The ESG smokescreen

Last week, mutual funds regulator SEBI permitted mutual fund companies to launch up to six ESG (environmental, social and governance) funds instead of only one that has been permitted until now. Instead of just one generic ESG fund, each AMC can now have one fund under six subtypes of ESG that it has specified: Exclusion, Integration, Best-in-class & Positive Screening, Impact investing, Sustainable objectives, and Transition or transition-related. As an investor, I'm sure you are excited and look forward to carefully evaluating the six ESG themes. I hope you find it entertaining.

However, I can assure you that the fund industry is overjoyed at this boost to environmental, social, and governance causes that the regulator has provided. Everyone knows that launching more funds is the bread, butter and jam of mutual fund companies, even though it means more confusion for the investor and more distraction from simple, understandable funds.

At Value Research, we have always strongly emphasised that all sectoral, thematic and such funds should be avoided, regardless of any particular purported quality, usefulness or track record. Every fund that follows a theme has some carefully crafted story to tell. However, diversified general-purpose equity funds are a superset of all the existing stories. There may be times when this or that theme or sector makes more sense than others, but that doesn't mean that you, the investor, have to identify those times and then identify the right fund to invest in. All it means is that if most (or all) of your money is invested in a general-purpose fund with a good track record, then the fund manager will appropriately emphasise whichever kinds of stocks when it's the right time to do so.

Within this framework, while comparing with the older concept of sectoral or thematic funds, I see ESG as the worst of the worst. A major reason is that there is an underlying objective reality to ESG. For example, if you consider a technology fund or a financial services fund, then a hard definition is possible as to what technology or financial services are. People try to game that definition and stretch it, but even a mildly knowledgeable investor can see through such chicanery. For example, defining a company as a financial service does not depend on a certificate or a declaration. Suppose a tyre company says that we have financial services on our articles of association and a certificate to the effect from some agency. In that case, investors will just laugh at it. ESG, on the other hand, is all about declarations, intentions, and certifications.

As to the effectiveness of these certifications and ratings, a large study found last year that around 70+ per cent of companies' ESG ratings do not correlate across agencies. This means that they are meaningless. The most famous absurdity of this process was last year when Tesla was dropped from the S&P ESG Index because of the company's "lack of a low-carbon strategy". If one business has single-handedly shoved the global transportation industry on the low-carbon path, it's Tesla, but S&P finds that Tesla has no strategy!

From the individual investor's perspective, what exactly is the logic of ESG? You probably believe that this is some do-gooding logic, whereby you don't mind investing in something that might have lower returns as long as it 'does good' according to some definition. However, as you can well imagine, institutional investors need a different story that does not involve any return compromise. So the theory is that not following the ESG path exposes a company to future risks that equity markets do not consider, so if we invest in ESG-compliant companies, the returns will be better. Stripped to the basics, the ESG rating agencies have taken it upon themselves to channel investments because the markets can't do it properly. This is the same role the Planning Commission played in the License Raj days. ESG is essentially a global License Raj where a committee decides which businesses are socially useful and which are not. We all know how effective that is going to be.

If you would like to risk your hard-earned money on this absurdity, then go right ahead - just don't have any illusions about its reality.