'ESG investing reduces potential risks in your mutual fund portfolio'

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ESG funds have started to pick up pace in the Indian Mutual Fund industry. Many fund houses have come up with ESG funds in the last one year. Shivani Bazaz of ETMutualFunds.com spoke to Amit Nigam– Fund Manager, Invesco Mutual Fund, to understand more about the ESG funds and their outlook in Indian markets. Edited interview.

ESG Funds are slowly gaining ground in India. How do you see this theme evolving in India?
Today investors consider ESG as an additional/ new theme. We are of the opinion that, in not so distant future, ESG will become an integral part of discussions when investors would engage with corporates, while evaluating investment opportunities. The reason we believe in such a future is because ESG principles at one level act as guiding posts for corporates, to be more aware of the softer aspects of the business and thus improve the way businesses are conducted.

Another reason for this theme gaining traction with investors lies in the fact that integrating ESG aspects into investment decisions tends to lower the risk profile of businesses that are owned; and hence offer a potential to enhance risk-adjusted returns.

As a new entrant to this ESG funds space, what do you think are the challenges for fund managers at the moment since the field is new?
Data is the backbone of all decision-making processes. Investment decisions are no different. ESG is understood to be a qualitative subject and hence weaving qualitative data into quantitative investment decision making, presents itself as a challenge. A few years ago, investors who wanted to evaluate a company on ESG parameters faced lot more challenges as very limited data was available in the annual reports/ public disclosures.

However, over the last few years, the availability of data and acceptability of this concept has improved. Due to regulatory push, top 500 corporates (by market capitalization) publish annually a BRR (Business Responsibility Report) which has facilitated investors to gain insights into ESG aspects of companies. This over the next couple of years would see an improvement – top 1000 corporates would release BRSR (Business Responsibility and Sustainability Report) which will have more quantitative data incorporated. Also, incrementally quite a few corporates are setting for themselves ESG related targets as tangible business goals and are engaging with investors to discuss the best global practices with respect to ESG.

Why do you believe ESG funds are important? We see a lot of fund managers talking about the sustainability part. What is in there for the retail investors?
ESG funds are creating a push for corporates to be aware of the ESG aspects when it comes to the conduct of businesses. Understood simply, ESG principles guide corporates towards better and more efficient use of resources – both natural and man-made. This facilitates the businesses to sustain for longer – with the same “limited” pool of resources.

All investors in a company and not only the retail investors, stand to benefit from this extended life, as equity compounding journey in the company can continue for longer. We believe, Investors while selecting investments if incorporate this additional level of underlying risks in businesses due to disregard of E, S or G factors will enjoy an additional benefit of better risk-adjusted returns in their portfolios over the medium to long term.

Many questions are also asked about the market capitalisation of ESG funds. Do you think these schemes generally will mirror large cap returns because most large cap companies are ESG compliant in India?
Reporting of ESG parameters was earlier mandatory for the top 500 companies by market capitalization, and hence the common notion that the larger companies are ahead in this journey. However, our proprietary ESG scoring process gives us good insights when we score the companies across market capitalizations. We are positively surprised by the efforts that a lot of smaller companies have taken on these aspects, of their own accord. Several mid & small cap stocks get good ESG scores – some even better than large cap stocks within the same sector.

As we write, out of our categorized (investable) universe of approx. 160 companies we have ESG scores on almost 150 companies which are spread across capitalizations – approx. 40% large cap stocks, 30% midcap stocks and remaining 30% small cap stocks. This gives us the flexibility to construct our portfolio of 30 – 40 holdings, with upto 35% of the investments in mid & small cap stocks.

How do you pick stocks in a relatively smaller universe like ESG?
The additional risk filter of ESG does reduce the investable universe, but not the potential to generate good risk-adjusted returns. The potential risks in the portfolio are lowered as these filters avoid investments in those companies/ sectors where, in the future, there might be a threat to the conduct of business in its current form due to environmental , social factors or non-transparent governance practices.

Our ESG equity fund seeks to invest in those set of companies where the threat to respective business models due to any of E, S or G, as assessed by us, are lower. We use our proprietary stock categorization framework which is integrated with an ESG scoring methodology to identify such companies. Our bottom-up stock selection in the fund is driven by the future business prospects of the companies, their superior ESG scores, and their entry valuations.

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