The best tax-saving avenue | Value Research Even though net flows of the ELSS category have entered the negative terrain, these funds are still the best tax-saving alternative.

The best tax-saving avenue

Even though net flows of the ELSS category have entered the negative terrain, these funds are still the best tax-saving alternative.


As of September 2021, the AUM of tax-saving mutual funds (equity-linked saving scheme or ELSS) has jumped to over Rs 1.49 lakh crore from Rs 98,000 crore in the last one year - a whopping increase of over 50 per cent. Tax-saving funds currently account for about 10 per cent of the industry's total AUM across open-end equity funds. A continuous bull run in the market during this period acted as a catalyst for this significant rise in the total AUM.

However, if inflows and outflows of the category in the last one year are taken into consideration, the picture is not very rosy. Even though the inflows have reduced marginally, there has been a massive spike in the outflows. As a result, after a long span of six years, the category's net flows have entered the negative terrain.

The situation could be attributed to several factors. A severe market crash in March last year might have scared investors and therefore, when the market recovered, they went ahead to withdraw the amount that had completed the three-year lock-in period. Besides, during this period, many people faced financial hardship due to the pandemic and had to dip into their savings. Also, many people might have opted for the new tax regime, which offers a lower tax rate but doesn't allow any deductions under Section 80C.

The silver lining is still there
Nevertheless, this ongoing trend should not demotivate investors. For those who stick to the old tax regime, tax-saving mutual funds are still the best alternative.

All tax-saving options can be broadly divided into two buckets. The first bucket comprises various traditional fixed-income options, comprising the Public Provident Fund (PPF), five-year bank FD, the National Savings Certificate (NSC) and so on. The second bucket, on the other hand, comprises products having exposure to equity, including ELSS, unit linked insurance plans (ULIPs) and the National Pension System (NPS).

ULIPs should be avoided because of their high expenses and hybrid nature. The NPS is a nice product and also provides you with an additional tax deduction of up to Rs 50,000 under Section 80CCD (1B). But it lacks liquidity and the money virtually gets locked in till the subscriber reaches 60 years of age. Besides, on maturity, one has to buy an annuity plan with at least 40 per cent of the corpus. On the other hand, ELSS has the shortest lock-in period of only three years. However, it is advisable to stay invested for a longer term for maximum benefits.

Even the PPF, which is the highest yielding tax-saving option among all fixed-income avenues, has a tenure of 15 years.

A comparative analysis
We have compared post-tax 15-year returns of the PPF with the category average of tax-saving mutual funds every month over the last decade. While returns from the PPF are tax-free, long-term capital gains in excess of Rs 1 lakh from ELSS are taxed at 10 per cent. For simplicity, we ignored the Rs 1 lakh exemption.

As mentioned in the graph titled 'ELSS vs PPF', tax-saving mutual funds clearly outperformed the PPF with a wide margin. Delving deeper, we have also plotted 15-year returns of the worst-performing fund in the ELSS category every month. Even the return of the worst-performing ELSS fund was above that of the PPF return for over 50 per cent of the time.

Recent performance
While the category is performing quite well and has yielded returns similar to those of its flexi-cap counterpart, it has been failing to outperform the S&P BSE 500 TRI since mid-2019. As mentioned in the graph titled 'ELSS vs BSE 500 TRI', the category earlier was comfortably beating the benchmark but the gap reduced and its return started converging with that of the S&P BSE 500 TRI in 2018. And since mid-2019, tax-saving funds have started underperforming the category benchmark.

Surely, there is a need for ELSS fund managers to improve their performance but lowering the expenses can also help. The median expenses (as of September 2021) of the regular plan in the category stand at 2.25 per cent. The median for the direct plan is 1.05 per cent.

Meanwhile, it would be interesting to see how long the trend of outperformance by the BSE 500 continues.

Composition of ELSS funds
Like most flexi-cap funds, the category's average exposure of around 70 per cent to large caps reveals that most schemes in the category are large-cap-heavy. Our recommended funds in the category have varied investment styles to cater to all types of investors. Click here to access the list.

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