FUND FLAVOUR

November 2016

Beyond tax-saving - two birds with one stone!

The positioning of the Equity Linked Savings Scheme (ELSS) is unique within the universe of instruments in which one can save and invest to bring down the income tax liability. ELSS is also the most unique mutual fund scheme as it is open for investments to only individual taxpayers and HUFs (Hindu Undivided Families). This diversified equity fund is approved by the Central Board of Direct Taxes (CBDT) to qualify as a tax-saving instrument. So, investments in this fund qualify for tax exemption under Section 80C of the Income Tax Act, 1961. The mutual fund structure ensures that these funds come with the dual advantage of capital appreciation and tax benefits. What this means is that by investing in ELSS, you effectively hit two birds with one stone — you can claim deductions under Section 80C of up to Rs.1.5 lakh besides being capable of generating a substantial amount of profit on a long-term basis. ELSS funds come with a lock-in period of three years, which means you can redeem them only after 3 years.  This works to your benefit, because the fund manager is in a position to take the best picks and channelize your investments in the best stocks for optimal returns.

A smart option…

Though not fixed or guaranteed, ELSS funds do provide higher returns than the other tax-saving schemes under section 80C, like PPF and NSC.

ELSS funds also have the lowest lock-in period of three years, unlike the other tax-saving investment options listed under section 80C.

These funds offer a dividend option which gives you a regular income during the lock-in period.

You can choose to invest in an ELSS fund through a Systematic Investment Plan (SIP) if you do not have enough money to make a lump-sum investment at once. SIP is the best mode of investing in ELSS funds for a number of reasons. SIP helps you to stay disciplined in tax savings and investments. SIP is convenient. If you start a long term SIP in a good ELSS fund, your tax savings, at least as far as ELSS is concerned, is in an auto pilot mode. If you start your tax saving investments later in the year, you miss out on a large part of the returns, generated during the year. This is not just true for ELSS, but for other 80C investments as well. SIP may help you get superior long term returns through the principle of rupee cost averaging.

ELSS funds are also the most tax efficient of the 80C options available. Dividends paid from these investments are completely tax-free, and capital gains received at the end of the three-year lock-in period are completely exempt from tax as well as they qualify as long-term capital gains from equity instruments.

…and the caveats

ELSS investments are equity mutual funds and have all the risks associated with the equity market. With a lock-in period of 3 years the risk factor seems augmented in the case of ELSS, but diversification of funds over a long period of time mitigates the associated risks. The good news is that the recent market analysis paints a much better performance picture for ELSS funds than the other diversified funds. ELSS funds have given an annual return of over 15%, whereas the diversified mutual funds over the same range of time have performed marginally lower than ELSS funds, at 14.3% annual returns.

In addition, 3-year lock-in period means less liquidity for the investor but it is a matter of solace for the fund manager, who is reliable in making long term investment decisions. These decisions invariably turn out to be beneficial for the investor.

Some people like to take SIP route for their ELSS investment. In such an event, each SIP installment is regarded as a separate investment and each of these monthly installments is locked for a period of 3 years.  For example, if you make a SIP payment in January of 2016 then you will be eligible for a withdrawal only in January 2019. And for your next SIP installment in February 2016, the withdrawal time will be February of 2019. So if there is no constraint on how much you can invest, then investing a lump sum annually or quarterly is a better choice than to go for the SIP option.

Tax benefits on investment in ELSS may soon be phased out with the introduction of direct tax code.

Ahead of the herd

At present, there are 22 ELSS schemes to choose from, which collectively manage assets amounting to Rs.37,290 crore, which is 12% of the equity component of the mutual fund industry assets according to AMFI. What this means for you as a taxpayer is that you can use the different benchmarks, portfolios, and investment approaches to select a fund that allows you to meet your twin needs of tax saving and wealth creation. These schemes have gone ahead to deliver superior returns than regular open-ended, non-ELSS mutual funds, due to certain inherent features of the scheme. Namely, ELSS funds, in general follow a passive and growth style of investment, which allows fund managers to take longer term calls and sustain it. The redemption pressure is the lowest in these schemes, compared to regular funds that again give the fund managers the leeway to take long term calls, especially in mid and small sized companies. Thanks to the ease of investing and the continued patronage of fiscal policymakers, today ELSS funds stand deviated from age-old LIC-for-tax-saving mindset and in turn provide the business world with the household supply of capital. Almost every fund house, excluding few newer ones, offers at least one ELSS product as part of its product portfolio. There are schemes that have been consistently delivering better returns than their own non-ELSS counterparts. That does not mean, an individual can consider investing all his ELSS allocation into one fund, nor does it also mean he can take smaller exposures into a number of funds. Remember, too much diversification eats away into the superlative performance of any individual fund. ELSS did not just beat diversified equity mutual funds in terms of average category returns; it also beat diversified equity funds in terms of most other category parameters like maximum return within category, minimum return within category, and median category returns.

Choice considerations

      It is advisable that the fund should be well settled in terms of its capital. So, Assets Under management (AUM) should be approximately greater than Rs. 1000 Cr.

         If the fund is performing well in the past, it is expected that the fund will keep performing well in the future. Generally we look at the past 3 year, 5 year, and 10 year returns of the fund.

·         Lower the expense ratio, higher the returns.

·        Beta is the volatility measure and tells how much the fund changes for a given change in the Index. Lower the beta, lower the volatility. Hence, your fund must have lower beta.

·     Standard deviation indicates the extent of deviation of fund returns from the average. Lower the standard deviation, lower the volatility. Hence, your fund must have lower standard deviation.

·        Sharpe ratio is used to calculate risk factor of the fund’s portfolio. Sharpe ratio of the fund should be close to 1.

·       Alpha is the risk-adjusted measure. By taking risks, how much the fund manager generated returns over the benchmark. Higher the alpha, higher the out performance of the fund.

·        Information Ratio is calculated by average excess return obtained compared to a benchmark and divided by the standard deviation of excess returns. Higher the information ratio, higher the consistency in beating the benchmark.

·         R-squared is the measure of how correlated the fund’s NAV movement is with its index.

Equity exposure to battle inflation

One of the biggest challenges that every taxpayer faces is to preserve the value of his money; basically ensure that it does not lose its worth, which is possible only if it beats inflation. The only known asset class that beats inflation in the long run is equity and it is for this reason that every taxpayer should make the most of the available tax deduction that can be deployed in suitable equity instruments. Compared to other fixed-return options, ELSS is the only option with significant equity orientation as a tax saver. Though the National Pension System (NPS) and even ULIPs have equity exposure, it is never as high as what ELSS tends to have. ELSS has a minimum exposure of 65% to equities compared to the maximum exposure of 50% allowed under the NPS and 40% in retirement plans from mutual funds. If you look a bit deeper into the equity allocation of some of the ELSS funds, it goes as high as 80-85%, or more. Yes, this does expose your investments to higher risk, however, the three-year lock-in when investing in these funds buffers the risk significantly.

Investors should always remember that, conditions in equity markets are constantly changing affecting the asset prices; volatility is an intrinsic characteristic of equity as an asset class. While, volatility is a function of investment horizon and decreases as the horizon lengthens, anecdotal evidence shows us that, fund managers who were able to outperform the market when it was rising and at the same time protected against downside when it was falling, were able to give superior long term returns and a majority of the ELSS funds fit the bill.