FUND FLAVOUR

November 2019

ELSS –Tax saving and the power of compounding

Equity Linked Savings Scheme falls under the diversified category of mutual funds. While their maximum exposure is in equity and equity-oriented securities, a part of the corpus is also parked in debt. ELSS aims at providing the dual benefits of capital appreciation and tax savings, simultaneously. In the case of ELSS, an investor can stop contribution but cannot withdraw wholly or partially of his total investment before 3 years from the date of the first contribution. The amount invested up to a maximum of Rs. 1.5 Lakh in a year will qualify for tax deduction under Section 80C along with other instruments like Life Insurance Premium, PPF, etc. Since, it is equity linked mutual fund, there will not be any tax implication on the long-term capital gain as there is no tax on long-term capital gains for up to Rs. 1 lakh profit within a year, when you are selling the units after the 3-year mandatory lock-in period. Capital gains above Rs. 1 Lakh per year will be taxed at 10%.So, the sale proceeds after 3 years will be totally tax-free in your hands if the capital gains are less than Rs. 1 Lakh . You get tax deduction on investing also. Investments of up to Rs. 1.5 lakh made in ELSS qualify for an income tax deduction under the Section 80C of the Income Tax Act. This implies that if you have invested in ELSS, you can deduct the amount of your investment in an ELSS from your total income in order to eventually reduce your taxable income (or taxes). For example- Mr. X earns Rs.10 lakh per annum. On this income, he is liable to pay an income tax of 20%. If he does not invest any part of his income, he will be paying Rs. 1,25,000 (5% tax on 5 lakh- 25,000 and 20% on remaining 5 lakh- 1,00,000) as tax (excluding the amount of Educational cess). Now if he invests Rs. 1.5 lakh in ELSS, he will be liable to pay income tax on Rs. 8.5 lakh (10 lakh- 1.5 lakh). Hence, the amount of tax that he will pay will be Rs. 95,000 (5% on 5 lakh and 20% tax on 3.5 lakh) as tax (excluding the amount of Educational cess). ELSS is best suitable for young investors as they have time on their side to unleash the power of compounding to the fullest to enjoy high returns while saving on taxes of up to Rs 46,800 a year. You are free to invest either by giving lump sum amount at once or make investment via SIP route.

 

Why ELSS?

Here are some reasons that make equity linked saving scheme a better investment option.

·         Dual purpose investment: ELSS is a dual purpose investment. You can save tax as well as generate wealth by making the investment in ELSS

·         Lock-in period: An ELSS features the shortest lock-in period of 3 years among all the tax-saving investment options including fixed deposits, PPF (Public Provident Fund), NPS (National Pension System), NSC (National Savings Certificate), etc. thereby offering greater flexibility in the medium term.

·         Flexibility to choose the investment tenure: ELSS has no fixed maturity date or period. You can continue to hold ELSS as long as you can.

·         Curb volatility: ELSS funds curb the volatility associated with the stock market. Many retail investors get panic when they see their investments are losing value significantly. But after a certain period, the market recovers its loss and yields a significant return. As the ELSS scheme has a mandatory lock-in period of three years a market can never be downward for three years. It will definitely go upward and offer a superior return in the long term.

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Potentially higher market-linked Returns: Being a market-linked investment instrument, ELSS has the potential of giving relatively higher returns than other tax-saving instruments. Since it invests in a portfolio of equity instruments, ELSS can provide you returns ranging between 15%-18%. Fortunately being market-linked, tax saver mutual funds can provide potentially higher returns that can beat the adverse impact of inflation in the long term. This is the key reason why many individuals who make investments with the intention of planning for retirement or other future expenses have moved away from old school options such as fixed deposits and PPF to mutual funds and ELSS instead. In case of mutual funds such as ELSS, the potential returns being higher, these compounding benefits tend to add up faster for investors. It must however be pointed out that ELSS returns do not have a fixed ROI, hence during some periods, returns will be considerably higher than during other periods with historic long term average returns of equity schemes recorded at 12% per annum.

·         Taxation: In addition to qualifying for a tax deduction of up to Rs. 1.5 lakh under Section 80C of the Income Tax Act, ELSS provides other tax benefits as well. Unlike tax-saving fixed deposits, the returns generated by an ELSS are only partially taxable as long-term capital gains of up to Rs. 1 lakh on ELSS are tax-free.

·         SIP option: An ELSS is the only tax-saving instrument that comes with a SIP (Systematic Investment Option) which brings discipline in regular investing. With the SIP option, an investor can invest an amount as low as Rs. 500 in an ELSS along with getting the benefit of the power of compounding.

·         Affordability: You can start with a minimum of Rs. 500 or a lumpsum amount. There is no maximum limit to invest.

·         High levels of Transparency: Mutual fund houses i.e., AMCs who manage ELSS and other mutual fund schemes are regulated by SEBI. As per SEBI guidelines, AMCs have to make periodic disclosures regarding key information of all schemes managed by them. Information provided through these mandatory disclosures include Net Asset Value (NAV), assets under management (AUM), scheme returns over different periods, total expense ratio (TER), current asset allocation, etc. While some of these have to be reported daily, others need to be reported as per a monthly or quarterly schedule. As of now, no tax saver investment in India features a higher degree of transparency than ELSS. Hence tax saver mutual funds ensure that you always have the latest information regarding the status of your investments.

·         Ease of Investment The advent of internet and related technology has significantly eased the pains related to making tax saving investments. However, many traditional tax-saving schemes such as PPF still require you to physically queue up at a designated bank or post office so that you can subscribe to the chosen instruments. Not in case of tax saver mutual funds. After having adopted Aadhaar-based e-kyc the industry as a whole allows investors to start investing online without having to leave the comfort of their home or office. You can of course still complete an in-person biometric KYC at designated RTA locations, but the advantage of a completely-online eKYC for tax saving investments is currently only available to mutual fund investors.

Why not ELSS?

Investing in Equity Linked Savings Scheme has the following drawbacks:

·         Risk involved: In comparison with its investment counterparts (such as NSC and PP), investments in ELSS have higher level of risk involved as it deals with equity instruments and related securities.

·         Unavailability of Partial Redemption: The amount invested in an ELSS scheme can be withdrawn only after the tenure of 3 years is over. In comparison, other investment options such as Fixed Deposits, etc. do not have such conditions.

·         Investment Horizon: ELSS mutual funds have delivered good returns if invested for more than five years. An investor should enter into equity (or ELSS) only if the holding period is more than five years, and with proper asset allocation.

 

Emergence of ELSS

ELSS is emerging as one of the preferred tax investment instruments especially among new and young investors. The young investors having a long term investment horizon and having ability to bear market risks usually prefer ELSS as there is an option to withdraw any time after the initial  3 years lock in period, with potentially higher returns. The Assets Under management (AUM) of Indian mutual fund industry as on December 31, 2018 was Rs. 22.86 lakh crore according to AMFI (Association of Mutual Funds in India). Out of the total assets under management, ELSS- equity schemes represent approximately 4% i.e. Rs. 88,152 crore. There are 70 ELSS schemes and out of that approximately 95% of ELSS schemes are open end equity funds (42 funds) and balance in close end funds (28 funds). Traditionally people prefer public provident fund, national savings certificates, and insurance plans for tax savings. A comparison carried out by valueresearchonline.com, between ELSS and PPF (Public Provident Fund) shows that if Rs.1.5 lakh were invested every year starting from 1999 till 2018 for 20 years in ELSS growing at peer group average return, the total corpus would have been Rs. 2.3 crore as compared Rs.77.8 lakh if invested in Public Provident Fund during the same period.

Growth of ELSS

The Assets Under Management (AUM) of mutual fund industry has grown from Rs.97,028 Crore in 1999 to Rs.22,85,912 Crore in 2018 at a CAGR (compounded annualized growth rate) of 18.09% whereas the ELSS AUM has grown from Rs.2,663 Crore to Rs.88,152 Crore @CAGR of 20.22% during the same period. As the growth of ELSS was higher than mutual fund industry AUM growth, the share of wallet of ELSS AUM to total industry AUM has increased from 2.745% to 3.856% in last 19 years. As far as the number of ELSS schemes is concerned, it has increased from 65 in 1999 to 70 in 2018 both in close and open end category. The number of schemes has not increased because of regulatory restrictions on having multiple schemes in the same category and consolidation of similar schemes.

ELSS performance

Performance analysis is carried out for 28 open end ELSS schemes having more than Rs. 100 Crore Average Assets Under Management (AAUM) as on January 21, 2019. The largest fund in the group is Axis Long Term Equity Fund (Rs. 17,852 Crore) representing 20% of total ELSS AAUM of the industry and the smallest fund in size is Baroda ELSS 96 (Rs. 142 Crore) representing 0.16% of the industry ELSS AAUM. The total ELSS AAUM analysed is Rs.80593 Crore (91%) out of industry ELSS AAUM of Rs.88,152 Crore. The compounded annualized growth rate for the 28 funds is calculated for 1, 2 years, 3 years, 5 years and 10 years period as on January 21, 2019. Even though the performance is calculated for various periods, it is ideal to compare for 3 years and above period as the ELSS schemes are locked in for minimum 3 years period. For scheme comparison the Net Asset Value (NAV) of Growth options of schemes on various dates taken and appreciation in NAV measured from point to point. Based on the analysis, it is observed that the peer group average return of ELSS schemes as on January 21, 2019 for 1 year period was (-8.91)% as compared to (- 1.80)% of S&P BSE 200 benchmark index. All ELSS schemes understudy have given negative returns except Canara Robeco Equity Tax saver fund in one year period. For 2 years & 3 years period the peer group average of ELSS schemes has given positive returns but lower than the benchmark. There will be minimum lock in of 3 years for ELSS, therefore, it is ideal to compare for 3 years and above period. It is observed that for 3 years, 5 years and 10 years period the average returns of the peer group was 13.66% (benchmark 16.33%), 15.68% (benchmark 14.58%) and 18.03% (benchmark 17.62%).

The latest S&P Indices Versus Active India Scorecard reveals that over the one-year period ending June 2019, 80.95 % of Indian ELSS funds, 76.67% of large-cap equity funds, 76.92% of Indian Government Bond Funds and more than 95% of Indian Composite Bond funds underperformed their respective indices. In fact, across all the periods studied, the majority of actively managed large-cap equity funds in India underperformed the S&P BSE 100. Large-cap funds witnessed a low style consistency of 16.67% over the ten-year period and a low survivorship rate of 68.33%. Over the 10-year period, the return spread for actively managed mid/small-cap equity funds, between the first and the third quartile break points of the fund performance, stood at 3.94%, pointing to a relatively large spread in fund returns. Meanwhile, the return spread for actively managed large-cap equity funds was lower at 2.98% over the same period. The asset-weighted return for large-cap equity funds was 85 basis points higher than the equal-weighted return over the 10-year period. During the same period, the asset-weighted return of Indian Equity Mid-/Small-Cap funds was 22 basis points higher than their equal-weighted fund return. Over a 10-year period, the return spread between the first and third quartile break points of the fund performance was 3.20% for Indian ELSS funds.

How to invest in ELSS through online and offline modes

Individuals can invest in ELSS using both online and offline modes. The requirements for both are as follows:

·         Online Investment: To invest in ELSS using the online medium, investors must complete their online registration by doing Aadhar-based KYC. Once the verification is done, you will receive a pre-filled bank mandate on your email, post which a final confirmation email with your FATCA details from NSE will be sent.

·         Offline Investment: To invest using the offline mode, you still need to complete your KYC first. For this, you will be required to carry documents such as Aadhaar, PAN card, post-dated cheques in favor of the mutual fund scheme are submitted with the bank. Investors can also contact the fund advisor for the same.

 

ELSS Evaluation

 

While selecting a fund, you should analyse and compare different parameters of various funds before choosing one. Also, investing depends on an individual’s financial goals, investment horizon, and risk appetite. In order to choose the best ELSS funds we can take the following parameters into consideration:

Consistent performance and track record
Expense Ratio
Asset size i.e. Assets under management (AUM)
Judge the portfolio characteristics
Financial Parameters
Investment Rating

When you select ELSS, give importance to the ones that have a consistent performance track record and follow robust investment processes and systems at the fund house. Looking for ELSS with a consistent performance track record, besides qualitative aspects like fund house pedigree, and investment process, quality of the fund management team among others is imperative.

Expense ratio is a charge that your Mutual fund Company or your agent/distributor/broker imposes for its services. You may rather increase your investment amount via SIP instead of increasing the number of your ELSS mutual fund.

The lower the asset size of your equity mutual fund the higher the risk involved. So you need to choose such an ELSS mutual fund which has a comfortable asset size.

The portfolio quality of an ELSS points could signal how the fund is likely to perform in the future. Ideally, an ELSS should not hold a very concentrated portfolio, since it heightens the risk involved. The portfolio of a fund should be well-diversified and the exposure to the top-10 stocks should be ideally under 50% while concentration to one particular sector should not exceed 30-35%. Further, the ELSS should not be churning the portfolio very often. Portfolio churning is indicated by the portfolio turnover, which ideally should not exceed 100%. Penalise a fund with a high portfolio turnover ratio.

Consider various parameters such as Standard Deviation, Sharpe ratio, Sortino ratio, Alpha, and Beta to analyse the performance of a fund. A fund having a higher standard deviation and beta is riskier than a fund having a lower deviation and beta. Choose funds having a higher Sharpe Ratio as they offer higher returns for each additional risk you take. The person who is managing the fund plays a key role in building fund trust. The fund manager plays a vital role as his competency skills and experience helps to build confidence as picking up the right stocks and creating a strong portfolio is what helps the fund to deliver high returns. Compare the performance of ELSS across bull and bear market phases to ascertain how best the scheme is able to get the most out of the bull phase and also how well it has been able to arrest the downside during the bear phase.

There are many rating agencies which are in operation like Crisil, Morgan-Stanley, Value Research, Standard & Poor etc. You have to follow the rating given by these rating agencies. Generally, A+ or Rank 1 or 5-Star rating is an ideal investment grade of an ELSS in which you are free to invest your hard earned money.

 

The ELSS Journey…

Include your ELSS investments in your overall financial plan. They are ideal to meet your long-term financial goals. You need not rush to redeem them as soon as they complete the mandatory lock-in period of three years. You may hold on to these schemes as long as they are performing well. You can sell them a year or two before (even earlier) the financial goal assigned to them. Selecting the best ELSS requires some hard-work and data crunching on your part, as an investor. While selecting your ELSS fund, remember that it is a long term commitment. Always go with the fund houses that have a reputation to protect. Five year returns are ideal as they give a long term perspective. However, in case of ELSS (considering its lock-in of 3 years), you must also look at 3-year returns to ensure that the exit cost is not too high. A small variance with the 5 year returns is understandable but wild variations are a sign of inconsistency. One year returns are meant to judge the short term flexibility of the fund manager and to keep a tab on whether the fund is trying to be too aggressive in search of returns. This can be a good starting point for your ELSS journey!