Thursday, January 14, 2010

Does it make any sense to invest in tax saving (ELSS) mutual funds?

If you are like most investors, then you probably haven't yet planned your tax saving investments for the Accounting Year 2009-10. Barely 10 weeks remain for you to decide and make your investments.

The more conservative investors will probably choose the 5 years fixed deposit at a bank, or the NSC VIII savings certificates at the Post Office to avail of tax benefits of up to Rs 1 Lakh under Section 80C of the Income Tax act. (I'm not including LIC insurance policies - because insurance should not be confused with investments.)

Both pay a risk-free interest of around 8%, with the NSC VIII certificates requiring a holding period of 6 years. (For those who are in the early stages of your career, it makes a lot of sense to make monthly or quarterly investments by buying these certificates. After 6 years, you get back about 1.6 times your original investment every month or every quarter. So, after systematically investing for 6 years, you won't need to make fresh investments, as you can keep reinvesting the amounts that mature.)

But I'm digressing. Let me get back to the original topic about ELSS funds. Since these have a lock-in period of only 3 years, many investors - particularly the younger ones - prefer them over the more 'old-fashioned' bank fixed deposit or NSC VIII certificates. But does it make any sense to do so?

I made a quick visit to the site and used their Point-to-point return calculator for ELSS funds, giving a start date of Jan 15, 2007 and an end date of Jan 14, 2010. That gives the return for all ELSS funds for a 3 year minimum holding period.

The results are interesting, to say the very least. Out of the 27 ELSS funds listed at the site, only 50% managed a return of 8% or more. Now, remember that ELSS funds invest mostly in equity shares - with its associated risks.

The 3 years holding period gives the fund managers some flexibility in buying shares with a longer-term perspective as there won't be an immediate threat of pull-out by investors should the markets turn for the worse in the near term.

That doesn't mean that the risks are reduced too much. On top of it, there is no guarantee that you will even get back your principal amount. If you had bought the units of either ING Tax Savings or Fortis Tax Advantage Plan on Jan 15 '07, your returns till date would be negative.

If we add a minimum 'Margin of Safety' of 5% above the risk-free interest of 8% in bank fixed deposits or NSC VIII certificates (to adequately cover the risk of equity investing), then only the top 6 funds out of the 27 make the grade of giving returns of 13% or more.

These are Taurus Tax Shield (21.35%), Canara Robeco Equity Tax Saver (18.09%), Sahara Tax Gain (16.08%), Religare Tax Plan (15.02%), Sundaram BNP Paribas Tax Saver (14.56%) and Fidelity Tax Advantage (13.27%).

So, should you just invest Rs 1 Lakh in any one of these 6 ELSS funds and be done with it for this year? Not quite, and I'll show you why. By pushing back the start date to Jan 15 '06 and end date to Jan 14 '09, the returns decline quite dramatically.

That isn't surprising considering the bear market during Jan '08 to Mar '09. Still, only the top 2 funds managed positive returns - Sundaram BNP Paribas Tax Saver (2.94%), Canara Robeco Equity Tax Saver (2.78%). The rest were all in the red.

Obviously, a lot depends on the state of the market - both at the time of investing, and nearer the time of maturity. Considering that the BSE Sensex is close to an intermediate top, the risk-return equation seems to be favouring the risk side more.

That was the long answer. The short answer is: avoid ELSS funds for your tax saving investments.


Nooresh Merani said...

Thats too generalized a view about Tax saving Mutual Funds !!

As you have said about monthly /quarterly payments in Post Office which is right.

Now try calculating the same with ELSS every month or quarter for last 3 yrs !! Results would SURPRISE pleasantly !

Prosenjit said...

Why you are not covering SIP in ELSS ?

Subhankar said...

Hi Nooresh and Prosenjit

Thanks for your feedback. Both of you have made an important point - about systematic investing in ELSS giving better returns.

But the article is not targetted towards systematic investors - as has been clearly mentioned in the opening paragraph. It wouldn't make much sense to start a SIP in an ELSS fund in January 2010 for Accounting year 2009-10.

So, the comparison is between a lump sum investment in ELSS with the same in an FD, or in NSC VIII.

Jasi said...


Your conclusion is correct if the conditions that prevailed during your evaluation period continue over the next 3 yrs, which may not be the case.
I guess this is true of equity in general, one cannot make decisions based on single bear/bull cycles.
ELSS i feel is a good balance between people who want both tax advantage and exposure to equity.
But an interesting insight nevertheless :)
Thanks as always

Ninad said...

This article comes down a bit too hard on the Tax Saving Funds. I agree that its futile to time the market but at the same time the unpredictability of the market cant be ruled out by the investors. I guess you could have ended in a better way like "Avoid lumpsum investment in ELSS just for the sake of tax saving and take the SIP route" instead of putting it the way you did

Zoher Doctor said...

Looking into the liquidity espects & long term return say atleast 5 yrs, ELSS turn out to be attractive.

Just a view

Zoher Doctor
Financial Planner
+91 9824063400

Subhankar said...

@Jasi: Many investors start to think about their tax saving investments during the Jan-Mar period - leaving too little time for a systematic investment plan. So they end up making a lump sum investment.

The unpredictability of ELSS returns does not justify the additional risk.

@Ninad: I don't have access to data regarding what percentage of investors in tax saving investments have SIPs in an ELSS fund. But my guess is that it would be an insignificant percentage. (An insignificant percentage invest in equities.)

Investors should understand that an ELSS fund is nothing but an equity fund. During the days when ELSS funds hadn't arrived on the scene, investors put their money into NSC certificates and ensured tax break, plus principal protection, plus a small return.

ELSS funds offer no capital protection. In trying to save tax, why should one put his capital at risk? The majority of ELSS funds haven't performed particularly well. These points are what I wanted to highlight.

@Zoher: In the longer term, a properly picked share portfolio will outperform most equity funds and ELSS funds. If one is going to put one's invested capital at risk, it is better to do so by investing directly in great companies like Infosys, Tata Steel, L&T.

For tax savings, investors are better off by investing in risk-free instruments like bank fixed deposits or NSC certificates.