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Citrus Analysis: Combine tax saving with high returns
Mon, Dec 10, 2012
Source : Sanjay Kumar Singh, Citrus Interactive

With just four months to go before the current financial year comes to an end, salaried employees would have received letters from their human resource departments requesting them to provide proof of tax-saving investments. All those who did not begin to invest systematically in tax-savings schemes from the beginning of the financial year would now be scrambling to make these investments. With equity markets having run up about 26 per cent year-to-date (December 6, 2012) and equity-linked savings schemes (ELSS) having turned in a stellar (see table below), these funds are likely to be among the top choices of many investors.

 

YTD

1-yr

3-yr

5-yr

10-yr

ELSS funds (Category average)

31.18

20.68

6.21

-0.08

22.26

All figures in %; as on December 6, 2012    

Why invest in ELSS funds

ELSS funds offer several advantages. One, no other financial instrument offers the dual advantage of equity investment (the asset class that offers the best returns over the long term) combined with tax benefits. Hence, ELSS is useful for people (especially the young who are short of funds) who are looking for dual solutions (tax planning and investment planning) out of the same corpus of money.  

Two, ELSS offers more flexibility than the other popular tax-saving product, Ulip. Exiting Ulips before five years is not possible now. On the other hand, if the ELSS scheme you are investing in underperforms, you can invest in another scheme next year and exit your investments in the current scheme after three years.  

Three, when you invest in an ELSS fund via systematic investment plan, it leads to enforced saving. This is especially useful for people who lack the discipline to save every month in order to meet their tax-planning needs.

 And four, ELSS allows you to recycle the same money, a characteristic that is again useful for people who are short of funds. After three years you can take out the money invested in an ELSS fund and invest it again to reap the benefit of tax deduction. In tax saving instruments with longer tenures, this is not possible. (However, this recycling is not something that we recommend unless you are short of funds; it may be wiser to let the money remain invested in the ELSS fund even after the completion of three years, unless the fund is underperforming, in order to build wealth over the long-term.)

Product mix to use for tax saving   

Of the many tax-saving products available, which ones you should use for meeting your Section 80C limit of Rs 1 lakh should depend on your financial goals, age and asset allocation.   

At a simplistic level, Employee Provident Fund (EPF) should be the first instrument for the salaried employee and Public Provident Fund (PPF) for the self-employed. If a person is relatively young (say, up to the age of 40-45) and requires protection against contingencies, then EPF/PPF should be followed by term insurance and then by ELSS.

Older people, who have already gathered the assets required to provide for their family's needs, should invest in EPF followed by ELSS.

Choosing the right ELSS fund

Investors looking for the right ELSS fund should take a number of factors into account:  

Performance. Check rolling returns over different time periods (six months, one-, three- and five years) and see whether the fund has beaten its benchmark both over the long term and the short term. Furthermore, make sure that the fund has been consistent. You may check this by comparing the fund's returns in different calendar years (at least the last five) with its benchmark’s returns. Even if a fund’s absolute returns are high, consistency is important because it is difficult for investors to stick to a volatile fund.

Risk and risk-adjusted return. In his seminal book "Common sense on mutual funds", Vanguard founder John Bogle says that while there is very little correlation between past returns and future returns, a fund’s level of risk remains remarkably consistent over a long period of time.

Bogle adds that a number of funds manage to earn good returns by adopting risky strategies. Investors who invest in such funds after looking up past returns often suffer as such funds are unable to sustain their high performance for long. Hence, not only should one ensure that the fund has high and consistent returns, these returns should also be accompanied by low risk and high risk-adjusted returns.

The median Sharpe ratio (a measure of risk-adjusted return) for ELSS funds comes to 0.0181 (calculated over three years; source: Ace MF), so you could look for a fund with a number higher than this. The median beta (a measure of risk) for this category is 0.8089 (again calculated over three years), so you could look for a fund with a figure lower than this.      

Corpus size. In the case of ELSS funds, corpus size ranges from Rs 2 crore to Rs. 4,714.76 crore. According to Vishal Dhawan, founder and chief financial planner of Plan Ahead Wealth Advisers, "If the ELSS fund you are investing in has a large-cap orientation, then you should not worry too much about large AUM. It is not likely to be a deterrent to performance. However, very large AUM size funds should be avoided if the ELSS fund is mid-cap oriented."

Dhawan further advises that on the lower side corpus size should be at least Rs 100 crore. "The management fee that the fund manager earns from the fund should be sufficient. If it is very small, then the fund may not get the required attention from the fund manager," he says.

Style sheet. If an ELSS fund is your first or only equity investment (as is the case with many young people), then it should definitely be a large-cap growth or large-cap blend fund. First-time investors should avoid the volatility of a mid-cap oriented fund.

However, if you already own several equity funds, then do look up the fund's style sheet. Avoid overlap between the funds already present in your portfolio and the ELSS fund you are adding to it. To cite an example, if you already have a couple of large-cap funds in your equity portfolio, then opt for a multi-cap or mid-cap oriented ELSS fund.

Expense ratio. A lower expense ratio is definitely advantageous for investors. In India a lower expense ratio is accompanied by larger AUM size. And usually funds that manage to accumulate a large AUM do so based on the strength of their performance. Hence, give preference to a fund with a lower expense ratio provided it is accompanied by a sound track record.

The median expense ratio for the ELSS category is 2.43 per cent, hence you could give preference to funds with an expense ratio lower than this.

The ELSS schemes that we recommend based on some of the criteria mentioned above include Reliance Tax Saver (ELSS) Fund, DSPBR Tax Saver Fund, ICICI Pru Tax Plan and Canara Robeco Equity Tax Saver Fund and Do read detailed analyses of these ELSS funds on our website before you make a choice.

Advantages of ELSS funds
  • Shortest lock-in period among instruments eligible for tax deduction under Section 80C.
  • Good instrument for youngsters entering the equity markets for the first time.
  • Due to three-year lock in, fund manager does not have to worry about redemptions and can take a longer-term view on equities.

Points to remember

  • Even if only four months are left, use SIP to take advantage of rupee cost averaging.
  • Once Direct Tax Code (DTC) is implemented, ELSS may not be eligible for tax benefit. Take advantage while the opportunity exists.
 
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