FUND FLAVOUR

November 2015

Tax planning may seem like a tedious exercise requiring tremendous effort that may make an ordinary investor nervous at the first glance. Equity Linked Savings Scheme (ELSS) offers a simple way to get tax benefits and at the same time get an opportunity to gain from the potential of Indian equity markets. Simply put, ELSS is a type of diversified equity mutual fund which is qualified for tax exemption under section 80C of the Income Tax Act since an investment of up to Rs. 1.5 lakh in ELSS funds qualifies as deduction from your taxable income, and offers the twin-advantage of capital appreciation and tax benefits. It comes with a lock-in period of three years. If you choose the dividend option for investing in either ELSS or diversified equity funds, dividends in either case are tax free in the hands of the investors. Long term capital gains from both ELSS and diversified equity funds are also tax free.

Why invest in ELSS funds

When investors put their money in a tax-saving product, they are usually concerned only with the amount of tax they will save. Ideally, they should also pay attention to the returns that these tax-saving investments will yield.

ELSS funds score highly on this count. ELSS is one of the instruments under Section 80C that takes 100% exposure to equities. Hence, along with tax saving, it also offers the benefit of wealth creation. The ELSS category has given an average return of 43.48% over the past one year and 22.99% over three years. Fixed-income schemes like PPF, EPF, and NSC pay an interest rate of 8-9% while Sukanya Samriddhi Scheme pays slightly more at 9.2%. The returns from NPS tend to be lower than that from ELSS funds as the former allows a maximum of only 50% investment in equities, and that too only in Nifty stocks. Traditional insurance plans give a return of barely 5-6%. While Ulips do invest in equities, a part of the premium goes into offering insurance cover. The higher returns in ELSS funds will, of course, come with higher volatility.

Conservative investors should, however, remember that the risk in equities declines as your investment horizon increases. If you are anyway going to have your money locked up for three years, you may as well invest at least a part of your tax-saving portfolio in an equity-based instrument like ELSS. The returns will be higher, and the interim volatility will not matter due to the lock-in. Investors keen on wealth creation should leave their money invested in an ELSS fund even after the mandatory three-year lock-in so as to earn optimal returns from it.

The risk of making a loss in equities becomes very small if you stay invested for 5-7 years. The three-year lock-in also allows fund managers do a better job. To deliver steady returns, a fund manager needs a steady and predictable inflow of AUM. The three-year lock-in period in ELSS funds gives fund managers the leeway to thoroughly analyse companies and invest with a longer time horizon. They can do so because they know that the money is going to stay with them for at least three years.

A boon to the investor

 

There are a number of benefits of investing in ELSS funds.

• Starts at just Rs. 500 – You can start investing in ELSS funds at a low starting amount of just Rs.500.
• Tax saving – ELSS funds qualify for tax saving. Investments in ELSS funds up to INR 1.5 lakhs will help reduce your tax burden (for people in the 30% tax bracket, you can save up to INR 45,000)
• Capital growth – Your money keeps growing. With power of compounding, you will accumulate a good amount by the time you withdraw
• Disciplined investing- With the power of monthly investment, you can get disciplined with your investing and tax planning
• Tax free returns- The returns you gain from ELSS funds are completely tax-free
• Shortest lock-in period- Out of all the 80C investment options that let you grow your wealth, ELSS funds have the shortest lock-in period of 3 years
• Inflation beating returns- Since ELSS funds are equity mutual funds, they give superior returns (14-16%) compared to other tax-saving options in the long term (5-7 years)

Choose the right fund

 

ELSS schemes typically invest in equity markets. So, comprehensive research goes a long way of moulding it into a sensible investment rather than a mere speculation. Any investor must analyze the following factors before investing in ELSS.

• Compare its risk-adjusted returns over the short (six-month and one-year), medium (three-year), and long-term (five-year) horizons vis-a-vis its benchmark and the category average. Ensure that the fund is consistent and has been ahead over all or most of these time horizons. Last five-year performance will help you understand the relative stability and pattern of the returns.
• The fund's expense ratio, level of churn, and level of risk should be lower than the category average. There should also be consistency at the helm.
• Track record of the fund manager.
• Investing fund house, its business performance, safety and experience in this domain.
• The quality of the investment stocks and their historical performance.
• Fund rating by rating agencies like CRISIL.
• It is better to choose the growth option under ELSS. Do not commit the mistake of opting for the dividend reinvestment plan, under which the dividend payout is again invested to buy more units of the same scheme. Every time this event happens, the new units get locked in for another three years.
• If you are cautious investor, it is better to opt for a diversified fund.

  What should you avoid?

 Avoid making a lump sum investment in ELSS funds. If the market is at a high level and it falls right after you invest— the sort of conditions that prevail today—you will see massive erosion in your portfolio value. Instead, use the SIP approach and take advantage of rupee-cost averaging to garner good returns from these funds.

When selecting an ELSS fund, take into consideration your own risk appetite. Conservative investors should avoid ELSS funds that take large exposure to mid- and small-cap stocks. They should stick to funds that invest primarily in large-cap stocks. Aggressive investors may opt for funds with a higher mid- and small-cap exposure.

Finally, since in all likelihood your purpose is to build up a corpus to meet various financial goals, avoid the dividend option and go for the growth option.

ELSS good for long-term investment

ELSS form a part of the tax saving investment basket as they not only reduce the tax outgo but are also an efficient long-term investment tool. Three-year lock-in period gives these mutual fund schemes a performance benefit above tax saving.

There are other products you can opt for that are eligible under section 80C of the Income-tax Act for a deduction of up to a maximum of Rs.1.5 lakh. These would include contributions to Public Provident Fund, Employees’ Provident Fund, life insurance premiums, National Savings Certificates, Senior Citizens Savings Schemes, five-year term deposits, and post office schemes. 

Although being equity linked means that ELSS investments come with some market risk, if you are making a tax saving investment with the intention to remain invested for 3-5 years or longer, ELSS is the most efficient choice.

The equity advantage

 

Mostly, funds in the ELSS category are considered only for tax saving. However, these are managed as diversified equity funds with a long-term investment outlook. ELSS is an equity fund and comes with a three-year lock in. The lock-in means that while you can continue to invest money as and when you desire, you will necessarily have to remain invested for three years. The obvious disadvantage is that you will not have liquidity to move your money as you need. Nevertheless, the advantages outweigh. For one, your money remains invested for at least three years, which is a reasonably long period for equity portfolios to accumulate profits and cultivate investor discipline.

At the end of three years, whether you want to withdraw your money or let it remain invested is your choice.

In the long run, equity investments can help you earn returns that beat inflation. Fixed deposits, bonds, and other interest bearing investments at best offer returns that may match the pace of inflation over a period of time, but the real return is low. If you consider the market barometer, S&P BSE Sensex, a large-cap index of 30 stocks, data shows that the 10-year rolling return over the past 20 years was an average of 15%.

ELSS has a brilliant structure, which lets investors remain in the fund for three years. This also allows for longer term calls in the portfolio. Then why not encourage investments through the year rather than focusing simply on tax savings?  In keeping with this focus, some fund houses have renamed their tax saving equity schemes, say for instance, Axis Long Term Equity fund.

Performance Matters

Once you have invested in an ELSS, there is no need to withdraw even after the lock-in period is over if the fund is performing well. Some investors are mis-informed that they have to withdraw money in three years. For investors who are not disciplined and might panic about short-term movements, ELSS works well.

Over the years, the popularity of such mutual fund schemes has increased. Ten years ago, there were 34 such funds with collective assets under management (AUM) of Rs.1,740 crore. By the end of 2009, the number had increased to 45 and the total assets under this category went up to Rs.23,000 crore. Now the number of schemes has gone up to 49, and total assets for the category to Rs.35,000 crore. But this is just about 10% of the overall equity AUM across mutual funds.

On an average, funds within this category have performed marginally better than a basket of open-ended multi-cap and large- and mid-cap schemes. The average compounded annual growth rate (CAGR) for the category in a five-year period is around 13.6%, and 28% for a three-year period. This is comparable with the average returns of around 12.2% and 25.3% for five and three years respectively in case of a basket of diversified open-ended equity funds. In the past one year, average returns from the ELSS category were close to 54% against 29% gains in the Sensex.

Alternative to closed-end funds 

Lately, we have seen a number of new funds being launched in the closed-end structure. An advantage that these are touted to bring to the table is forcing investors to be disciplined and remain invested. The ELSS category does the same thing, thanks to the lock-in, and has the added benefit of giving investors the choice of redemption at the end of the tenor. They also come with a performance track record stretching to 5-10 years, which is missing in case of new closed end funds.

Unlike in the case of closed-end funds, you can make regular investments or invest in systematic investment plans (SIPs) of these funds. But before doing so, do keep in mind that the lock-in period will apply to each SIP successively. This means that an investment made in, say, January 2015 will be available to you after January 2018, and one made in October 2015 will be available only after October 2018. This may be inconvenient if you want to withdraw in a lump sum at the end of the initial three-year period.

The category is worth looking at not just for your tax saving needs but also for your overall long-term investment requirements, especially if you lack the discipline to remain invested through short periods of market volatility. But the task to manage long-term investments would be yours.

Many fund houses have only one ELSS and hence, the focus is not divided across many funds within the same category. After your three-year lock-in is over, evaluate the performance of the scheme and then decide whether you want to remain invested for longer. Unless you need funds, it is always better to let equity investments remain for as long as possible. However, do keep in mind that this is an equity-linked investment and comes with a risk or uncertainty of returns. Returns are not assured as is the case with some other investments linked to the section 80C deduction.

ELSS – Ideal for Tax Savings and Wealth Creation

The ELSS funds have been successful in creating wealth for investors over longer period of time. The performances of the ELSS funds are determined by the stock market performance in general. If an investor, whose risk taking appetite is low, gets better tax-adjusted returns from other investment avenues like debt, he will prefer to go for that, as risk is lower. But over a longer period of time, ELSS funds are the best tax saving investment especially if you are willing to take a little amount of risk.

ELSS is suitable for investors with moderate to high-risk appetite with a long-term investment horizon. Keep in mind that returns in these schemes fluctuate depending upon the equity markets. In a nutshell the scheme does not guarantee any fixed amount of returns. So if you are one of those who would accept lower but guaranteed returns, then ELSS may not be the right product for you. So if you want to save taxes, invest for the long term, and get higher returns, then make sure you choose good ELSS funds having proven track records, for your portfolio. Though there is no age to get started on an ELSS, it is a 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.