Deductions under 80C: ELSS Mutual Funds

This is part 3 of the series about Tax Savings and I will be explaining in detail about one of my favourite tax savings investment – ELSS Funds. Click here for the previous parts about tax slabs and Life Insurance.

ELSS Funds

ELSS stands for Equity Linked Savings Scheme and it is just a fancy name for a equity mutual fund which has a lock-in period of 3 years and investments under which you can claim tax savings under 80C.

Now that is a lot to take in that previous line – lets break it down.

Equity Mutual Fund: You invest your money along with thousands of others to collect a huge corpus of fund. There is a dedicated professional who handles all your money and invests it in different stocks/bonds. He is called the Fund Manager. For this he charges a small percentage per year as fund management fees (also called expense ratio). Equity Mutual Funds are the most efficient investments which can also beat inflation.

Lock-In period: Any normal equity fund doesn’t have any lock-in period. Which means you can put your money today and choose to take it out in a few days. There might be some charge, but your money isn’t locked in.

But ELSS mutual funds have a lock-in period of 3 years. If you invest your money on Jan 1 of 2017, you will be able to take it out only on Jan 2 of 2020. Having a lock-in makes sure that you are invested for the long time which is very important for equity funds.

Usually all tax savings investments have a lock-in period. ELSS funds has the shorted lock-in period of 3 years.

Tax Savings under 80C: Investment made in ELSS funds are eligible for tax deductions under section 80C. You can invest any amount in ELSS funds, but a maximum of Rs.1.5 lakhs will be eligible for 80C deduction.

So how does one invest in ELSS funds?

There are numerous fund houses which has a tax saver or ELSS fund. You have to first identify a fund which is good. Since your money is locked in for 3 years, choosing a good fund is important.

There are numerous websites which list mutual funds and one website that I use is Value Research Online. Go there and select all ELSS funds available and go through each of them. See how well it has performed over the past years.

  • Has the fund manager consistently beaten the benchmark?
  • How many years has the fund manager been managing the fund?
  • Is the expense ratio small enough?
  • You can also look at the portfolio of the fund to see if the companies it has invested in are diverse enough and well performing companies.

Always do SIP

Once you decide which fund to invest in (pick only one) start an SIP on the fund. Most mutual funds allow investing directly online through their website. If not, you would have to download and fill up the form and write out a cheque for the amount and send it to one of the investor centres.

It is important to start a monthly SIP so that your investment isn’t affected by the volatility of the market. Whether the market is up or down, you keep investing in it and let the investment take its own time to bear fruits.

Though ELSS are my favourite of the tax savings investments, it isn’t the only place where I invest. There are also other instruments which would be a good fit for your risk taking abilities. In the next part I will explain about those.

ETF vs Mutual Fund

When it comes to buying a collection of stocks, there are two different ways one can invest in – via Mutual Funds or ETFs (Exchange Traded Funds). Since both have “funds” in it’s name, what is the difference between both? And which is better for an ordinary retail investor? ETF vs Mutual Fund – it is one common question lot of beginners have while investing.

etf vs mutual fund

Mutual Fund

Wikipedia says “Mutual Fund is a professionally managed investment fund that pools money from many investors to purchase securities.” Note that I have added emphasis on the “professionally managed” part.

That means there is a fund manager who’s only job is to manage the investor’s money and purchase the best security based on what the fund’s goals are. So if you are investing in an mid-cap equity fund, the fund manager is supposed to pick a few specific mid-cap stocks from the list of thousands of stocks and put in all the money you give in it.

The job of each mutual fund is to try and beat it’s benchmark index. If you see this graph of Mirae Asset India Opportunities Fund, you can see that it’s benchmark fund is the BSE 200 and it consistently beats the index. (Note: Not a buy recommendation.)

Mutual Fund vs BSE 200 Index

Since each mutual fund has a fund manager who is actively managing the fund, he charges a small percentage of your money (typically 1%-2.5%). This is called the “expense ratio” of the fund and it is what pays everyone in the fund house – right from the fund manager to the security guy in their office.

This expense ratio is also what pays the mutual fund advisor his fees for advising you to buy a fund. So every time you do a SIP in your fund, a small percentage of your money goes to everyone involved in this fund.

The price of one unit of a fund is calculated every day called its Net Asset Value (NAV) and any money you give will fetch you an equivalent quantity of the mutual fund. Usually you can get units upto 4 decimal points.

Exchange Traded Funds (ETF)

An exchange-traded fund (ETF) is an investment fund traded on stock exchanges, much like stocks. ETFs track an index like Nifty or Sensex or Gold price. A Nifty ETF will hold all the stocks in the Nifty index and will naturally be priced close to the value of the Nifty Index.

If you see this graph of Nifty BeES, you will see that there is practically no difference between the red and black lines. Similarly a Gold ETF will track the price of the gold.

nifty bees

Whenever a share is removed or added to the Nifty Index, the fund manager replicates the exact transaction and so the price of the ETF will match the Index price. The fund manager is “passively managing” your money and the expense ratio will be very very low compared to active managers.

The minimum ETF you can buy is 1 unit and you can’t get fractions of units – only multiples of 1 unit.

When are ETFs good?

Since ETFs are continuously traded in the market, the price of the ETF continuously changes depending upon the value of the index. So if you have invested in an ETF and one fine day you see that the markets are falling rapidly, you can immediately call your broker and sell some units before the market falls even further.

Compare this with mutual funds, the NAV of the fund is calculated at the end of the date based on the closing price of each stock. So if you want to buy or sell some units you have to give the order before 3PM and the order will be executed based on the NAV of the fund at the end of date. So if the market falls, you will be unable to get out of the units fast enough.

To know how your investments are doing, you just have to look at the index price of that day and you can easily know how it performed. Simple and no-frills investing.

When are Mutual Funds good?

Despite being slower to react, mutual funds does have it’s own advantages. Primary advantage being that it is actively managed. Even though you pay a little extra for the fund manager, you are giving your money to professionals who know how to play this game.

Professionals with teams who are much more intelligent and with resources to evaluate which companies are good to invest. Imagine you doing this for each of the 1000s of stocks without proper training in fundamental analysis. I would prefer to give my money to the professionals than poring over hundreds of pages of financial statements.

And since Mutual Fund managers are paid to beat the indexes you will definitely get better returns than ETFs over a longer period. And the risk of market falling a by thousands of points in a single day is very rare. The Risk-Reward ratio of the extra returns of Mutual Fund is better than ETFs.

At the end of the day it is up to you to decide whether to invest in ETFs or Mutual Funds. Personally I have invested in both ETFs and Mutual Funds. I have a few lakhs of rupees in ETFs invested over 2-3 years ago, but am still continuing my SIPs in multiple Mutual Funds.

In India at least, the equity market is still not mature enough and it is very easy for fund managers to easily beat the returns of a general index. So I would prefer to invest in Mutual Funds.

Which do you want to put your money in? Comment below about your preference and why?

Common Misconceptions about Mutual Funds

Mutual Funds are an easy way to invest your money and let professional fund managers handle the hard part of choosing the right place to put your money in. But there are numerous confusions and misconceptions around mutual funds that I want to clear in this article.

Myth: Mutual Funds is just for equities

Fact: Mutual Funds are not only about investing in stocks or the equity market. There are different types of funds which are classified based on the underlying asset classes they invest in.

  • Equity Mutual Funds – invest mostly in equities (note mostly. SEBI says minimum it should have 65% in equity)
  • Debt Mutual Funds – invest mostly in debt or fixed income
  • Liquid Funds – invest in very short term (< 91 days) instruments like treasury bills.
  • Gold Funds – they invest in gold and track the price of gold.
  • International Funds – they invest in stocks of international companies and track foreign stock indices like Nasdaq.

People who want to invest in any kind of assets can invest using Mutual Funds and get the help of professional fund managers to handle their money.

Myth: A mutual fund with lower NAV (Net Asset Value) is cheaper and better

Fact: A fund’s NAV doesn’t matter because it represents the market value of all the fund’s investments and doesn’t depict the market price.

To understand it better: Lets say Fund A and B invests in the same portfolio of stocks. Only difference between then is the NAV of fund A is Rs.10 and fund B is Rs.100. After a year the stocks increase in value by 10%. So the NAV of fund A will be Rs.11 and of fund B will be Rs.110.

NAV of two funds

So your money grows by 10% and it doesn’t depend whether you invest in fund A or B.

Myth: Mutual funds are long term investments only

Fact: There are mutual funds which are suitable for short term investments too. They are funds which invest in bonds or even treasury bills which are protected for returns for a short duration. If you are in the highest tax bracket parking your excess money in Liquid funds or ultra short term funds are better and tax efficient than fixed deposits.

Myth: One needs lot of money to invest in Mutual Funds

Fact: No. You can invest in mutual funds even if you have just Rs.1000. And you can start an SIP even with Rs.500/month. Compared to investing in real estate or Gold, this is one of the best investments which doesn’t require lot of money.

Myth: Any investment in mutual funds enjoys tax benefits

Fact: Only ELSS (Equity Linked Savings Scheme) funds enjoy tax benefits under section 80C. And they too have a limit of Rs.1.5 lakhs per year. Remember any investment made in ELSS are locked in for 3 years.

Myth: Invest in lot of funds to properly diversify

Fact: Investing in lot of funds doesn’t help. Remember a fund just a collection of different stocks that a fund manager chose to invest in. Most of the funds would have a lot of overlap in the stocks. Also over diversification also hurts your returns. It is better to invest in only 1 good fund under each fund type.

Multiple funds

I personally am invested in 1 ELSS, 1 Large Cap, 1 Mid Cap and 1 Small Cap fund. There is no use in investing in 3 or 4 funds under each category.

I hope this has cleared some common myths surrounding mutual funds. Now the only problem is how to choose the right fund and how to invest in it the right way. Will cover it in future articles.