Feb 25, 2010

5 Guidelines for ELSS Investing



Your first choice should be equity linked tax savings scheme (ELSS) for making tax-saving investments.

While investing in ELSS, remember the following guidelines:

1. It is not without reason that ELSS is considered as best option u/s 80C. We say ELSS has potential to deliver good returns over a period of time in comparison to other options u/s 80C. So let’s study the numbers to see the actual performance of ELSS funds over last 10 years. Here’s the ELSS returns
during last few years as per Value Research, a mutual fund rating agency (as on Feb 19, 2010):

Time---- Category Avg.------Best Fund------Worst Fund
1-Yr------ 84.81-----------------126.26--------------52.20
3-Yr-------6.55--------------------18.02-------------- (3.35)
5-Yr------18.20-------------------26.75----------------8.79
7-Yr------30.45-------------------44.67---------------19.14
10-Yr----12.92-------------------23.81-----------------3.46

Now just compare the returns with other tax-saving options available u/s 80C. Although 2yr & 3 yr returns are very bad due to the market meltdown of 2008, the 5 year, 7 year & 10 year returns are indeed very good.

But now that the Sensex has already risen by about 85% during last one year (closed at 16,286.32 on 23rd Feb 2010, with a P/E multiple of 20)and is currently oscillating in the range of 16K to 18K, going forward can we still expect good returns from equity?

Though the current Sensex valuation of around 20 times looks expensive, but considering the future growth in earnings, we can expect good returns from stocks. Remember, India’s long term growth story is still intact!!


2. Don’t invest in ELSS except from tax saving point of view. Otherwise, it is better to invest in plain vanilla diversified equity funds. There are basically two reasons:

i.) Liquidity: Unlike plain-vanilla diversified equity funds, investment in ELSS is locked for a minimum period of 3 years. But doesn’t one invest in equity for long term? Yes, indeed, but in case of an emergency you’re stuck. Secondly, suppose that the fund gets downgraded to 2- or 1- Star in next 1 or 2 years and you would like to transfer your money to a better performing scheme. Again, you can’t!

ii.) Performance: As compared to ELSS, equity diversified category is performing a lot better. See the excel table.



We notice that equity-diversified funds are in fact performing better than ELSS category, but the performance gap narrows down over a period of time.

Average hides a lot more than it reveals. We also observe that although category average of diversified is a little better than ELSS, but the variation in returns between best & worst is too high in case of diversified funds as compared to ELSS funds. What exactly does it mean?

-First, it implies that while choosing equity diversified funds one needs to be a little more extra careful. Put another way, negligence in choosing the right fund can prove more expensive in case of equity diversified funds as compared to ELSS.

-Second, ELSS funds category provides more downside protection (see the performance of worst funds) than equity diversified funds. In other words, performance of worst fund in ELSS category is much better than worst Equity diversified fund during all the years. So, we can say that ELSS funds are comparatively less risky. There is a valid reason behind it. First, lesser number of funds in ELSS category and second, the lock-in period of 3 years provides stability to returns—fund managers can take long term bets.


3. Understand why choosing the right mutual fund matters and can make a significant impact over a period of time. Invest in any of the 5-star or 4-star rated funds by Value Research.

However, it will be a lot better if you preferably go for top three among the best ELSS funds for 2010. Anyhow, if would like to go for others, know that since my last review of ELSS funds in November 2009, two new funds DSPBR Tax Saver & Religare Tax Plan have been upgraded to 5-star while Fidelity Tax Advantage stands downgraded to 4-star. But remember all the 3 ELSS funds are less than 5 year old. Further, Franklin Tax shield stands downgraded from 4-star to 3-star.

Don’t invest in new funds without a track record. First know that at present (Feb 2010) there are total of 37 ELSS as follows:

Not Rated—10
1-STAR-------03
2-STAR-------06
3-STAR-------09
4-STAR-------06
5-STAR-------03
Total--------37

Out of total of 37 ELSS funds, four funds have been launched in the year 2009 and other four in 2008. So, avoid them because these don’t have any track record (there’s no long term performance history). Once again I repeat, choose only out of 5-star & 4-star funds.


4. Taking a long term view can do wonder to your investment returns. So, invest for the long term. Put a self-imposed lock-in-period of minimum 10 years (ignoring the mandatory lock-in-period of 3 years). In other words, lock-in period of 3 years doesn’t mean that you can’t remain invested after that. So don’t ever think of making an exit after 3 years.


5. Lastly, remember the following tips:

i.) Spread your investment across 2 ELSS funds but not more.

ii.) Invest regularly in small amounts.

iii.) Choose growth over dividend and reinvestment option.

iv.) Be wary of advertised returns (even the claim that the scheme is best performing equity fund in the world might not be true)


This is my sixth post about ELSS and I think that by now I’ve covered almost every aspect of ELSS investing.

Make the most of your ELSS investments!!


Also see:

1. 10 Principles of Mutual Fund Investing
2.
10 Smart Tips for Section 80C Tax-Savings
3.
How to Invest in ELSS Funds

7 comments:

  1. I invest 1.22000/- in ICICI pru tax saver fund(Div. payout) 2.20000/- in HDFC tax saver fund(Div.payout) 3.11000/- in SundramBNP tax saver fund(Div. payout)4.10000/- in Birla Sun Life tax relief 96 fund (Growth).......on 23/02/2010 WHAT ABOUT MY INVESTMENT?????? PLEASE TELL ME.

    ReplyDelete
  2. Dear Fisher,

    Another good write-up

    Please write about the 5-year tax-free bankFD(max limit per year-Rs i Lakh). Not much is written about it.There are lot of misconceptions about this instrument.You can also suggest some shrewd ways to make the best use of this FD.
    Raveendran

    ReplyDelete
  3. Raveendran,

    Ok, I’ll try.

    ReplyDelete
  4. Hi,

    Thank you maintaining such a regular and useful blog! I had a question about investments in ELSS (for tax savings) and Mutual Funds. I have a bank account with HDFC bank and have got my KYC done - and got my 'Mutual Funds' tab activated - so I can buy/redeem ELSS as well as General Mutual Funds from my online bank accesss.
    My question to you is whether this is the best way for buying MFs online? I can see in the options that I can sign up for one time investments as well as start SIPs. I couldn't find much information online about this - so thought of taking your advice before I make the purchase using my bank account.

    Thanks in advance and keep you the great work with the blog!

    Cheers!

    Pancham

    ReplyDelete
  5. Pancham,

    Don’t worry... go ahead.

    ReplyDelete
  6. AnonymousMay 04, 2010

    Hey Fisher,

    Very nice blog. I am 26 and going to commence my job in June this year after completing my post-graduation. Your blog has been helpful in understanding otherwise complex investment world.

    I am looking for long term investment horizon (may be upto 30 years) for monthly disposable income of around 30K that I expect to grow by 10-15% YoY. Would you still recommend ELSS for such long term? Given my higher income bracket, I wouldn't get much benefit of tax saving under 80c since my PF deduction itself will account for ~80K. Please suggest a suitable way to think in my situation.

    ReplyDelete

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