Tax Planning Time: Should You Invest In Tax Saving Funds Now?

Nov 29, 2016

As the tax season draws near, you would be once again seeking a host of investment avenues to save tax.

If you invest in equity, now may appear a good time to invest as the Indian equity market (S&P BSE Sensex) has corrected by nearly 10% (or 3,000 points) from the peak in September 2016, as foreign investors have turned pessimistic. This makes Equity Linked Savings Schemes (ELSSs), also known as tax saving funds, attractive as compared to other tax-saving investments, especially if you have a high risk-appetite.

Investor sentiments have been nervous, and there is a good reason for it. Several global and domestic threats are looming, which could send the equity market in to a lull. Uncertainty prevails over the policies to be adopted by Mr Donald Trump (as the 45th President of the US), Federal Reserve's (Fed) decision on interest rates, implementation and impact of Goods and Service Tax (GST), and the effects of demonetisation on the Indian economy.

So, there are multiple factors at play...

Emerging markets suffered heavy foreign outflows ever since Trump won the elections. The policies adopted by Trump are likely to have a far-reaching impact on international markets. Generous tax cuts coupled with other aggressive fiscal policies, might send markets into frenzy. With trump in power, the Fed may take begin to increase rates. Moreover, if that indeed happens, it may lead to further outflows from emerging markets, including India.

The timing of demonetisation could not have been worse. With the scrapping of the old Rs 500 and Rs 1,000 notes, the Government has implanted a risk of economic slowdown. Given that 90% of the economy operates on cash, even corporate earnings may take a hit. The Government's poor execution and hurried effort is evident with the frequent changing of rules and the printing of defective Rs 500 notes.

The impediments to implement the GST Bill before the 1 April 2017 deadline on account of the washout of the winter session of the Parliament thus far, is evident and may have negative impact on the economy; because still many critical nitty-gritties need to be sorted regarding GST.

Keeping all these factors in mind, market sentiment is pessimistic. The uncertainty will keep the markets volatile over the short-to-medium term. However, this is the very nature of the market. There will always be rough patches, but over the long-term, the market finds a way to recover.

So, amidst such times would it be worthy for you to take the risk and invest in ELSS funds?

If you are a first-time equity investor, you need to understand that investing in equity is risky. Just because the stock market may have delivered double-digit returns over the past few years, the trend may not always continue. Even if you are an experienced investor, a 10% drop may seem attractive, but tread cautiously.

When you are investing to save tax, you need to weigh your options. You need to invest based on your risk profile and investment horizon. If you are a risk-averse investor, you should stick to fixed income investments. You can choose from the several fixed income options available such as Public Provident Fund (PPF), National Savings Certificate (NSC), 5-year tax saving bank deposits etc. However, with interest rates falling, you should consider investing some part of your portfolio to high-yielding assets such as equity.

If you're an aggressive investor, one who is willing to take risk, considering allocating to equity through ELSSs, Unit-Linked Insurance Plans (ULIPs) and National Pension Scheme (NPS). Of these, for an investment horizon of about 5 years, ELSSs would be a promising option. Skip ULIPs, as you should never mix investments and insurance. Coming to NPS, since the money remains locked-in until retirement, you should consider it as a part of your retirement portfolio.

You can invest a dominant portion to ELSS as a part of your "tax planning portfolio" to generate optimal returns, if you are risk taker. But, those who are risk averse should clearly stay away.

Many flock to ELSSs in the last quarter of the financial year. But that may not be the right approach as you may end up taking an unwise investment decision. It is best not to speculate, as it can be hazardous to your wealth and health. If you wish mitigate volatility, opt for Systematic Investment Plans (SIPs) as they provide you the benefits of rupee-cost average and compounding.

Choose the right ELSS

There are as many as 43 open-ended ELSSs available. With no dearth of choice, you need to select the right scheme. The difference between the best and worst performers can be huge.

Choose Wisely

The table above reveals that even the schemes that rank the lowest, have delivered double-digit returns. But what matters is how consistent the returns have been across market phases - both during bull and bear phases of the market. That'll distinguish the men from the boys. After all, you don't want to be on a roller-coaster ride, isn't it?

Performance of ELSSs Across Market Cycles

You need to look where the scheme invests. Certain schemes invest across all market capitalisations. Others may have a market-cap bias, investing predominantly in either large-cap or mid-cap stocks. This does influence the risk of your portfolio. Your returns would be more stable with large-cap stocks and would turn more volatile as the proportion of mid-caps in the portfolio increases. So, it depends how the fund manager has played the investment strategy.

As per their latest portfolio disclosure, schemes such as DHFL Pramerica Tax Savings, Taurus Tax Shield, Principal Personal Tax saver, JPMorgan India Tax Advantage and Franklin India Taxshield have a high proportion of their assets in large-cap stocks. BOI AXA Tax Advantage, IDFC Tax Advantage (ELSS), ICICI Prudential Long Term Equity, L&T Tax Saver and Sundaram Tax Saver are a few schemes with a high allocation to mid- and small-cap stocks.

While schemes with a high allocation to mid-caps involve a higher risk, they hold the potential to earn higher returns as compared to large-cap oriented schemes. However, the allocation may change over time, as the fund manager may vary the allocation based on his outlook of the market. You need to choose wisely. When you select a mutual fund scheme for your portfolio, you should evaluate the performance track record (returns, risks, performance across market cycles), portfolio characteristics, costs, along with the investment processes and systems followed at the fund house.

ELSSs are a good avenue for your tax-saving investments, if invested in prudently. Do not wait for the last three months of the financial year to invest in ELSSs. In a volatile market, you may not see returns immediately come your way. Patience is the key. Do consult a SEBI registered investment adviser who will prudently select tax saving funds for your portfolio.

Disclaimer:

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