Last Updated on September 8, 2020 at 11:19 am
When a young earner enters the taxable income slab for the first time, their immediate concern is to save tax. A common question that then arises is, “should I invest in PPF or ELSS mutual funds for saving tax? Which would give me better returns?” A discussion on when to consider what and how to look beyond returns.
I recently saw an article by an “expert” (read mutual fund distributor) that suggested an investor to completely switch from PPF to mutual funds because the latter would only give 7% returns while the former 12% “on average”. This “advice” is wrong on four counts.
1: It is ridden with conflict of interest. A mutual fund distributor only thinks in terms of commissions. 2: The asset allocation of the investor was neither mentioned in the question nor considered in the response. Investing begins and ends with asset allocation – it determines return, risk and how successful we are. Yet, most investors never bother about it.
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3: Taking an average return of mutual funds seriously is like taking an average of 6% and 18% and assuming we can expect that when we start investing. The simple truth that no one associated with the mutual fund industry wants you to consider seriously is: no one knows what returns a mutual fund can produce in future. Either you put in money with wrong expectations and learn it the hard way or consider the data and appreciate reality: Do not expect returns from mutual fund SIPs! Do this instead!
4: Finally, financial journalists constantly ask “expert opinions” from those with a strong conflict of interest and lead investors astray. If you ask the CEO of a mutual fund house offering 15 actively managed funds, “is it possible for mutual funds to beat the market in future?”, what kind of answer should you expect?
Which would give more returns? PPF or ELSS Mutual Funds?
The simple truth: no one knows. In the middle of a bull run, ELSS would seem like the right choice. During a bear run or prolonged sideways movement, PPF would seem like the right choice. It depends on when you choose to look and all views are in hindsight.
It is incorrect to say PPF returns would just keep going down from now on. PPF rates are linked to the 10-year govt bond returns. If inflation increases (and it has started to) then PPF rates would increase too.
Yes, over a 10 to 15 year period, one should expect rates to gradually lower as the economy grows. This does not mean an equity mutual fund (ELSS or otherwise) would beat PPF. See: 15-year SIP returns for 71 out of 148 equity MFs is less than 10% and 15-year Nifty SIP returns crash to 8% (51% reduction since 2014) and Nifty SIP provides 2% real return over 15 years but underperforms Japanese equity by 50%
PPF has (so far) always beat an inflation assumption of 6%. Equity or equity mutual funds have not dont that or at least not always beat PPF. Results will depend on when you did the analysis – January or July!
Since returns are so variable, asset classes are categorized in terms of risk and not return. Asset allocation – how much of equity you should have in your portfolio and how much of fixed income – is determined in terms of risk, not return.
‘Risk’ here refers to the commonly observed day to day price fluctuations and hidden risks like creditworthiness or fraud which affect price/returns only when they suddenly come to light.
Instead of asking which would give more returns, investors should learn to ask which would give more risk?!
Too much of EPF + VPF + PPF or too much of equity can damage your portfolio beyond repair. It is all about the right mix. For a person who is less than 35 today, a 50-60% exposure to equity is necessary to combat inflation in future. See for example Rs.1000 in 1980 is only worth Rs. 66 in 2020! How to protect our money?
Therefore young earners should not make the mistake of investing too much in VPF or PPF for the sake of “safety” and saving tax. Many investors are struggling to increase their equity allocation today after realising late the mistake of not planning early and investing only in fixed income.
How should one allocate money between PPF and ELSS for saving tax?
The first question to ask is, “how much can you invest each month (including mandatory EPF/NSP deduction)?”. If this is less than Rs. 12,500 a month, say Rs. 8000. If out of this Rs. 4000 goes to EPF (employee contribution), then the rest can be invested in an ELSS fund. This would reduce taxable income and also result in an asset allocation of about 56% in EPF* and the rest in ELSS. PPF is not necessary. *The employer contribution is not part of 80C but should included in total EPF contribution for calculating asset allocation.
Suppose you can invest Rs. 25,000 and Rs. 8000 goes to EPF (employee contribution). Now out of the balance Rs. 17,000, suppose Rs. 4500 a month was invested in EPF or VPF, it would take care of the 80C deduction. ELSS mutual funds are not necessary. The balance Rs. 12,500 can be invested in a Nifty or Sensex index fund.
This means about 48% is invested in equity (including employer contribution) and rest in EPF/VPF/PPF. Some people would argue (distributors or investors who have not seen a ‘proper’ market crash) that young earner should allocate more to equity. A 50% equity 50% fixed income allocation would work very as shown before: Will Benjamin Graham’s 50% Stocks 50% Bonds strategy work for India?
In summary, it is not about which would provide better returns. It is about what asset allocation mix is right for an individual and how best to save tax without deviating from such an allocation.