Q. I am a 27-year-old salaried professional working as a mechanical engineer with a multinational company in Pune. I consider myself to be an environmentalist and have been looking to invest in mutual funds which invest only in those companies which are environmentally conscious and are not damaging the environment. I understand from friends that ESG funds fit the bill. Can you please elaborate what ESG funds are and in which companies do they generally invest and their tax treatment?
Abigail Norbuk, Shillong, Meghalaya
Environment Social Governance mutual funds (“ESG Funds'') are a subcategory of thematic mutual funds. Under SEBI regulation thematic funds are required to invest a minimum of 80% of their corpus in a particular theme or trend. For instance, a thematic fund investing in renewable energy themes will be required to invest at least 80% of its corpus in companies which are in the renewable energy business.
An ESG Fund is a mutual fund that includes environmental, social, and governance concerns into the investment process There are a handful of ESG Funds at present in India, and there are numerous distinct ESG-focused investment techniques used by fund managers running these funds to identify companies aligned to their investment goals.
Most investors investing in ESG Funds believe that the future performance of a firm is more predictable if it adheres to ESG norms. Sustainable investing is another name for ESG investing. In essence non-financial performance metrics including corporate governance, ethics, environmental sustainability, etc., of the business are key focus areas in identifying whether a company is an ESG compliant business or not.
Practically speaking in the past many companies' share price has been affected by a blow to their reputation because of a corporate governance scandal or environmental pollution. Businesses that integrate ESG values into their operations relatively display lower volatility, which in turn lowers business risk. They can reduce outside shocks and build a highly powerful brand. However, it is important to note that all investments in the stock market are subject to market risk and the returns are not guaranteed.
How mutual fund managers identify ESG stocks?
ESG fund managers can build their portfolios using a range of strategies, including internal proprietary criteria and third-party ESG scores (given, among others, by raters like MSCI).
While not all-inclusive, the following are some instances of ESG investing strategies:
Negative screening strategy focuses on removing companies which do not match particular sustainability standards or criteria by recognising unfavourable features such as excluding companies in the cigarette manufacturing sector or companies situated in the oil and gas sector.
Positive screening is the opposite of negative screening, also known as the inclusion strategy. Instead, of excluding stocks, analysts and fund managers at asset management companies invest in companies with high ESG score. Most companies which adhere to ESG norms get themselve rated from ESG rating providers in order to get an ESG score.
An ESG fund manager will use thematic investing strategy to pinpoint longer-term macroeconomic patterns that they believe have advantages and will collectively improve E, S, or G outcomes for example an ESG Fund investing in solar power companies.
Why to invest in ESG companies?
There have been several social and environmental developments recently. Organisations today need to concentrate on safeguarding the ecology in our surroundings, whether it is due to pollution, climate change, or the negative consequences of technology. Companies that are socially conscious are also thought to be more employee-friendly and humane in their actions. The demand for such ethical organisations has constantly been growing among educated investors.
For instance, does a clothing manufacturer create environmentally friendly clothing is the question in the minds of lakhs of youth. Whether a manufacturing company is disposing of its waste products in an environmentally responsible manner or dumping it into our rivers and oceans is another question in the minds of educated investors.
These are some of the behaviours that will eventually lead to a polluted planet. ESG companies are more prepared to control the damage they can cause because they are more aware of it. Investors now have a significant influence in the behaviour of companies because of the money which a company can raise if it is ESG compliant. The other businesses may be compelled to adopt ESG practices if more and more investors start investing in more ethical businesses.
Taxation of ESG funds
Capital gains from ESG Funds are taxed the same way as capital gains from other conventional equity mutual funds. If your holding duration of ESG funds units is less than 12 months, the short-term capital gains (STCG) tax will be levied on your capital gains, at the rate of 15%. If your holding period for the ESG Funds is 12 months or more the long-term capital gains (LTCG) tax will be levied on your capital gains, at the rate of 10% if the gains made in the financial year exceed ₹1 lakh, LTCG below ₹1 Lakh is tax exempt.
If you are an educated investor who is concerned about the environment and other ethical issues you should definitely explore ESG Funds. However, it is important to note that ESG investment in India is a new and developing investment strategy, there are only a handful of ESG Funds and there is not much historical data available to analyse and compare their performance with other mutual funds.
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Note: This story is for informational purposes. Please speak to a financial advisor for detailed solutions to your questions.