How to Choose the Best Tax-Saving ELSS Mutual Funds
Equity Linked Savings Schemes (ELSS) are a popular category of mutual funds in India that offer dual benefits of tax savings and wealth creation. These funds qualify for tax deductions under Section 80C of the Income Tax Act, allowing you to claim deductions of up to ₹1.5 lakh per year on your taxable income. ELSS mutual funds primarily invest in equity markets, offering potential for higher returns compared to other tax-saving instruments like PPF or NSC.
This guide will help you understand how to choose the best ELSS funds, what factors to consider, and how they fit into your overall tax-saving and investment strategy.
What is ELSS?
ELSS is a type of equity mutual fund with a lock-in period of 3 years. It invests predominantly in stocks and equity-related instruments, aiming to deliver high returns by capturing market growth. Here’s why ELSS is unique:
- Tax Savings: Investments up to ₹1.5 lakh qualify for deductions under Section 80C.
- Lock-in Period: ELSS comes with the shortest lock-in period (3 years) compared to other Section 80C instruments like PPF (15 years) or NSC (5 years).
- Growth Potential: Being equity-focused, ELSS has the potential for higher returns, but it also comes with associated risks due to market volatility.
Key Factors to Consider When Choosing ELSS Funds
a. Historical Performance and Returns
While past performance does not guarantee future results, it offers insights into how a fund has performed across market cycles. When evaluating ELSS funds:
- Look for funds with consistent long-term performance over 5 to 7 years.
- Compare the annualized returns against the benchmark index and peer group.
Typical ELSS returns vary, but historically they have delivered around 12-15% over the long term. Be cautious of funds that have only shown short-term spikes in performance.
b. Fund Manager's Track Record
A competent and experienced fund manager can significantly influence a fund’s performance. Assess the following:
- The experience and reputation of the fund manager.
- How well the manager has handled market volatility and different economic conditions.
A fund manager with a good track record of delivering consistent returns can help balance the risk in equity investments.
c. Risk Profile
Since ELSS primarily invests in equities, they are subject to market fluctuations and can be volatile. Consider the following:
- Risk-Adjusted Returns: Use metrics like Sharpe Ratio or Sortino Ratio to see if the fund offers good returns compared to the risk taken.
- Volatility: Funds with very high returns can sometimes be more volatile. Ensure that the fund's volatility aligns with your risk tolerance.
Young investors with a long-term horizon can take on more risk, while investors closer to retirement may prefer funds with a more conservative investment approach.
d. Expense Ratio
The expense ratio is the annual fee charged by the fund to manage your money. A lower expense ratio means more of your returns stay with you. When comparing ELSS funds, consider:
- Choose funds with reasonable expense ratios (ideally under 2% for regular plans and under 1% for direct plans).
- Avoid overly expensive funds unless their performance justifies the cost.
e. Investment Style and Portfolio Composition
ELSS funds vary in their approach to stock selection. Some may be large-cap heavy, while others might have exposure to mid-caps or small-caps. Key things to check:
- Diversification: Ensure the fund is well-diversified across sectors and stocks.
- Investment Style: Funds that invest in high-quality stocks tend to offer stable returns. Avoid funds with excessive concentration in any single sector or stock, which can increase risk.
Lock-in Period and Liquidity
One of the main features of ELSS funds is the lock-in period of 3 years. This means that once you invest, you cannot withdraw your money for at least three years. However, this lock-in can be an advantage because:
- Encourages Discipline: The lock-in forces you to stay invested for the long term, which is essential for equity investments to perform well.
- Tax Efficiency: The returns after 3 years are treated as long-term capital gains (LTCG), which are taxed at a lower rate (12.5% for gains over ₹1.25 lakh).
Since liquidity is restricted, ensure you are comfortable with locking your funds for the required period and that this aligns with your overall financial goals.
Potential Returns
ELSS funds have the potential to deliver higher returns compared to traditional tax-saving instruments like PPF, FD, or NSC. Over the long term, ELSS funds have historically delivered returns in the range of 12-15%, although this is not guaranteed, and returns fluctuate based on market conditions.
Comparison of Returns:
- Public Provident Fund (PPF): ~7-8% (guaranteed)
- Fixed Deposits (FDs): ~5-6% (guaranteed)
- ELSS Funds: ~12-15% (historical, market-linked)
For a long-term investor, ELSS can generate substantial wealth while providing the benefit of tax savings.
Risk Factors
While ELSS funds offer high returns, they are not without risks, as they are equity-oriented schemes. The main risks include:
- Market Risk: ELSS is subject to stock market volatility. A downturn in the market can impact the NAV of the fund, reducing the value of your investment.
- Sectoral Risk: Some ELSS funds may have high exposure to specific sectors (like IT, banking, etc.). If that sector performs poorly, the fund’s returns may be affected.
- Lock-in Risk: Once you invest in an ELSS fund, you cannot withdraw for 3 years. If the market underperforms during this period, your returns might suffer.
To manage these risks:
- Invest for the long term: ELSS funds tend to perform well over a longer horizon of 5-10 years.
- Diversify: Don’t invest all your money in one ELSS fund. Diversify across different funds and asset classes to spread risk.
Top ELSS Funds
Here are some well-performing ELSS funds that you can consider based on their historical performance, fund manager experience, and risk-adjusted returns. (Note: Always check for the latest data and consult a financial advisor before investing.
Here, Check :> Top performing ELSS funds
Conclusion: How to Pick the Best ELSS
When choosing an ELSS fund, focus on a combination of performance consistency, risk-adjusted returns, and your personal financial goals. Look for funds that have performed well over longer periods (5-7 years) and align with your risk appetite. A low expense ratio and the fund manager’s experience are also key considerations.
Remember, while ELSS is a great tax-saving tool, it should also fit within your overall investment strategy. Investing regularly through a Systematic Investment Plan (SIP) can help you average out market volatility and build wealth over time.
Lastly, always consult a financial advisor before investing to ensure that the selected ELSS funds match your risk tolerance, time horizon, and financial objectives.
Check :> Top performing ELSS funds