Should you be investing in ELSS funds? Answer these 3 questions to know

Friday, December 23, 2016 Swati Aggarwal 0 Comments

 

As we approach the last quarter of this financial year, chances are that you have seen multiple advertisements promoting ELSS funds and why you should invest in them. While investing in ELSS funds is definitely a good idea for many investors, a lot of this marketing goes overboard in selling you the idea that ELSS funds are the best investment you can make. A large part of this has to do with the fact that your distributor will earn fat commissions if you buy ELSS funds irrespective of whether it is the right investment for you or not.

In this article we aim to demystify ELSS funds and who are these funds suitable for. With our 3 question checklist, you can make an informed decision on whether this is the right investment for you or not.

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What are ELSS funds?

ELSS stands for Equity-linked Saving Scheme. ELSS funds are equity mutual funds. Period. Before going into the tax benefits etc associated with these funds, the first thing that any investor thinking of investing in ELSS funds should realize is that they are investing in equity funds. Within equity funds, ELSS funds are most like large-cap funds with some mid/small cap flavour.

What is special about ELSS funds?

Any investment in ELSS equity funds is exempt from income tax under Section 80C of the Income Tax Act. So it can be deducted from your income before calculating taxes. This is subject to a cap of Rs 1.5 lakh on the investment amount. So if you are somebody in the 30% tax bracket (taxable income above 10 lakhs) then you can save Rs 45,000 (= 30%*1.5lakhs and excluding education cess) by investing Rs 1.5 lakhs in ELSS funds. For those in the 20% and 10% tax brackets, they can save Rs 30,000 and Rs 15,000 respectively. To enjoy this tax benefit, there is also a lock-in of 3 years. During this period any gains are tax free and the withdrawal amount after 3 years is also tax-free. Aa result ELSS is classified as an EEE investment - Exemption from tax of investment amount, Exemption from tax of gains and Exemption from tax of withdrawal amount.

Should you invest in ELSS funds?

To decide whether you should invest in ELSS funds and in what proportion, you need to answer 3 questions. If the answer to all these three questions is YES, then you should consider investing in ELSS funds.

#1: Do you have any investment limit left under Section 80C?

Apart from ELSS, there are several other forced savings/common expenditures which are eligible for deduction under Section 80C. Some common ones are:
1. Contributions to Provident Fund/Voluntary Provident Fund
2. Payment towards repayment of principal amount on Home Loan
3. Children's education expenses
4. Life insurance premium
Before thinking of making investments such as ELSS under Section 80C, you first need to check what proportion of your 1.5 lakh limit is already getting exhausted by these other routes.

Our research shows that the performance of ELSS funds is pretty much in line with that of other non-ELSS equity funds. Hence if you are already exhausting your 80C limit through other expenditures then it does not make sense to invest in ELSS funds since you will have an unnecessary 3 year lock-in period which does not exist with other equity funds. Gains on equity funds are as it is tax-exempt after 1 year investment.

#2: Are you willing to say invested for the long term?

I have seen many ELSS ads touting the twin benefits of high expected returns (~15%) and low lock-in period (3 years) compared to other 80C investment options. However this is misleading. Unless you turn out to be quite lucky in terms of timing your investment, you may not be able to enjoy both of these benefits. Performance of equities and consequently equity funds is notoriously difficult to predict. Equities have the potential to give double digit returns over the long-term (say 7+ years) but performance can vary a lot from one year to next and even over 3 year periods.

Hence you should consider investing entirely in ELSS funds only if you have an investment horizon of 7+ years. For investment horizons between 3 and 7 years, you should consider investing in a some combination of interest-paying debt investments eligible under Section 80C and ELSS. Even though your expected returns will be lesser, you will have a much higher probability of getting positive returns at the end of your investment horizon.

One thing that I would like to add here is that apart from ELSS, the two other 80C investments which are also EEE (and hence are the most beneficial) are PPF and Sukanya Samriddhi. Unlike ELSS, both are fixed return investments but you can only invest in them if you have a long investment horizon since they have long lock-in periods of 15 years and 21 years respectively. As a result, to get the maximum benefit from your 80C investments it is recommended that you should use the 80C bucket for long-term goals like retirement. This way you can invest unhindered in the EEE investments such as ELSS and PPF and get maximum tax benefit.

#3: Can you stomach the risk in equities?

While it is true that if you invest in equities for the long-term, you can significantly increase your changes of double-digit returns but you may still have to sit through significant ups and downs in the meantime. Not everyone has the risk appetite to do that. If you are someone who will panic an sell your ELSS investment early if they are down 20%, then you are again better-off holding a combination of ELSS and debt investments eligible under Section 80C rather than entirely in ELSS.

Distributors get commissions for selling ELSS funds while nobody gets anything if you invest in PPF (say). That is one big reason why we see extremely rosy picture being painted for ELSS investments. You need to start looking beyond ads and see if your answer to the above the 3 questions is Yes. Its only then that you should invest 100% of your (residual) 80C limit in ELSS funds. Else opt for some combination of ELSS with other 80C investments.

Also if you decide to invest in ELSS funds, also way invest in 0-commission funds. You can save an additional 6000Rs by not paying commissions.



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