With returns no better than flexi-caps, ELSS faces an uncertain future

Equity-linked savings schemes (ELSS) are staring at an uncertain future with the government pushing for the new income tax regime, which offers no tax deduction or incentive for investing in mutual funds (MFs). 

Beyond tax-saving benefits, fund houses highlight ELSS’ better return generation potential due to the compulsory three-year lock-in. Data, however, does not validate this claim, making ELSS a potential hard sell if the tax advantage is taken away.

A comparison of ELSS returns with those from similar categories, such as flexi-cap and large-cap funds, shows fund managers in recent years haven’t taken advantage of the lock-in period. In the past three years, ELSS have delivered annualised returns of 14 per cent, the same as that of flexi-cap funds. The returns are almost similar even if we look at rolling returns. Over five years, ELSS trail both large-cap and flexi-cap funds.

An ELSS as a tax-saving option is mostly preferred by younger taxpayers. People in the higher tax brackets have their provident funds, home loan principal, insurance, and above all, their children's tuition fees to claim deductions. This means they hardly have much room for taking advantage of ELSS, according to industry experts.

The category has lagged in assets under management (AUM) growth over the past few years when compared with other popular equity fund categories. For example, ELSS AUM grew 6 per cent in 2022, against over 14 per cent in the case of flexi-cap schemes. With the new tax regime becoming relatively attractive for lower-income investors, these schemes may find it even more difficult to scale up further.

Investment advisors say ELSS have hardly any use beyond tax saving. "I would any day recommend an open-ended diversified scheme rather than ELSS due to three factors: First, the expense ratio of ELSS is higher than schemes like multi-cap and flexi-cap; there’s a lock-in which takes away liquidity in the short term; we don't have control over the style of investing,” said Mohit Gang, co-founder and CEO, Moneyfront.

“Given the availability of a similar open-ended option in flexi-caps, I see no merit in locking in funds for three years, unless tax saving is involved,” said Viral Bhatt, founder, Money Mantra.

Still, most advisors see one merit in ELSS: Making investors stay invested at least for the medium term. “The advantage lies on the behavioural side. An ELSS ensures the investor stays invested for a minimum of three years,” said Tarun Birani, founder of TBNG Capital Advisors.

Active ELSS funds face another challenge in passive ELSS. Last year, the Securities and Exchange Board of India introduced a new product category in passive ELSS, which mimics the index and charges a lower fee. At present, there are two passive ELSS funds -- both mimic the Nifty 50 index. 

"If the investor tends to withdraw frequently, I may suggest ELSS just to bring in discipline," Viral added.