What are ELSS?
Equity Linked Savings Schemes (ELSS) is a type of open-ended mutual fund investment where a minimum of 80% of the capital is invested in equity and equity-related instruments. One of the key features of ELSS is that it comes with a mandatory lock-in period of 3 years.
Features and benefits of ELSS
Investing in ELSS comes with a number of advantages apart from the high rate of returns earned from the investment. They are as follows:
- ELSS come with a lock-in period of 3 years.
- ELSS investments come with two options- dividend and growth. At the end of the 3-year investment, investors who opted for the growth option are paid a lump sum amount. On the other hand, investors who choose the dividend option are paid a regular income whenever the dividends are declared.
- One of the most obvious advantages of ELSS is the fact that the dividends earned are free from taxation. Additionally, the investment itself qualifies for a tax deduction up to Rs.1.5 lakh under Section 80C of the Income Tax Act, 1961.
- Unlike other tax-saving investments, ELSS has a relatively short lock-in period. Additionally, the rate of returns on the investment is considerably higher. While traditional investments such as the PPF or NSC have an interest rate of 8%, the interest rate for ELSS can be anywhere between 15% to 18%.
- With regard to the mode of investment, individuals who opt for ELSS can choose between making a lump sum investment or can choose a Systematic Investment Plan (SIP) where small amounts can be deposited at a regular interval. SIP installments can be as low as Rs.500.
- Despite the cap on the investment amount that can be claimed for tax deductions, there is no limit on the amount that can be invested in an ELSS.
- Since an ELSS fund invests primarily in equity and equity-related instruments, the likelihood of the fund’s Net Asset Value (NAV) fluctuating is relatively high. However, since an investment in ELSS is long-term, it has the potential to overcome this volatility and gain substantial returns.
- An added perk of an ELSS investment is that entry and exit loads are not charged.
Choosing an ELSS fund
The following factors need to be analysed before making a decision to invest in an ELSS fund:
- Examining the fund returns
- Fund composition
- Risk-return framework
When trying to choose an ELSS fund to invest in, examining the funds returns play a crucial role. While high-performing funds seem like an obvious choice, it is important to analyse the consistency of the fund’s performance. Additionally, the returns should be analysed based on the investment horizon of the investor.
The assets and securities in which the fund invests can give the investor a clearer picture of how their capital will be invested and the market risks that they will be exposed to. Diversification in the investment portfolio and the type of equity instruments in which investments are made can be a fairly accurate way to analyse the risk profile of the fund. An investment can be made based on whether or not the fund portfolio matches the investor’s risk tolerance.
The Sharpe Ratio is a sound way to analyse a fund’s risk-return potential. Ideally, a fund that has a higher risk exposure should also earn higher returns. A high Sharpe Ratio implies that the risk assumed by the investor will be compensated accordingly.
How to Invest in ELSS
The following are the steps to invest in ELSS:
- The first step to investing in an ELSS fund is to determine the amount of income that is taxable and the tax slab under which it falls. This step can help determine the amount that one can invest to claim tax deductions.
- Choose a fund to invest in after analysing the performance of the fund, risk tolerance of the investor and the investment horizon.
- Choose an intermediary to assist with the investment process. Investments can also be made directly through mutual fund houses, but intermediaries assume all responsibilities of the investment, including the paperwork. KYC-related documents and in-person verification will have to be completed before the investment is made.
- Pick the payment mode for the investment-lump sum or SIP.
- After the investment is complete, the investor should obtain a statement of accounts from the Asset Management Company (AMC) as proof of investment.
As previously stated, investments made in equity instruments carry a higher level of risk than other types of mutual fund investments. ELSS funds are a good way of minimising an investor’s risk exposure while also obtaining high returns. The added benefit of obtaining tax deductions on the investment and the tax-free earnings further add to the appeal of an ELSS investment. These factors, among many others, are the reason for the growing popularity of ELSS fund investments.