"All men make mistakes, but only wise men learn from their mistakes."- Sir Winston Churchill.
"A man must be big enough to admit his mistakes, smart enough to profit from them, and strong enough to correct them." - John C. Maxwell
Both these proverbs are quite relevant to our daily lives - be it handling finances or even in any other facets of life. While undertaking your tax planning exercise too, many of individuals tend to repeat the same mistake of waiting till the eleventh hour and are arrogant enough to admit it. As the financial year draws to a close, the heat is felt and we repeat the same mistake of waiting till the eleventh hour and are arrogant enough to admit it. But is this a prudent way for tax planning?
Well, in our opinion it’s certainly not, as waiting till the eleventh hour drives the whole exercise towards mere "tax saving" rather than "tax planning"; which we believe is sub-optimal way to undertake tax planning. It is noteworthy that "tax saving" is merely done through investments in tax saving instruments/products, while "tax planning" takes into consideration one’s larger financial plan after accounting for one’s age, financial goals, ability to take risk and investment horizon (including nearness to financial goals). Thus commencing your tax planning exercise well in advance enables complementing it with your overall investment planning exercise.
From April 1, 2012 it is most likely that the Direct Tax Code (DTC) comes into effect, and your most dependable tax saving section - Section 80C of the Income Tax Act, 1961 would undergo amendments. While the proposed the DTC has increased the eligible deduction to 3 lakh (from the earlier 1 lakh); Equity Linked Savings Schemes (ELSS) - also known as "tax saving mutual funds", would no longer continue to be a part of eligible tax saving instruments, thus leaving you with fewer market-linked investment options to accelerate the process of wealth creation. And ascertaining this fact, mutual fund houses are doing their best to increase their AUM (Assets Under Management) share under the ELSS category of mutual funds.
In order to make hay when the sun shines, they (mutual fund houses) are doling out generous commissions (in the range of 2.5% to 5.0%) from their own pocket, to their distributors thereby pushing ELSS funds before they lose out their "tax benefit" status with effect from April 1, 2012. So now, the next time you approach your mutual distributor / agent for investing to obtain a tax benefit (under Section 80C of the Income Tax Act, 1961), he would be all ready with the ELSS funds return chart (and off course his commission chart!) thereby persuading you to invest in them. But you got to wary of such deceitful mutual fund distributors / agents / relationship managers who are interested in filling up their own pockets (through hefty commissions). In our opinion, while investing to avail a tax benefit (under Section 80C) it is vital that you consider the following aspects of financial planning too before signing a cheque, which would enable you in making prudent tax saving investment decisions.
Your age should determine your asset allocation. To simply put, how much percentage of your total investible amount should be in equity related instruments, fixed income instruments and gold. So, if you are young, you can take more risk and vice-versa. Hence, for prudent tax planning too, if you are young, you should allocate more towards market-linked tax saving instruments such as ELSS. Moreover, you would also enjoy the advantage of greater investment tenure which would enable you make more aggressive investments and create wealth over the long-term to meet your financial goals.
Similarly, if your income is high, your willingness to take risk is generally high. This thus can work in your favour, as you can skew your portfolio more towards equity related instruments such as ELSS, and make your portfolio appear more aggressive. Similarly, if your income is not high enough (i.e. it is low), you can invest in tax saving instruments which provide you assured returns. These instruments can be Public Provident Fund (PPF), National Savings Certificates (NSCs), 5 Yr Bank Fixed Deposits, 5 Yr Post Office Time Deposits, Senior Citizen Savings Scheme (provided you are a senior citizen) and Non-ULIP insurance plans.
- Financial goals
If you have financial goals set in your life, the same too should influence the way you do your tax planning and invest in tax saving instruments. So, say for example your goal is retiring from work 5 years from now, then your tax saving investment portfolio should be less skewed towards market-linked tax saving instruments, as you are quite near to your goal and your regular income will stop. Likewise if you are many years away from the financial goal, you should ideally allocate maximum to market linked tax saving instruments and less towards those instruments (tax saving) which provide you assured returns.
- Risk Appetite
It refers to your ability to take risk while investing, and it is function of your age, income, expenses, and nearness to goal. So, if your willingness to take risk is high (aggressive), you can skew your tax saving investment portfolio more towards the market-linked instruments such as ELSS. However if you aren’t willing to take very high risk, then while planning your tax saving portfolio you can invest in traditional non-market linked instruments such as PPF, NSC, 5-Yr bank FDs, 5-Yr Post Office Time Deposits, Senior Citizen Savings Scheme etc.; which offer you assured returns. Similarly, if you have a moderate risk profile then you can take a mix of 60:40 into market-linked tax saving instruments and assured return tax saving instruments respectively.
Thus now if your age permits (i.e. if you are young), income is high, and therefore willingness to take risk is high along with your financial goals being far away; you may look at ELSS mutual funds to avail a tax benefit under section 80C. Please note that ELSS mutual funds are 100% diversified equity funds and a distinguishing feature about them is the compulsory lock-in period of 3 years (which in our opinion helps in infusing a sense of discipline towards holding one’s investments for the long-term). Also they demand a petite minimum investment amount of 500, which is unlike the other equity oriented funds (which generally demand 5,000 as the minimum investment amount).
How ELSS Funds have fared so far?
(NAV data is as on September 13, 2011. Standard Deviation and Sharpe ratio is calculated over a 3-Yr period. Risk-free rate is assumed to be 6.37%)
*Category average returns are calculated taking all the ELSS funds, and not only the scheme mentioned in the table
(Source: ACE MF, PersonalFN Research)
Ideally while evaluating ELSS mutual funds, one should assess their performance over a 3-Yr time frame, as this would enable you to judge whether they have created wealth for you post the lock-in period. The table above reveals that over the 3-Yr time frame most ELSS mutual funds have delivered competitive returns with Religare Tax Plan being the frontrunner (by delivering a return of 16.1% CAGR). Moreover it has exposed its investors to fairly low risk (as revealed by it Standard Deviation of 7.72%), but has provided luring risk-adjusted returns (as revealed by the Sharpe Ratio of 0.15), thus making it a low risk-high return investment proposition in the category. Also interestingly the returns have been clocked by the fund without indulging in much portfolio churning (as revealed by its low portfolio churning of 0.66 times).
Similarly the others such as Fidelity Tax Advantage Fund, Reliance Tax Saver Fund, Franklin India Taxshield Fund, HDFC TaxSaver Fund and DSPBR Tax Saver Fund too have delivered appealing returns over a 3-Yr time frame (as reflected in the table above) by managing their risk well (i.e. keeping it low) and thus providing luring risk-adjusted returns. Moreover they too haven’t indulged in loathsome portfolio churning in an attempt to deliver luring risk-adjusted returns.
(Source: ACE MF, PersonalFN Research)
The aforementioned chart reveals how the respective ELSS mutual funds have presently occupy their place in the risk-return quadrant while generating returns for their investors.
|Top 10 Stocks |
|Name of the company ||Market cap ||% of holding* |
|Infosys Ltd. ||Large cap ||4.9 |
|Bharti Airtel Ltd. ||Large cap ||4.5 |
|Reliance Industries Ltd. ||Large cap ||4.4 |
|ICICI Bank Ltd. ||Large cap ||3.0 |
|ITC Ltd. ||Large cap ||3.0 |
|HDFC Bank Ltd. ||Large cap ||2.7 |
|Oil & Natural Gas Corpn. Ltd. ||Large cap ||2.5 |
|State Bank Of India ||Large cap ||2.2 |
|Tata Consultancy Services Ltd. ||Large cap ||2.2 |
|Cairn India Ltd. ||Large cap ||1.8 ||Top 10 sectors |
Stock and sector holdings are as on August 31, 2011.
Consolidated holdings of all ELSS funds in the peer comparison table, have been taken for top-10 sector calculation.
*Top-10 stocks are also consolidated for all the ELSS funds in the peer comparison table
(Source: ACE MF, PersonalFN Research)
As far as portfolio strategy of is concerned, most ELSS funds hold a fairly diversified equity portfolio but predominantly of large caps. Moreover, most ELSS mutual funds generally follow a blend style of investing which enable them to follow both - growth as well as value investing. Speaking about the sectoral exposure; they generally occupy positions depending upon how the respective fund managers perceives each sector to be resilient and offering promising long-term growth prospects. However, as an approach to stock picking they follow the bottom-up approach, which help to identify promising investments.
Hence while ELSS mutual funds offer good opportunities for long-term wealth creation (while you intend availing a benefit under section 80C) it’s imperative that you complement your financial planning exercise with your tax-saving (by considering the aforementioned aspects of age, income, risk appetite and financial goals) as this would enable in making a prudent investment decision. Moreover, please do not wait till the eleventh hour as this may lead you to making a wrong choice. While considering an ELSS mutual fund for your market-linked tax-saving portfolio, give importance to those ELSS mutual funds that have completed at least 3 years of track record and select schemes from mutual fund houses which follow strong investment systems and processes. Don’t get just lured by the returns chart which you mutual distributor exhibits to you; as remember there’s more to a mutual scheme than just returns. Look for the consistency in the performance instead, with relevance to risk and returns, portfolio turnover ratio expense ratio and the portfolio of ELSS mutual fund(s).
This article was written exclusively for Equitymaster, India's leading Independent research initiative. Trusted by over a million members all over the world, Equitymaster is known for its well-researched, unbiased and honest opinions on the Indian Stock Market.