Conservative investors, novices should choose passive ELSS funds

Those desiring index-beating returns, but willing to tolerate underperformance, may choose the active plan

The Securities and Exchange Board of India (Sebi) recently allowed asset management companies (AMCs) with an actively managed equity-linked savings scheme (ELSS) to launch a passive ELSS. To do so, they must shut down their existing active scheme.

Most fund houses that have large assets under management (AUM) in their active schemes are unlikely to respond.

One passive ELSS index fund from IIFL AMC, which tracks the Nifty50, exists.

Younger fund houses that are passively inclined may take advantage of this directive to convert their active scheme (acquired when they took over another fund house) into a passive one.

New fund houses may also offer the passive option. The real game changer would be if the regulator were to allow each AMC to offer one active and one passive ELSS.

Meanwhile, investors need to decide whether to go for the active or passive option in ELSS.

Passive means simplicity  

Active funds pose a few challenges.

“Selecting the right active fund is not easy, especially for novices. Another issue arises when you invest in an active fund and it starts to underperform,” says Deepesh Raghaw, founder, PersonalFinancePlan, a Sebi-registered investment advisor (RIA).

Amateur investors may find it hard to decide whether the underperformance is due to the fund manager’s incompetence or because the market is not favouring his fund management style. They may find themselves in a quandary over whether to stay put or exit the fund.

Such dilemmas don’t exist in a passive fund. Since they offer market-equivalent returns, investors don’t have to wrestle with underperformance-related issues.

Says Avinash Luthria, Sebi RIA, and founder, Fiduciaries: “I would recommend the passive ELSS option because I prefer low-fee products.”

The IIFL ELSS Nifty50 Tax Saver Index Fund has an expense ratio of 0.27 per cent for the direct plan and 0.52 per cent for the regular plan.

In the case of active funds, the expense ratio ranges between 0.26 per cent and 1.76 per cent for direct plans and 1.55 per cent and 2.62 per cent for regular plans.

According to the SPIVA (S&P Indices Versus Active) India mid-2022 report, which compared the performance of ELSS funds with the S&P BSE 200 Index, 64 per cent of active ELSS funds underperformed this index (36 per cent outperformed) over a 10-year horizon.

“Given these low odds of outperformance, I would prefer a passive approach,” says Luthria.

Whom are they suited for

Raghaw says passive ELSS is a good option for investors whose first equity investment is an ELSS.

According to Nidhi Manchanda, head of training, research and development at Fintoo, “Investors with a conservative to moderate risk profile should opt for a passive ELSS.”

When investing in a passive fund, keep an eye on both the expense ratio (watch out for hikes) and the tracking error (a measure of how closely the fund replicates the returns of the index).

Higher risk/reward in active

Aggressive investors, who want market-beating returns but are ready to bear the risk that their fund could underperform the benchmark, may opt for an active fund.

“Most actively managed ELSS have a 70-80 per cent exposure to large-cap stocks and 20-30 per cent to mid- and small-cap stocks,” says Manchanda.

The mid- and small-cap exposure have the potential to provide a kicker to returns. Active ELSS funds have given a category average return of 14.8 per cent (direct) and 13.8 per cent (regular) over the past 10 years (compared to 13.7 per cent for the S&P BSE 200 Total Returns Index).

To select an ELSS fund, compare long-term (seven- or 10-year) performance with that of its benchmark and the category average. Evolved investors may compare the fund’s rolling return with that of its benchmark.

“In addition to returns, look at parameters of volatility, such as standard deviation. Also, assess the fund’s risk-adjusted performance with ratios like Sharpe and Treynor,” says Manchanda.

It is advisable to opt for a fund that has a lower expense ratio.

As with all equity categories, enter with at least a seven-year horizon.