How to Select the Best ELSS or Tax Saving Mutual Funds in 2019?

How to Select the Best ELSS or Tax Saving Mutual Funds in 2019?

Last Updated: Jul 08, 2019 - 03:30 am 132k Views

Equity linked savings schemes (ELSS) has emerged as an important method of tax saving in the last few years, although they have been in existence for a very long time. It is only now that the share of ELSS in the overall equity AUM pie has grown.

Data Source: AMFI

As the chart above shows, ELSS now accounts for 13% of the total equity fund AUM of Rs.7.25 trillion as of the end of June 2019. So, this is surely an indication of the increasing interest in ELSS schemes. So what are ELSS schemes and why are they taking off in India?

What exactly is an ELSS scheme?

An ELSS scheme is an equity fund that typically invests more than 85% of its overall portfolio mix into equities. Such ELSS funds can invest in large cap stocks and also in mid cap stocks as long as they are invested in direct equities. In terms of costs and management they are exactly like an equity fund. The only difference is that ELSS is an equity fund with a 3 year mandatory lock in period. During this lock in period the ELSS cannot be sold.

ELSS is one of the many tax saving schemes that the Income Tax Act offers. For example, to save on tax, you can opt for Section 80C exemption up to Rs.1.50 lakhs per annum. The eligible outlays include PPF, CPF, ELSS Funds, Long-Term FDs. LIC premiums, ULIPs etc. ELSS is one of the many options available under Section 80C but it is the only pure equity offer; as the remaining options have a large debt component or insurance component.

What makes ELSS attractive to investors?

A number of factors combine to make ELSS mutual funds interesting and profitable for investors. Let us look at some of the key highlights.

  • ELSS has the lowest lock in period among the Section 80C options. For example, PPF has a lock in period of 15 years while ULIPs and long term FDs have a lock in period of 5 years. Only ELSS (a wealth creating mutual fund investment) gives you the Section 80C benefit with just 3-year lock in.

  • ELSS is one of the few options in the Section 80C list that allows you to create wealth in the long run without any investment limit. The 3-year lock in period automatically forces a long term investment approach, which favours wealth creation.

  • ELSS Funds help to enhance the effective rate of returns. Let us understand this better from the table below.

Non-ELSS Equity Fund

ELSS Mutual Fund

Investment Rs.1,00,000 (10,000 units at Rs.10)

Investment Rs.1,00,000 (10,000 units at Rs.10)

NAV at the end of 3 years (Rs.16)

NAV at the end of 3 years (Rs.16)

Nominal Return at the end of 3 years – 60%

Nominal Return at the end of 3 years – 60%

Tax Breaks Under Section 80C - Nil

Tax Breaks Under Section 80C – 20% (Assumed the investor is in 20% tax bracket)

Effective investment Rs.1,00,000

Effective Investment Rs.80,000 (Rs.20K rebate)

Effective Returns after 3 years – 60%

Effective returns after 3 years – 100% (cost of the fund is down to Rs.8 due to tax rebate)

How to select ELSS funds for maximum savings

There is a wide choice of ELSS funds but here are a few basic rules that you must follow.

  • ELSS is the best method of on-boarding first time investors into equities. It ties them down to a long term investment approach and also introduces them to an equity investing at an early stage.

  • Focus on past returns but also focus on consistency. There is no point in looking at 1 year returns when the lock in period is 3 years. But you must look at 3 year rolling returns on an annual basis. Focus on funds that give returns with consistency.

  • Focus on risk adjusted returns. Some fund managers take on additional risk due to the lock-in period. That is not a great idea. Measures like Sharpe and Treynor help to highlight such aspects.

  • Preferably use the SIP approach to investing in ELSS funds. It helps make tax saving a round-the-year discipline and helps you benefit from rupee cost averaging.

  • Don’t buy ELSS funds if you have exhausted your Section 80C limit. There is no point in locking in funds for 3 years; plain equity funds are good enough.

ELSS is a great value addition to your portfolio; especially when you look at it from the perspective of effective post-tax returns.

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