FUND FLAVOUR

November 2013

In today’s era of high inflation, one cannot afford to put all his/her savings in fixed deposits / debt instruments as the returns from those assets will not even cover the rise in cost of living, not to mention earning returns on top of inflation. Thus, it is essential to have some part of savings in equities, and within that, Equity Linked Savings Scheme (ELSS) fund is the best option.

ELSS - one up on traditional tax-saving avenues

Going by its name, ELSS invests a majority of its corpus in equity and equity related products. An investment in ELSS comes with a lock-in period and has tax benefits attached to it. ELSS schemes are open-ended, that is, investors can subscribe to the fund on any day. NAV or the price of the fund is declared on every business day. Like all investment options, ELSS too comes with its share of advantages and disadvantages.

Advantages of ELSS

·       CRISIL Research, India’s largest independent and integrated research house believes that ELSS offered by mutual funds scores over other traditional tax saving products by offering higher inflation-adjusted returns. ELSS gave 26% and 22% annualized returns over three and ten years respectively vis-à-vis 8-9% offered by traditional tax saving instruments like PPF and NSC. ELSS is not only an attractive option to save tax but it also helps to create wealth in the long run. ELSS as a category has outperformed the benchmark S&P CNX 500 index across three and ten years. With the average inflation hovering at around 7% over the past three years, top ELSS funds analysed by CRISIL gave an inflation adjusted return of 14%, which is significantly higher than returns offered by the other tax saving products. Thus, investors who are willing to take a certain degree of market risk could look at ELSS to generate superior long-term returns.

·       There is no ceiling for investments in ELSS. However, investments in ELSS qualify for tax deductions under sec 80C of the income tax act subject to a maximum of Rs 100000 in a financial year whereas investments under normal mutual fund do not qualify for income tax deductions. Any dividend received or long term capital gain earned by the investor is tax free. Long term capital gain arises on selling units of mutual fund after one year of purchase. Since there is a lock-in period of 3 years, every investor will realize long term capital gain/loss on selling their holdings.

• PPF and NSC are popular tax savings instruments issued by the Government of India. Public provident fund (PPF) has a lock-in period of 15 years; National savings certificate has a lock-in period of 6 years. Main advantage of ELSS is its short lock-in period of 3 years only.

Disadvantages of ELSS

• Risk factor is very high compared to NSC and PPF. ELSS funds invest in stocks and carry the same risk as any other equity fund. In fact, the risk is greater because you cannot touch the investment before the three-year lock-in period.
• Premature withdrawal is not allowed but it is allowed in other instruments under some specific conditions.
• Tax benefits on investment in ELSS may soon be phased out with the introduction of Direct Tax Code.

The balancing act

However, investors need to be wary of the fact that ELSS funds typically invest in a mix of small, mid, and large cap and that the returns can be volatile. The investment should be more than five years for higher inflation adjusted returns. Further, investors must choose funds that have fared well in good and bad times. The minimum three-year lock-in period for ELSS provides the investment manager with a longer investment horizon and leads to a lower portfolio churn. This also leads to lower transaction costs for investors. Most AMCs offer an ELSS scheme and investors have 48 such schemes to choose from. In addition, investors can invest as low as Rs 500 through SIPs, and reap the benefits inherent in disciplined long-term investment.

The superiority of SIPs

Monthly investments on a pre specified date in mutual funds is possible through systematic investment plan (SIP). An investor has the option of investing monthly in equity linked savings schemes with a minimum investment of Rs 500. This type of investment is better suited to small investors who cannot invest a lump sum amount. SIP has the benefit of averaging out the cost of investors. As the amount of investment is fixed, the units purchases every month varies depending upon the NAV of the fund. At a higher NAV the investor gets fewer units and more number of units at a lower price thus averaging out the cost of investors. Instead of making a lump sum investment just for the sake of saving tax, advisors suggest investors to stagger their investments from the start of the financial year. This will help even out volatility of the stock market in the near term. For example, if you did a monthly SIP of Rs 2,500 for 12 months starting April 2008 in Franklin India Taxshield, you would have invested a total of Rs 30,000 by the end of the financial year. The value of that investment now is Rs 58,231, giving a return of 15.63%. However, if you had done a lump sum investment of Rs 30,000 on April 1, 2008, the value of that investment would be lower at Rs 47,022 today — giving an annualised return of 9.66%.

Scintillating asset growth…

Although ELSS funds were available from 1996, it is only in the past few years that the ELSS funds have become very popular with tax savers and investors alike. Prior to 2005, the assets in ELSS funds were around Rs. 500 crores but by January 2010, the assets in ELSS schemes grew close to Rs. 22,500 crores, a jump of close to 4400%, in just a matter of 4 years. Part of this spectacular growth is due to the stock market performance from 2004 to 2007; although the assets in the ELSS funds reduced in 2008, the market crash of 2008 did not deter the investors from investing in ELSS funds. Once the market recovered in 2009, by January 2010, the assets of ELSS funds reached close to Rs. 22,500 crores. This is much higher than Rs. 16,000+ crores of assets reached in December 2007, when the Indian stock markets were at an all time high. 

… subdued by mediocre performance

The performance of ELSS funds has been a cause for concern lately for investors. According to Value Research, a mutual fund tracking firm, the ELSS category has delivered a mere 1.28% in the last three years, and 4.13% in the last five years. Tax-planning mutual funds, or ELSS, as a category have lost 13.87% over the past year, as on October 28, 2013 according to Value Research, an independent mutual fund tracking firm. No wonder, many investors are not keen to invest in ELSS this year.

 

ELSS suits first time equity investors

ELSS has become the vehicle for most first-timers in equity investments. It is suitable for all types of investors who are not risk averse and need to invest in tax planning instruments. Though there is no age to get started on an ELSS, it is good investment to have for those who are just starting their careers as it can help them shed their inhibition about investing in equities through mutual funds in a big way. The newly launched Rajiv Gandhi Equity Saving Scheme is best left untouched. It gives additional tax deduction to first-time investors who want to enter the equity market. Instead of taking this route, which will give them only 50% tax deduction, the ELSS funds are a better option.

… and is at the heart of financial planning framework

 

 

The most important rule of tax planning is that it is no different from financial planning. The Section 80C offers a wide range of options, each suited to a different need. Choose an option that fits into your overall financial plan, not because it offers good returns or your relative or friend is selling it. It is easier to identify the best option if you do not leave tax planning for the dying days of the financial year. You get a rough idea of how much you need to save at the beginning of the fiscal year. Allocate your Rs 1 lakh limit across different Sec 80C options as dictated by your financial goals, following the same principles of asset allocation that apply to other investments. Given that these goals are a good 15-20 years away, you can start a monthly SIP of Rs 5,000, thus aligning your tax-saving investment with a long-term financial goal.