Is it a good idea to have only ELSS funds in your mutual fund portfolio?

As ELSS funds become popular, investors are wondering whether they should invest exclusively in them.

As Indian investors begin to warm up to mutual funds, equity linked savings scheme (ELSS) is emerging as a popular option. Incidentally, from January 2020 till March 2021, 20%[1] of investors on a popular India-based investment platform chose to invest in ELSS.

So what is ELSS?

ELSS is an open-ended equity scheme that enables investors to create wealth while enjoying tax benefits. It comes with a mandatory 3 year lock-in period. At least 80% of the total assets are invested in equity or equity-related instruments. Since the bulk of ELSS investments is in equity, it is subject to the volatility of the market.

There are two ways to invest in an ELSS – either through a Systematic Investment Plan (SIP) or through a lump sum. Through a SIP, you can invest a fixed amount of money in an ELSS fund at regular intervals (weekly, bimonthly, or monthly). The lump sum payment enables you to invest by parking a certain amount of money in an ELSS fund. Equity Linked Savings Schemes: High returns + tax savings (Part I)

What are the features of ELSS?

Tax benefits

ELSS are equity mutual funds. Since they invest in organisations of all sizes – small, mid, and large – they are also called multi-cap funds. Under section 80C of the Income Tax Act, they also offer a tax deduction to the tune of Rs 1.5 lakh.

If you belong to the highest income bracket and pay 30% in taxes, you can save up to Rs 46,800. This includes an income tax cess of 4%. In addition to creating long-term wealth for investors, ELSS is the only mutual fund that offers tax benefits.

Related: ELSS vs NPS: Which one can help you save more tax and grow wealth?

Lock-in period

ELSS has the shortest lock-in period among tax-saving options for investment (see table below).

Related: Taxation on mutual funds and what you should know about it?

T​​​​he SIP option

Just as with any other mutual fund, you can also invest in ELSS with the help of SIPs. As mentioned earlier, SIP is a disciplined investment approach. It allows an investor to instruct their bank to deduct a certain amount every month (or weekly or bimonthly) and direct it towards the ELSS. It is a hassle-free and straightforward process.

The starting ticket size for an SIP is Rs 500. As with other mutual funds, you can always increase your monthly investment amount through a top-up. If you invest Rs 12,500 every month, you could enjoy annual tax deductions of up to Rs 1.5 lakh. Other options like ULIP and PPF also offer these features but they have higher lock-in periods.  Other tax-saving instruments do not offer such attractive features. What to do with your money when your SIP matures? Read here

Should you invest all your mutual fund investments in ELSS?

For investors keen to enjoy tax benefits in addition to long-term wealth, ELSS is increasingly becoming the financial instrument of choice. However, does it make sense to invest only in ELSS? Let us consider a few factors:

Short-term goals

You are likely to have short-term, mid-term, and long-term goals. Due to the lock-in period of ELSS funds, you would not be able to consider ELSS funds for meeting any goal within three years. So, if you have short-term goals such as purchasing an electronic gadget or enjoying an international holiday, you would have to invest in appropriate funds that can enable you to achieve these.

Related: The effect of COVID-19 on your mutual fund investments

Performance

One of the most important factors for evaluating a mutual fund scheme is the performance it offers. Investors scrutinise the CAGR (compound annual growth rate) or absolute return offered by multiple mutual funds. It is important to compare the performance delivered by ELSS funds with other equity funds. If you invest only in ELSS funds, you may end up missing out on better returns delivered by non-ELSS mutual funds. How interest rates impact mutual funds.

Diversification

Diversification is the cornerstone of investing. By investing solely in ELSS funds, an investor gets exposed to the risk of taking a concentrated bet. Therefore, it is imperative to diversify across different types of mutual funds.

Related: Here’s how you can invest in mutual funds for different goals

Liquidity crunch

ELSS funds have a lock-in period of three years. This may be welcomed by investors who are keen to invest for a long term. However, an ELSS fund may not be suitable for those who wish to park their funds in a mutual fund for a short term[2] – especially by investing a lump sum. Being completely invested in an ELSS fund could result in a liquidity crunch.

Related: Savvy millennials betting big on Mutual Funds

80C Benefits

In many ways, ELSS is the best investment option if you are looking to make the most of 80C benefits. No other instrument will offer you the same kind of return while delivering tax benefits as well. If you are a high roller with a risk appetite who does not wish to invest in the more conservative instruments under 80C, ELSS should be your investment option of choice.

There is no rule of thumb on how much you should invest in ELSS, especially if you are already availing 80C benefits through other options. For instance, if you are already availing 80C benefits through PPF, you can combine your ELSS investment with PPF to enjoy the best of both worlds. You do not miss out on the high earnings from ELSS while experiencing the stability that PPF has to offer. 

Furthermore, if you combine your ELSS with PPF, your portfolio becomes well diversified with a mix of equity and debt instruments. On one hand, you have the safety of government-backed securities to fall back on. On the other, you can enjoy growth through equities.

Please note – Long Term Capital Gains (LTCG) tax is applicable on ELSS returns. Furthermore, you will no longer be able to avail EEE benefits on your ELSS investments. However, you will continue to enjoy EEE if you have invested in PPF.  

A Disciplined Approach Towards Your Retirement Planning 

Let’s face it – there is no waiting period to start your retirement planning. ELSS offers you the advantage of tax benefits while making the most of your younger years to earn rich returns through equity exposure. 

If you have a disciplined approach towards securing your long-term future by pursuing investments in an orderly fashion, ELSS is the ideal instrument of choice. 

3 Year And 5 Year Returns On Top 5 ELSS V Index Funds – Which One Performs Better?

When we compare the top Equity Mutual (Index) and ELSS funds of the last 3 to 5 years, ELSS outperforms the Index funds. 

The turnover ratio, also known as churn ratios, is lower in the case of ELSS. This is one of the primary reasons why returns are also higher in the case of ELSS. 

Since there is a lock-in period of 3 years, an ELSS fund manager can include growth or value stocks within the portfolio. Unlike Index funds where there are no lock-ins, he does not have to worry about short-term redemption pressures in ELSS. 

Since the holding period is longer in the case of ELSS, the returns are also higher than Index funds.

Different year, different fund

There is a well-known practice where investors choose a new ELSS fund each year for availing of tax benefits. Over time, they end up with half a dozen of these in their portfolio. Prudent fund managers discourage this practice. Instead, they recommend that you select one or two ELSS funds for investment based on expert advice and keep increasing your SIP amount in those funds on a yearly basis.

Often, when you are invested in more than two ELSS funds, you end up redeeming the funds that are the worst performers. Furthermore, over-diversification leads to lower returns on your portfolio. It is important to create a balanced mutual fund portfolio with multiple types of funds that align with your goals and expectations. So, it wouldn’t be a good idea to invest all your mutual fund investments in ELSS funds. Know different types of funds available under mutual funds.

Disclaimer: This article is intended for general information purposes only and should not be construed as investment or tax or legal advice. You should separately obtain independent advice when making decisions in these areas.