Monday, November 03, 2014

November 2014

A fund qualifies to be an Equity Linked Savings Scheme (ELSS) if it invests more than 65% in equity, has a three-year lock-in on investments, and has the necessary approval from the tax authorities to qualify as a tax-planning scheme. This unique fund category is the only one that is open to retail investors and HUFs, are open-ended, and have equity exposure.

Ups and downs of ELSS inflows…

There is a distinct seasonality in the inflows in ELSS. Every year, in the months of January, February, and March, one can see a spike – with the month of March being easily identifiable. The last quarter contributes to around 50% of the entire year’s investments. Approximately 25% of the entire year’s inflows in ELSS come in the month of March. According to AMFI's data, it has been seen that for the financial year 2013-14, in April 2013 only 6% of collection was done, whereas in the month of March 2014, 28% of sales took place for the ELSS category. Thus, we can say that most of them start their tax saving at the end of the financial year instead of at the start of the financial year.

… ELSS SIP – the answer

Incidentally, investment in a scheme like ELSS should be done through systematic investing, or through investing a fixed amount every month out of the monthly savings. The discipline of regular saving helps one through a principle called “Rupee cost averaging”. This approach of investing a fixed sum every month helps one buy more units when they are cheap and fewer when they are costly. This brings the average cost of purchase down.

On the brighter side

Shortest lock-in

All tax-saving investments have lock-in periods ranging from three to 15 years. ELSS funds have a lock-in period of three years, the shortest among all Section 80C investment options. While this reduces liquidity and prevents the investor from making changes, it can be a blessing in disguise. It also means that redemptions are not a worry for the fund manager and he can take long-term investment decisions, which generally prove beneficial for the fund. For the investors who take the SIP route, each monthly instalment is treated as a separate investment and gets locked in for three years. So, the SIP started in July 2014 will be eligible for withdrawal in July 2017. Similarly, the SIP invested in August 2014 will be open for withdrawal only in August 2017. Further, do not make the mistake of opting for the dividend reinvestment plan, under which the dividend payout is reinvested to buy more units of the scheme. Every time this happens, the new units get locked in for another three years. 
Tax advantage 

ELSS funds fall under the exempt-exempt-exempt (EEE) category. Investments get tax deduction under Section 80C. So you do not have to pay tax on the amount invested in the ELSS fund. The capital gains generated by the fund are also exempt from tax as the investments are not withdrawn. Finally, withdrawals are also tax-free because there is no tax payable on long-term capital gains from equity-oriented mutual funds. Since the holding period necessarily exceeds one year, there is no capital gains tax. The Employee Provident Fund and the Public Provident Fund are the only other investment options that enjoy the EEE tax treatment. From 2014-15, this fund has another attraction added to its already long list; the investment limit in this fund which qualifies for tax benefits under Section 80C of the Income Tax Act, 1961 has been increased by Rs. 50,000 to Rs. 1.5 lakh, which is deductible from taxable income.
Affordable investment threshold

Most equity funds have a minimum investment limit of Rs 5,000, but ELSS funds have a lower threshold of Rs 500. New investors who want to test the waters before jumping in will find this especially useful. These funds also offer a greater flexibility to investors. Unlike an insurance plan or a unit-linked insurance plan (ULIP), you do not have to commit multi-year investments. Even a one-time investment of Rs 500 can be held till perpetuity. In the PPF, the investor must make at least one contribution in a year or pay a penalty. However, there is no such compulsion in ELSS funds.
These funds provide equity exposure and are an alternative to other tax saving instruments like NSC, PPF, and fixed deposits. This is the only pure play equity investment option available compared to the otherwise fixed return, fixed tenure options. Considering the Finance Minister's budget speech, there is no committed deadline for introduction of the long-awaited new tax code or the DTC. The future of ELSS funds is still bright.

On the flip side

Since these funds invest 65% in equity, there is some element of risk. Moderate risk and high-risk investors can consider this as a tax saving investment option. In addition, the past performance may or may not repeat in future. Hence investors should consider this risk element while investing in such funds. ELSS funds are essentially diversified equity funds and carry the same risks. In fact, the risk is higher in ELSS funds because you cannot exit before three years. 

Consistent performer

However, the average ELSS fund has performed better than the average diversified equity fund in the past few years. The average returns of the ELSS category over different time horizons are 35.02%, 16.22%, 11.02%, 12.91%, and 12.91% over the 1-year, 3-year, 5-year, 10-year, and 15-year horizons. While the ELSS category has given 15.2% annualized returns, the diversified funds have given 14.3%. This is partly because a large number of equity diversified funds pull down the average returns. However, not all ELSS funds have performed so well. While the best performing ELSS fund has given 21.7% annualized return in the past five years, the worst performer has given only 3.8%. So, choosing the right fund is crucial. It is enough to hold 1-2 tax-saving equity funds. As you would also be holding a few traditional diversified equity funds, having more ELSS funds will only duplicate your portfolio.

Ideal long-term investment

Ideally, you should choose a fund for investment purposes based on different investment time frames and fund corpuses. In many cases investors tend to exit an ELSS investment once the lock in period is complete because they suffer notional losses due to market fluctuation or due to poor selection of funds. While the three-year milestone can be used to review the performance of an ELSS investment, it should not be used as an automatic exit point. Holding ELSS for a period of 10-15 years, as the data clearly shows, is better than stepping out at the end of 3 years. It is not only more fruitful for investors in terms of returns but it reduces the probability of facing negative returns as well. A minimum of 10-15 years is an ideal horizon for any ELSS investments, mainly because it gives the fund manager the room to take a long-term view on the market and invest accordingly. If we are comfortable with PPF and insurance products for 10-15 years, why not with ELSS? 

Equity can be a risky investment if you are investing for a short period of time, but with time on your side, equity is extremely rewarding. So, why not look at equity as a part of your long-term corpus? This asset class has proven to be the best performer over the long term. The icing on the cake is that no tax is levied on the long-term capital gains from equity funds and dividends are tax-free too. ELSS is undoubtedly one of the best tax saving products available in India.

No comments: