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.
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