INVESTMENTS SHOULD never be made under duress; they should be the outcome of either discipline or opportunity. Unfortunately, most of us still wait for the March deadline to near before rushing in to make our tax investments. With saving tax the prime motive behind such investments, performance often tends to get the short straw in this investing equation. If you’re going to follow this last-minute approach, you might end up passing up a great returns-cum-tax saving opportunity going in the equity market today.
The tax edge. Do you know that if your annual taxable income is between Rs 1.5 lakh and Rs 5 lakh, you can effectively buy the BSE (Bombay Stock Exchange) Sensex 15 per cent below its current 3,050 levels, near its eight-year low of 2,600. It gets better if your annual taxable income is between Rs 1 lakh and Rs 1.5 lakh–your discount goes up to 20 per cent. And if your annual taxable income is less than Rs 1 lakh, the discount goes up to 30 per cent, which means you can buy the Sensex at 2,135.
Sounds too good to be true? Well, it’s for real. When you invest in equity-linked savings schemes (ELSS) of mutual funds, your effective acquisition cost drops 15-30 per cent, depending on your annual income. That’s because investments in ELSS qualify for a tax rebate under Section 88. Thus, if your annual taxable income is between Rs 1.5 lakh and Rs 5 lakh, you can claim a 15 per cent tax rebate on investments in ELSS, subject to a maximum investment of Rs 10,000 in a financial year. This is within the overall Section 88 investment limit of Rs 80,000. So, if you invest Rs 10,000 in an ELSS, you pay the taxman Rs 1,500 less. Alternatively, your investment cost stands reduced by 15-30 per cent, as explained through the Sensex example above. There’s one rider, though: your investment is subject to a lock-in of three years.
Bottoms up. Although you can also avail of the same Section 88 rebate through debt instruments, there’s one compelling reason why you should consider exhausting your Rs 10,000 annual ELSS limit now: great odds to take home top returns without stretching yourself on the risk scale.
The Section 88 debt instruments practically offer risk-free, assured returns, but these are moderate single-digit returns. By comparison, returns from equity instruments (like ELSS) are uncertain, but the upside can be huge, provided you invest in a well-performing scheme when the market is near its bottom, as this one appears to be.
This fact is borne out by the performance since the previous market bottom in October 1998 of the top two ELSSs. During this period, the Sensex has come full circle– it has gone up from about 3,000 to cross 6,000, before slipping back to 3,000 again. However, top-performing ELSSs like Alliance Tax Relief 96 and Zurich (I) Tax Saver have both given annualised returns worthy of equities, even in a roller-coaster market . Even if you didn’t catch the bottom but invested somewhere close to it, you would still have had similar returns to show.
The current market situation is similar to the one in October 1998. The market is edgy and threatening to dip further, but rock-bottom valuations mean that it is unlikely to fall dramatically. More importantly, it promises a big upside from current levels. If you invest in an ELSS today, there’s a good chance you are getting in near a bottom, and therefore stand to reap the strong returns that equities are known to give over a three- to five-year period.
The key is in the lock. The low valuations in the market aside, the very nature of an ELSS–the terms and conditions mandated for investments– suits an equity investment made for at least three years.
On the face of it, the three-year lock-in stipulation might seem harsh, even a deterrent to investing in an ELSS, but it has its advantages. By forcing you to take a long-term view on the market, it induces discipline into your investing habits. You can lock yourself in at low valuations, but you also have to give your investment time to work for you.
The lock-in, along with the ceiling of Rs 10,000 for availing tax rebates, also lends an element of stability to ELSS portfolios. It keeps corporate money out, which means these schemes don’t have to deal with sudden, large-scale redemptions. As a result, ELSSs tend to have a more stable corpus and an optimum corpus size, which encourages good fund management.
This gives ELSS fund managers more leeway to plan their portfolios than those of conventional equity funds, who have to contend with unpredictable redemptions (often large-scale ones). No surprise then that most ELSSs are doing better than their open-ended diversified peers.
WHAT TO LOOK FOR IN AN ELSS
There are 59 ELSSs in the market. Of these, 36 are closed-end schemes, which makes your task easier, as such schemes don’t make fresh sales. That leaves 23 open-ended schemes. Needless to say, all of them are not at par. As a group, these 23 schemes have shown an annualised gain of a measly 2.5 per cent in the past three years. That’s better than the performance of the Sensex during the same period (down 13.3 per cent a year), but less than the yields from Section 88 debt instruments. Hence, you need to be selective. Look for two basic attributes in an ELSS:
- Good track-record in fund management. Broadly speaking, the big, private fund houses have done well, while the performance of the public sector fund houses has been patchy.
- Portfolio diversification across sectors and companies. This is important, as the lock-in means you cannot make a mid-course switch.
Of the ELSSs in the market, our picks are Franklin India Tax Shield (formerly Pioneer ITI Tax Shield), Zurich (I) Tax Saver (Div) and Alliance Tax Relief 96. In addition to meeting our two-fold investment criteria, they have performed impeccably in good markets and held their own in bad markets–in the past three years, for instance, each has given an annualised pre-tax return of 20 per cent-plus (See table: Advantage ELSS).
Alternatively, you can opt for the passive option–an index fund. At present, the only index fund that offers the ELSS option is Franklin India Index Tax Fund (linked to the Nifty); more fund houses plan to extend the ELSS option on their index funds. However, a caveat is merited here: a holding period of three years could be inadequate to optimise gains from an index fund. In the past decade, the market has moved in a range. Since index funds don’t book profits and you can’t during the lock-in period, you might just end up where you started after three years. Therefore, it’s preferable to go with an actively managed ELSS.
Advantage ELSS | ||
Scheme | Returns (%) | |
Pre-tax | Post-tax | |
Franklin Tax Shield (G) | 28.7a | 25.9b |
Alliance Tax Relief 96 | 20.8a | 18.8b |
PPF | 9 | 9 |
NSC | 9 | 6.2c |
NSS | 8.5 | 5.8c |
Infrastructure bonds | 9 | 6.2c |
a Based on performance over the past three years, and therefore only indicative | ||
WHEN SHOULD YOU EXIT?
Once you complete three years in an ELSS, review your investment. After all, one of your objectives (the tax rebate) has been met. Tax laws don’t allow a rollover for claiming the Section 88 benefit–they insist on fresh investments. Hence, evaluate your "matured" ELSS investment as a normal equity investment–your decision to stay on or exit should be based on your perception of the market.
At the same time, if you feel the market offers value over a period of three years or more, utilise your Rs 10,000 limit for that financial year. You can do that by investing an additional Rs 10,000 in the same scheme or in another. Or, you can withdraw the earlier ELSS investment, reinvest an identical amount again, and claim the Section 88 benefit again. The best time to get into an ELSS is when the market is at or near its bottom–and this is as good an opportunity as you are likely to get.
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