To Invest In An ELSS To Save Tax Or Not?

Equity linked savings schemes (ELSS) are essentially diversified equity funds which offer tax benefits under Section 80C of the Income Tax Act. If you invest in an ELSS, then you can save as much as Rs.30900 of tax per year (if you are in the highest tax bracket). This investment exemption does not apply to regular equity funds.

The caveat is that you must retain your investment in ELSS for at least three years. This lock-in period provides the fund manager of an ELSS with more flexibility as s/he does not have to worry about redemption pressure from investors. This allows the fund manager to keep relatively less cash in reserve to meet redemptions. During a bull market, scheme 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, may outperform an otherwise identical equity fund which has a higher allocation towards liquid assets.

In spite of this, it is important to be very selective when choosing an ELSS as the three-year lock-in period means that you cannot redeem your investment early even if you are disappointed by the fund’s performance in the interim. The past performance of some ELSS schemes has been erratic. There are currently about 35 ELSS schemes which have 3-year track records. During this period, 11 of these schemes have underperformed the Nifty. On a rolling return basis, very few funds have been consistent outperformers. The table below shows that some funds have underperformed the Nifty by a large margin.

Nevertheless, some ELSS funds have generated exceptional returns. The table below shows the returns of some of the largest ELSS schemes (by AUM). Funds such as Axis Long Term Equity Fund and Franklin India Taxshield are amongst the best performers in the category. These funds are geared towards large-cap stocks and have managed to outperform the Nifty as shown in the table.

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Furthermore, these funds have also managed to limit downside risk. The Nifty fell by nearly 30 per cent between November 2010 and December 2011 but Axis Long-Term Equity Fund and Franklin India Taxshield managed to restrict losses and fell by less than 20 per cent as shown in he chart. Axis Long Term Equity Fund and Franklin India Taxshield Fund have also outperformed the index in rising markets as shown in the chart.

Between December 2011 and March 2014, the Nifty rose by 43 per cent. During the same period, Axis Long- Term Equity Fund generated a return of 69 per cent, while Franklin India Taxshield Fund generated a return of 46 per cent.

In conclusion, an investment During a bull market, scheme returns can be in Axis Long Term Equity dragged down by investments in liquid assets Fund or Franklin India like cash. Therefore, an ELSS which holds less cash Taxshield should help you during a boom can be fully invested in equity and save tax and simultaneously hence, may outperform an otherwise identical benefit from capital equity fund which has a higher allocation towards appreciation. These ELSS funds have all the liquid assets. tax benefits of regular equity funds.

If you choose the dividend plan, then 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. But you should avoid the dividend reinvestment option for ELSS schemes because the lock-in period will prevent you from exiting fully.

However, lump sum investments are not the ideal way to invest in equity funds, especially because the Nifty is currently very close to its all-time high. Current valuations are lower than they were at the previous peak in November 2010 but are still not very attractive. On March 11 2014, the Nifty traded at a price-earnings (P-E) ratio of 18.34x – very close to its long-run average of 18.38x.

Consequently, in the next fiscal year, you may be better off using SIPs to invest in an ELSS from April instead of investing a lump sum in March. SIPs are a better investment route as they allow you to benefit from rupee cost averaging. However, each investment will then be DS subject to a three-year lock-in period.

KEY POINTS

During a bull market, scheme 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, may outperform an otherwise identical equity fund which has a higher allocation towards liquid assets.

It is important to be very selective when choosing an ELSS as the three-year lock-in period means that you cannot redeem your investment early even if you are disappointed by the fund’s performance in the interim.