Mr. Khan, who is a photographer by profession, has been earning from investing stocks for some time now. But his fruitful side-hustle was hit with a dilemma when the income from his job increased and he was forced to think about tax-saving investment options. Mr Khan had the belief that tax-saving investments are not as aggressive as equity investments but that was only until he heard about Equity Linked Savings Scheme. Excited by the opportunity, he began searching the parameters to consider before investing in ELSS mutual funds. Let’s join Mr. Khan in his journey to understand ELSS better and examine parameters that you, as an investor, should consider before investing in ELSS in India.

What are ELSS mutual funds?

Simply put, an Equity Linked Savings Scheme is a mutual fund with an added tax-saving benefit. Just like any other mutual fund, there will be a fund manager who pools money from different investors to invest in a portfolio according to the theme of the fund.

When it comes to the portfolio, ELSS mutual funds are, as the name suggests, equity based. At least 65% of the portfolio will be reserved for equities here.

As mentioned above, its biggest advantage is the tax benefit. ELSS mutual funds are considered as a tax-saving investment option under section 80C of the Income Tax Act of India, 1961. You have the opportunity to claim a tax break of up to Rs. 1.5 lakhs and save up to Rs. 46,000 in taxes every year.

Apart from that, ELSS funds come with a three-year lock-in period. Here, your returns are considered as long-term capital gains and they are tax-deductible up to Rs. 1 lakh. Any gains above Rs. 1 lakh is taxed at a rate of 10%.

Diversity in ELSS funds

A lot of people have the misconception that diversity is scarce when it comes to ELSS mutual funds. Although all funds invest primarily in stocks, there is enough diversification in terms of the market capitalisation of the invested equities, sector of the invested equities, etc.

Here, Mr. Khan likes to choose a fund that is aggressive in nature. But if you are someone who is risk-averse, there are options for you as well, which makes ELSS funds highly efficient and suitable for a larger variety of investors.

ELSS benefits

Before we jump into parameters to consider before investing in ELSS mutual funds, let’s see why they are lucrative enough to be one of your top choices, apart from it being a tax-saving option.

• ELSS mutual funds have a lower lock-in period

Compared to its peers in the Section 80C tax savings investment options, ELSS has a shorter lock-in period of just three years, compared to a minimum of five years that other investment options have.

For instance, PPF, which also comes under the same tax-saving section, has a lock-in period of 15 years and a tax-saving fixed deposit has a lock-in period of a minimum of five years.

This factor makes ELSS one of the most liquid tax saving options.

• ELSS benefits from the magic of compounding

One thing that makes ELSS mutual fund investments more fruitful than their peers is the power of compounding. All your profits are re-invested in to the fund itself and you will start gaining profits from the compounded amount every time.

For instance, at the end of the first month, if your returns were 12%, you will start earning profit for the amount accounting to this profit also from the next month and the process goes on and on.

This gives your money an immense chance to grow and when invested for a longer term, compounding could give your money substantial growth.

• ELSS tends to give you higher returns than its peers

ELSS is market-linked unlike most 80C investment options, and it gives you the ability to earn higher returns than the rest. This is because fixed interest giving options tend to have a lesser return prospect than equities. The caveat here is that there is a risk that is parallel unlike a fixed deposit, where market movements and economic conditions don’t play a role.

Historically speaking, ELSS investments tend to give returns in the range of 15% to 20% annually while other tax-saving investment options like FD and PPF tend to give you between 7% to 10%.

• ELSS is SIP friendly

You don’t need a lump sum to start investing in ELSS and that is one of the greatest advantages of this mutual fund. You can start from an amount that is as little as Rs. 500 and reap all the benefits the fund gives. The power of compounding, like mentioned above, plays a critical part here and if you stay invested through an SIP for a longer period of time, you have a chance to take home a substantial amount of money, if markets don’t play spoilsport.

Six parameters to consider before investing in ELSS in India

Now that you and Mr. Khan have understood why ELSS mutual funds are a top choice, let’s go through some important factors you should check before you make the choice.

• The composition of the fund

As said above, ELSS mutual funds are required to have at least 65% of their portfolio filled with equities and equity instruments. But there is no upper limit to this. Fund managers can choose to invest up to 100% of the money in equity itself. This is where a closer look into the composition of an ELSS mutual fund is important.

Different ELSS funds will have different themes and the composition might be different accordingly. A more aggressive ELSS mutual fund could have a composition that has more than 65% of equities while a fund with a more conservative approach could stick to the bare minimum requirement. One important thing to understand here is that ELSS funds could have limitations in being conservative as the fund mainly invests and focuses on equities. So, understanding your risk appetite and choosing a fund that fits the same is vital.

• Where the fund invests

We can divide the equity investment choices ELSS funds have into two - market capitalisation wise and sector-wise.

Market capitalisation wise equity options can be divided into three - Large-cap, mid-cap and small-cap. The classification here is based on the Securities and Exchange Board of India’s (SEBI) ranking. The top 100 companies come under the large-cap section, while the next 150 (101 to 250) companies come under the mid-cap section. All the remaining companies are considered small-cap. Different market capitalisation groups could have different risk and return potential and investing in a fund that focuses on what is in line with your horizon is important. The same goes for sector classification. Different sectors might have different potentials and risks and choosing the right one is important.

• Returns and risks

Just like we have discussed above, making choices that are a match with your investment horizon is very important when it comes to ELSS fund investments. The first step here is to identify your risk and return horizon. If you don’t have that figured out, you can get in touch with a financial advisor who will help you figure out the same.

Once you have that figured out, it is all about finding the right fund for you. Past performance and the fund’s portfolio choices are the right tools here. An expert can help you regarding this too if needed.

• The fund manager

Choosing a tax saving mutual fund with the right fund manager is equally important. Different managers will have different approaches to risk and return and the one you choose should match with what you want out of your investment. One way to gauge this is by looking at the performance history of the funds the manager has taken care of before. You can take a look at how they have performed in the past and how the manager has managed the funds during tougher economic times.

You can also analyse the manager’s moves in times of crisis and see if they are a match with your style of investing.

• The fund house

Choosing the right fund house is also very important when it comes to investing in tax saving funds. The choice is mostly between established fund houses that have a history to show but charge more and new ones that charge less but have less history to analyse. There are no right and wrong choices here and the decision should be based on your preferences.

• The expense ratio of the fund

ELSS funds also come with an expense ratio aka annual fee for the management of the fund. The expense ratio could differ from fund to fund according to the rules of different fund houses. Here, choosing something that is affordable is important as a higher expense ratio could affect your overall profit.

Conclusion

Mr. Khan made the right choice and invested in a fund that was a match with his aggressive investment style. Now he can be invested in equities and those investments will save tax for him as well. If you find this lucrative and you’re not invested yet, waste no time and invest in an ELSS fund of your choice soon!

Interested in ELSS funds? Check them out here.

** All articles, columns, news, market updates, opinions and such other similar materials (“hereby referred to as Content”) published on Kotak Cherry (“hereby referred to as Platform”) is for information purpose only. The views and opinions expressed in this Content published on this Platform do not constitute the views of  Kotak Investment Advisors Limited, its parent company or its subsidiaries group companies and its affiliates (“hereby referred to as Kotak Group or Kotak”). The Kotak Group makes no warranty of any kind with respect to the accuracy, reasonableness and/or completeness of the Content published on this Platform. The information contained in this Content published is sourced from external sources and internal means, which includes the information developed by outsourced content writers and in-house writers and editors of the Kotak Group for the benefit of the customers and it does not constitute any advice from the Kotak Group. Also, all such Content published on this Platform shall not be construed as legal advice from the Kotak Group. All customers should before dealing and or transacting in any of the products or taking any investment decision based on the information referred to in this Content, shall make their own investigation and seek appropriate professional advice.

Such Content published on this platform is only for knowledge and learning purpose and is informative in nature and shall not constitute an investment advice under SEBI (Investment Advisory) Regulations, 2013. The Content published shall also not be construed as a research report as per the SEBI (Research Analyst) Regulations, 2014.

Kotak Group and any of its officers, directors, personnel and employees, shall not be held responsible or liable for any loss, damage of any nature, including but not limited to direct, indirect, punitive, special, exemplary, consequential, due to reliance on or use of any information contained herein.

No part of this Content published on this Platform may be duplicated in whole or in part in any form and or redistributed without the prior written consent of Kotak. The Content published on this Platform should not be reproduced or disseminated to anyone else without the prior written consent of Kotak.