InvestorQ : How is ELSS (tax saving) funds a good choice for the investors like me who is a young executive just starting out on a career?
Anu Biswas made post

How is ELSS (tax saving) funds a good choice for the investors like me who is a young executive just starting out on a career?

Neelam Naik answered.
8 months ago

In fact, ELSS funds are most relevant in the case of people like you who have time in their favour as well as risk appetite. Equity linked savings schemes (ELSS) are like any other mutual fund equity scheme with a lock-in period of 3 years. Effectively, once you invest in an ELSS fund, you cannot withdraw the money for 3 years. That is the pre-condition for availing the tax exemption under Section 80C of the Income Tax Act. ELSS is part of the overall limit of Rs.150,000 that is granted to individual tax payers under Section 80C and includes other investment instruments like provident fund, life insurance, long term deposits and housing loan principal repayment. For investors it can be a very cost-effective wealth creating mechanism that offers the additional benefit of a tax break. Let us understand why...

ELSS compels towards an equity savings habit

ELSS is currently the only popular equity instrument that offers a tax benefit too. There is the RGESS scheme that was designed for first-time equity investors but that has not taken off in a big way. An ELSS can be taken up as a lump-sum investment or as a systematic investment plan (SIP). The advantage with the SIP is that you get the additional advantage of rupee cost averaging too as it is a phased approach and hence market gyrations tend to get smoothened out. One needs to remember that in an ELSS-SIP, each SIP will have a 3-year lock-in period from the date of the SIP.

There is also an investor discipline angle to it. Mutual funds are liquid investments and hence investors have the tendency to take profits out of the fund at every opportunity. This forces many investors to become short-term traders in mutual funds, which is against the grain of mutual fund investing. ELSS solves this problem through its lock-in as it forces investors to take a long term approach to their investments in equity funds.

Tax break under Section 80C substantially enhances post tax returns

While ELSS funds have been generally outperformers among equity schemes (as we will see in the next point), there is also the angle of post-tax yield. Let us take a simple example to understand this concept better. Assume that you invest Rs.10,000 in an ELSS fund with a lock in period of 3 years. Normally, ELSS funds have returned around 15% annually over a 3 year holding. That means that the investment of Rs.10,000 would grow to Rs.15,208 at the end of 3 years. If you think that a 52% return over 3 years is attractive, you will be in for a pleasant surprise. Your effective post tax return is much higher. Here is how!

When you invest Rs.10,000 in an ELSS scheme, you get a tax exemption to that extent. Assuming that you are in the highest tax bracket, you will enjoy a 30% tax rebate (let us avoid surcharges for simplicity). That effectively means you invested Rs.7,000 and not Rs.10,000 as you have got Rs.3,000 back as a tax rebate. When you consider Rs.7,000 as your effective investment, then the above return becomes a lot more attractive. Effectively, since your corpus is now worth Rs.15,208, you have earned a return of Rs.8,208 on an investment of Rs.7,000. That translates into a post-tax yield of a whopping 117% over a 3 year period. Even in annualized terms your yield is 29% and not 15%. Therefore the tax rebate under Section 80C has been responsible for nearly doubling your annualized yield from 15% to 29%. That is the power of effective post-tax yield!

Fund managers are induced to churn less with the comfort of mandatory 3 year lock-in

The big advantage for ELSS funds is that since they have a lock-in, fund managers are able to predict the liquidity demand with a greater degree of certainty. Since all investments in an ELSS fund necessarily have a 3-year lock in period, fund managers are in a position to take a long-term view in their investment decisions. This enables the fund manager to stay with quality stocks longer and reap the entire benefit of their investment decision. This is one of the reasons that ELSS funds have managed to outperform other equity mutual funds as fund managers are required to churn their stocks less compared to normal equity funds. This long-term approach adopted by the fund manager eventually tends to benefit the investor.

Why ELSS makes a lot of sense currently

In the current scenario, Indian economy is delicately poised as the fastest growing large economy in the world. Over the next 3 years, retail investors are likely to pump in $75 billion into equities. The government will ensure the supply of quality paper through its disinvestment programs, strategic sale as well as a vibrant IPO market. The time is ripe for investors to capitalize on the benefits of an ELSS fund. You can actually combine tax efficiency with a long-term approach to equity investing. When you are talking about the attractive Indian equity market, the ELSS surely makes a lot of sense at the current juncture. In your case, you have risk appetite and tax liability in your favour to invest in ELSS funds.