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5 Things you must consider before investing in an ELSS

As we get closer to March 31, if you’re a working professional, you would be flooded with investment proof reminders from your respective HR departments. Consequently, a lot of you would be rushing to find a good tax saving investment to save on income tax. From all the assets available under Section 80C, Equity Linked Saving Schemes (ELSS) are a good option to consider putting your money in.

ELSS is a diversified equity mutual fund scheme that provides tax benefits (under Section 80C of the Income-tax Act, 1961), up to Rs 1.5 lakh. However, these schemes have a three-year lock-in during which capital invested in the scheme cannot undergo redemption or withdrawal.

If you’ve procrastinated all this while and are now in a rush to find an ELSS scheme to deposit your money in, the easiest way investors find is, to see which one performed the best last year. It’s natural to think that you just need it for tax saving, why should you give it so much thought? But there are better ways to treat your savings and wealth. Hence, just a plain vanilla analysis of returns may not give the right picture. There are other compelling factors that you must assess to find a good mutual fund, and optimise your personal finance decisions. Let’s take a deeper look at the same.

1) Market cap Composition or Portfolio Tilt

ELSS are structured as multi-cap schemes (80 per cent in equity) giving the fund manager flexibility to buy shares across large cap, mid-cap and small-cap. Usually, investors try to redeem (withdraw) their capital in the scheme as and when the three-year lock in period is over. Any concentration towards small and mid-cap stocks is generally oriented towards generating higher returns over the long term. Funds with higher small and mid cap companies would perform better when the economy and markets are in momentum, and hold a risk of underperformance during slowdowns or falling markets.

Since three years is too short a period for economic cycles, investors with this time horizon should avoid investing in funds with a higher concentration in small and mid-caps. Such investors should look for schemes investing in large cap stocks where the decline in values in market downturn is moderate and subsequent recovery is quicker.

In simple terms, if your investment horizon is longer than five years, provide capital for investing in mutual funds with a tilt towards small-cap and mid-cap investment. Else, schemes with higher large-cap weight would better suit your needs.

2) Stock Concentration

There is no thumb rule here. Concentrated portfolios can reduce diversification, but also provide more visibility into what fund managers are doing. A fact sheet of the stocks is available on the mutual fund website or with the platform you are using, and hence can be tracked easily. Given the choice between diversification and transparency, you need to match the fund’s risk profile with your own risk tolerance. A risk seeker’s fund choice (as all financing decisions) will be completely different from an investor who is less risk aggressive. The decision to invest in ELSS should not be an isolated one but taken in the context of the individual’s financial situation and goals.

This leads to another topic about, if youput up the money for this through Systematic Investment Plans (SIP) or go with a lump sum amount. However, SIP helps in terms of countering market volatility compared to hurried lump sum investing.

3) Return Consistency

While the objective of investing in ELSS is tax benefits, generating good mutual fund returns is always a prime factor. As mentioned earlier, in a hurry to find an ELSS, investors find the top performing fund for the past one year and invest in the same. It is not the best way to select a fund. Mutual fund returns over just one year shouldn’t be the sole criteria. Selection should be based on your comfort and portfolio strategy.

For instance, in 2017 funds having greater exposure to small-cap and mid-cap were top performers. While in 2018, the ones earnings money to a larger extent were large-cap oriented schemes. Hence analysing the fund returns in different phases of the market cycle is necessary. In some cases where the five or ten year returns are not available (relatively new schemes) – one must see that the fund consistently demonstrates the ability to garner higher than its benchmark in rising markets and should fall less in declining markets. Look for funds staying in the top quartile for a longer term period.

4) Expense Ratio

As Net Asset Value (NAV) of funds is always announced after reducing the Expense ratio, it becomes an important parameter to analyse. High expense ratio of the fund shows the high amount of expenses paid by the fund. Expense Ratio in the ELSS categories ranges between 1.46 percent to 2.50 percent. Investors should choose the fund with a low or moderate expense ratio along with a higher rate of return. Lower the expense ratio, the better it is.

However, you must not look at it in isolation. It would always be looked at on a comparative basis. Like when two funds are similar in terms of returns consistency and risk profile of your market cap composition, the one having a lower expenses ratio should be preferred. A difference of just one percent on expense ratio may not look high. But we must consider it in terms of compound annual growth rate (CAGR). It must be understood that ELSS is considered as a relatively long-term investment, even the 0.5 percent or 1 percent difference affects long-term compounding.

5) Fund Manager

If a fund has a good and consistent fund manager who has given good performance in the past, then it supports the idea that the fund will give good returns in the future too. Simple reason being, a fund manager with longer experience has seen the different economic cycles and has aligned the portfolio accordingly. Further, if a fund manager is handling the fund for a longer duration its positive factor. Consistent change in the fund managers of the scheme may result in a constant change of strategy to manage the funds and hence eventually losing the crux. Always check the fund manager’s profile and his record not just in the fund you are investing in but also in other funds managed by him. As regards the fund houses selection while selecting a tax saving fund, investors shall consider an established fund house rather than new fund houses. Simple reason being, when a fund house is established, you can trust it has an experience to handle the large amount of investments and that too for longer durations coming through different economic peaks and troughs. Established fund houses are process oriented so the impact of change in fund managers may not significantly affect the fund performance.

You may end up in a wrong fund due to a hurried selection. Investment in ELSS funds has to be a well thought out decision after considering all the factors.


Pro-tip: Start thinking about ELSS investments a little in advance. While you have to invest Rs. 1.5 lakh before March 31, you may not necessarily have the cash lying free in your bank account for funding these investments. It is in your best interest to think in advance on finance decisions.

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