A few years ago, ESG mutual funds entered India, offering investors a new choice in the thematic funds segment. These funds promised something different from regular investing. The idea was to put money
only into companies that care about the environment, treat people fairly and follow good management practices. The aim was to promote ethical and sustainable investing.
For many investors, this felt like a way to earn returns without supporting companies that harm nature or ignore social responsibilities. Over time, however, the reality of ESG investing in India has turned out to be more complicated. There are only a limited number of ESG schemes, rules are still evolving and questions are being raised about how these companies are rated.
Before deciding whether ESG funds are right for your portfolio in 2025, it is important to understand how they actually work.
What ESG Funds Aim To Do
As the name suggests, the ESG funds pick companies based on three factors. The first is the environment, which includes things like pollution levels, water use and waste handling. The second factor pertains to social responsibility, such as worker safety, fair pay, diversity, and how companies treat customers and communities. The third parameter is linked to governance, which covers board structure, honesty in reporting and how shareholders are treated.
As the name suggests, these funds invest in companies that meet higher standards of environmental, social and governance (ESG) practices. As per the market regulator, the Securities and Exchange Board of India (SEBI), these funds are mandated to invest 80 per cent of their capital in the ESG segment. The ESG funds were first introduced in India in 2018-19.
Fund managers use company reports and ESG scores from rating agencies to build portfolios. The goal is to avoid companies that may face trouble due to poor practices and focus on those seen as more responsible in the long run.
Why ESG Ratings Raise Concerns
One big issue with ESG funds is that ratings are not uniform. The same company may score high with one agency and low with another because each one uses different methods. In India, this problem is bigger because company disclosures are still improving.
Because of this, investors may not always know why a company is included in an ESG fund. Regulators have noticed this gap and are pushing for better data and clearer rules, but the rules and industry practices are still evolving.
How ESG Funds Have Performed
In the beginning, ESG funds did well because they mostly invested in large, stable companies. When these stocks performed strongly, ESG funds provided decent returns. But this has not always been the case.
When markets moved in favour of sectors like metals, energy, or other high-emission industries, ESG funds lagged behind. This shows that ESG performance depends a lot on market trends, not just good intentions.
Who Should Consider ESG Funds
ESG funds can suit investors who care about how companies operate and are willing to accept lower returns. These funds could be a suitable addition for investors who prioritise sustainable and ethical investment practices over high returns. Despite the limitations, ESG funds could be helpful in diversifying your portfolio.
However, they should not replace regular equity funds. The range of companies is still limited and the regulatory framework has not fully evolved. For most investors, broad equity funds remain a better main option.
How ESG Fits Into A Portfolio
Investing a small amount in ESG funds could be an ideal choice for diversification. According to financial advisors, around 5–10 per cent of equity mutual funds in your portfolio should comprise ESG funds. They add a value-based layer for long-term gains, but may not be expected to beat the market trends every year.
