The process involves compiling historical five years prices as of September 30th, 2022, of almost 65 Indian Equity Regular Growth Mutual funds and creating a Mutual Fund screener that screens 65 Mutual funds based on four main factors A) 5-year Sharpe Ratio B) Mean 3 Year Rolling Return C) 5 Year Alpha/Downside risk D) Mutual Fund P/E (-) Benchmark Historical average P/E. Following weightage is given to the factors in screening and using the top 5 Mutual funds: 40% weightage to 5 Year Sharpe Ratio, 30% weightage to Mean 3 Year Rolling return, 20% weightage to 5 Year Alpha/Downside Risk, and 10% weightage to the Price/Earning factor. I decided to compare the ESG (Environmental, Social & Governance) inclusive portfolio of Mutual Funds with the non-ESG portfolio of Mutual Funds. The top 5 Mutual Funds were shortlisted from each list of funds, including and excluding ESG funds, and allocated using the Portfolio Optimization method with the Excel Solver tool.
Note: Morningstar provides ESG scores.
The picture above shows the Top 5 screened Mutual Funds from a list of Mutual Funds that do not include ESG funds. This Top 5 list includes Tata Digital India Fund, Quant Active Fund, Axis Small Cap Fund, Axis Midcap Fund, and PGIM India Midcap Opportunities Fund. All funds are Regular plan and Growth.
The above picture shows the Top 5 screened Mutual Funds from a list of Mutual Funds that include ESG funds. This Top 5 list includes Quant ESG Equity Fund, Axis ESG Equity Fund, Tata Digital India Fund, Quant Active Fund, and Axis Small Cap Fund. All funds are Regular plan and Growth.
The purple worksheets in excel represent the best results from the list of Mutual Funds that includes ESG Mutual Funds, whereas the blue worksheets in Excel represent the best outcomes from the list of Mutual Funds that do not have ESG Mutual Funds or that are non-ESG Mutual Funds. In short, blue is for non-ESG portfolios, and purple is for ESG portfolios. Within the ESG and non-ESG results, three scenario analysis is done in portfolio allocation of the top 5 Mutual funds. Portfolios 1, 2, and Optimal Portfolios are calculated for each of the ESG and non-ESG groups, and comparisons of the portfolios between ESG and non-ESG groups are made with market returns as well. I will talk about the conclusion at the end but first, let's go through the screener factors' calculations and assumptions.
As seen in the enclosed individual Mutual Funds worksheets, Returns, Standard Deviations, and Sharpe ratios are measured in two ways. Worksheet calculations on the left side of each sheet show financial estimates for Compounded Returns, Standard Deviations, and Sharpe ratios from the monthly historical prices of that specific Mutual Fund. Then on the far right, Excel Formulas Calculations use Excel formulas such as the Average formula for annualized returns by multiplying them by 12 and STDEV.S Excel formula for Standard Deviations, which are then annualized.
· The 5-year Sharpe ratio numbers used in the Mutual Fund screeners for ESG and non-ESG portfolios are selected from Worksheet calculations located on the left of each mutual fund worksheet.
· Mean 3 Year rolling returns for each Mutual Fund are rolled monthly for three years and compared with Benchmark rolling returns and are entered in the Mutual Fund screener.
· 5-year Alpha, which appears on both ESG and non-ESG lists screener, is inserted from Morningstar data that uses Jensen's Alpha based on expected returns. In addition, Jensen's Alpha is calculated using the CAPM formula based on realized returns. It is located under the heading Excel Formulas Calculations of each Mutual Funds sheet for comparison purposes. Morningstar Alpha is used in the Mutual Fund screener mostly because Morningstar data for Alpha is more conservative than Alpha based on realized returns from Excel Formulas. The primary purpose of having Morningstar Alpha, Returns, Standard Deviations, and Sharpe ratios data is to compare and cross-verify such data with that of Worksheet calculations on the left and Excel Formulas calculations on the far right of Morningstar data.
· Downside Risk for each Mutual Fund is calculated by considering only the negative returns and then squaring those negative returns to get rid of the negative sign and then square rooting the sum of those squared negative returns to get the downside risk number, which is then annualized.
· To factor in the price of each Mutual Fund, I have compared the P/E number of each Mutual Fund, which is sourced from The Economic Times, with that of an average P/E of Benchmark for each Mutual Fund and have given more weightage to the Mutual Fund with smallest P/E.
After screening both the list containing the ESG Mutual Funds and the list not containing ESG funds based on the factors mentioned above, each group's top 5 Mutual funds are applied in portfolio allocation and optimization.
The pictorial representation concludes that an Optimal portfolio with ESG funds gives better returns with less risk and more diversification than an Optimal portfolio without ESG funds.
In the picture above, Tatadigi1 represents the weight allocated to Tata Digital India Fund under the Risky Optimal Portfolio of the list, excluding ESG funds. Similarly, Quantactive1 represents the weight given to Quant Active Fund under the Risky Optimal Portfolio of the list excluding ESG funds. Axissmallcap1 means the weight allocated to Axis Small Cap Fund under the Risky Optimal Portfolio of the list, excluding ESG funds. At the same time, Tatadigi represents the weight given to Tata Digital India Fund under the Risky Optimal Portfolio of the list, including ESG funds. Quantactive represents the weight allocated to Quant Active Fund under the Risky Optimal Portfolio of the list, including ESG funds. Axissmallcap means the weight assigned to Axis Small Cap Fund under the Risky Optimal Portfolio of the list, including ESG funds.
Further allocations are done between Risky portfolios of both the ESG and non-ESG groups and Risk-Free assets by applying Excel's solver tool. Such allocations give rise to Complete Optimal portfolios, Complete Portfolios 1, and Complete Portfolios 2 for both groups. After comparing the Sharpe ratios of Complete Optimal portfolios and Complete portfolios 1 and 2 of Mutual Funds containing ESG with those of Mutual Funds excluding ESG funds, it can be concluded that ESG Mutual Funds offer better returns for less risk and more diversification across various sectors as well as beat the market returns for 5-year investment horizon.
We can choose different sets of Mutual Funds considering other factors such as Assets Under Management (AUM), exposure to various sectors, and management objectives, and come up with different lists as desired and do scenario analysis with portfolio allocation for those lists as desired.
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