ELSS vs Equity Diversified Mutual Funds

Life is all about competition.  Who is the best? Are you good or is your friend better? There is competition even among personal finance products. While most personal finance products are good, which one would help meet financial goals. This is the call you have to make.

This is a story of a fight between two friends, Satish and Suman. Not a physical fight, but an intense competition. Both of them were in their early thirties and worked in reputed IT Firms. They liked to compete with each other and today the fight was which financial product was better. Was it ELSS or equity diversified mutual funds? Satish says ELSS and Suman says equity diversified funds. Who is right?

For those who don’t know, an equity diversified mutual fund invests in stocks across sectors. If you are an aggressive investor, try equity diversified mutual funds. Money is in stocks and there’s a measure of protection as the investment is spread across sectors like pharma, IT, Oil and Gas, Automobiles and so on, called diversification.

Lets take a look at the opponent, Equity Linked Saving Schemes or ELSS. ELSS is a type of equity diversified mutual fund where most of the investment is in stocks. It has a compulsory 3 year lock-in which means you cannot touch this investment for 3 years. What’s special about ELSS is it’s the only tax saving mutual fund. ELSS enjoys a tax deduction under Section 80C of the income tax act, up to Rs 1.5 Lakhs a year. Does this make ELSS better than equity diversified mutual funds? Let’s find out.

ELSS vs Equity Diversified Mutual Funds

ELSS is a long term investment

ELSS has a 3 year lock-in and forces you to stay invested for this time period. Equity is an excellent investment only if you stay invested for the long term. A bare minimum of 3 years is a must. This is where ELSS scores over equity diversified mutual funds.

Equity diversified mutual funds have no lock-in and allows an exit, whenever you wish. This is bad for you as most investors exit when stock markets crash. The key to make money in stocks is to stay invested in the market for the long term. Invest in ELSS with a time horizon of 7 years.

ELSS Saves Tax

Lets say you invest the same amount in an equity diversified scheme and an ELSS. Both of them give the same returns, but ELSS wins over the diversified fund as it enjoys the Section 80C benefit. ELSS is an excellent investment if you fall in the higher tax brackets.

If you fall in the 30% tax bracket, invest up to Rs 1.5 Lakhs a year in ELSS and save Rs 46,800 a year. ELSS enjoys Section 80C tax deduction and beats equity diversified mutual funds.

ELSS is like killing two birds with one stone. You get good returns and you save tax. Top ELSS schemes have given an average of 16-20% over 5 years. This is higher than equity diversified schemes. Then there’s the tax benefit.

Satish earns Rs 11 Lakhs a year and falls in the 30% tax bracket. He invests Rs 1.5 Lakhs a year in ELSS via SIPs. This helps him save 30% on Rs 1,50,000 which is Rs 45,000 + a cess of 4% which is Rs 1,800. Satish saves Rs 46,800 a year by investing in ELSS.

ELSS is a stepping stone to equity diversified mutual funds

In recent times many first-timers are investing in equity. Novice investors are rushing to equity diversified mutual funds without understanding them, in the hope of quick profits.

Why not first invest in ELSS and then try equity diversified mutual funds? ELSS with a compulsory lock-in, forces you to stay invested for the long term. ELSS handholds you and helps get familiar with equity. You can now invest in equity diversified funds with confidence and make a profit.

Today, stock markets are falling and many first-time investors are heading for the exit in panic. Many of these investors have bought high and sold low, taking home immense losses. If these panic-stricken investors had invested in ELSS, they would not have been able to exit the stock market and in a few years, they would have seen profits.

What do you take home from this article?

  • ELSS sticks to the top 500 Companies and an ELSS comparison must be made with large-cap funds.
  • ELSS generally beats large-cap funds as it enjoys a tax advantage.
  • ELSS enjoys true competition from multi-cap funds, which invest in large-cap, mid-cap and small-cap Companies.
  • ELSS funds have locking, but face lesser redemption pressure on market falls and hence could deliver superior returns in the long term.

ELSS Saves Tax And Makes You Rich

Heard this great saying by former US President Richard Nixon? “Make sure you pay your taxes; otherwise you can get in a lot of trouble.” Sampath a young 28 year old man, works in an IT firm in Bengaluru. He had never heard of Richard Nixon, but he knew he had to pay taxes.

Sampath earned Rs 12 Lakhs a year. This salary meant he paid a lot in taxes, as he never bothered to do tax planning. He grumbled, he cursed, but he paid his taxes.  All this changed the day a friend introduced him to mutual funds, or more specifically a type of mutual fund called Equity Linked Mutual Funds or ELSS. His friend also told him something he would remember all his life, “A rupee saved is a rupee earned.”

ELSS is an equity diversified mutual fund which invests most of your money in stocks across sectors. An investment in stocks is risky, but investing across sectors called diversification, offers a measure of protection. ELSS has a compulsory lock-in period of 3 years. This means you can’t touch the investment for this time.

Sampath had another problem. Where to invest? He had some money in fixed deposits. Fixed deposits offered decent interest, but you can never get rich, just by investing in FDs.

You must be having a lot of questions, the first one being, how does ELSS save tax? You enjoy the Section 80C deduction up to Rs 1.5 Lakhs a year. ELSS is the only mutual fund which enjoys this benefit. There’s a 10% long term capital gains tax (LTCG) on capital gains exceeding Rs 1 Lakh a year.

ELSS is an excellent investment if you fall in the higher tax brackets. Sampath earned Rs 12 Lakhs a year which put him in the 30% tax bracket.  ELSS saved Sampath Rs 46,800 a year.

Sampath invested Rs 1.5 Lakhs a year in ELSS. Now 30% of Rs 1,50,000 is Rs 45,000. Add a cess of 4% on income tax of Rs 45,000 which translates to Rs 1,800. Sampath saves Rs 46,800 a year by investing in ELSS.

He enjoys the highest returns among Section 80C options with the lowest lock-in. Sampath chooses the best way of investing in ELSS which is through SIPs.

ELSS invests most of the money in stocks. Doesn’t this make it a risky investment? Any investment involves risk. Even FDs are risky as a part of the interest you earn is swallowed by inflation. Equity investments offer high returns at high risk. The key is to stay invested for the long term and cut risk in investment.

ELSS is an excellent investment for a young man like Sampath. He doesn’t have many responsibilities and can stay invested for the long term. This makes ELSS an excellent investment for many youth in India.

Now to the second question. How does investing in ELSS make you rich? Ever heard of compounding returns? Compounding returns are return on return. The returns you get are reinvested to give more returns. Find this difficult to understand?

Let’s see how much Sampath has if he retires at 60, having invested just Rs 8,000 a month in ELSS via SIPs. Sampath has 32 years left till retirement. Let’s assume a conservative return of just 9%. Sampath would have built around Rs 1.77 Crores at retirement from this SIP. Looks a massive amount. Sadly, Sampath will have much less at retirement. Inflation eats up a lot of his returns and if you assume an average inflation of 5% over the period, Sampath will have only Rs 60 Lakhs at retirement.

Here’s the good news. ELSS can give average returns of 12-14% over 3 years and 15-17% over 5 years, depending on the type of ELSS. This is nearly double the returns most conservative investments offer. The longer you stay invested, greater are the returns. The power of compounding ensures you are a Crorepathi at retirement.

ELSS saves tax and makes you rich. You can save Rs 46,800 a year on being in the highest tax bracket. This amount when invested in the ELSS gives returns much above inflation. ELSS combines the double benefits of tax saving and compounding returns to make you rich at retirement.