Equity-linked savings scheme (ELSS) is an asset class where investors can get equity-like returns with tax saving benefits. However, often people make mistakes while choosing a ELSS. Let us discuss, what are the points to be considered while investing in ELSS.
Start investing early
Generally, investors invest in ELSS funds towards the end of the financial year, when they realise the need for showing proof of investment for tax computation purposes. This is an extremely poor strategy. First, as it is towards the end of the year, you may be in cash-flow tight positions. Second, as you are investing towards the end of the year, you may be under pressure to invest large sums which may deteriorate your cash flow position. There is an additional risk of market timing, which means that if the equity markets are up you end up buying the fund’s units at higher prices which in turn influences the returns.
Don’t pull out just after the end of lock-in period
Among the available tax saving instruments in the mutual funds space, ELSS funds provide the shortest lock-in period of three years. The most common mistake that investor make is to pull out the money immediately after the three-year lock-in ends. This is really a costly mistake. As the underlying asset class is equity, one should stay invested for a time horizon of at least five-seven years to get a good rate of returns.
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Track returns for longer period
Instead of paying attention to those funds which have generated good trailing returns over the past one or three years, focus on those funds who have a track record of consistent performance. To select a consistent performer, you should compare the fund’s performance with that of its comparable category over a period of five or six years. Instead of trailing returns you could compare the rolling returns. This is a good measure to capture consistent performance. The above point holds true not only for ELSS but also for all mutual fund schemes.
Pay attention to type and philosophy of fund
Often investors do not pay attention to the type of fund such as large cap, mid cap and small cap. Generally, large cap funds tend to be less volatile than that of mid cap and mid cap funds are less volatile than small cap. Similarly, you should check the investment philosophy of the funds. This is an important point. For instance, a fund which takes a lot of risk to generate good rate of returns may not suit a conservative investor.
Avoid dividend trick
Several investors are attracted by the dividend option when they invest in ELSS, but fail to understand that the dividend is paid to them from their own money. It is suggested not to go for dividend schemes, unless one really needs periodic income. If you want to create wealth, subscribe to growth option schemes.
Avoid too many funds and schemes
Many investors put in their money in a new ELSS fund every year or three years. Over a period, say five to seven years, they end up accumulating many ELSS funds. This is a case of excessive diversification and results in a burdensome portfolio that becomes difficult to track and manage. Another issue is that investors keep on investing in different kinds of schemes at the end of every three years on the rationale that other schemes are giving better returns than that of the current scheme wherein their funds are invested.
The return depends on a variety of reasons such as market timing, number of securities, size of the fund, etc. So, it is not advisable to pull out your money when the returns are less. Think of re-allocation only when markets are growing and your fund is not doing well consistently. Choose those funds which are large enough, which have assets under management of five billion rupees or more, who are in business with consistent performance for at least five years and do not over diversify your funds.
The writer is associate professor of finance & accounting, IIM Shillong