How to choose a ELSS mutual fund for saving tax

The start of the financial year is the best time to plan for saving tax. For those who recognise the importance of tagging tax saving instruments with long-term financial goal portfolios, there is not much to do! Linking tax planning with goals is a one-time affair and all it needs is investing and review. In this post, I would like to focus on how someone can choose an ELSS mutual fund for saving tax.

This post is more about factors to be considered before selecting a mutual fund and not about the selection process itself, which is not different from that outlined here: How to select an equity mutual fund – Making a Choice!

The starting point is this post which discusses the way Ashal Jauhari saves tax: Making the best use of section 80C for tax saving: an example.

The essence of the approach, first use applicable expenses like tuition fee for children, term life insurance, and home loan principal  (assuming one does not buy a property just to save tax!) to cover 80C.

Next, the mandatory EPF or NPS contribution is obviously part of 80C, but is also part of the debt component of our retirement portfolio.

If this exhausts the 80C, there is no need for ELSS mutual funds. If there is some room left, that amount alone can be used to invest in ELSS mutual funds, provided the investment is not touched at least until retirement (which is assumed to be decades away). If your retirement is close by, do not touch for at least 10 years.

ELSS mutual funds are being sold by advisors by comparing them to PPF. Ignore such illustrations.

A portfolio requires both fixed income and equity in a pre-planned proportion after understanding risks.

Example 1: Consider a young earner with no home loan liability , no term cover+and no child tuition fee expenses.

If the EPF contribution is say 4500 a month, 54,000 is mandatory tax saving under 80C. Say 10,000 can be invested each month, excluding the 4500 from EPF.

The total investment made towards financial freedom is 10,000+4500.

Out of this about 31% goes to EPF. About 8000 a month can be put in ELSS funds to complete the 80C rainbow.

The rest 2000 can be invested in stocks or equity mutual funds.

Example 2: Consider a married with kids earner servicing a home loan. Suppose after factoring in tax saving expenses (tuition+  principal component of EMI+ term insurance), the 80C target is reduced from 1.5 Laks to  1 lakh.

Say 8000 is the EPF contribution. So 8000 X 12 = 96000 covers most of the 80C limit. There is no need for ELSS funds. If necessary a 4000 lump sum can be put into ELSS.

Suppose the asset allocation desired is 50% equity and 50% fixed income and total investment = 17000 +8000(EPF) = 25000.

About 32% of fixed income comes from EPF. Rest 4500 can go to PPF even though there is no need for it under 80C.

The rest 50% or 12500 can be in stocks or non-ELSS equity funds.

The point is,

  • do not invest in ELSS if your intended holding period is just a few years.
  • do not invest in ELSS any more than necessary
  • do not invest in ELSS if you don't want the tax break.
  • Invest in PFF if the asset allocation calls for it, and even if  80C deduction is not necessary.

PPF can be an integral part of your portfolio (if needed) because despite the lock-in it is a tax-free fixed income instrument. ELSS is required only as long as you have space to fill in 80C. Equity should be an integral part of a long-term portfolio, not ELSS. Therefore, the comparison between ELSS and PPF is pointless aside from a sales pitch.

Trail commission in ELSS funds  is paid upfront to a limit of 1% and this could well be a carrot for ELSS pushing. I will not be surprised if the 'higher return' myth About ELSS Fund Lock-in originated due to the commissions (when there no limit and entire trail was upfront).

Many people start a SIP for 3 years because the lock-in is 3 years!  I would suggest investing in a few chunks each year without starting a SIP. This gives you full control.

Do not follow the crowd! Or should I say, do not invest in Axis Long Term Equity because everyone is doing so! There is almost a 3000 Cr gap in AUM between the Axis ELSS fund and the one with next highest AUM (Reliance Tax saver)!!

If this gap is due to performance, it is only short-term performance as the fund is relatively young, if the gap is due to higher commissions then no further comment is necessary.

This kind of herding both by investors and distributors could well result in disappointment. Look for consistent performers both in terms of risk and reward that no one is talking about. It would be much calmer there!

The Axis ELSS fund fell by 8% in the last year. How many first time ELSS investors were ready for that or would be able to stomach that? Almost all ELSS funds fell during the period, but investing by looking at popularity (immediate good returns) or star rating will not last long.

If you use the Freefincal Mutual Fund Screener (Google sheets) you can shortlist many 'quiet' performers. There so many of them in this category that one is spoilt for choice.

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10 thoughts on “How to choose a ELSS mutual fund for saving tax

  1. Rajesh

    Hi,

    You made here an opinion that ELSS shouldn't be opted out if there is no room for tax exemptions. In this aspect can I know what is a difference between the Equity and ELSS Mutual Funds ?
    Also, why do you prefer investing in chunks rather than SIP's?

    Thanks & Regards
    Rajesh

    Reply
    1. freefincal

      Difference be ELSS and mutual funds, not much except for the lock-in and because of the lock-in I prefer not to invest via SIPs.

      Reply
  2. p a bande

    Take a case for 75yr old Sr Citizen. Lockin period for other tax saving instruments are are more than ELSS. So would like to know which are the best tax saving alternatives for Sr Citizen?

    Reply
    1. freefincal

      Senior citizens should exercise caution while using ELSS. They should only put away money there that they do not need for many years. This is is also the reason why a PPF acct can be kept alive by repeated extensions. Will help upon retirement.

      Reply
  3. Raj Mehta

    I was about to choose one ELSS mutual fund for myself in the coming future and thereby found this article extremely helpful for me. The way explained all the things by providing examples was very good. Bravo and keep this good work on.

    Reply
  4. Maheswaran R

    So, here's what I did. Would appreciate any valuable critique.

    I spent time on the freefincal website and my biggest takeaway was that one should pay attention to risk and not just return. (I had chosen Axis Long Term as it had the highest return over the past 3 - 5 years.)

    I then asked myself what I expect from my ELSS pick - I decided that I only want a modest return of 10% as the alternate was a risk free 7 - 9% in PPF. I then shortlisted all ELSS funds that returned at least 10% over a 3 and 5 year period from MorningStar. (I did not choose 1 year as ELSS has a 3 year lock in). This gave me a list of 32 funds. I then captured all the ratios - Std Dev, Alpha, Beta etc. for a 5 year period (I didn't choose 3 years as I felt that interval was too small and I didn't choose 10/15 years as a lot of funds didn't have that history in MorningStar). I then sorted from based on ascending order of Std Dev, Beta, Downside Capture Ratio and interestingly, Axis figures in the top 3 across these metrics. The problem (if any) with Axis is that the metrics have degraded over a 1 year period, but over a 5 year period, the fund looks really good (risk and return).

    So, does the above mean I stick with Axis or not (to clarify, I'll anyway stick with Axis for the invested amount as there is a 3 year lock in, I mean should I invest more of my 80C limit going forward)?

    Link to spreadsheet https://docs.google.com/spreadsheets/d/1zfKXPkk__ldrMIdvjzWJFdiA1m6Q_b4IvBAPFCZJHxo/edit#gid=1763791054

    Reply
  5. Maheswaran R

    Hi Pattabiraman,

    I was actually hoping you had some thoughts on my query 🙂

    Posting the query again -

    So, does the above (my analysis) mean I stick with Axis or not (to clarify, I'll anyway stick with Axis for the invested amount as there is a 3 year lock in, I mean should I invest more of my 80C limit going forward)?

    The problem (if any) with Axis is that the metrics have degraded over a 1 year period, but over a 5 year period, the fund looks really good (risk and return).

    Reply
    1. freefincal

      I do not make peer comparisons to decide on funds that I hold. I only check performance from the date of investment wrt benchmark and my own requirements.

      Reply
  6. Maheswaran R

    Yes, that is my query.

    Over a 5 year period, the fund outperforms the benchmark comfortably. However, over the last 1 year, it has under performed the benchmark considerably (for example, downside capture for the last 5 yrs wrt the benchmark is a stupendous 60% while over a 1 year period it is 98%). So, how do we decide whether we should wait longer or ditch the fund?

    I'm looking more for an approach/framework than any specific answer. For example, it is OK if the return related metrics (Return, Upside capture) over a 1 - 2 yr period are much below the benchmark, but say, risk related (beta, Std Dev, Sharpe, Sortino, Downside) have to always be at least of a minimum threshold? Or is there any other way to think about this?

    Reply

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