Should you invest in small caps instead of ELSS for better returns?

Small-cap funds are returning more than most of the other equity fund categories. Given the same, some of our readers have written to us asking if they should give-away the tax benefits under section 80C for which they usually invest in Equity Linked Saving Schemes (ELSS) and rather invest the surplus in small-cap funds for the long-term benefit.

Section 80C of the Income Tax Act allows you to avail a deduction of up to Rs 1.5 lakh from your taxable income on making certain investments and expenses. Investment in tax-saving funds or Equity Linked Saving Schemes (ELSS) is one of them. This means that one can straight-away save up to Rs 46,800 on the tax outgo by investing Rs 1.5 lakh in ELSS, assuming that you are in the highest tax bracket of 30 per cent. This is a very tangible benefit and should not be compromised.

Small-cap funds have undoubtedly returned more than ELSS. As of June 7, 2022, their 10-year SIP return stands at 16.78 per cent while tax-saving funds have returned 12.89 per cent. But it is important to understand that small-cap funds are not meant for everyone. Though they have the potential to give extraordinary returns over the long-term, they are highly volatile and prone to sharp ups and downs. This can be a reason for anxiety for many investors during tough phases of the market and eventually driving them out of equities permanently which can be a bigger problem. Know the promise and perils of small-cap funds.

Moreover, it is not advised to make small-caps as the core of your portfolio because of their inherent nature. Only a small portion of your portfolio should be allocated to small-cap funds. Ideally, one should have around 60-70 per cent in large-cap funds to keep their portfolio stable and the remaining in mid-cap funds and small-cap funds for providing growth and higher returns. And that is exactly what tax-saving funds and flexi-cap funds do. So while investing in ELSS, you automatically get exposure to small-caps as well.

However, if you still wish to have a higher allocation towards mid- and small-caps, we do have tax-saving funds in the ELSS category which follow an aggressive approach and invest more in mid- and small-caps. It can be easily checked under the 'Portfolio' section of any fund page on Value Research Online.

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This article was originally published on June 08, 2022.