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ELSS Funds – Does This Category Really Benefit The Taxpaying Investors?

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ELSS Funds

What is ELSS Fund?

Equity Linked Savings Schemes (ELSS) are unique investment funds within the mutual fund family, designed to promote savings and help reduce one’s income tax liability. The uniqueness results from the tax deductions that these funds offer under section 80C of the Income Tax Act (IT Act), 1961. ELSS funds primarily invest in equity and equity-related securities, with a minimum of 80 percent going to equities. They are often referred to as tax saving mutual funds.

ELSS funds allow Indian citizens tax deductions up to INR 150000. Although, the income earned under this scheme will be considered as Long-term capital gain (LTCG) and will be taxed at 10 percent if the income exceeds INR 100000. In addition to tax saving, these funds provide an opportunity for wealth creation. Investors have the option to invest in ELSS funds either through a systematic investment plan (SIP) or a lump sum investment option.

ELSS funds have a lock-in period of three years, meaning that investors cannot withdraw their funds for three years from the day of the investment. For instance, if an investor decides to invest INR 10000 per month into an ELSS mutual fund on 1 November 2020, then INR 10000 invested on 1 November 2020 will be locked in till 1 November 2023. Similarly, INR 10000 invested on 1 December 2020 will be locked in till 1 December 2023 and so on.

Advantages of ELSS Funds

Why should you invest in ELSS Funds?

Lock-in period: Saving instruments such as public provident funds (PPF), fixed deposits (FDs), national pension scheme (NPS), etc. come with a higher lock-in period compared to ELSS funds. The saving instruments mention above all have a lock-in period exceeding 5 years, whereas ELSS funds have a lock-in period of 3 years.

Controlled flows: Given the lock-in period mentioned above, there are no sudden outflows in ELSS even in tough market conditions. This helps stabilize the outflows leading to improved chances of capital appreciation.

No upper limit on investment: ELSS funds have no upper limit, meaning that investors can invest as much as their risk appetite allows them to. The tax deductions make them a favorable choice for investors; however, the deductions being capped at INR 150000 limit the attractiveness.

Inflation-beating returns: ELSS funds invest primarily in equity markets, giving them an edge over other fixed return instruments that provide tax deductions such as fixed deposits. The tax saving mutual funds can provide higher returns than can beat the adverse effects of inflation in the long term.

A higher level of transparency: Mutual funds are regulated by the SEBI, which requires asset management companies (AMCs) to make periodic disclosures about the schemes. No other tax-saving instruments in India have such high disclosure requirements.     

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Do ELSS funds benefit the taxpaying investors?

There are various other tax-saving investment avenues available to an investor including Public Provident Fund (PPF), Fixed Deposits (FDs), National Pension Scheme (NPS), and National Savings Certificate (NSC) among others.

Here is a comparison between ELSS and other tax-saving instruments:

Name of the instrument Lock-in Period Investment Risk Tax on Return
ELSS 3 years High LTCG at 10 percent
Fixed Deposit 5 years Low Income Tax
National Saving Certificate (NSC) 5 years Low Income Tax
PPF 15 years Low Exempt
National Pension Scheme (NPS) Till retirement Moderate Taxable Partially

Although the ELSS scheme has been popular with investors looking for tax savings and wealth creation, they have fallen out of favor in recent years, with net ELSS inflows during Q3FY20 being 36 percent lower than the net inflows during the same period in FY19 and 55 percent lower compared to FY18.

The most probable reason why investors are shying away from ELSS funds is their poor performance in recent years. For instance, the average 3-year SIP return on ELSS funds for 2019 is only 6 percent. When compared to returns other tax saving instruments that carry lower risk than ELSS funds, investors don’t have a reason for placing their money with ELSS funds.

Factors to consider before investing in ELSS Funds

  1. Evaluating the Past Performance: Evaluate a fund’s performance by comparing it to the benchmark returns and returns generated by the peer funds. This helps you determine how well the fund has performed relative to others. ELSS funds’ performance records are available from multiple sources online. Remember, that this does not indicate how the fund will perform in the future. It is better to look for funds that have performed consistently in the past.
  2. Fund Size: Investors tend to favor funds that have historically performed well and have strong fundamentals. Thus ELSS mutual funds that have a good track record tend to have larger AUM (assets under management) than funds that have underperformed in the past. Therefore, when deciding between various ELSS schemes, the fund size is important for the quality of the fund. This criterion only applies for funds with past records and does not hold for new fund offers or newly launched ELSS mutual funds.
  3. Fund Rating: Rating agencies such as CRISIL rate ELSS schemes based on their performance and risk factors. These ratings should guide investors when choosing between various ELSS schemes. However, it is important to remember that fund rating are based on historical performance and do not indicate how the fund might perform in the future.
  4. Investment Strategy: Before investing in an ELSS fund, it is imperative to understand the investment strategy of the fund. Different schemes have different capital market allocations and different portfolio composition. Investors should choose a fund based on his/her risk appetite. A young investor with no immediate financial needs should choose an aggressive ELSS fund having a higher allocation in small and mid-cap stocks.
  5. Portfolio Churn Ratio: The portfolio churn ratio is defined as the percentage of the portfolio holding that has changed over a period of time. Investors should choose funds that have a low portfolio churn ratio. This increases the likelihood of holding a good quality portfolio for a longer duration. A low portfolio churn indicates that the fund manager has high conviction in his picks.
  6. Fund manager track record: In addition to the performance of the fund, investors should also evaluate the track record of the fund manager. Investors can analyze the performance of the other funds managed by him and the return that he generated across different market cycles. Understanding his strategy, skills, and experience would help the investor immensely.
  7. Expense Ratio: The expense ratio measures the annual fund operating expenses of an investment fund. It is expressed as a percentage of the fund’s AUM (asset under management). The fund’s operating expenses include expenses on administration, management, and advertisement.
  8. Dividend and growth: There are different ways to invest in ELSS. Investors can choose either the Growth option or the Dividend option depending upon the requirement of money. Under the growth option, you will not receive any benefits in the form of dividends. The gain accrues at the time of the redemption. Under the dividend option, investors receive benefits from time to time in the form of dividends. The dividends are tax-free and are declared only when there are excessive profits. There is also a third option, where dividends are reinvested. Under this option, the dividends are reinvested for buying more units of the scheme. This works well when the market is in an upswing and will continue to witness that.

Top performing ELSS Funds

Some of the top-performing ELSS funds are:

Fund Name 1-Year Return (percent) 3-Year Return (percent) 5- Year Return (percent) Expense Ratio (percent)
BOI AXA Tax Advantage 19.82 6.27 11.70 2.58
Mirae Asset Tax Saver Fund 9.81 7.65 NA 1.77
Axis Long Term Equity Fund 3.50 8.24 11.11 1.72
Kotak Tax Saver Fund 5.09 4.17 9.73 2.26

Source: Value Research, As of 6 November 2020

What are the tax benefits of ELSS Funds?

As we have mentioned above, investments up to INR 1.5 lakh are eligible for deductions from taxable income in a financial year. Let’s look at an example:

Suppose an investor has INR 3 Lakh as taxable income in a given financial year and the investor decides to invest the entire amount in one of the ELSS funds mentioned above. In this case, only INR 1.5 lakh would be eligible for deductions, so your taxable income for the year reduces from INR 3 lakh to INR 1.5 lakh.

Investors should also be aware that the return generated by the portfolio is taxed for capital gain at the time of the redemption. Since the investment in ELSS funds have a lock-in period of 3 years, these investments are only taxed at the Long-Term Capital Gains Tax (LTCG) of 10 percent on return above INR 1 lakh.

For instance, suppose an investor has a capital gain of INR 2 lakh at the time of the redemption from the scheme, LTCG of 10 percent would only be levied at INR 1 lakh in that financial year. The tax payable would amount to INR 10000.

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