Things you need to know about investing in ELSS

Equity linked savings schemes (ELSS) has emerged as a solid tax-saving avenue in the last few years. The reasons are not far to seek! ELSS combines the best of equity returns and tax savings giving a powerful post-tax performance. But here are a few things you need to be aware of an ELSS

ELSS is just like any other equity fund

While the ELSS is classified as a separate category of fund, it is in effect an equity fund for all practical purposes. It is predominantly invested in equities. The only difference is that there is a 3-year lock in for these funds. That means once you are invested in these funds then you cannot redeem them for a period of 3 years from the date of investment. Otherwise, for all practical purposes, the portfolio of an ELSS is exactly like a normal equity fund.

ELSS funds are very tax efficient

Like all equity funds, the ELSS offers the normal benefits like tax-free dividends and tax-free long-term capital gains. In addition, the ELSS also offers you the additional rebate under Section 80C of the Income Tax Act for the amount invested in ELSS during the year. Section 80C of the Income Tax Act offers rebate up to an outer limit of Rs.150,000 per year. If you are in the peak 30% tax bracket, then you get a tax rebate of Rs.45,000/- in the year of investment. This can substantially increase your effectively post-tax returns as we will see in the next point.

ELSS substantially enhances your post tax returns

This is the big story in favour of ELSS funds. The effective post tax yield goes up substantially in the case of ELSS. Let us compare Fund-A which is a normal equity fund and Fund-B which is an ELSS with an almost similar portfolio and past performance.

Fund-A: The NAV of the fund was Rs.20 on November 01st 2014 and the NAV appreciated to Rs.36 on October 31st, 2017. Thus the profit was Rs.16 (36-20), which translated into an absolute return of 80% over 3 years. If you consider the CAGR of returns over the last 3 years for Fund-A, it comes to 21.7% annualized. That is surely a phenomenal annual return on a fund. Now, what happens in case of Fund-B?

Fund-B: The NAV of the ELSS Fund-B also appreciates from Rs.20 on November 01st 2014 to a NAV of just Rs. 34 on October 31st, 2017. That translates into a profit of Rs.14 (34-20), which can also be expressed as an absolute return of 70% over 3 years. In CAGR terms, this works out to an annualized return of 19.4%. If you are disappointed, there is room to cheer. Consider your effective post-tax returns. When you invested Rs.20 in 2014, you got a rebate of Rs.6 (30% of 20) for the financial year 2014-15. Therefore you effectively invested only Rs.14 three years aback. That means your investment of Rs.14 has appreciated to Rs.34 in 3 years. That is an absolute return of 143% over a period of 3 years. In terms of CAGR returns that translate into 34.5% annualized returns on the ELSS. Therefore, despite the ELSS underperforming in NAV terms, its effective returns are substantially higher than the equity fund due to the tax rebate.

Actually, ELSS funds tend to perform better than equity funds

The truth is that even in absolute terms, the ELSS funds normally tend to outperform the normal equity funds. Here is why. Since ELSS funds have a lock-in period of 3 years, the need to maintain liquidity to fund redemptions is much lower in case of ELSS funds. That allows these funds to deploy more into equities and hold less in cash. Secondly, with the automatic 3 year lock in period, fund managers have the luxury of taking more long term approach to equities. This tends to be more wealth accretive in the longer run. This stability of corpus due to the lock-in is one of the main reasons why ELSS funds tend to outperform normal equity funds even in nominal terms.

Don’t worry; you can do a SIP on ELSS too

Just as you do a SIP on normal equity funds, you can also do a SIP on ELSS funds. So, if you are planning to invest Rs.120,000 in ELSS during the fiscal year, then start an ELSS SIP of Rs.10,000 each month. That way you achieve the target for the full year and also get the benefit of rupee cost averaging. The phased approach makes your tax planning exercise more systematic rather than trying to rush for liquidity in the last few months. It also aligns with your income pattern.

There is one thing you need to remember with respect to your SIP on ELSS Funds. The 3-year lock-in for each SIP will commence from the month it is invested in. You need to factor that in when you are planning your redemptions. Otherwise, the ELSS is a great investment tool to hit two birds with one stone. On the one hand you get fabulous returns and on the other hand, you get tax breaks. That is surely a good way to create wealth!

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