FundsIndia explains: ELSS funds

Every year, around this time, there is enough talk floating around on ELSS and their tax benefits. For you to understand what ELSS funds are, what they do, and how they fit your investments, here is a quick FAQ.

What is an ELSS?
ELSS expands into Equity Linked Savings Scheme. An ELSS is a mutual fund that invests in stocks, therefore making it ‘equity-linked’. A mutual fund is, of course, a financial instrument that pools together money from different investors and invests in equity or debt securities. An ELSS scheme is among the financial instruments that allow you to save tax under Section 80C. Remember that a fund should be specifically classified as ELSS by the fund house – all equity schemes are not automatically tax-deductible. Each investment you make in an ELSS is locked for 3 years. That is, you will not be able to sell that investment for three years. While you can invest any amount in ELSS, you can only claim up to Rs 150,000 for your tax purposes.

How does an ELSS generate returns?
An ELSS invests in the stock market. Its returns thus depend on how the stocks it holds in its portfolio moves. Returns are both a factor of the general market trend as well as the fund’s own ability to pick winning stocks. Generally, ELSS funds do not have investment restrictions on the market capitalisations of stocks, and they invest where they find opportunities. An ELSS fund is thus like a diversified equity fund, investing across large-caps, mid-caps, and small-caps. The proportion in which they do this depends on the market conditions and the fund manager’s views.

Does an ELSS guarantee returns?
No, ELSS funds cannot predict or guarantee returns. Returns depend on the stock market and it is not possible to predict by exactly how much the market will move. Markets can also be volatile in the short term, correcting in one phase and rising in another. While analysts do have predictions on stock prices and market index movement, they are estimates based on several factors that are subject to change and are in no way certain. Secondly, a fund holds a portfolio of stocks; this composition will change depending on the market movement and fund manager calls. It is thus not possible to predict an individual fund’s performance. However, in the long term, stock market volatility evens out. Long-term holding minimizes risk and significantly improves returns. Equity is the best asset class to generate inflation-beating returns over the long term. Debt-based instruments such as fixed deposits cannot boast of this.

Are all ELSS funds the same?
No. Each ELSS fund has a different way of stock selection, different reads on market and economic trends, and different proportions of large-cap, mid-cap, and small-cap stocks. This, thus, makes each fund very different in terms of risk and return from the others. You would have to select a fund that matches your risk level – for example, if you are a conservative investor, its best to avoid funds that invest excessively in small or mid-cap stocks. You would also consequently have to settle for lower returns, as mid-cap stocks generally deliver higher returns to compensate the higher risk. Next, the ability of the fund to deliver returns that are better than the market at all times also depends on its strategy; not all funds have shown this ability to outperform the market consistently. Fund selection, thus, is very important.

Is there a good time to invest in an ELSS?
Any time is a good time to invest in an ELSS, in order to save taxes. You can use the systematic investment plan (SIP) route, under which you invest every month. This ensures that your investments are disciplined and go through without any last minute scramble on your part. It also allows you to invest across market phases and addresses the problem of timing the market. Note that each SIP investment each month locks in for 3 years. If you want to avoid keeping track of this, you could make one-time investments.

How are ELSS funds taxed?
The way you make an actual gain is by redeeming your units and pocketing the difference between the redemption value and your investment cost. That is called capital gains in finance-speak. For equity-oriented funds (which includes ELSS), capital gains on holding the investment for more than one year (called long-term capital gains) are not taxed. As you cannot anyway redeem an ELSS before 3 years, your capital gains will be long-term and thus tax-exempt. Funds also pay dividend; for ELSS and other equity funds, this dividend is tax-free.

What is the difference between ELSS and retirement funds?
Pension and retirement plans are also mutual funds. These funds form a part of Section 80C deductions as well. They differ from ELSS funds in a few ways. Pension or retirement funds are hybrid funds, mixing equity and debt. Depending on the fund, they are either oriented towards debt or oriented towards equity. These funds usually have a five-year lock in, against the 3 years for ELSS. They also have long periods for which exit load applies. There are very few retirement funds on offer, and most lack a good track record to judge performance.