ELSS v/s Regular Equity Funds

I had invested Rs 1 lakh in JM Tax Gain Fund in January 2010. I have been disappointed by the performance of this fund but have not been able to exit the fund so far because of the three-year lock in period. The lock-in period will expire soon, and I would like to redeem my investment and invest in another fund. Please advise me on whether I should invest in another ELSS or choose a normal equity fund.

- Rajul Vatsa

You are quite right in considering redeeming your investment in JM Tax Gain Fund. This fund has not added value to your portfolio, as it has generated negative returns and has underperformed its category as well as its benchmark (the BSE 500 index) over the past three years. As on 19th November, 2012, the three-year CAGR returns of the BSE 500 index stood at 2.83 per cent while JM Tax Gain Fund generated a CAGR of -1.37 per cent over the same period. Since its inception in 2008, the fund has generated returns of -8.5 per cent (CAGR). It also had a higher downside risk relative to its category.

However, don’t judge a category by only one fund. As opposed to the disappointing returns of JM Tax Gain Fund, some other ELSS funds have generated exceptional returns. These have all the tax benefits of regular equity funds. If you choose the dividend plan in an ELSS or an equity fund, the dividends you receive are tax free. Additionally, long-term capital gains (if your investment is more than a year old) are also exempt from tax.

In fact, ELSS funds also offer an added tax benefit over regular equity funds, i.e. investments up to Rs 1 lakh qualify for income tax deduction under Section 80C of the Income Tax Act, 1961. If you invest in an ELSS, you can save as much as Rs 30900 of tax per year (if you are in the highest tax bracket). This exemption does not apply to regular equity funds.

Additionally, because an ELSS has a three-year lock-in period, investors cannot redeem their investments during this time. This may appear to be a drawback but can actually be advantageous for investors if the fund generates high returns.

The fund manager of an ELSS needs to keep relatively less cash in reserve to meet redemptions. During a bull market, the scheme’s returns can be dragged down by investments in liquid assets like cash. Therefore, an ELSS which holds less cash during a boom can be fully invested in equity and hence, outperform an otherwise identical equity fund which has a higher allocation towards liquid assets.

Franklin India Taxshield is a fund that is diversified across sectors (just like a regular equity fund). The fund has consistently been among the top performers in its category.

On a three-year and five-year basis, Franklin India Taxshield Fund also had the lowest downside risk. This is because unlike the majority of ELSS funds, the fund focusses on large-cap stocks, which are usually more stable and less volatile than small- and mid-cap stocks. Over the past three years, on an average, Franklin India Taxshield had 75 per cent of its corpus invested in large-cap stocks. In contrast, JM Tax Gain Fund only had 48 per cent invested in large-cap stocks over the same period.

Franklin India Taxshield has delivered returns comparable to the top performing large-cap funds on a one-, three- and five-year basis, as seen in the table below.

On a five-year risk-adjusted return basis, Franklin India Taxshield was in the top quartile 60 per cent of the time. On a three-year basis, the fund was in the top quartile 92 per cent of the time.

By investing in this fund, you can enjoy the double advantages of lower tax and capital appreciation from a diversified portfolio of stocks despite the three-year lock-in period. Remember that you should invest in a new ELSS before 31st March, 2013 to avail yourself of the tax benefit.