Active vs Passive ELSS: Which Is Worthwhile for Your Tax Saving Needs

As compared to traditional investment options, ELSS offers higher returns. ELSS operates like any other open-ended equity fund and is a type of diversified tax-saving equity mutual fund scheme. An ELSS must invest at least 80% of its assets, as per the SEBI Regulations, in equity and equity-related instruments. In recent years, the assets under management (AUM) of the ELSS category have increased. The three benefits of investing in ELSS are tax savings (under Section 80C of the Income Tax), wealth creation through equities, and the lowest lock-in period as compared to other tax-saving products.

Currently, there are 37 ELSS or tax-saving mutual funds in India offered by different mutual fund houses. Under Section 80C of the IT Act, tax-saving mutual funds or Equity Linked Savings Schemes (ELSS) assist you in reducing your income tax. You can invest a maximum of Rs 1.5 lakh in ELSS and claim tax deductions on your investments every financial year.

In contrast to other open-ended equity schemes, ELSS has a 3-year lock-in term, which means you may only withdraw your money once the lock-in period has passed. Each contribution made through a Systematic Investment Plan (SIP) is subject to a 3-year lock-in period. Notably, compared to your usual investments like Public Provident Fund, ELSS does not offer guaranteed returns.

However, the Securities and Exchange Board of India (SEBI) recently allowed Indian mutual fund houses to start passively managed open-ended Equity-linked Savings Schemes (ELSS), providing investors with yet another investing option.

With effect from July 1, 2022, mutual fund houses may introduce Passive Equity-linked Savings Schemes (ELSS) according to the capital market regulator SEBI. Under the heading "other schemes," mutual fund houses may introduce passive ELSS (via Index Fund). The ELSS will be benchmarked to a particular index in the passive mode without the involvement of a fund manager.

As per the SEBI circular dated May 23, 2022, passive ELSS funds would be based on selected indices, which are composed of stocks from the top 250 market capitalisation companies. This means that passive ELSS can invest predominantly in large-cap and mid-cap companies, tracking indices such as Nifty 50, Nifty 100, Nifty 200, Nifty Large Midcap 250, etc.

However, there is one caveat to this rule by the SEBI. The Asset Management Companies (AMCs) cannot have both active and passive ELSS funds. They need to choose between the two options. According to SEBI's circular, 'Categorisation and Rationalisation of Mutual Fund Schemes', it has been decided that mutual funds can launch either of the following ELSS scheme in open ended Scheme Category, subject to compliance with guidelines on Equity Linked Saving Scheme, 2005 notified by Ministry of Finance:

- Active ELSS Scheme - In terms of Clause A (10) of Annexure of the SEBI Circular dated October 06, 2017, under the "Equity Schemes" category or;

- Passive ELSS Scheme (through Index Fund) - In terms of Clause E (1) of Annexure of the SEBI Circular dated October 06, 2017, under the "Other Schemes" category.

However, presently, all ELSS funds are managed by a fund manager and follow an active fund management approach. Before proceeding further, you should first familiarise yourself with how the existing active ELSS funds are managed:

These active ELSS funds invest primarily in stocks of listed firms in a particular ratio in accordance with the fund's investment strategy. Market capitalisation (large-cap, mid-cap, and small-cap) and industry sectors are taken into consideration when selecting stocks. Over the long term, these funds seek to maximise capital appreciation. To produce the best risk-adjusted portfolio returns, the fund manager selects stocks after conducting a thorough market analysis.

Here's a list of a few best active ELSS funds and their portfolio allocation:

Currently, most active ELSS invest across market cap but with a large-cap bias. The data shows that most ELSS funds have a preference for large-cap stocks (in the range of 65-80%). A couple of them also hold a sizable percentage of mid-and small-cap stocks. Higher exposure to mid-and small-cap stocks comes with high risk; however, they can contribute to optimal returns during bull markets, but they can also fall further during turbulent markets.

How Passive ELSS differs from the existing Active ELSS funds?

Essentially, Passive ELSS funds will be 'Index ELSS' funds and will offer investors an option to save tax with the benefits of an index fund. One of the several advantages of index funds is the low cost. Let us see the different aspects of Passive ELSS funds.

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Portfolio Allocation: The investment decisions of an Active ELSS fund depend on the fund manager and the processes set by the fund house. At the moment, most ELSS funds invest in large-cap stocks. But they can invest in mid-cap and small-cap stocks as well. As previously stated, the fund manager must make sure that equity instruments account for 80% of the portfolio.

With Passive ELSS funds, things would be slightly different because the Passive fund must match its underlying benchmark. You will only be exposed to the top 250 companies in Passive funds, and the allocation will be identical to the index. The scheme will mirror the benchmark it is based on. As a result, a Passive ELSS fund will invest in the companies in the same proportion as the benchmark.

Cost of Investment: The cost of passive funds is lower than that of actively managed funds since they have a lower expense ratio. The expense ratio is the annual fee a fund house charges for managing the fund; in the case of a Passive ELSS fund, the fund managers are not actively involved. A Passive ELSS fund will therefore be less expensive. A lower expense ratio can help you get higher returns and save on costs over the long term.

Investors are happy about the introduction of Passive ELSS since it will allow them to take advantage of the growth potential of stocks at a low cost. It also shows the keenness of the capital market regulator to encourage passive investing among investors in a variety of mutual fund categories.

To conclude...

The SEBI has allowed fund houses to introduce Passive ELSS funds. However, SEBI has stated that mutual fund houses can either launch Active ELSS or Passive ELSS and not both. The rationale for this may be to promote Passive ELSS among new AMCs and prevent clutter in the mutual fund space.

As almost all fund houses already have Active ELSS funds available in their bouquet of funds, it remains to be seen which passive funds will see the light of the day, as AMCs cannot have both Active and Passive ELSS funds. Since Active ELSS funds have a bigger revenue impact for AMCs than Passive ones (due to higher investor expense ratios), fund houses may not be too enthusiastic about choosing Passive ELSS. As a result, AMCs with current active ELSS may not switch to passive ELSS. As a result, only a select few new AMCs that lack ELSS funds in their product basket may introduce passively managed ELSS schemes. Thus, it is unlikely that Passive ELSS will materialise in a significant way anytime soon.

In the interest of investors, SEBI may allow fund houses to offer both Active and Passive ELSS funds to investors at a later date. In my opinion, a better option would have been to allow AMCs to have both active and passive ELSS fund options and leave the choice to the investor as per their suitability.

Therefore, while choosing an ELSS fund for your portfolio, investors need to pick one which suits your risk appetite, investment horizon and objectives and simultaneously complements the other non-ELSS funds in your existing portfolio.

As you begin tax planning for FY2022-23, it's far more vital to make sure you are investing in the right tax-saving mutual funds and that your tax investments are in line with your financial plan.

However, if you are not sure about how to exercise your tax planning, save yourself from the last-minute stress and initiate your tax planning with the help of PersonalFN's Definitive Guide to Select ELSS (Edition 2022).

This Guide will show you how picking a worthy ELSS, a Tax-saving Mutual Fund, could potentially maximise your wealth and act as an effective tool for tax planning. It includes:

• Why ELSS is a worthy option for tax planning

• Mistakes to avoid while investing in ELSS

• How to select the best ELSS for tax planning

• How ELSS has performed as a category

• Some of the best ELSS to invest in

• Who should consider investing in ELSS

• How should one go about investing in ELSS

If you are looking to exercise your tax plan and invest in tax-saving funds for the year 2022, then get your free copy of PersonalFN's Definitive Guide to Select ELSS (Edition 2022).

Warm Regards,
Mitali Dhoke
Jr. Research Analyst