Why ELSS Is Your Best Choice to Build Wealth and Save Tax

February 23, 2023 Mutual Fund

If you are young, earning a respectable or high income, want to achieve your envisioned financial goals, counter inflation, have an investment time horizon of 3 years+, are willing to take a calculated risk, and want to save tax while you invest, then Equity-Linked Saving Schemes or ELSS is a worthwhile investment avenue.

Investment in ELSS entitles you to a deduction of up to Rs 1.50 lakh (from the Gross Total Income) under Section 80C of the Income-tax Act, 1961 in the financial year in which the investment is made. Effectively, you could save up to Rs 46,800 a year, assuming you are in the highest tax bracket and opting for the Old Tax Regime.

What is ELSS?

ELSS, also known as a tax-saving fund, is an open-ended diversified equity scheme that comes with the dual advantage–tax-saving benefit under Section 80C and wealth-building potential. In short, you get two birds with one stone.

As per the regulatory guideline, an ELSS is mandated to invest at least 80% of its total assets in equity and equity-related instruments in accordance with the equity-linked savings scheme 2005, as notified by the Ministry of Finance.

Furthermore, there is a mandatory lock-in period of 3 years. Simply put, you cannot redeem your investment in ELSS before the completion of three years from the date of your investment.

Now, while some of you may find the lock-in period restraining your liquidity and, therefore, a deterrent, note that compared to the other tax-saving avenues, ELSS has the least lock-in period.

Table 1: Lock-in Period And Return Potential of ELSS versus Other Tax-Saving Avenues

*Depends on your ELSS selection.
#Depends on the type of asset class orientation of the fund you choose under ULIP.
$ 5-Yr Tax Saver Bank FD interest rate considered is that of SBI.
The current rate of interest as applicable is taken for other tax-saving instruments. Interest rates are subject to change.
@Depends on the scheme chosen under the NPS 

In my view, the 3 years lock-in for ELSS inculcates the needed discipline of staying invested for the long term considering that your hard-earned money is invested by the fund manager in equity and equity-related instruments with the objective of capital appreciation.

Having said that, enough care should be taken when selecting ELSS or tax-saving mutual funds. As you can see in Table 2, the difference between the top and bottom-performer in the ELSS is glaring. Not all ELSS are worth your hard-earned money.

Table 2: Performance of ELSS or Tax-Saving Mutual Funds

Data as of February 20, 2023.
Returns are Point to Point and in %, calculated using the Direct Plan-Growth option.Std. Dev and Sharpe Ratio are calculated over a 3-Yr period assuming a risk-free rate of 6% p.a.Past performance is not an indicator of future returns.*Please note, this table only represents the best-performing schemes based solely on past returns and is NOT recommendations as such. Speak to your investment advisor for further assistance before investing.Mutual Fund investments are subject to market risks. Read all scheme-related documents carefully.
​(Source: ACE MF, PersonalFN Research) 

How to select the best ELSS for the tax-saving portfolio?

Closely evaluate a host of quantitative and qualitative aspects of ELSS (or tax-saving mutual funds), such as…

• Past performance across various time frames (6-months, 1-year, 2-year, 3-year, 5-year, 10-year, since inception)
• The performance across market phases (bull and bears)
• The level of risk it exposes its investors (as denoted by the standard deviation)
• The risk-adjusted returns clocked (as reflected by the Sharpe and Sortino Ratio)
• The expense ratio (as it weighs on the returns you make)
• The portfolio characteristics (such as the top-10 holdings, top-5 sector exposure, how concentrated/diversified is the portfolio, the market capitalisation bias, portfolio turnover, etc.)
• The credentials of the fund management team (i.e., the experience of the fund manager, the number of schemes he/she manages, the track record of the mutual fund schemes under his/her watch, the experience of the research team)
• The proportion of AUM of the fund house actually performing (to check the efficiency of the fund house and whether it is an asset manager or a mere asset gatherer)
• And on the whole, the investment process & systems are followed at the fund house.

In the current times of elevated inflation, central banks raising policy interest rates, chances of global economic slowdown or recession in 2023 (as forewarned by the World Bank and the IMF), fraud accusations of conglomerates such as Adani, and volatile Indian equity markets, you need to follow a prudent approach.

Given that valuations in the Indian equity markets do not look cheap and the margin of safety is narrow, consider ELSS (also known as a tax-saving mutual fund) following a value style of investing, as opposed to chasing growth or momentum.

I believe, like in the year 2022, where value investing worked well for investors, the year 2023 also is expected to support the value-style investing thesis. If the value-buying opportunities that exist across market capitalisations (large-cap, mid-cap, and small-cap) and sectors are aptly tapped by an ELSS fund manager, over the next 3-5 years or more, it could create value proving to be a rewarding experience for you, the investor. Parag Parikh Tax Saver Fund and Quantum Tax Saving Fund are among the value-oriented ELSS or tax-saving funds.

This article first appeared on PersonalFN here