First, your worst nightmare came true. Like other global indices, the BSE Sensex plunged. And then, there was some good news. From its low of 25,381 on March 23, 2020, it recovered 60 per cent of its losses over the next three months. Now, there’s better news. Worldwide, as also in India, certain funds, dubbed ESG or “sustainable” ones, showed “resilience” during the sell-off triggered by the COVID-19 pandemic. In terms of both assets and inflows, these funds performed better than the global universe.
Towards the end of March 2020, the assets of sustainable funds, which focus on companies that rank high on Environmental, Social, and Governance (ESG) issues, were down 12 per cent from their all-time high at the close of 2019. According to a May 2020 report by Morningstar, this was lower than the 18 per cent decline for the global universe of all the funds. The sustainable funds “pulled in $45.6 billion in the first quarter of 2020” compared to “an outflow of $384.7 billion for the overall fund universe”.
In Asia, and specifically in India, the ESGs performed better than in Europe and North America. “Bolstered by new fund launches”, their assets in Asia (minus Japan) went up by 21 per cent. The report stated that “Indian (ESG) funds experienced record inflows of $507 million in first-quarter 2020”. Clearly, there is a huge investor interest in sustainable funds. At present, there are seven such funds in India with combined assets of $1 billion. Globally, there are almost 3,300 ESGs with assets of almost $840 billion.
Several reasons can explain the fascination for the sustainable funds. COVID-19 has highlighted issues related to health, safety, environment, and sustainability. “More companies are under scrutiny for decisions that affect their employees, vendors, customers, and other stakeholders. COVID-19 is a litmus test to verify a company’s true sustainability, and its commitment to ESG best practices in these difficult times,” explains Chirag Mehta, Senior Fund Manager - Alternative Investments, Quantum AMC. In the future, both companies and investors will be obsessed with non-financial parameters, apart from profits, revenues, and other financial figures and ratios. “As we rethink our personal values and priorities, several companies went out of their way to help the society. The theme of ESG or sustainability is becoming not just a luxury but indeed a necessity in the present-day scenario,” feels Jinesh Gopani, Head – Equity, Axis AMC. Social responsibility will emerge as a priority for companies.
At the governance level, investors will keenly watch how companies engage with specific stakeholders like labour, and evolve meaningful policies to grapple with the new challenges. Ruchit Mehta, Fund Manager-SBI Magnum Equity ESG Fund, SBI Mutual Funds says that shareholders will focus on the risk-mitigation options that managements adopt. “The strengthening of supply chains will be one of them. Import-dependent companies may change their practices, and evolve alternative supply chains,” he adds.
In the post-COVID world, there will be a paradigm shift, as sustainability and responsible investing gain importance. Asset managers will approach investments differently, and investors will demand this change. “Hence, the adoption of ESG is likely to accelerate. It will emerge as a new investment philosophy, even in a nascent market like India,” says Shibani Kurian, Head of Equity Research, Kotak Mahindra AMC. Like growth and momentum stocks, sustainable shares will become part of our lexicon.
Global experience shows that ESG investing generates long-term and competitive returns for both asset managers and investors. This is also true for the not-so-mature Indian market. For example, the two funds of SBI Magnum gave annualised returns of 6.29 per cent and 5.41 per cent over a five-year period. The returns were lower at 2.45 per cent and 1.55 per cent, respectively, over a three-year timeframe. Given the current state of the stock markets, the returns were negative in absolute terms in the past three to six months. Gopani indicates that the more significant aspect of the sustainable funds is that their investment strategies “bring down the risk of disruptions in the companies’ business models and performances due to ESG factors”. The stocks, which they buy are likely to show lower volatility due to possible controversies and occupational mishaps related to environment and governance issues. Hence, the investors and asset managers can be more confident about the price stability of such stocks.
Unlike the other mutual funds, the sustainable ones incorporate ESG analysis in their research and decision-making process. However, despite the single underlying philosophy, the various ESG funds can have different approaches and tactics. According to SBI Magnum’s Mehta, “some funds invest in companies that are broad ESG leaders, and others focus on those with specific positive value-add such as clean energy, healthcare, education, gender equality, and waste management”.
“We weigh stocks based on our proprietary ESG scores, and check tolerance on sector guardrails to arrive at the final weights assigned to each stock in the portfolio,” explains Quantum’s Mehta. He adds that an ESG score, which is a tally of 150 to 200 parameters of a company’s ESG footprint, can be considered a measure of its long-term sustainability. The higher the score, the better it is as an investment option. “A high score translates into steady and sustainable performance,” reveals Gopani.
The most favoured stocks in the portfolios of ESG funds are TCS, HDFC, Marico and Shree Cements. “The choice of Marico is because 93 per cent of its packaging material is recyclable and, despite a high promoters’ holding of 60 per cent, the business is managed by a professional CEO. In the case of Shree Cements, almost a fourth of its raw material comes from alternative sources, and its plants have zero liquid discharges and are equipped with air-cooled condensers to conserve water,” says Quantum’s Mehta. The most promising sectors include technology (which has the lowest ESG risk score), followed by consumer cyclical, communication, and real estate. The riskiest ones are healthcare and utilities. “Most healthcare companies have severe or high ESG-related risk. The issues include business ethics, product quality, and safety and access to healthcare,” says Harish Toshniwal, Product Manager, Morningstar Indexes. His list of companies with severe risk comprises Lupin, Cadila Healthcare, Sun Pharma, Piramal Enterprises, GlaxoSmithKline, and Dr Reddy’s Lab.
But an ESG score of a company or sector is not a static figure or concept. There are no guarantees that certain stocks or sectors will always remain high on such rankings. Therefore, the fund managers need to nuance and fine-tune their analyses, and include future trends in their calculations. The steps that a company plans to take and the changing state of an industry are crucial factors. Even the past is important. Companies with a past record of high controversies scores should be avoided.
It’s not an easy task to be an ESG fund manager. The problem becomes more complex in India because of the paucity of information. For example, as per Sebi’s rules, only the top 1,000 listed companies need to furnish Business Responsibility Reports, which highlight their initiatives on ESG issues. There is also a lack of regulatory desire to push companies to reveal additional information. Thus, ESG research becomes difficult, which limits the choices for the fund managers, as also the investors.
By default, the funds fall back on safe strategies. For example, they assiduously shun stocks of companies that derive significant revenues from businesses such as tobacco, liquor, and controversial weapons. In addition, there is the tendency to keep portfolios well-diversified, and not to unduly penalize specific sectors, even those like energy and utilities that rank high on ESG risk scores. The standard practice is to keep the sector-wise exposures in sync with the overall market or the benchmark index.
COVID-19 will lead to several changes. Investors will become sensitive, and gauge companies’ efforts to tackle the ESG issues. As they pump money into sustainable funds, the asset managers will be forced to become picky, and discard certain stocks. The managements will pursue sustainable practices. Like CSR, ESG will emerge as a win-win for the stakeholders, who will realise that such strategies lead to higher operational, financial and stock value, and benefit communities and societies. In several ways, the performances of the ESG funds vis-a-vis the global universe in the first quarter of this year prove these trends. As the Morningstar report contends, the “continued inflows” into the sustainable funds “speak of the stickiness of ESG investment.” It is evident that investors are increasingly driven by values, even non-financial ones. Hence, they are willing to invest in stocks that rank high on ESG for a longer term and, most importantly, they are “willing to ride out periods of bad performance.”