The ultimate guide to ESG mutual funds for sustainable investing

Did you know that as of March 3, 2024, ESG-focused funds had attracted ₹9,753 crore in investments, which is a 36% compound annual growth rate (CAGR) since January 2020?

The numbers tell a clear story: More investors like you want their money to make both profits and a positive impact. However, choosing the right ESG mutual funds can feel overwhelming, with hundreds of options available and complex sustainability metrics to consider.

You need a clear strategy to identify genuine ESG investments that align with your values while delivering competitive returns. Whether you're new to sustainable investing or looking to optimise your existing portfolio, understanding how to evaluate and select ESG mutual funds is crucial.

This guide will cover everything you need to know about ESG mutual funds, from understanding the basics to building a balanced, sustainable investment portfolio that matches your goals. Let's get started!

Understanding ESG mutual fund basics

ESG mutual funds represent a significant shift in investment strategy. They focus on companies that prioritise environmental, social, and governance factors alongside financial returns.

What makes a fund truly ESG-focused

A truly ESG-focused fund evaluates investments based on three core components:

• Environmental: Assesses a company's impact on nature, including carbon emissions and waste management
• Social: Examines employee welfare, gender equality, and community engagement
• Governance: Evaluates corporate policies, regulatory compliance, and ethical business practices

Key ESG investment approaches

Your ESG investment journey can take multiple paths. The most common approaches include ESG integration, where fund managers assess financially significant ESG factors alongside traditional metrics. Another approach is exclusionary screening, which removes companies involved in controversial sectors like weapons or tobacco.

Different types of ESG mutual funds

You'll find several distinct types of ESG funds to match your investment goals. Best-in-class funds select top-performing companies within each sector based on ESG criteria. Thematic funds focus on specific environmental or social objectives, such as renewable energy or gender diversity. Impact funds aim for both financial returns and measurable positive outcomes in specific areas like climate change or healthcare.

Fund managers use ESG scores from research organisations like MSCI and Sustainalytics to evaluate companies, ensuring your investments align with sustainable practices. These scores help determine how well companies manage their ESG risks compared to industry peers.

How to evaluate ESG mutual funds

When evaluating ESG mutual funds, you need to consider more than just the returns. Start by understanding how rating agencies assess these funds.

Analysing fund ESG ratings and scores

ESG ratings range from CCC to AAA, with AAA representing the highest score. Focus on funds rated AA or AAA, as these are considered industry leaders in managing ESG risks. The Fund ESG Quality Score, calculated on a scale of 0 to 10, offers another vital metric for assessing fund performance.

Assessing fund holdings and strategies

Your chosen fund must invest at least 65% of its assets in companies that provide comprehensive Business Responsibility and Sustainability Reporting (BRSR). Look for funds that clearly disclose:

• Monthly portfolio BRSR scores
• ESG Rating Provider details
• Voting decisions on ESG matters

Understanding fees and expenses

ESG funds typically involve various costs that affect your returns. These include:

• Management fees: Cover portfolio management and administrative costs
• Distribution fees: Known as 12b-1 fees for marketing and distribution
• Operating expenses: Include custodial, legal, and accounting costs

Remember that even small differences in fees can significantly impact your long-term returns. Compare expense ratios across similar funds to ensure you're getting value for your money. A high-cost fund must perform better than a low-cost fund to generate the same returns.

When reviewing fund performance, examine both financial metrics and ESG impact measurements. Look for transparent disclosure of the fund's ESG strategy and regular updates on how this strategy is implemented in practice.

Building an ESG mutual fund portfolio

Building a strong ESG mutual fund portfolio starts with understanding your values and financial objectives. Global ESG assets under management are projected to exceed INR 3375.22 trillion by 2030, showing the growing importance of sustainable investing.

Setting sustainable investment goals

Start by identifying your core ESG priorities. Research shows that companies with strong ESG practices often manage risks better and show more resilience during market uncertainties. Your goals should balance:

• Financial returns expectations
• Environmental impact priorities
• Social responsibility preferences
• Governance standards

Asset allocation strategies

Consider implementing the proven 12|20-80 strategy for your ESG portfolio:

1. Allocate 12 months of expenses in liquid funds
2. Invest 20% in gold for diversification
3. Direct 80% towards ESG equity funds

This approach helps balance risk while maintaining strong ESG alignment. Studies indicate that companies following sustainable practices perform better in the long term.

Portfolio rebalancing considerations

Regular portfolio monitoring is essential to maintain your desired ESG standards. Focus on:

• Tracking ESG rating changes
• Reviewing company controversies
• Adjusting allocations based on performance
• Ensuring continued alignment with your goals

When rebalancing your portfolio, remember to conduct comprehensive due diligence and incorporate ESG factors. This will help you maintain the right balance between financial returns and sustainable impact.

Measuring ESG fund performance

Recent studies reveal that sustainable funds generated better returns than traditional funds in 2023, with a median return of 12.6% compared to 8.6% for traditional funds.

Key performance metrics

Your ESG fund evaluation should focus on the ESG Quality Score, which measures how well holdings manage environmental, social, and governance risks. The Fund Percentile Rank compares your fund's ESG score to peer groups. Consider these core metrics:

• Overall Fund ESG Quality Score (0-10)
• Environmental Score
• Social Score
• Governance Score

Risk-adjusted returns analysis

Research shows that ESG funds often display stronger resilience during market volatility. When analysing risk-adjusted performance, focus on:

Impact measurement frameworks

To gauge your fund's real-world impact, use established frameworks like GIIN's IRIS+, which provides:

• Thematic taxonomy
• Core metrics
• Implementation guidance
• Comparable data

The Impact Management Project offers fifteen categories across five dimensions: what, Who, how much, Contribution, and Risk. These frameworks help you consistently measure financial returns and positive impact.

Studies indicate that ESG-focused companies often demonstrate better innovation, operational efficiency, and risk management, which can enhance shareholder returns.

Optimising ESG fund selection

Making smart choices about ESG mutual funds requires a systematic approach to optimise both financial returns and sustainable impact. Let's explore the key factors that will help you make informed decisions.

Cost-benefit analysis

Your ESG investment decisions should balance both financial and non-financial objectives. Consider these essential factors:

• Expected risk-adjusted returns
• ESG impact measurement
• Portfolio management costs
• Long-term sustainability goals

Research shows that companies with strong ESG practices often demonstrate better innovation and operational efficiency. A thorough cost-benefit analysis can help you identify investments that align with your values while maintaining competitive returns.

Tax efficiency consideration

The Inflation Reduction Act of 2022 offers significant tax incentives for sustainable investments, including over INR 31,220.77 billion in climate-related provisions. These benefits fall into four main categories:

• Power generation credits
• Transportation incentives
• Industrial production benefits
• Real estate-related advantages

Portfolio fit evaluation

To optimise your ESG fund selection, use a multi-index model that considers both traditional financial metrics and ESG factors. This approach helps you:

• Assess risk-adjusted performance
• Evaluate ESG characteristics
• Monitor portfolio alignment
• Track sustainability targets

Regularly review your portfolio's ESG ratings and adjust holdings as needed. This ensures your investments continue to meet both your financial goals and sustainability standards while maintaining optimal tax efficiency.

Moving ahead

ESG mutual funds offer a powerful way to align investments with values while pursuing competitive returns. Careful evaluation of fund ratings, holdings, and fees helps build a portfolio that matches financial goals and sustainability standards.

Smart portfolio construction starts with clear ESG priorities and follows proven allocation strategies, such as the 12|20-80 approach. Regular monitoring of ESG ratings, impact measurements, and risk-adjusted returns ensures your investments stay on track.

Remember that successful ESG investing requires a balance—between costs and benefits, tax efficiency and impact, and financial returns and sustainability goals. Companies with strong ESG practices often show better long-term performance through improved risk management and operational efficiency.

Your investment choices shape the future of sustainable business practices. Start your ESG investment journey today by choosing funds that match your values and financial objectives. Keep tracking your portfolio's performance using both traditional metrics and ESG impact measurements to achieve lasting positive change through your investments.

Disclaimer: This article provides general information on ESG mutual funds and sustainable investing. Investment performance may vary, and past results don't guarantee future returns. Always consult a qualified financial advisor before making investment decisions. ESG criteria and fund strategies can change over time.

Contributed by Denila Lobo

Denila is a content writer at Winvesta. She crafts clear, concise content on international payments, helping freelancers and businesses easily navigate global financial solutions.