows.

Greenwashing means presenting something as more responsible than it really is. A fund with "ESG" in its name may still hold companies you would not consider responsible, depending on how it defines the term.

Read the scheme information document to see the actual method, and look at the holdings. Our page on the scheme information document explains where to find this.

These are equity funds, so they rise and fall with the market. Whether they do better or worse than the broad market depends on the period and the fund. There is no reliable rule either way.

We do not publish return projections. Judge each fund against its own benchmark over several years, as our page on the benchmark explains.

Some are actively managed, with a manager choosing companies. Others follow an ESG index, which is a rules-based list of companies screened by ESG criteria.

Index-based versions are usually cheaper and more predictable. Active ones may adapt more, but depend on the manager. Our page on active versus passive funds explains the general trade-off.

These schemes are actively managed or rules-based with extra screening, and their expense ratios vary. Compare them with similar funds before investing.

Our page on expense ratio explains how costs work and why they matter over the long term.

Review once a year, like any equity holding. Check the holdings, the method, and the performance against the benchmark over several years, not months.

Someone who wants their equity investing to reflect certain values, and who already has a diversified core portfolio.

Because it is thematic, an ESG fund is usually better as a part of a portfolio than the whole of it. Our page on how many funds to hold explains how to keep things simple.

It is fine to choose one because it matches your values. Just keep that decision separate from expectations about returns.

If the fund lags the market for a few years, ask yourself whether you still value what it does. If yes, stay. If you bought it only hoping for better returns, you may be disappointed.

• How does this fund define ESG, and who provides the scores?
• What industries does it exclude?
• How much does it overlap with funds I already hold?
• What is its expense ratio and benchmark?
• How has it done against the benchmark over several years?

Like any equity fund, this category suits a long horizon and works well with a monthly SIP. Themed funds can lag for years, so patience matters even more.

Our page on your SIP when the market falls explains why staying invested through weak periods is important.

• ESG funds use environmental, social and governance scores to pick companies.
• They are thematic, so treat them as part of a portfolio.
• Read the method, and watch for greenwashing.
• Judge them like any equity fund.

We are distributors rather than investment advisers and we recommend no schemes. If you want help understanding an ESG fund, get in touch.