- April 12, 2021
- Posted by: CFA Society India
- Category:In Conversation With
Industry Expert- Ruchit Mehta, CFA
(Fund Manager & Analyst, SBI Mutual Fund)
Interviewed By- Parvez Abbas, CFA
(Member, Public Awareness Committee, CFA Society India)
Environmental, Social and Governance (ESG) factors are becoming an important part of investment thesis. The world is already dealing with climate change and the recent pandemic has increased awareness for social issues further supporting the case for ESG investing. Investors around the world are increasingly using a variety of analytical approaches to incorporate ESG data into the investment process. To delve deeper and get more insights on ESG investing, we interviewed Ruchit Mehta, CFA who is a Fund Manager and also responsible for equity research on automotive sector at SBI MF.
Parvez: Why is ESG investment as an investment theme attracting the attention of mainstream investors in recent times?
Ruchit: There are significant challenges that the world is facing, not unlike in the past. The difference this time around is that the challenges are universal and impacting everyone equally. In the past, the world faced issues of solving for poverty, hunger, housing etc. issues in the sphere of government responsibility. The capitalistic world saw a limited impact. In-fact the focus was squarely on governance issue, as that was the prime ex-operating business risk factor. The current challenges are much different, and more severe in their impact. They are partially caused by the unfettered access that the corporate world has had to natural resources and human capital. It is difficult to imagine such unfettered continued access to continue. The challenges of a rapidly changing climate are agnostic to any country or business. So are issues of income inequality. These are issues that businesses also need to address to ensure long term sustainability of the business, to maintain the long-term viability of their business model. Investors in the same breath need to look at the emerging risks from ESG factors in order to protect existing investments and look at newer opportunities.
In a more recent post Covid context, the vulnerability of the global economic system has been laid bare. This throws up a question, is there a risk that could similar disruptions occur when a climate event strikes? Untenured lockdowns, supply chain constraints, large scale migration of climate refugees and consequent production loss are now real risks that investors need to consider factoring into their investment decision
Parvez: Why are ESG funds gaining prominence among the investors in India?
Ruchit: When you look at the various ESG risk factors, such as a changing climate, social inequality, board independence and governance, are agnostic of geography and domicile. India and Indian companies will face the same challenges as any other global firm. There are risks and opportunities at the same time. Making business operations more sustainable is perhaps in everyone’s interest. As more and more investors start to appreciate these factors, we see ESG only gaining more prominence.
Indian regulatory paradigm has already been evolving on the governance aspect since the last decade. Most funds anyway incorporate governance concerns in their evaluation methodologies irrespective of their ESG strategies. However, now with newer concepts and terms like net zero, just-transition, carbon and water positivity etc reverberating across the global landscape, the environmental part has assumed critical importance. Companies and investors are no more approaching environmental issues as an after impact of a toxic spill or leakage, rather, it is being proactively monitored at the strategy level. Application of the ESG lens on a stock has now become an essential risk mitigation approach to safeguard future investments. This approach can be easily applied on Equity funds. Moreover, with regulators mandating more transparency in ESG disclosures by companies, and stewardship for investors, the system is more conducive for sustainable finance avenues to be created through ESG themed funds. This is exactly what has been happening in the Indian context. Where there were only two ESG themed funds in India till 2019, in 2021, there are at least 10 products on the ESG theme in the Indian market. We feel that the trend would only accelerate from here as the millennials’ demand of responsible use of their money weighs on fund managers.
Parvez: How are ESG funds different from existing investment funds?
Ruchit: ESG funds are not unlike existing investment funds. they just tend to look at an additional layer of business risks which, hitherto were underappreciated. So, from that context, there could be additional steps in the methodology adopted by managers of ESG themed funds while drawing its constituents. On the basis of the theme, there could be sectoral exclusions, or exclusions of controversial companies. Most funds would also look at the ESG ratings/scores of the companies also in order to select the higher scored companies from its peer set (best-in-class approach). This perhaps makes them ‘higher quality’ in nature. There also tends to be this misnomer that ESG funds will invest into a particular type of securities or sectors, like clean tech, but these are like any other thematic fund. Any company in any sector can be a ESG leader amongst its sector peers.
Parvez: How do you identify companies that meet the ESG investment universe? Are there any principles or standards?
Ruchit: We see ESG analysis as an extension to the core research process of any company or security. From our perspective, every company qualifies for investment after it crosses a certain threshold. One of those thresholds is absolute performance on ESG factors. We use a range of tools, internal and external, to assess how well a company is addressing its relevant ESG risks. The bottom scoring ones are excluded. The second is excluding companies which have high level of on-going controversies on material business issues. For the specific ESG focussed funds we also exclude certain vice/controversial sectors such as Tobacco and Controversial weapons.
Parvez: Incorporating ESG in investment decision-making is challenging. How do you incorporate the ESG aspects while valuing a company?
Ruchit: One of the esoteric aspects of ESG investing is trying to quantify an explicit impact on valuations due to ESG factors. One of the ways we think it will make an impact is on the long-term sustainability of cashflow growth. There may be cases where the expected growth in cashflows may need to be adjusted lower due to risks emanating from ESG factors. For example, a company prone to labour multiple strikes in a year would end up losing on man days of production. This is a tangible monetary impact for a company, moreover it may face higher attrition rates, which may lead to spending on resources at higher rates, training and onboarding costs etc. Another, more tangible impact will be on the cost of capital. Many firms tend to see significant changes to the cost they are paying for debt funds and changes to the availability of equity capital.
Parvez: Green bonds, sustainable bonds, transition bonds, and sustainability linked loan issuances are on the rise in developed countries. Would the trend follow in emerging markets as investors look for more avenues in search of additional yield or mitigating risks?
Ruchit: We expect the trend of ESG linked bonds to pick up in emerging markets as well. One factor we expect to be is a confluence of investor demand and corporations looking to reduce capital costs. There will also be a factor of investors shunning ESG laggard companies or demanding a higher yield from them, such as is the trend witnessed in the fossil fuel sector. The creation of a sustainable finance ecosystem in the country would go a long way to meet our commitment to the Paris accord and the UNG SDGs. Green or Sustainable bonds would serve as an important part of that ecosystem. We have recently witnessed large corporations coming out with sustainability bonds, which shows an appetite for such instruments in the country. Risk mitigation would certainly be the most important outcome for these bonds as responsible investment would become the need of the hour and the social license to operate rather than an additional theme to cater to.
Parvez: What are the types of skills needed among ESG professionals? What advice would you like to give to budding professionals who want to make a career in this field?
Ruchit: Firstly, having a good analytical capability is important. ESG factor analysis is no different than analysis of a security or a company. Having an eye for detail, being inquisitive, curious are traits of a good analyst, and the same extends to an ESG analyst as well. Second, it is important to understand and appreciate why ESG analysis is important. It is not about being an environmentalist or taking an activist stance. It is being appreciative of the fact that ESG factors are as much a risk factor with material business impact as any other factor. Another important trait is to understand how the intangible risks or consequences would have an actual tangible impact on the valuation/profits or increased costs for a company. ESG analysts need to coordinate well with the financial analysts as well as the corporations and fill the gap of non-financial contributing factors, that currently the former two are unable to cater to.
About Ruchit Mehta
Ruchit has industry experience of over 16 years. He joined SBI Funds Management in 2010. He has fund management responsibilities and covers sectors such as Automotive OEM. In his previous role, Ruchit worked for HSBC Asset Management where he was an Analyst and Assistant Portfolio Manager for four years. Prior to HSBC, Ruchit was a Sell Side Analyst with leading broking firms like ASK Raymond James and Prabhudas Liladhar for two years. Ruchit is a Commerce Graduate from Mumbai University and holds Master’s Degree in finance from Lancaster University, UK. He is also a charterholder of the CFA Institute, USA.
About Parvez Abbas
Parvez Abbas is a Manager in the Commercial Lending division at Acuity Knowledge Partners. He has more than 12 years of experience spanning across investment research, credit solutions and structured products. He has served clients including global banks and asset managers providing assistance in securitization, credit risk management and portfolio analytics. In the past, Parvez has worked for Cians Analytics, Genpact and American Express. He is an MBA finance and a CFA charterholder.