Beating The Street

Equity Linked Savings Schemes are superior alternatives to plain-vanilla equity funds, thanks to the tax advantages they offer

Once again, it is that time of the year when people are busy scouting for tax-planning instruments. Conventionally, government guaranteed schemes like the Public Provident Fund and National Savings Certificates have attracted huge sums. While the high rate of return they offer makes them extremely lucrative investment vehicles, there is no scope of capital appreciation beyond what is promised. It is here that an Equity Linked Savings Scheme (ELSS) can provide a boost to the returns on your entire portfolio.

Equity Linked Savings Schemes were introduced by the government as tax savings instruments in the beginning of the last decade to give a boost to capital markets. What makes ELSS a unique tax-saving vehicle is that it is the only equity product available with a tax relief. As equities are deemed the best long-term investment vehicles, they must find a place in the investors' portfolio. Also, ELSS has the shortest lock-in period among tax-saving instruments. These funds offer 20 per cent tax rebate for investments up to Rs 10,000 with a three year lock-in period under section 88 of the Income Tax Act. For instance, if the tax liability of an investor is Rs 3000 and he invests Rs 5000 in ELSS, 20 per cent of Rs 5000, or Rs 1000, would be reduced from his tax liability, thus bringing the liability down to Rs 2000.

 

ELSS is similar to diversified equity funds except that it offers the additional merit of tax benefits. At all times, ELSS deploys over 90 per cent of the corpus in equity or equity-related instruments. In other words, it invests in a portfolio of shares, and as the value of shares fluctuates, the net asset value (NAV) of ELSS also changes. Like other mutual funds, an ELSS declares its NAV on a daily basis and investors can invest in itbased on daily NAVs.

Unlike three years ago, ELSSs are now allowed to be structured as open-ended funds. With the introduction of an open-ended structure, these funds undoubtedly look like superior tax planning vehicles. This open-ended structure provides for natural product enhancements with features of a regular investment plan (rupee cost averaging) which could be of special appeal to marginal taxpayers while planning investments. Right in the beginning of the year, the investor can estimate his tax liability and chalk out a tax planning strategy.

Having said that, the underperformance of many ELSSs launched in the early nineties has deterred investors from putting money in these schemes. But in recent years a number of tax planning funds have shown incredible performance, with returns quite higher than in other tax planning alternatives. For instance, Alliance Capital Tax Relief, launched in March 1996, has given a return of 34 per cent per annum since launch. This was despite volatile market conditions. Similarly, Zurich India Tax Saver and Sun F&C Personal Tax Saver have given returns of 30 per cent and 24 per cent per annum respectively.

Today, the fact that there are numerous open tax-savings schemes competing for the investor's pie, has helped in optimising investment performance by fund managers. So far, they could sit back in comfort - at least for three years. "Now, they are under constant pressure to retain existing investors as well as to attract fresh inflows," say industry observers. However, the three-year lock-in period ensures that the corpus is relatively stable and keeps aside undue pressures on the manager. Due to this advantage, many ELSS funds have been able to outperform the plain vanilla open-ended equity funds also. The average return in an open-ended ELSS in the past one year has been 8.45 per cent as compared to -1.18 in the benchmark index Nifty.

Investors have a wide choice with 19 open-ended ELSSs in the market already. More are said to be in the pipeline. And unlike before (when only closed-end ELSSs were allowed), the investor can now buy an ELSS based on its track record. Earlier the investor could take his cue from the performance of tax plans of a particular AMC, but could invest only in a tax-plan launched for that year and not in existing schemes. The result was that investors could not put their money into a fund with a good performance track-record.

Also, they could not access the portfolio of the fund as they had to invest in an Initial Public Offer (IPO) of a fund which was yet to invest its corpus. Now with the open-ended ELS schemes, an investor can buy a fund of his choice and also know the portfolio he is buying beforehand.

Inside Box

How to choose

Choosing an ELSS is pretty much the same as selecting a plain vanilla equity fund. One must keep in the mind that since ELSSs are equity products, the price or the NAV of the fund may fluctuate widely due to gyrations in stock markets. However, long-term, equities have proved to be the best investments. So, even though the lock-in period is only three years, one must consider these instruments with a longer time-frame in mind.

Also, not all ELSS products are alike. Within the ELSS category there could be wide divergence in the performance of various schemes. So, if one makes the wrong investment choice, it could lead to huge losses. Consider this: Out of 19 open-ended ELSS instruments, 14 outperformed the Nifty over the past one year. But returns in this category ranged from 36.33 per cent (HDFC Tax Plan 2002) and -11.88 per cent (Canequity- Tax Saver) on an annualised basis. Even over the past five years, returns ranged from 41.93 per cent (Zurich India Tax saver) to -4.38(LIC Tax Plan). So, here is what to look for in an ELSS.

Performance: While analysing the performance of an ELSS one must look for two details - the performance of the scheme as compared to the benchmark index and performance against its peers. If a fund has been able outperform its benchmark and peers consistently, it is a reflection of responsible fund management. The fund is most likely to give superior returns over a period of time. Also, do not get swayed by short-term performance. Long-term performance, at least over three years' is what matters.

In case the fund is newly launched or you plan to invest in a fund's Initial Public Offer, you must take a look at the performance of other funds under the same fund manager. This would be a pointer to the fund manger's style and gives you a reasonable idea about what to expect.

Portfolio: The only thing that leads to a difference in the performance of various schemes is the portfolio or the shares that the fund possesses. Depending upon the portfolio components, two funds launched at the same time can have a sharp divergence in performance. Typically, the portfolio of large-cap blue-chip scrips delivers the best appreciation with relatively lower risk. On the contrary, a portfolio of small-cap stocks appreciates very fast during a bull phase with the risk of declining rapidly during a bear phase. The safest thing for a investor would be to choose a portfolio which has a large-cap tilt with good representation of Index-based stocks.

Service & transparency: Apart from its portfolio and performance, one must also see to it that the Asset Management Company maintains a good service standard. Responsiveness and quick redemptions are the important service parameters investors should look out for. Also, one must make sure that the fund is transparent and prompt in its disclosures. On-line account access is another factor to be considered.