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Good for environment and your money

Companies that focus on environment and society along with financial metrics perform better over the long run and offer higher risk-adjusted returns

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In 2015, German auto manufacturing major Volkswagen was hit by a scandal when it was discovered that many of its cars were fitted with a software which showed lower emissions at the testing stage. The company had to subsequently pay over $20 billion in fines and the share price fell by over 30%. If you had invested in the Volkswagen stock then, given its strong financial metrics, your portfolio would have taken a huge hit.

To get a holistic view of any company, and to perhaps foresee and avoid such incidents, investors globally are investing based on Environment Social Governance (ESG) principles. The principle behind the investment concept is whatever is good for the environment and society is also good for shareholders. As such companies are likely to sustain over the longer term, investors can expect superior risk-adjusted returns from such investments.

Under ESG investment, if a company is doing something right financially but doing wrong in terms of environmental, social and governance, then at some point in time the company will encounter a tail risk which could in a very significant way erode shareholders' value. Let us understand in details how it works. 

What is ESG investing

ESG is the systematic inclusion of environmental social and governance factors in your fundamental analysis of companies, says Abhay Laijawala, MD and fund manager, Avendus Capital Public Markets Alternate Strategies. Avendus recently launched an ESG-based fund and hopes to raise up to $1 billion through offshore and onshore investors. “When you do ESG investing, you look at intangibles and not just the tangible financial metrics,'' he says.

Generally, when you analyse a company you tend to rely on reporting frameworks. So you largely analyse the company based on its financial statements such as profit and loss account and balancesheet. You try and understand the company's business, etc. But you do not consciously look at the company's environmental footprint or what the company is doing to improve its environmental footprint. For instance, is it focusing on conservation, is it responsible as far as carbon emissions are concerned, does the company have any policy on plastic waste management, etc? You also do not necessarily look at the social factors such as is the company or any of its vendors employing children labour, etc. Or there could be corporate governance factors such as how the company is handling its minority shareholder?

“One may ask why is it important to assess these factors? Does it really make a difference? Yes, it does because if a company is not focusing on these factors, in the new world that we are looking at, a world which is facing a risk of climate change, a world where institutional investors are demanding transparency on corporate governance, you are likely to have an accident,'' Laijawala explains.

While there is higher recognition of ESG issues in portfolios, in India we are yet to see that reflecting into inflows into ESG funds, yet, says Navneet Munot, executive director & chief investment officer, SBI MF.

SBI MF's, SBI Magnum Equity ESG Fund (an older scheme that has been renamed and now follows the ESG investing principle) has total assets under management (AUM) of Rs 2,125.83 crore as on January 31.

“We have been trying to create awareness, but in terms of flows, it will take time. It is just lack of awareness. Recent events pertaining to environmental, social and governance issues, be it through investors appreciating the role of sectors in portfolios, has brought focus on ESG investing,'' he says.

Given all that is happening on the corporate governance side this is becoming a lot more relevant for investors, says Prateek Pant, co-founder and head of products, Sanctum Wealth Management. “To generate economic profit, you need to be aware of what you are doing. For instance, in India, we have the CSR Act which talks about 2.5% of your profit to be given as part of the philanthropic initiative. It's supposed to be voluntary. But are there companies which comply with that? That becomes very important from a social cost perspective,'' he says.

Returns can be higher over long term

Investors think that these factors may have a trade-off with returns. But increasingly it is becoming clear that by focusing on ESG issues, you are not sacrificing on returns. You are actually better off by having these funds, says Munot.

Agreeing with this, Pant points out that ESG indices, not just in India but globally, have done much better over a longer term than the broader MSCI indices.

“It is not just good for the environment and society, it is also good for shareholders. In the longer run, over a five year period, all these indices have significantly outperformed the broader indices in that period. The classic ESG investment philosophy is that companies that follow this, will in the longer run, tend to do a lot better than companies which are just focused on profitability metrics, irrespective of anything that happens,” Pant says.

Benchmark for ESG investing

SBI's fund is benchmarked against the Nifty 100 ESG Index, which is a thematic index, and has outperformed the broader Nifty 100 over the last seven or eight years, says Munot.

Companies engaged in the business of tobacco, alcohol, controversial weapons and gambling operations are excluded.

SBI MF and Kotak Mahindra MF are two fund houses that are signatories of the United Nations Principle of Responsible Investment (UNPRI).

Avendus's has tied up with Institutional Investor Advisory Services (IiAS), a Sebi-registered research firm, which will put in place a ranking framework covering ESG principles.

The MSCI India ESG leaders index has companies from sectors such as financials, infotech, consumer staples, consumer durables and communication services.

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