FUND FLAVOUR

August 2020

 

ELSS in a nutshell

 

Equity Linked Saving Schemes (ELSS), popularly known as tax saving mutual funds, are equity-oriented mutual funds. As per the SEBI regulations, ELSS funds have to invest at least 80% of their corpus in equity or equity related instruments. ELSS funds are also called tax saving schemes since they offer tax exemption of up to Rs. 150,000 from your annual taxable income under Section 80C of the Income Tax Act. These funds come with a mandatory lock-in period of 3 years in order to get tax-free returns. However, after the re-introduction of LTCG tax in the budget and taxation of ELSS in the hands of the recipient, returns from the investments in ELSS funds would be taxed. Long-term capital gains from equity mutual funds above Rs 1 lakh would be taxed at 10 percent without any indexation benefit. Investors typically make their tax-saving investments in the last three months of the financial year (January-March), known as tax-saving season. If you are opting to invest in this excellent tax saving instrument, you should do so early in the financial year when the Net Asset Value is generally lower. In a nutshell, ELSS is an excellent tax saving instrument in which one must invest. 

ELSS – One up on other avenues

ELSS investments have historically offered the greatest potential of creating wealth over the long term and these can be an excellent tool for achieving long term financial goals like children’s education fund and post-retirement corpus with contributions lower than its fixed income alternatives. The 3-year lock-in period in ELSS funds also reduces the redemption pressure for their fund managers during volatile markets. This allows their fund managers greater flexibility to take a more long term view while dealing with market volatility with respect to other open-ended funds.

 

ELSS  vs Tax Saving Fixed Deposit ( 5 year FD)?

ELSS has a 3 year lock-in period while tax saving FD has a 5 year lock-in.

Returns on ELSS: 11% - 17%.

Returns on Tax saving FD: 7.5%.

ELSS is better than 5 year FD because you get access to your funds in just 3 years, and annual historical annual returns have been much higher than regular tax saving FDs.

 

ELSS  vs Public Provident Fund (PPF)?

PPF is for creating a safety net on which to retire. ELSS is for creating wealth and enabling tax savings. PPF provides great returns if the investment is grown to allow interest to compound over a long term of 15 years. ELSS invests in equities which are riskier but more profitable in the short to medium term of 3 years (mandatory lock in) to 5 years. ELSS makes money now while PPF gives you a retirement pillow.

ELSS vs National Pension Scheme (NPS)?

Much like the PPF, the NPS is also for creating a retirement corpus. The point of ELSS is to invest in equities through a mutual fund scheme, with the added benefit of having your investment amount (up to Rs.1,50,000) exempted from taxable annual income. While the NPS is a long term investment, it allows for up to Rs.2,00,000 to be exempted from taxable income allowing for slightly higher savings depending on your tax bracket. If you wish to earn wealth in the short to medium term through equity mutual fund schemes ELSS is better. If you wish to create a decent sized retirement amount that you will only get on retirement NPS is better. Again, depending on the investor’s preference for either equity investing or retirement planning, ELSS or NPS are strong contenders on either side.

ELSS vs Sukanya Samriddhi Yojana (SSY)?

SSY or Sukanya Samriddhi Yojana Account is an investment scheme to enable unorganized workers, etc. to invest for the future of their female children. Deposit and withdrawal rules for this scheme differ greatly from a tax saving mutual fund investment scheme like ELSS.
While both are tax saving investments, ELSS is specifically designed for wealth generation, and SSY is specifically designed to enable savings. For a wealth generating investment that will also save Rs.1,50,000 from taxable income, ELSS is better.For an investment that is locked until your girl child is ready to get married or go to college, SSY is better.

ELSS vs Senior Citizens Saving Scheme?

Senior Citizens Saving Scheme or SCSS can be invested in by people above 60, or 55 in certain cases. Senior citizens can invest in ELSS as well - ELSS has a shorter 3 year lock in for funds.

Returns on ELSS are historically higher than those of SCSS.Both provide for up to Rs.1,50,000 to be exempted from taxation. ELSS is a better investment option than SCSS depending on goals.

ELSS vs Unit Linked Insurance Plan (ULIP)?

Both provide the same amount of Rs.1,50,000 to be exempted from taxation. ELSS is subject to LTCG Tax, ULIP is not. ULIPs are essentially insurance policies that use a part of the premium to invest and generate returns just like any other mutual fund scheme. ELSS funds are straight up equity market investment schemes with tax benefits. A standard life insurance policy, for example, functions better as a life insurance policy - providing greater benefits. Similarly, a standard mutual fund scheme investment provides better returns and is easier to navigate should you wish to exit or switch. ELSS is a better choice to fill the requirement of a tax saving investment scheme with a 3 year lock in, and nothing more.

ELSS vs National Savings Certificate (NSC)?

NSC has a mandatory 5 year lock in. ELSS has a 3 year lock in.

Average returns on NSC: 7.6%

Average returns on ELSS: 11% - 17%

Why invest in ELSS?

 

One: To beat the inflation

Most investment options available under Section 80C like Public Provident Fund, National Savings Certificate, etc. are government-backed investment options. These schemes typically offer modest returns of 7-8% per annum as these schemes invest the money in debt instruments, bonds, and government securities. That means investors would find it difficult to create wealth after beating inflation with these investments as the inflation rate is 7%. It is important to beat inflation to create wealth for long-term goals. On the other hand, ELSS invests the maximum amount of money in equities. It has given around 15-16% return over the past 10 years.

 

Two: Better Growth potential over a long-term horizon

An ELSS invests mostly in stocks. It is a well-accepted fact that equity has the potential to generate superior returns than other asset classes over a long period. Many studies and records justify this claim. So, if you want inflation-beating, better post-tax returns, you should invest money in ELSS funds. Suppose you start investing with Rs. 1000/- per month in ELSS Mutual Fund, after 15 years your absolute return will be Rs. 6,17,355/- assuming 15% CAGR.

 

Three: Shortest Lock-in Period

ELSS has the shortest lock-in period among the investment options available like PPF, NSC, etc. under Section 80C of the income tax act, 1961. An ELSS has a mandatory lock-in period of three years. It has a plus point that investment can be stopped even after one month. But one can withdraw money partially or wholly after the completion of 3 years lock-in-period.

 

Four: Minimise the Market Volatility

ELSS funds curb the volatility associated with the stock market. Many retail investors panic when they see their investments losing value significantly. But after a certain period market recovers its loss and yields a significant return. As the ELSS scheme has a mandatory lock-in period of three years a market can never be downward for three years. It will definitely go upward and offer a superior return in the long term.

 

Five: You can start an investment with a small amount of Rs. 500

Rs.500 is a more affordable amount for majority of the population.

Six: Reduce Taxable Income

Let us understand this with an example.

Usually, Bank FDs offer a 7-8% interest rate. In this case, let us assume that the interest rate is 8%.

Investment corpus = Rs. 5 lakh.

Time horizon = 5 years

Rate of interest = 8%

Interest earned = Rs. 2 lakh

So, you need to pay tax of 10% on the Rs. 2 lakh which equals Rs. 20000.

So, your absolute return after taxes = Rs 5 lakh + Rs. 1.8 lakh = Rs 6.8 lakh

In the case of ELSS,

Assuming that equity asset class gives a 15-16% return per annum,

Investment corpus = Rs. 5 lakh

Time horizon = 5 years

Rate of interest = 15%

According to Government rule, you need to pay 10% taxes as a long-term capital gains tax if your return is more than Rs. 1 lakh. So, you need to pay taxes on the rest. In this case, you need to pay 10% taxes on Rs. 4 lakhs which means you  need to pay = 10% of Rs. 4 lakh = Rs. 40000.

So, your absolute return after taxes = Rs. 5 lakh + Rs. 4.6 lakh = Rs. 9.6 lakh

 

Seven: Investing in ELSS is a lot easier now

Due to the advent of modern technology, an interested individual can invest in the stockmarket sitting from his or her home. All you need is an e-mail id, a PAN card, a document as an address proof, a passport size photograph and an internet connection. You can start investing within 24 hours of uploading the documents in the website of the stockbroker or the mutual fund house.

How to invest in ELSS?

 

Here is a step-by-step guide to investing in ELSS mutual funds:

Step 1 - Research: Finding the right ELSS fund to suit your needs is the first step in ELSS investing. There are thousands of ELSS funds on offer from hundreds of AMCs, banks, and fund houses.

Step 2 - Deciding the amount: The primary benefit of ELSS investments is the fact that they are tax-saving investments. A total of Rs.1,50,000 can be saved from taxation under Section 80C, but any amount over Rs.1,50,000 will not qualify for tax benefits. That being said, if the investor has an existing investment under Section 80C (like a 5-year FD, PPF, etc.) only the remaining amount (Rs.1,50,000 minus other Section 80C investments) will qualify for tax deductions. Example: If Mr. A has invested Rs.60,000 in a 5-year fixed deposit, he will only be able to claim tax benefits on Rs.90,000 of his ELSS investments under Section 80C (even if he has invested more than Rs.90,000 in ELSS). This is because Rs.60,000 + Rs.90,000 = Rs.1,50,000.

Step 3 - Investing: The standard process of investing involves endless hours of paperwork and trips to and from the fund house, AMC, or bank through which the investment is being made. Online portals offer a paperless, hassle-free, and efficient investment platform through which investments can be made almost instantly and tracked in a fully secure online environment.

Step 4 - SIP or Lump Sum: Once the fund scheme has been selected, the investor must decide between investing the amount in a large lump sum, or in smaller and regular installments. The main benefit of investing small amounts regularly through SIPs is rupee cost averaging - more units are purchased when the price is low and vice versa - making full use of market fluctuations to benefit the investor.

Step 5 - Redemption: Redemption of an ELSS scheme means selling off your invested interest in the scheme and earning any profit due from the investment. ELSS has a minimum lock-in period of 3 years to make use of tax benefits. The fund can be allowed to grow beyond 3 years as well in order to generate maximum returns.

How does ELSS SIP work?

It is simple - you invest a certain amount every month in this scheme, and it stays locked in for 3 years from the date of investment. So, if a person wanted to invest their full Rs.1,50,000 Section 80C quota into ELSS mutual funds through equal SIPs throughout the year, it would look something like this:

Rs.1,50,000 / 12 = Rs.12,500 per month

Rs.12,500 invested in April 2020 will be locked in till April 2023

Rs.12,500 invested in May 2020 will be locked in till May 2023

Rs.12,500 invested in June 20206 will be locked in till June 2023

And so on, until the investor has fulfilled the investment limit. The tax benefit in the above example can be claimed for 2020-2021.

When is the best time to invest in ELSS?

Investments in ELSS can be made at any time during the year. Most often, however, ELSS investments see a spike in popularity just before the tax filing season, as Indians scramble to reduce their tax liability by any means possible. Thus, those that invest in ELSS at the end of the financial year will definitely save on taxes, but will have almost neither the chance to benefit from any capital growth nor receive any dividends in that financial year. The best time to invest in ELSS is at the start of the financial year, i.e. after April 1. Since ELSS is an equity-oriented investment, it is a good idea to average out the rupee-cost by investing in ELSS every month through SIP. Thus, regular SIP investments in ELSS have the potential to provide the highest returns along with being a tax-saving investment.

Who should invest in ELSS?

Any individual or HUF can invest in ELSS. It is suitable for those who have enough knowledge and appetite to take risks and stay invested with a long term perspective. Young investors in the initial years of their professional career can invest with a long-term horizon. ELSS is best suitable for young investors as they have time on their side to unleash the power of compounding to the fullest to enjoy high returns while saving on taxes of up to Rs 46,800 a year. ELSS funds also serve as a stepping stone to the world of equity schemes for many investors.  Once these investors get used to the volatility and witness their investments bounce back after a bad run in the stock market, they gain the confidence to start their investment in other equity mutual fund schemes. In fact, double-digit returns from ELSS convince many investors to take a serious look at equity mutual fund categories. With that, they learn the importance of investing in equity mutual funds to earn inflation-beating returns to create wealth over a long period.

Misconceptions about ELSS

Equity Linked Saving Scheme or ELSS may be the stepping stone to the stock market for many individual investors. However, many of them nurse a lot of misconceptions about these mutual funds that help investors to save taxes of up to Rs 1.5 lakh under Section 80C in a financial year. Here are a few common misconceptions shared by mutual fund investors.

ELSS funds are good only to save taxes

Sure, investments in ELSS mutual funds help you to save taxes under Section 80C of the Income Tax Act. However, that is not the only use of ELSS mutual fund schemes in your portfolio. Just like any other equity mutual fund schemes, you can use tax saving mutual funds to achieve your long-term financial goals. Remember, these schemes also invest their corpus in equity. Most of them follow a multi cap strategy. So, you can use them like any other equity schemes.

You should sell ELSS after three years

It seems, some investors just cannot see anything other than tax saving when they look at ELSS. All tax-saving investments permitted under Section 80C come with a mandatory lock-in period. ELSS mutual funds come with a mandatory lock-in period of three years, arguably the shortest lock-in period among the tax-saving options available under Section 80C. However, this does not mean that you have to sell your investments as soon as the mandatory lock-in period is over. You are free to hold on to your ELSS mutual funds as long as the scheme is performing well or you need the money to meet your goal.

You should invest in the same ELSS

Another common notion many mutual fund investors have is that they have to continue investing in the same ELSS fund to claim tax deduction year after year. Remember, the basic tax-saving premise is simple: your investments in ELSS funds qualify for tax deductions of up to Rs 1.5 lakh in a financial year. That means you are free to change or even invest in multiple schemes to claim tax deductions. There is no stipulation that you have to invest in the same scheme year after year to claim the tax deduction.

Recycling ELSS funds is a great strategy

Some investment geniuses believe that selling ELSS mutual funds immediately after their mandatory lock-in period of three years and investing it again in ELSS funds is a great way to save taxes. They say the strategy helps you to save taxes without making extra investments. However, the strategy often backfires. Many investors stop saving/investing separately for the tax saving purpose and end up spending the money. It can have a huge impact on your long-term wealth creation.

Dos and…

Quantitative Parameters:

1.      Performance and risk analysis

Analyse if the fund has shown consistency in performance across various market periods with decent risk-adjusted returns.Under this, you need to rank the fund based on quantitative parameters like rolling returns across short-term and long-term periods, such as a 1-year, 3-year, and 5-year timeframe, and on risk-reward ratios like Sharpe Ratio, Sortino Ratio, and Standard Deviation over a 3-year period.

2.      Performance across market cycles

You need to ensure that the fund has the ability to perform consistently well across multiple market cycles. Therefore, compare the performance of all the available ELSS vis-a-vis their benchmark index as well as category peers across bull phases and bear market phases. A fund that performs well on both sides of the market should rank higher on the list.

Qualitative Parameters

1.      Portfolio Quality

Adequate Diversification - The scheme should not hold a highly concentrated portfolio. It should have a well-diversified portfolio and the exposure to the top-10 holdings should be ideally under 50%.

Low Churn - Engaging in high churning can result in higher cost impacting the overall return of the scheme. Therefore, you also need to consider the portfolio turnover ratio and expenses, and penalise funds involved in high churning, i.e. those funds with a turnover ratio of more than 100%.

2.      Quality of Fund Management

You must consider the fund manager's experience, workload, and the consistency of the fund house. Therefore, assess the following criteria:

The fund manager's work experience - He/she should have a decent experience in investment research and fund management, ideally over a decade.

The number of schemes managed - A fund manager usually manages multiple schemes. Thus, you need to check if the fund manager is burdened with managing a large number of schemes. If he is managing more than five open-ended funds, it should raise a red flag.

The efficiency of the fund house in managing your money - Research about the fund house's performance across schemes; find out if only a few selected schemes are doing well. A fund house that performs well across the board is an indication of sound investment processes and risk management techniques in place.

Don’ts…

Don’t begin late: It is better to invest regularly through an SIP or STP in a tax-saving mutual fund to maximise returns. Also, it gives you enough time to do proper research about your investment. Remember, if you pick the wrong ELSS, you do not have the option of correcting it for the next three years. Start investing early, so that you have ample time to research about where to invest and how to invest in ELSS.

Don’t judge schemes on short-term performance: This point hold true for all the mutual fund schemes and not just ELSS. It is not advisable to invest your money based on six-month or one-year returns given by a particular scheme. The scheme that you are investing in should be a consistent performer for at least five years.

Don’t just look at the returns: Returns are primary but don’t just focus on returns when you are investing in an ELSS. Look whether its investment philosophy matches your view. For example, a scheme that takes a lot of risk to stay on top of the performance chart may not suit a conservative investor. The person would be better off with a scheme with conservative style of investment.

Don’t fall into the dividend trap: Many investors are lured by the dividend option when they invest in ELSS. The fact is that the dividend is actually paid to you from your own money. Unless you really need periodic income, don't opt for the divided option. If you want to create wealth, you should stick to the growth option.

Don’t invest just for tax saving: ELSS schemes provide you tax benefits but in the end, they are equity schemes. So you should remember that they can be risky, but they can be extremely rewarding. Whenever you are picking a tax-saving instrument like ELSS, be careful about the risk, lock-in period, returns, etc.

Don’t redeem after the lock-in period: The money is locked for three years in an ELSS. Some investors tend to pull their money out as soon as the lock-in is over. There is no need to pull the money out if the scheme is performing well. Also, since ELSS invests in equity, you should be prepared to stay invested for at least five to seven years.

Don’t switch funds every three-years: Some investors wait for the lock-in period to end and jump to another scheme. Don’t jump from one fund to another only because the other scheme is giving better return than your scheme. If your fund is not performing well, you need not always pull your money out. The returns depend upon many aspects, like the size of the fund. Find out the reasons for the underperformance. Only if the underperformance continues for long, while the markets are blooming, you need to rethink about your decision.

Don’t accumulate too many ELSSs: Some investors invest in a new ELSS every year. This leads to hindrance in managing the portfolio over a long period of time. Having more ELSSs in your portfolio will lead to over-diversification and the portfolio will become hard to monitor.

Current downtrend…

Equity-linked saving schemes (ELSS) are popular among those looking to save taxes as well as getting some equity exposure. Typically, ELSS inflows are higher during the last three to four months of the financial year as investors rush to make tax-saving investments before the 31 March deadline. This year, however, the inflows during this period have dwindled. According to data released by the Association of Mutual Funds in India (AMFIi) on 9 April 2020, net ELSS inflows between December 2019 and March 2020 is ₹3,834 crore, 36% lower than the net inflows during the same period in FY19, and 55% lower than the number in FY18. The net inflows in ELSS in this four-month period in FY19 was ₹6,001 crore and ₹8,440 crore in FY18. It may be noted that the deadline for making tax-saving investments was extended to June 2020.

 

So what explains the fall in ELSS net inflows in FY20?

 

Lower net inflows

It is likely that with increasing awareness about systematic investment plans (SIPs), investors are starting SIPs at the beginning of the new FY instead of investing a lump sum at the end of the FY. This could account for the slower sales in the ELSS category this year. However, this is unlikely. Net inflow in ELSS in whole of FY20 was lower than FY19— ₹8,187 crore in FY20 compared with ₹12,771 crore in FY19. Market volatility may be another reason for investors to stay away from ELSS as they have the equity component. But net inflows in equity funds jumped 52% to ₹24,343 crore between December 2019 and March 2020 compared to the previous year. So what else?

Confusion over tax regime: The year-end popularity may have reduced due to the budget announcement. Budget 2020 introduced a new optional tax regime which does away with most of the tax deductions, including the one available on ELSS investment under Section 80C of the Income-tax Act. Taxpayers have the choice of continuing with the old regime. The confusion about whether to opt for the new tax regime may have resulted in lower inflows this year. In March 2020, the net inflows in ELSS funds were 43% lower at ₹1,551 crore compared with ₹2,742 crore in March 2019. The new tax regime will be applicable from FY21.

Poor performance: This may be one of the major reasons why people are shying away from ELSS funds. Data from ICRA Research shows that ELSS funds were delivering double-digit returns on systematic investment plans (SIPs) in 2017 and 2018, but returns came down to single digit in 2019. The average three-year SIP returns of ELSS funds for 2017 and 2018 were around 14%, and only 6% in 2019. Many funds yielded negative three-year SIP returns in 2019 and 2020. Lower returns from ELSS funds over the last few years and the polarization of returns from only a few stocks in 2018 and 2019 may have contributed to the poor performance. As investors look at past returns, which are not very attractive for ELSS funds, the inflows may have been lower.

Allocation plays a role

Because of the lock-in (of three years), fund managers in ELSS funds generally take high exposure to mid- and small-cap stocks, which performed badly in the past two-three years. This has resulted in the poor performance of these funds. As of February 2020, the average large-cap allocation in tax-saving funds was around 65%, while the rest was allocated to mid- and small-cap stocks, according to data provided by Value Research, an investment research company. Some ELSS funds have an even higher exposure to mid- and small-cap companies. As of February 2020, seven out of 42 ELSS funds had over 50% exposure to mid- and small-cap stocks. The returns of ELSS funds are in line with that of multi-cap funds. The 10-year category average return from multi-cap funds is 7.78% compared with 7.83% from ELSS funds, as per Value Research data. Some of the funds also change the allocation of stocks of different market capitalizations, as per the fund manager’s view of the market. For example, Tata Tax Saving Fund had increased its allocation to large-cap stocks from 52% in February 2017 to 80.31% in February 2020. The Fund manager followed a bottom-up strategy. So, the increase in allocation is because of the respective stock picks. However, the Fund Manager also ensures that the large-cap exposure does not go below 50%.On the other hand, the exposure of PGIM India Long Term Equity Fund to large-cap stocks has gone down from 82% in February 2017 to 70% in February 2020. It was a deliberate move to lower the large-cap allocation. After the correction in mid- and small-cap stocks that started in February 2019, they looked attractive and the Fund Manager decided to increase the exposure. These funds are among those that significantly changed their market cap allocation between February 2017 and February 2019.

The bottomline…

Today’s winner may not remain the winner for tomorrow. Top 10 ELSS funds or Top 5 ELSS funds of today may not remain the same after 3 or 5 years. Therefore, it is better to diversify across 1-3 ELSS schemes rather than relying on only the best performing ELSS schemes. To avoid duplication, choose ELSS schemes with varying portfolio allocations across different sectors, market capitalisation and stock holdings. And, in case the returns are low even after the 3-year lock-in period, continue with the fund once the lock-in period ends. Link your ELSS investment to a long term goal and not invest merely to save tax. Invest in ELSS only if you can bear short-term volatility in the equity market, hold a high-risk appetite, and have an investment time horizon of at least 3 years. Investments in equities take time to grow and generate meaningful returns. This means that there can be short-term underperformance. As a result, you may have to hold on to your investment beyond the mandatory lock-in period. A number of ELSS have successfully created wealth for investors outperforming their respective benchmark indices and category average across time frames. A long-term investment in ELSS is a more prudent choice as compared to other fixed-income products. But as with all market-linked investments, there is a risk. Go for an ELSS whose portfolio matches your risk profile.