What Are ELSS (Equity Linked Savings Scheme) Mutual Funds And How To Invest

Amidst the quest to achieve various crucial life goals through wealth creation and also reduce their income tax outgo through tax saving instruments, many individuals often have to compromise on either of these two aspects during financial planning. While some financial instruments suffice on the wealth creation front but fail to offer enough or any tax benefits, some on the other hand, offer sufficient tax benefits but not enough returns for wealth creation, especially after factoring in inflation and taxability on interest income. However, one tax saving instrument that adequately offers the dual benefits of wealth creation and tax saving, is ELSS (Equity linked savings schemes). Let us deep dive and understand ELSS funds and why you should invest in them.

What is ELSS?

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Simply put, Equity-Linked Savings Schemes (ELSS) are tax saving equity mutual funds that invest a major proportion of their portfolio into equity or equity related instruments across different sectors, market capitalization etc. Being equity oriented funds, ELSS come with the same market risk as other equity funds, but their returns usually outperform not just inflation but also the various fixed income investment options under section 80C, as well as other asset classes, by a wide margin over the long-term.

Key Features of ELSS Funds

-Lock-in period of 3 years, which is the shortest amongst all investment options available under section 80C. After completion of the lock-in period, ELSS funds can be easily redeemed, with the redemption amount being credited to the linked bank account within a few days.

-ELSS offers the benefit of claiming tax deductions of up to Rs 1.5 lakh per financial year under Section 80C of Income Tax Act.

-Option to invest through lump sum mode or the SIP (Systematic Investment Plan) route.

-No tax levied on gains upto Rs 1 lakh in a financial year. However, any long term capital gain above Rs 1 lakh attracts LTCG tax @10%. (Note-Gains made from equities redeemed after 1 year of investment are termed as LTCG).

-As a category, ELSS has generated average annualised returns of about 60.53%, 16.28%,15.28% and 14.41% p.a. over the last 1-year, 3-year, 5-year and 7-year periods respectively. (As per valueresearch data dated 08.09.2021).

What to factor in before investing in ELSS Funds?

1. Investment horizon

Given that ELSS are equity oriented mutual funds and equities have a proven track record of delivering higher returns along with less volatility over the long term, ensure you have at-least a medium to long term investment horizon of 5 years and above when investing in ELSS. Besides factoring in the mandatory lock in period of three years in ELSS funds, aim to stay invested for a long term instead of redeeming as soon as lock in period ends. Keep in mind that the presence of equity exposure in ELSS funds enables investors to mitigate market volatility by remaining invested for longer periods. Investing just for the sake of tax saving and redeeming quickly post lock in period would deprive you from maximizing the potential of returns from equity investments which would otherwise have been generated over the long term investment horizon.

2. Returns

When investing in ELSS funds, remember that the returns are entirely dependent on the performance of the underlying securities, i.e. the equity. The returns displayed are based on past performance, hence they do not guarantee the returns. It¡¯s an indication of the potential returns, which would eventually depend on the fund performance and market scenario. Given that equities have displayed much higher returns than other asset classes over the long term, it¡¯s advisable to remain invested in the ELSS funds for a longer investment horizon.

Moreover, ensure to periodically review your portfolio and chosen schemes. In case the funds have been consistently underperforming since the past few quarters, you can consider redeeming them and switching to better performing ELSS funds to ensure wealth creation.

3. Risk appetite analysis

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As different ELSS funds have varying investment strategies, the market risk related to their portfolios can differ across numerous ELSS funds. Hence, ideally, it¡¯s advisable for those with low or moderate risk appetite to invest in ELSS funds with inclination towards large cap stocks, as these tend to involve relatively lesser degree of risk. Whereas those with high-risk appetite can go ahead with ELSS funds having inclination towards mid/small cap stocks and/or multicap funds, as these usually involve higher degree of risk.

Now that you have grabbed the basic understanding of what ELSS is and how it works, it becomes imperative to move forward and know its benefits and how it outscores other tax saving schemes such as ULIPs, PPF, 5-year tax saving FD, SCSS,SSY,NPS etc. by a wide margin.

Benefits of ELSS and how it outscores other tax saving investment options

1. Higher liquidity via shortest lock-in period

ELSS mutual funds involve the lowest lock-in period of just 3 years, when compared to other tax saving investment options, such as PPF (15 years), Tax-saver FD, ULIP and NSC (5 years each). Whereas, investment in National Pension Scheme (NPS) remains locked-in until retirement. With their investments getting locked in for the shortest period amongst its peers, ELSS allows a higher degree of liquidity to its investors in case they need to redeem their investments due to various reasons during post lock in tenure of three years.

2. Higher returns and wealth creation potential than peers

Since ELSS primarily invests in equity and equity-related instruments, it¡¯s able to comfortably outscore over its peers like ULIPs, tax saver FDs, PPF, etc., in terms of inflation beating returns over the long term. Moreover, despite the re-imposition of LTCG tax @10% on gains above Rs.1 above in a financial year, the post tax returns of ELSS are still usually higher than its peers by a wide margin, especially over the long term investment horizons of above 5 years.

3. SIP route instils disciplined investment

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Similar to other mutual fund categories, ELSS funds too allow the investor to either choose the lump sum or SIP (Systematic investment Plan) mode of investment. SIPs involve periodic and automatic investment, as the amount is auto debited on the pre-set date and frequency (usually monthly). This mechanism enables SIPs to instill financial discipline by prompting the investor to save and invest regularly. Moreover, rupee cost averaging concept of SIPs leads to averaging out of the cost at which the mutual fund units are bought, therefore negating the need to time the market even during market fluctuations.

Smart moves to follow when investing in ELSS Funds

1. Do not rush into redemption when the lock-in period ends

Many investors commit the mistake of exiting/redeeming their ELSS investments as soon as their lock in period of 3 years lapses. Such investors who rush into the decision of redeeming upon the end of lock-in period must remember that equity mutual funds are most suitable for achieving long-term goals of 5 years and above. Hence, redeeming the ELSS funds upon completion of 3 years may not allow enough time for your investment to grow and garner expected returns. It would therefore be prudent to remain invested for as long as you can, until the desired corpus is accumulated. However, it would be prudent to redeem in case your scheme has been consistently underperforming in comparison to its benchmarks index and peers.

2. Ensure tax saving is primary but not sole purpose of investing

Each investor must adopt goal based investment strategy while investing. Even though the primary reason to invest in ELSS funds largely is tax saving, investors should make sure the objective of wealth creation should be given equal weightage, to fulfill long term goals such as child¡¯s higher education and marriage. However, its prudent to act with due diligence before investing in ELSS, by ensuring your financial goals are aligned with the investment and you¡¯ve carefully assessed the associated risk, expected returns etc.

3. Stay invested even post retirement

Contrary to the popular advise that investors should redeem their equity investments and shift to less risky avenues such as debt funds and fixed income products post retirement, it¡¯s a better move to not do so. This is because, more often than not, the fixed income products to which you shift your ELSS and other equity investments, fail to beat inflation rates. This may lead to loss post tax deductions for those falling into higher tax brackets. Moreover, if you end up living longer than the expected life expectancy, the longevity risk of running out of your retirement corpus could worsen your financial life.

Hence, those who have been investing in ELSS prior to retirement, shouldn't entirely exit them. Instead, whatever portion of your corpus is intended to be consumed after a long term, i.e. five years or more, has to be remain invested in equity funds itself, since equities as an asset class have been consistently beating its peers by providing inflation beating returns over long term. Rest of the corpus can be redeemed and shifted to less risky avenues.

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