ESG Funds in India: Underperformance Despite Rise in Popularity

The bull market rally that began after the COVID-19 lows witnessed a surge in ESG (environmental, social, and governance) investing in India. Investors shifted their focus from profitability to how companies achieve those profits. This led to a wave of ESG thematic offerings by fund houses in India, mirroring a global trend. However, three years down the line, the story is not as rosy as anticipated. Most ESG funds have failed to deliver exceptional returns, raising questions about their efficacy in the Indian market.

ESG Investing Explained

ESG investing is based on a company’s environmental, social, and governance practices. ESG-focused funds primarily invest in companies that pass muster based on ESG criteria as defined by the fund’s investment framework. The ESG theme gained popularity after the COVID-19 pandemic, coinciding with a time when investors sought justification for the premium valuations of certain stocks. Between 2020 and 2021, new ESG funds were launched in India.

Performance of ESG Funds

The following table details the performance of six actively managed ESG funds compared to an average Large Cap Fund

Looking at the one-year and three-year returns of the ESG funds in the table compared to the large-cap fund average, ESG funds underperformed. The one-year average return for ESG funds was 32.50% while the large-cap fund average was 35.40%. This trend is consistent over the three-year period, where ESG funds averaged 15.07% while large-cap funds averaged 17.80%. This underperformance suggests a potential limitation of the current ESG fund strategy in India, possibly due to a restricted investment universe or premium valuations of ESG-compliant companies.

Reasons for Underperformance

Several factors contribute to the underperformance of ESG funds in India.

• Limited Investment Universe: ESG funds in India are biased towards large-cap stocks, with portfolio allocations ranging from 50 to 80%. Compared to the US market with hundreds of large-cap options, India has a much smaller pool (around 100). Adding another layer of ESG criteria further restricts the investable universe for fund managers.
• Premium Valuations: The ESG theme itself might struggle due to premium valuations. A focus on “quality” stocks can lead to portfolios with slightly higher valuations, potentially limiting upside potential.
• Top Bank and Tech Stock Drag: The underperformance of top bank stocks and tech stocks in the past year has negatively impacted returns for ESG funds, which often hold these companies.

Portfolio Positioning and Risk Management

Despite underperformance in terms of absolute returns, ESG funds have exhibited better downside capture compared to the market. This aligns with the expectation that companies with strong ESG practices offer better cushioning during market downturns.

Challenges in ESG Data and Reporting

ESG data and reporting pose significant challenges for investors. ESG scores are not mandatory, and there is no standardized format for disclosures. This vulnerability creates opportunities for “greenwashing,” where companies selectively highlight positive ESG practices while concealing negative aspects. The lack of standardized data makes it difficult to accurately assess a company’s true ESG impact and consequently, select them for fund portfolios.

Conclusion

ESG investing in India is still evolving. While the concept has gained traction with investors, translating that interest into consistent outperformance has proven challenging. The limited investable universe in large-cap stocks, potential premium valuations of ESG-compliant companies, and underperformance of certain sectors within ESG portfolios have all contributed to lackluster returns from ESG funds. However, ESG funds have shown promise in terms of downside protection.

Investors considering ESG funds in India should be aware of these factors and have realistic return expectations. ESG data and reporting remain an ongoing hurdle, making in-depth research crucial for evaluating a company’s true ESG commitment. Ultimately, ESG investing should be viewed as part of a holistic investment strategy that considers financial goals, risk tolerance, and alignment with personal values. As the ESG market matures in India, with potentially improved data standardization and a wider range of ESG-compliant companies across sectors, these funds might become more competitive in terms of returns.

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Disclaimer: This blog has been written exclusively for educational purposes. The securities mentioned are only examples and not recommendations. The information is based on various secondary sources on the internet and is subject to change. Please consult with a financial expert before making investment decisions.