Why to invest in ELSS funds?

Written on Saturday, December 5, 2015
By Sudipta Mitu

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If you belong to the salaried class, then in late December or early January the HR Department of your office will ask for proof of tax saving investments. If you have not done any for this year, equity linked savings schemes (ELSS) or tax-saver funds are one option that you should definitely go for, despite the shaky performance of equities so far this year.

 

When making tax saving investments, you should keep in mind your larger investment goals and also your asset allocation. If you are a salaried person, you would already be contributing to Employee Provident Fund (EPF). In addition, you would have probably invested in Public Provident Fund (PPF) also. This means that your Section 80C investments are already skewed in favour of debt instruments. To restore balance and to maintain your overall asset allocation, some portion of your Section 80C investment (whatever is left after including the premium on your insurance policy, principal repaid on home loan, child’s tuition, etc.) should surely go into ELSS funds.

 

This year onwards the limit on Section 80C has been hiked to Rs. 1.5 lakhs, so you should be able to find some headroom for investing in ELSS funds. Since this is one instrument that invests entirely in equities, it has the potential to build long-term wealth along with providing tax saving. Even at a time when the one-year return from the Sensex is a dismal -8.34% and year-to-date return is -6.87%, the three-year category average return from ELSS funds still looks good at 18.59%. Over the very long-term (10 years) also the return is a reasonable 12.48%. The return from fixed-income schemes like PPF and EPF is 8-9%.

 

The higher returns will, of course, be accompanied with volatility. But, investors fearful of losing money in equities should remember that the risk of equities declines as the investment horizon increases. Since, your money is going to be locked-up for three years, it is better to invest it in equity schemes like ELSS, where it can compound at a higher rate. In fact, at the end of three years, you can withdraw the money and then reinvest it in an ELSS scheme again, thereby availing tax deduction on the invested amount. Once your investment horizon has gone past 6-7 years, the possibility of losing money in equities becomes very low, while the chances of earning high returns increases.

 

The lock-in feature of ELSS funds also works to the advantage of these funds, allowing them to churn out better performance. Since the money is locked-in, fund managers know that it cannot be pulled out for three years. They do not have to keep aside too much cash to meet redemption pressure in a volatile market. They can also take a long-term view while investing.

 

Points to remember

 

Ideally, you should have begun investing in an ELSS fund from April. This would have allowed you to invest via Systematic Investment Plan (SIP), thereby, giving you the advantage of rupee-cost averaging. Spreading your investment out over the year also helps avoid a cash crunch towards the end of the year. With four more months left in the financial year, spread your investments out over the remaining period, and start right from April in the next financial year. ELSS funds are varied lot. Some of them may be conservative, large-cap oriented funds, others may be multicap funds, while yet others may be the more risky mid- and small-cap oriented funds. Choose a fund that matches your risk appetite. To know the nature of a fund, visit Morningstar India’s website and look up the style sheet of the fund that you are interested in. The style sheet will tell you where the fund lies on the market cap spectrum.

 

If you have already filled your section 80C limit through other instruments, then, it doesn’t make sense to lock-up your investment for three years. In that case, put your savings in ordinary diversified equity funds instead of ELSS funds.

 

Invest in just one or two ELSS funds. If you invest in more, it will only result in overlapping the diversified equity funds, already there in your portfolio. You should not have more than 8 funds in your portfolio altogether. After a point, adding new funds to the portfolio doesn’t give you the advantage of further diversification. Also avoid investing in a new ELSS fund every year. It will only make your portfolio unwieldy without bringing any benefits. When investing in ELSS funds, it is best to go with the growth option, if your primary purpose is to build wealth. At all costs, avoid the dividend reinvestment option. If you do so assuming that the fund pays out dividend regularly, you will have a difficult time withdrawing all your money.

 

If you have invested in an ELSS fund via SIP method, then you must know how many of your units are eligible for redemption. Redemption will happen on a FIFO (first in, first out) basis. If you apply for redemption on more units than eligible, the fund house will reject your application.

 

When investing in an ELSS fund, avoid doing an SIP for more than one year, or maximum two years. Remember, that you will be able to redeem units, three years from the date of investment via a particular SIP. But, what if the fund’s performance declines or the star fund manager who was responsible for fetching the good returns quits the fund house? In that case, you don’t want to be stuck with the fund for a very long time.

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