What factors should you consider while investing in ELSS funds?

Introduction

Mutual funds have been a viable investment option for decades now attracting millions of investors and offering different categories of funds that are suitable for every investor class. Mutual funds are a relatively safer investment option as compared to investment in pure stocks as it gives the benefits of diversification at the same time spreading the risk. One of the most popular mutual funds categories is ELSS funds.

Given below is the meaning of ELSS funds and the key factors that need to be considered while investing in them.

What are ELSS funds?

ELSS funds stand for Equity Linked Savings Schemes. These funds invest primarily in equities (minimum 80% in equities and equity-related instruments) along with investment in other securities like debt instruments, money market instruments, etc. These funds are also known as tax saving funds which is also the key feature of these funds. These funds have a minimum lock-in period of 3 years and can be claimed as a deduction from the gross taxable income. 

What are the key features of ELSS funds?

Some of the key features of ELSS funds are highlighted below.

1. The USP of these funds is that the unitholders can claim a deduction under section 80C of the Income Tax Act 1961 to the tune of Rs. 1,50,000 in any financial year.
2. These funds require the investors to stay invested for a minimum period of 3 years to claim this deduction.
3. These funds are a good way to invest in equities and save tax along the way in the form of deduction.
4. Investors can invest in these funds through a lump sum mode or SIPs. an important point to note is that the period of 3 years in the case of SIPs will be calculated from the date of investment for individual SIP.
5. There is no maximum limit that can be invested in ELSS funds, however, deduction under section 80C is restricted up to Rs. 1,50,000.

What are the factors to be considered for investment in ELSS funds?

After learning the meaning and the prime features of ELSS funds, let us now discuss the essential factors that need to be considered while investing in these funds. 

1. The lock-in period of the fund

ELSS funds are the only mutual funds that have a lock-in period of 3 years for claiming the tax deduction. This means that the investors cannot exit the fund before the expiry of this tenure. However, the lock-in period is relatively quite small in comparison to other tax saving schemes like PPF or NSC giving it an advantage over the traditional investment options.

2. The expense ratio of the fund

It goes without saying that the higher the expense ratio, the lower the net earnings. hence, the expense ratio of a fund is one of the many important factors to consider while making an investment decision. The expense ratio of the fund includes expenses like fund manager’s fees, register fees, distributor’s commission, advertising and auditing charges, etc. The expense ratio of an ELSS fund is usually up to 2.25% for equity funds. Investors should therefore select the funds that have the lowest expense ratio as it has a direct impact on the net earnings. 

3. Taxation of ELSS funds

Prior to the budget of 2018, the taxation of ELSS funds was quite straightforward. The dividends earned by the investors were tax-free along with any LTCG. However, post amendment in the budget of 2018, dividends are taxable in the hands of investors and any LTCG above Rs. 1,00,000 is taxable at the rate of 10% without the benefit of indexation. Investors have to therefore consider the tax implications and their impact on the net returns while considering any ELSS fund for investment.

4. Risk parameter of the fund

Another important consideration is the risk of investment. The risk-return analysis is the prime factor for any type of investment, especially in equities or equity-dominated funds as the volatility is relatively higher. An ELSS fund investing in mid-cap or small-cap stocks will be relatively riskier than an ELSS fund investing primarily in large-cap stocks. Therefore, the risk parameter of the fund should be in line with that of the investors to meet their financial goals. 

5. Returns of the fund

The returns of equity funds are higher than debt funds in the long run however, the volatility is also quite high. Investors should analyze the performance of the fund for the past 8 to 10 years to get a clear idea of the consistency of the returns and the average returns that it can generate in any market condition. The type of returns that need to be analyzed by the investors are training returns, rolling returns, CAGR, etc. The funds that have the ability to generate higher returns at lower expense ratios and risks should be the preferred choice of the investors.

6. Fund manager and the reputation of the fund house

Fund managers are the captain of mutual funds and are responsible for steering them in the right direction for generating maximum investor wealth. It is therefore important to check the profile of the fund manager (their educational qualifications, expertise, experience, etc.) to have a fair idea of the performance of the fund. At the same time, it is also equally important to check the reputation of the fund house launching the fund. If the fund house is established and has many other successful mutual fund schemes under its belt, it is safe to assume that the ELSS fund will be a safer investment in comparison to a relatively new fund house. An established fund house has set procedures in place and therefore the fund may not be drastically impacted due to a change in the fund manager. 

Conclusion

ELSS funds are a key investment in the portfolio of millions of investors. It provides tax savings at the same time wealth creation which is a win-win situation for the investors. It is, therefore, hugely popular over traditional investment options like Bank FDs or NPS, etc. However, it is also equally important that the fund should be in line with financial goals and the investment horizon of the investors.