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Understanding the basics of ELSS

ELSS has a three-year lock in period and provides tax benefits, however ELSS investment requires some amount of market risk

May 16, 2012 4:03 IST | India Infoline News Service
What is an ELSS mutual fund?
Equity-linked saving schemes (ELSS) is one of the types of mutual funds with tax benefits. The scheme primarily invests in equity market by buying equity stocks of companies listed on the stock exchanges.
 
The units of the scheme are offered at the NAV (net asset value). The NAV is announced for all business days and keeps changing primarily depending upon the movement in the prices of stocks held in the portfolio of the scheme. The minimum investment in ELSS is Rs. 500.
If you opt for dividend option, then you get dividends whenever it is declared in the scheme. Pankaaj Maalde, head-financial planning, ApnaPaisa.com, says, “If you opt for dividend pay out option then dividend is paid to you whenever it is declared in the scheme. The dividend is paid even in first three years lock-in period and there is no such restriction.” He adds, “You do not have to withdraw, but it is paid automatically whenever dividend is declared.” It is credited directly to your bank account or paid through cheque.

Some ELSS also offer personal accident death cover insurance. However, one needs to a background check with the mutual fund company before buying the product.
 
ELSS & diversified equity schemes
Both ELSS and diversified equity scheme operates in same way. Both are high return and high risk schemes. But, ELSS has a three-year lock in period and provides tax benefits under Section 80C of the Income-tax Act. The maximum limit is Rs. 1 lakh. Premature withdrawal is not allowed in ELSS, while it is allowed in diversified equity schemes and other financial instruments like fixed deposits (with some conditions).
 
ELSS & traditional investments
According to a report by CRISIL, investment in an ELSS of a mutual fund can yield higher returns compared to traditional instruments like PPF (public provident fund) and NSC (national savings certificates).
 
The rating agency said, “Our analysis shows that ELSS gave 22% annualised returns over the past10 years. While, the PPF accounts fetched 8.12% over the last 10 years and NSC gave an interest of 9.10%. The average inflation over the past 10 years stood at 6.05%.”
Though traditional debt products are considered to be safe as they are not affected by market fluctuations, they are unable to generate higher inflation-adjusted returns over the long term. However, ELSS investment requires some amount of market risk and investors need to cherry pick those schemes which have performed consistently well.
 
ELSS also provides a lock-in period of three years, while for NSC it is five years and for PPF it is 15 years. Since ELSS units can only be redeemed after the lock-in period of three years, any gain on their redemption will be long-term capital gain, which is tax free. However, in case of NSC, the interest received is taxable at the end of the five-year period.
 
Systematic investment in ELSS
The best way to invest in ELSS is through systematic investment plan (SIP). With SIP, you can invest a small amount every month for a specific period. The SIP option helps investors to take advantage of fluctuations in the stock market. Thus, investors get more units when the market is down and get fewer units when the market is doing well.
 
Let’s assume: You invest Rs. 1,000 every month in an ELSS at a time when market is down. The NAV of the unit is 10 so you get 1,000 units. However, after some time, the market has improved and gone up. Now, the NAV of the same ELSS is 20 so you get 50 units. Investing a fixed amount every month in an ELSS helps you to cover the market fluctuations.
 
Redeeming ELSS
According CIEL (Centre for Investment Education and Learning), investments in ELSS cannot be redeemed before the end of three years from the date of investment. This applies even if the investor does not claim tax benefits under Section 80C of the Income-tax Act.
Each SIP instalment is treated as a separate investment and the instalment must complete three years of holding for it to be redeemed. Redemption is on a first-in first-out basis since the units allotted first will be redeemed first.
 
Before making a redemption request, check the latest account statement to know the units that are eligible for redemption. If the request is for more than that is eligible, the request may be rejected.
 
Investments in ELSS are subject to market risks, investors must take into consideration their age and risk-taking abilities. The investment horizon should be more than five years for higher inflation-adjusted returns. Further, investors must choose funds that have performed well both in good and bad times.

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