FUND FLAVOUR

November 2012

Uncertainty looms large…

Death and taxes are the only two things that are certain in life. But uncertainty looms large over Equity-linked Savings Scheme (ELSS), which offers both tax breaks and total exposure to equities. Sales of tax-saver mutual funds was Rs 1,106 crore in the March 2012 quarter, 34.7% lower than the same period in 2011, according to AMFI data. This has been the worst March quarter show for tax saver funds in seven years. According to AMFI, tax savings schemes as a category has seen net outflows of Rs 934 crore in the half year ended September 30, 2012. Across 49 schemes, Rs 24,635 crore worth of assets are under management in this category.  New investors are not keen to invest in these funds as they have attractive options such as public provident fund offering 8.8% returns to save tax. As existing investors are logging out and new investors are not keen to invest, these funds have been experiencing net outflows. The uncertainty over the fate of the ELSS category under the new Direct Taxes Code (DTC) regime and the lacklustre show by equity markets impacted sentiments, driving down investments.

Let us start with the simple part first… the tax benefit.

When you buy an ELSS fund, you are allowed to reduce your taxable salary by the amount you invest (subject to certain limits), and since your taxable salary is reduced, your tax liability is also reduced. There are no other tax benefits of investing in this type of mutual fund. So, if you bought ELSS Fund this year and benefited from the tax breaks, it does not matter if those tax benefits are withdrawn next year because you would not get any deductions on your existing funds next year even if Section 80C were to remain in place. So far, so good, but the tax structure today favours equity funds since there are no long term capital gains on them, and there are no dividend distribution taxes on them either. There is a short-term capital gains tax of 15% if you sell an equity fund within a year but since these funds have a lock in period of 3 years, you would never incur a short-term capital gains tax on them. Now, the zero long term capital gains, and no tax on dividends is because these funds invest in equity, and if these rules were to be changed in the future for all equity funds then such rules will be applicable on ELSS funds as well. The difference from your perspective is that while you can get rid of the other equity funds if you do not like the new taxes, you cannot get rid of ELSS funds since they have a lock-in period.

So should that turn you away from investing in an ELSS fund?

This alone is not a valid reason because the tax treatment on long-term capital gains could change today without DTC coming in, and you would still be stuck with your existing ELSS funds. Some people are concerned that the sole reason investors opt for ELSS funds are tax savings, and if that is withdrawn then would these funds not gradually shrink in size, and what is the incentive for the fund house to focus on the performance of these funds and would they even continue with them? So while this is a heated topic in the corridors of personal finance and there are arguments flying thick and fast, invest if you want to do so from a tax saving perspective. An icing on the cake could be the dividends which some of them have delivered – approximately between Rs 1 to 3 per unit. Do not worry about the imminent looming divorce between DTC and ELSS… enjoy the honeymoon while it lasts.

A case for ELSS investment

Do not shun your ELSS just because of depressed stock market or better returns in PPF, and five-year FDs. Always remember that equities are risky and you should have at least a time frame of five to seven years. If you have earmarked money for the stock market, you can still go ahead with your investments. If you are investing for the first time in equities, be cautious as the market is going through a rough period. Do not let the confusion on implementation of DTC and the status of ELSS in the new regime bother you. Equities can still earn you superior returns in the long-term. The best ELSS Fund has returned over 13% in the last five years.

Be systematic and plan ahead

Most salaried taxpayers awaken to tax planning only in December when the accounts department at the office rings the alarm bell for proof of tax saving investments. A few calls / visits to tax planners, insurance agents and postal savings agents later, the immediate objective of investments and proof submission is met. However, no attempt is made to understand the tax planning process thoroughly. As such, individuals end up investing in avenues, which may not necessarily map out their long-term financial goals. At that point, saving tax is the objective and not investment. An analysis by CRISIL suggests that it is possible to do both tax planning and long term financial planning together. Further, if one is willing to take some risks, ELSS offered by mutual funds provides an opportunity to generate attractive long-term returns, if invested for longer period (more than five years). Ideally, one must follow a comprehensive financial planning model, which includes tax planning along with risk profiling, goal setting, and asset allocation. This not only lends a long-term perspective to tax saving investments but also indulges in a disciplined approach to tax planning. Importantly, tax planning should be a yearlong exercise and not a blink-of-an-eye moment. It helps in planning the monetary outflows for the entire year instead of making lump sum contributions at year-end. It also gives investors adequate time to understand and evaluate different investment options.

This is how Mutual Fund ELSS stands out of the crowd... 

Investors generally prefer traditional debt instruments for tax saving. While these may provide safety and stability, they fall short of generating higher inflation adjusted returns over the long run. For example, instruments earning 9% rate of interest when average inflation is around 9% will yield 0% real rate of return. Hence, investors willing to take some amount of market risk may look at equity linked investments via mutual funds for the long term. This asset class has historically provided high returns over longer periods. The S&P CNX Nifty has returned over 16% in the 10-year period ended December 30, 2011, almost double compared with around 8-10% yielded by tax saving debt instruments. Among equity tax saving instruments, ELSS, ULIPs, and the equity option of the NPS are available for investment. The lock-in period for ELSS is three years, for ULIPs, it is five years, and NPS, has a lock-in period till 60 years of age.

Points to ponder... 

Before deciding to go for mutual fund ELSS, here are some points to ponder over. First check your overall portfolio. Does it need more equity exposure? If yes then you can go for ELSS; if no then you can go for PPF or NSC.  Second thing is to keep in mind that equity investments are for long term, say 5 years or more. Though the lock-in period in ELSS is 3 years it is better to invest with a time horizon of 5 years or more. Moreover, investors need to keep in mind that SIP is the best form of investing in mutual funds and ELSS is not an exception. So a SIP in ELSS is a good strategy to be followed. The poor performing ELSS has given around 10% annualized return in the last 5 years whereas the best performing ELSS has delivered around 25% annualized return in the last 5 years. So investors need to be careful in choosing the right ELSS scheme. Past performance, risk adjusted return, consistency are a few parameters to be evaluated in selecting a best performing ELSS scheme. All together 49 Equity Linked Saving Schemes are available in the market. Of these, 37 funds are open-ended funds, of which 30 funds have a track record of 3-years or more. Only 14 funds out of 30 managed to beat the category average in the 3-year period. So selecting a right fund is more important, as the money is going to be locked in for 3 years. Equity Linked Saving Schemes have a good track record, with performance similar to diversified funds. The category average returns on 3-yr, 5-yr, 7-yr, and 10-yr are 22.23%, 5.20%, 15.41% and 22.17% CAGR respectively. However, market slumps in recent times have hit the performances of equity-oriented funds including ELSS. 

The verdict... 

Hence while ELSS mutual funds offer good opportunities for long-term wealth creation (while you intend availing a benefit under section 80C) it is imperative that you complement your financial planning exercise with your tax-saving (by considering the aspects of age, income, risk appetite and financial goals) as this would enable in making a prudent investment decision. Moreover, please do not wait till the eleventh hour as this may lead you to making a wrong choice. While considering an ELSS mutual fund for your market-linked tax-saving portfolio, give importance to those ELSS mutual funds that have completed at least 3 years of track record and select schemes from mutual fund houses which follow strong investment systems and processes. Look for the consistency in the performance, with relevance to risk and returns, portfolio turnover ratio expense ratio, and the portfolio of ELSS mutual fund(s). We all love ELSS mutual funds because they help us save taxes and at the same time give better returns that conventional tax saving instruments. Though there is a lock-in period of 3 years with ELSS mutual funds, which is usually not applicable for other Equity mutual funds, but then one should not invest in equity or equity linked instruments for a time horizon lesser than that. ELSS helps in infusing a sense of discipline towards holding one's investments for the long-term.