This article was written by Personalfn for Business India, and was carried in its January 31, 2005 issue with the title, Taxing times.

It's that time of the year when tax-planning is on investors minds. Investments in National Savings Certificates (NSC), Public Provident Fund (PPF) and infrastructure bonds offering rebates under Section 88 of the Income Tax Act generally make the grade as rank favourites for investors. Apart from the stated tax benefits, assured returns and high safety levels also add to their appeal.

Another investment avenue featuring in the list of eligible instruments is the Equity Linked Saving Scheme or tax saving funds. Simply put, these are mutual fund schemes wherein investments upto Rs 10,000 qualify for Section 88 benefits. Investors are given the unique opportunity to invest in an equity-linked product and still claim tax benefits on the same; which is quite a departure from conventional tax saving instruments. Tax saving funds have a mandatory 3-Yr lock in period, which distinguishes them from conventional equity-oriented funds, which have no constraints on liquidity.

While the 3-Yr lock-in period may seem regressive to some, the same is significantly beneficial for investors. Tax plans like other equity-oriented products need time to unlock value and deliver returns. The lock-in period ensures that the fund manger has sufficient time at his disposal to make long-term investment decisions. The fund manager has the liberty to remain oblivious to redemption pressures and market events which are of short-term consequence. This is contrary to a conventional equity-oriented fund, wherein the fund's performance is constantly under the scanner; as a result, the fund manager is often forced to take short-term calls

Tax saving funds: Smart long-term performers!

Tax Saving Funds	NAV (Rs)	1-Yr	3-Yr	5-Yr	SD	SR
HDFC LONG TERM ADV.	46.63	41.52%	68.36%	-	6.17%	0.76%
BIRLA EQUITY PLAN	35.50	19.55%	55.01%	12.10%	7.23%	0.62%
MAGNUM TAXGAIN	32.45	47.12%	51.95%	0.13%	7.96%	0.64%
PRU ICICI TAX	41.91	30.89%	51.93%	15.76%	7.93%	0.59%
HDFC TAX SAVER	61.15	42.46%	51.40%	-	5.72%	0.78%

(Source: Credence Analytics. NAV data as on Jan 7, 2005. Growth over 1-Yr is compounded annualised)
(The Sharpe Ratio is a measure of the returns offered by the fund vis-à-vis those offered by a risk-free instrument) (Standard deviation highlights the element of risk associated with the fund.)

This brings us to the pertinent question  who should invest in tax saving funds. The smart performance of tax saving funds notwithstanding, investors must be aware of the additional risks associated with investing in tax saving funds vis-à-vis investments in avenues like NSC and PPF. Investments upto Rs 100,000 in specified instruments including infrastructure bonds qualify for tax rebates under Section 88. Out of the aforementioned amount, investments upto Rs 10,000 in tax saving plans are eligible for claiming tax rebates. As a result if you are an investor with an appetite for investing in high risk equity-linked instruments, utilising the upper limit would be a prudent choice. On the other hand, if you are a risk-averse investor, you could contemplate investing a proportionate amount in a tax saving fund. Investors must remember that even if they are making investments purely from the tax saving angle; their investments should hold good on the returns parameter as well. Tax saving funds being high risk instruments; have the ability to deliver higher returns over a 3-Yr time frame, thereby holding good on the risk-return trade off.

There is another vital aspect to tax saving plans which is overlooked by investors. While it is universally accepted that investing in equities should essentially be treated as a long-term phenomenon, investors have very few products that are positioned as long-term ones. Offerings from the diversified equity funds segment which are touted as long-term products are often seen getting invested in the season's flavour. Tax saving funds (powered by the mandatory lock-in period) give investors the opportunity to get invested in a truly long-term product and benefit from the power of equities. So even if you don't need or aren't eligible for the tax benefits, take the tax saving fund route to benefit from long-term investing,

Selecting the right tax saving fund is important. The fund manager's investment approach and solid fund management systems should serve as important pointers. Past performances of tax saving funds is another parameter that can be used for evaluation. However performances over longer horizons like 3 years and more should be considered for this purpose. Similarly the fund's performance on parameters like standard deviation and risk-adjusted returns needs to be studied. Standard deviation measures the volatility in a fund's performance, a well-managed fund would score well on this front since the fund manager can afford to steer clear of risky investment decisions, thanks to the time at his disposal. Risk-adjusted return (measured by Sharpe Ratio) as the name suggests is a measure of returns in light of risks borne. A good tax saving fund should rank low on volatility and high on risk-adjusted return.

Tax saving plans will make a good fit in your portfolio, regardless of whether you are investing for tax-planning or otherwise. Choose the right plan and add the much needed verve to your investments!

 

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