Things to Know Before Investing in ELSS Funds

 




Equity-Linked Savings Schemes (ELSS) are a type of mutual fund in India that offers the potential for high returns by investing in equities and provides tax-saving benefits. This unique combination makes ELSS a popular choice among investors seeking capital growth and tax savings under Section 80C of the Income Tax Act. If you're considering investing in ELSS funds, it's crucial to understand how they work and the key factors to remember.

What are ELSS Funds?

ELSS funds are equity-oriented mutual funds that invest primarily in stocks and equity-related instruments. They stand out because they provide exposure to equity markets while also offering tax deductions. As per Section 80C of the Income Tax Act, an individual can claim a deduction of up to ₹1.5 lakh by investing in ELSS funds in a financial year. ELSS funds are the only mutual funds eligible for tax deductions, making them a preferred option for tax-saving investments.

Let's delve into the key aspects of ELSS funds that every investor should know.


  1. Asset Allocation in ELSS Funds

By mandate, ELSS funds must allocate at least 80% of their assets to equity and equity-related securities. The remaining portion can be invested in fixed-income or money market instruments. This allocation allows ELSS funds to harness the stock market's potential for higher returns than traditional tax-saving instruments like PPF or NSC.

The performance of an ELSS fund is heavily influenced by the choices made by the fund manager. Fund managers can select stocks based on the fund's objectives and risk tolerance. For instance, high-risk ELSS funds may invest a larger portion in small-cap stocks, known for their growth potential and higher volatility. On the other hand, medium or low-risk ELSS funds may allocate more to large-cap stocks, which are relatively stable but may offer moderate returns.

Understanding the asset allocation and the fund manager's approach is crucial for investors to ensure that the fund aligns with their risk appetite and financial goals.


  1. Lock-in Period

One of the defining features of ELSS funds is the mandatory lock-in period of three years. This lock-in period is the shortest among all Section 80C investment options. For comparison:

  • ELSS: 3 years

  • Public Provident Fund (PPF): 15 years

  • National Savings Certificate (NSC): 5 years

The three-year lock-in period means that once you invest in an ELSS fund, you cannot withdraw your funds for at least three years. However, this lock-in is much shorter compared to PPF or NSC, making ELSS funds an attractive choice for investors who want liquidity in the medium term.

It's important to note that each SIP instalment has its lock-in period in ELSS funds. So, if you invest monthly through a SIP, each contribution will be locked in for three years from the investment date. This aspect should be considered when planning your investment horizon and liquidity needs.


  1. Investing in ELSS via SIP

Systematic Investment Plans (SIP) are a popular way to invest in mutual funds, including ELSS funds. SIPs allow you to invest small, fixed amounts at regular intervals (e.g., monthly or quarterly), making it easier to accumulate wealth over time without the need for a large lump sum upfront.


One of the most significant advantages of SIPs in ELSS is Rupee Cost Averaging. This concept means that you buy more units when the market is down and fewer units when the market is up. Over time, this averages out the cost of purchasing units, reducing the risk of market volatility. SIPs are particularly effective during market downturns, allowing you to accumulate more units at a lower cost.


It's also important to understand that every SIP instalment in ELSS funds is subject to the same three-year lock-in period. So, for instance, if you invest ₹5,000 every month through a SIP, the amount invested in January 2024 will be locked in until January 2027, while the amount invested in February 2024 will be locked in until February 2027, and so on. This means you must plan your withdrawals carefully, especially if you intend to redeem your investment in stages.


  1. Avoid Overloading Your Portfolio with Multiple ELSS Funds

A common mistake investor make is purchasing units from a new ELSS scheme each year from different Asset Management Companies (AMCs) without proper portfolio planning. This approach is often driven by the desire to save tax each financial year, but it can lead to an unbalanced investment portfolio.

Over time, you may end up with multiple ELSS funds within the same category, which can create overexposure to a particular asset class. This lack of diversification can increase your portfolio's risk. For instance, if all your ELSS funds are heavily invested in mid-cap or small-cap stocks, your portfolio might suffer during market downturns, as these stocks tend to be more volatile.

To avoid this, it's crucial to select ELSS funds that complement your overall investment portfolio strategically. Diversification across different asset classes, sectors, and fund types can help mitigate risks and enhance returns over the long term.



  1. Risk Level of ELSS Funds

ELSS funds primarily invest in equities, and like any equity investment, they carry a certain level of risk. The risk level of an ELSS fund depends on its portfolio composition. Funds that invest more in small-cap or mid-cap stocks tend to be riskier but may offer higher returns, while funds that focus on large-cap stocks may provide stability but with potentially lower returns.

It's crucial to assess your risk tolerance before investing in ELSS funds. A high-risk ELSS fund may be suitable if you have a higher risk appetite and a long-term investment horizon. However, if you prefer stability and lower risk, you may opt for a more conservative ELSS fund focusing on large-cap stocks.


  1. Taxation of ELSS Returns

While ELSS funds offer tax deductions on the investment amount under Section 80C, the returns from these funds are subject to Long-Term Capital Gains (LTCG) tax. Any gains above ₹1 lakh in a financial year are taxed at 10%. For example, if you earn a profit of ₹1.5 lakh from your ELSS investments, the additional ₹50,000 will be taxed at 10%.

Investigating this taxation is essential when calculating your overall returns from ELSS investments. Despite the LTCG tax, ELSS funds remain one of the most tax-efficient investment options due to their potential for higher returns than traditional 80C investments.


Conclusion

Equity Linked Savings Schemes (ELSS) are an excellent investment option for individuals looking to save on taxes while gaining exposure to the stock market. With their three-year lock-in period, potential for high returns, and tax benefits, they offer a unique blend of growth and savings. However, like all equity investments, ELSS funds carry a degree of risk, and it's essential to choose funds that align with your risk appetite and long-term financial goals.

Before investing, thoroughly research different ELSS schemes, assess the fund's performance, expense ratio, and asset allocation, and ensure that the fund fits well within your broader investment strategy. With the right approach, ELSS funds can be a powerful tool for wealth creation and tax saving.

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