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Should you invest in ELSS Index Funds like the new IIFL ELSS fund?

Posted on 28 Dec 2022
Author: Sayan Sircar

Tags: Review ; Tax ; Mutual Funds

5 mins read

This article discusses a new category of ELSS funds relaunched in India that are run as index funds. Should investors invest in ELSS index funds for tax-saving purposes?

Should you invest in ELSS Index Funds like the new IIFL ELSS fund?

Disclaimer: The fund names mentioned in this article are not recommendations to invest/not invest in those funds. Please perform adequate due diligence before making any investments.

📚 Topics covered:

Introduction
Passively managed ELSS funds are not a new concept
AuM vs TER
How long should you invest in ELSS funds?
How have ELSS funds fared against index funds for a 3-year investment horizon?
What should the investor do then?
- Step 1: Evaluate if ELSS funds are really needed
- Step 2: Choose a suitable ELSS fund

Introduction

This article is a result of the IIFL Nifty 50 ELSS fund that got launched in December 2021. This fund will be investing in the same stocks as the Nifty 50 index, like every other Nifty 50 passive fund but with an extra feature. This fund will be an ELSS fund where:

the investments made in the fund are tax deductible, up to ₹1.5 lakhs/year, under Section 80C
each fresh investment made in the fund, SIP or lump sum, is locked for three years

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Passively managed ELSS funds are not a new concept

There used to be a “Franklin India Index Tax Fund” that was closed way back in 2011 due to a lack of interest. The fund was merged with the Nifty 50 fund of the same AMC.

AuM vs TER

AuM vs TER of Nifty 50 index funds vs ELSS funds

This is the current status of Nifty 50 index funds and ELSS funds in India. There is a good amount of spread in terms of the assets managed by both categories of funds but the distinction in terms of fund expense (TER) is very clear. Index funds charge lower expenses while active funds, like ELSS in this example, charge more. The question to ask here is “does more fees necessarily lead to better returns?”. We examine this question in detail below.

How long should you invest in ELSS funds?

It is our opinion that the ideal duration for investing in ELSS funds is three years. We are not advocating that equity investing is only for a short-term horizon like three years. Instead, we are saying that as soon as the 3-year lock-in period is over:

sell the units and reinvest immediately in the funds where you are investing for long-term goals
or, sell the units and reinvest in a different ELSS fund of your choice so that you do not have to invest additional capital to reach your 80C investment limit

How have ELSS funds fared against index funds for a 3-year investment horizon?

We have chosen index funds benchmarked against the Nifty 50 since the new IIFL fund is a Nifty 50 fund as well. In the sections below, we will show how ELSS funds have fared, as a point-to-point return estimate, vs the Nifty 50 index funds for 3-year investment periods. In each case, we will show how the performance vs. the expenses (TER) for the mutual fund. It should be noted that for equity funds, there is no guarantee of returns but the higher the expense, the lower the expected returns for two funds with the same investment philosophy.

3-year SIP return

3-year SIP return vs TER of Nifty 50 index funds vs ELSS funds

We are plotting the TER of the funds vs the 3-year SIP returns of the funds, for the 3-year period ending 21-Dec-22. However, for the active ELSS funds the returns are all over the place. There is no guarantee that even by paying the higher expenses, about half of the funds have given returns lower than the index funds.

3-year Lump sum return

3-year lump sum return vs TER of Nifty 50 index funds vs ELSS funds

We see the same result for a lump sum investment. Since these returns are point-to-point, here is the same chart for rolling 3-y lump sum returns.

3-year Lump sum rolling return

3-year rolling lump sum return of Nifty 50 index funds vs today's best and worst performing ELSS funds

The chart shows that today’s “best” performing ELSS fund has fluctuated around the returns of the index fund over a 3-year period using the previous 13 years’ worth of historical data. Today’s “worst” performing fund has also performed in the same way. This proves that there is no guarantee that either choice of today’s best or worst-performing ELSS will beat the Nifty 50 index fund over the next three years.

What should the investor do then?

Step 1: Evaluate if ELSS funds are really needed

If there is no need for an 80C tax deduction, there is no need to invest in ELSS mutual funds. Basically, there are two questions to ask here:

will switching to the new tax regime where there are no tax deductions be helpful?
are the better alternatives to ELSS suitable for your current situation? A guide: How to best use 80C deductions to plan your taxes?

This is an article that will help you decide: How to plan tax deductions for salaried income?.

Step 2: Choose a suitable ELSS fund

If you are convinced that you do not wish to chase returns by investing in active funds, then index funds are suitable. The IIFL fund is a step in that direction.

If you are willing to take a punt with active funds, please refer to our guide on choosing ELSS funds: What are the best tax-saving ELSS Mutual Funds?.

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