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Equity Linked Savings Schemes (ELSS)

Equity Linked Savings Schemes
The Equity Linked Savings Schemes are popularly known as ELSS. ELSS is a
variant of diversified equity funds however these schemes come along with
income tax benefits. Investment in ELSS is eligible for a tax deduction under
section 80 (C) of the Income Tax Act. However the income tax deduction
comes with a lock-in-period of 3 years. ELSS are governed by ELSS 2005
guidelines of Central Board for Direct Taxes, Ministry of Finance, Govt. of
India apart from the usual SEBI (Mutual Funds) Regulations, 1996.

ELSS – More Than Just A Tax Saver

An ELSS fund is very similar to an equity fund. The main difference however
is a three-year lock-in period which means you cannot withdraw your money
for the first three years. This may seem harsh, but the lock-in period can work
to your advantage. Why? Because it helps the fund manager to build a
portfolio without worrying about holding large amounts of cash to service
redemptions. This means the fund manager can devote a larger portion of the
portfolio to equities, which have the potential to perform better.

While past performance does not guarantee future returns, you can see that
the ELSS lock-in rule (though it may seem like bitter medicine at the start of
the investment period) has provided the impetus for out-performance.

Which Tax Saver Is Right For You?

Section 80c offers you the flexibility to offset up to Rs.1lakh of your annual
income against long term commitments including life insurance premiums,
housing loan repayments and educations fees. Alternatively you can choose to
make investment for your future. Or, combine both! If you are opting to
invest, the key is to choose the route that suite your personal circumstances
and attitude towards risk.

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Here’s an overview of some popular tax savers:

PPF, NSC, KVP and Infrastructure bonds earn a fixed rate of interest
every year (or every six months, as the case may be), Many of these options
are considered ‘safe’. Since they are backed by the government or by
established

banks and financial institutions. However, none of these instruments are safe
from inflation! PPF currently provides 8% a year, NSCs fetch you a return of
around 8% a year (interest earned is subject to tax), and infrastructure bonds
return about 5-6% a year (again, subject to taxes). With inflation currently
ranging between 4-6% every year, real returns on these investments may not
be very high.

Insurance Policies: Generally return a pre-determined amount on maturity.

However, some unit linked plans are an exception, but they are not actually
investments in the strict sense- a part of the amount goes towards providing
insurance cover – which does not earn you a return, while the balance goes
into long term investments.

While fixed rate savings and insurance are useful in their own right and
should be part of a well-balanced portfolio, if you are looking for tax benefits
coupled portfolio, if you are looking for tax benefits coupled with the earning
potential of equities, then consider an ELSS.

Risk and return: Such schemes carry the same risk as equity diversified
schemes. Yet they could deliver better returns since the lock in period gives
the scheme’s fund manager the freedom to invest without fear of redemption
pressures.

Suitability: These schemes are suitable for investors who are looking for a
tax break from their mutual fund investment and can safely lock away their
funds for a period of three years.

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Invest systematically through the ups and downs

The Easy and Affordable Way to Build Your Investment
If you don’t have immediate access to a large amount of ready cash, investing
a regular amount each month can help you build up a lump sum and benefit
from growth potential of the stock market.

Saving on a regular basis in this way is easy as you treat your investment as
part of your monthly budget. What’s more, you can benefit no matter how the
markets are performing:

Saving regularly allows you to capitalize on a phenomenon called “rupee cost

averaging”, illustrated in the following tables. This compares the returns
achieved by a lump-sum investor and someone who saves the same amount
every month for six months.

The regular saver finishes the period with a investment that is worth more
than that of the lump-sum investor-even though the starting price, finishing
price and average price are exactly the same. It sounds unlikely, but it’s true.
Check the figures for yourself!

• If the market goes up, the units you already own will increase in value.
• If the market goes down, your next payment will buy more units.

Lump-Sum Investor Regular Saver

Amount
Unit Price Unit Amount Units
Month Invested
(Rs.) Bought Invested (Rs.) Bought
(Rs.)
1 20 60,000 3,000 10,000 500
2 18 - - 10,000 555
3 14 - - 10,000 714
4 22 - - 10,000 454
5 26 - - 10,000 384
6 20 - - 10,000 500
Total Invested (Rs.) 60,000 60,000
Average Price Paid (Rs.) 20 20
Total Number Of Units Bought 3,000 3,107
Value Of Investment After
60,000 62,140
Six Months (Rs.)

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5 point checklist for tax-saving mutual funds

Tax-saving funds are a great way for risk-taking investors to invest their
monies for the long-term and earn tax benefits on the side.
However, selecting the right tax-saving fund is not so simple. There is a need,
as with regular diversified equity funds, to evaluate tax-saving funds on
critical parameters to ensure that you don't invest in the wrong scheme.
Remember, all tax-saving funds offer a tax benefit, so there isn't much to
choose from over that parameter, but not all tax-saving funds make great
investments, so there is plenty of evaluation to be done before you short-list
the right tax-saving funds.
We have formulated a 5-step strategy for every investor looking at investing
in tax-saving funds.
1. Assess your risk profile
Since investing to save tax is no different than investing for retirement or for
child's education, investors need to consider the important principles of
investing while selecting tax-saving funds. That is why it is important for you
to have your eye on your risk profile at all times.
While, it is a given that a tax-saving fund investor has the requisite risk
appetite, it still does not make his task any simple. The reason is that there
are plenty of tax-saving funds out there that pursue varying investment styles.
So you must find the one that best suits your own risk profile.
For instance, HDFC Tax Saver is an aggressively managed, growth style, tax-
saving fund. Another fund from the same fund house -- HDFC Long Term
Advantage -- is a value style fund and hence conservatively managed.
As an investor you have to evaluate where you fit in -- with the aggressive
fund or the conservative one.

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2. Evaluate the fund house

Since the fund house plays a vital role in the performance of every scheme, it
is crucial for investors to identify the right fund house while choosing a tax-
saving fund.
Investors must avoid fund houses that are overly dependent on star fund
managers. Because when a star fund manager leaves, he takes the
performance with him. And given that tax-saving funds that have a 3-year
lock-in, you can't even chase the star fund manager (we don't recommend it
anyways). So it's important that you go for fund houses that are managed by
teams.
Teams are usually guided by well-documented processes and systems (like
having investment caps on individuals stocks or sectors), which make
individual fund managers dispensable. Over the long-term, it is best to be
'married' to a team than an individual.
Our research team has come across instances of both -- fund houses run by
teams as well as those run by star fund managers. Franklin Templeton Mutual
Fund, HDFC Mutual Fund, DSP Merrill Lynch Mutual Fund are some of the
fund houses that are run by teams.
SBI Mutual Fund, which owns the popular brand of Magnum funds, for a
long time had a star fund manager who propelled the fund house to great
heights. But even this fund house has realised the perils of relying too much
on one individual; they are now setting up processes to de-risk an individual
fund manager's departure.
3. Compare returns over 3-year period
Once you have a fix on the fund house with processes, your scanner must
now shift to the tax-saving fund's performance. Too many investors are
obsessed with short-term performance (1-month, 6-month, 1-year) while
evaluating equity funds. Comparing returns over such short periods of time in
an equity investment is unreasonable, even more so for tax-saving funds
because of the mandatory 3-year lock-in period.

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Hence the 3-year period should be treated as the minimum time frame for
evaluating the performance of a tax-saving fund (as also all other equity
investments).
While evaluating performance, it is important to note how the fund has fared
over varying time periods. Every equity fund has its day under the sun during
a bull run; it's the bear phase that separates the experts from the punters.
So your view on a tax-saving fund should not be based on its performance on
the last rally, it should be dictated based on its performance on the last market
downturn.
4. Compare performance on the risk parameters
The NAV performance is not the only parameter to be considered for
evaluation in your quest for a well-managed tax-saving fund. Parameters like
Standard Deviation and Sharpe Ratio must be given equal weightage.
How often have we seen a diversified equity fund deliver a brilliant
performance on the 'NAV return' parameter by sacrificing all the rules of
prudent investing and making aggressive investments across stocks and
sectors and apportioning an above-average allocation to high risk investments
like mid cap stocks or technology stocks for instance.
Therefore it's important for investors to keep an eye on the risk that the fund
has taken to deliver that high-voltage performance. Risk parameters like
Standard Deviation and Sharpe Ratio are important indicators.
Standard Deviation measures the degree of volatility that a fund exposes its
investors to. Similarly, Sharpe Ratio is used to measure the returns delivered
per unit of risk borne.
The ideal combination for an equity/tax-saving fund is lower Standard
Deviation (i.e. lower volatility) and higher Sharpe Ratio (i.e. higher return vis
the risk-free investment).

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5. Select the right option

The 3-year lock-in makes tax-saving funds relatively illiquid. While all equity
investments must be made with a 3-year investment time frame, with tax-
saving funds, this is 'imposed' on the investor.
For investors who want to eke out some liquidity (over the lock-in period)
from a tax-saving fund, there is the dividend option. Tax-saving funds like
regular equity funds declare dividends (although this is not assured and
depends mainly on the performance of the fund) at periodic intervals.
Investors who want a cash flow (even if at infrequent intervals) can opt for
the dividend option.
Investors not looking for a cash flow should opt for the growth option. Over
the long- term it is best to be invested with this option as taking out money
from your investment (by way of dividends) works against the principle of
compounding.

Pension schemes – are also allowed the same tax break that is applicable to
ELSS, i.e., an investor can claim a deduction from taxable income for
payments made to specified pension plans, up to a limit of Rs.1 lakh under
Section 80C of the Income Tax Act. These funds aim to build up a corpus for
investors that can be converted into an annuity on retirement. This annuity
will ensure that the investor receives a regular stream of income post
retirement.

Risk and return: These schemes invest most of their funds in conservative
instruments since capital preservation is their prime objective. Accordingly,
the risk exposure of such funds is minimal.

Suitability: Such schemes are ideal for individuals who are currently in a
high tax bracket due to the magnitude of their current income but expect to
witness a drastic fall in income post retirement.

Such individuals can avail of the dual benefit of a tax break at present along
with the comfort that they are saving for their post-retirement years.

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