1-Tax saving By Equity Linked Saving Schemes ELSS -Part I

Continuing further from my previous article on analysis of tax saving PPF, in this article I’ll focus on the ELSS or Equity linked saving schemes that offer tax benefit along with the investments in Equity markets.

Typically, Equity linked saving schemes or ELSS are Mutual Funds – such mutual fund schemes that have a lock in period of 3 years and offer you tax benefit on the amount of money you invest. Lock in period implies that the money you invest in ELSS cannot be withdrawn before the end of lock in period, which in case of ELSS is 3 years. The tax advantage that you get is on the invested amount – say you invest 10K in a particular ELSS scheme. This 10K will be giving you exemption from tax, depending upon your tax bracket – either 10%, 20% or 30% meaning 1K, 2K or 3K.

The basic idea of ELSS is nothing but a Mutual fund. The financial company (AMC – Asset Management Company) offering ELSS scheme collects money from the market through NFO or New fund offer. The money is then invested in a variety of financial products, depending upon the scheme type – stocks, bonds, or other instruments. Before this money is invested, the AMC deducts the administrative charges and other commission from the invested amount. The commission may range anywhere from 2% to 5% each year. Say you invest in an ELSS scheme that has 3% charges and you opt for investment in equities. If you invest 10K in 2001 and you withdraw your money in 2004. Then initially in 2001, your actual investment will be 97% of 10K = 9700. Using this 9700, the fund manager of ELSS will purchase shares as per his analysis. Suppose by 2002, your investment in shares worth 9700 grows to 11,000. Then the AMC will again deduct 3% charges on this 11000 by selling shares equivalent to 3% of 11000 and the remaining will be your investment = 97% * 11000 = 10670. This will go on for each year of investment. After 3 years, you will be eligible for withdrawal of your money.
Suppose after 3 years, your investment reaches a value of 12000 – after deduction of all kinds of charges. You decide to withdraw your money and take back 12000 Rs.
So if you look at your investment for the entire 3 year horizon, you have the following:
• Invested amount: 10,000
• Tenure: 3 years
• Maturity Amount: 12,000
• Tax benefit (One time only): 3000 (Maximum if in 30% tax bracket)
• Total gain over 3 year: 12000 + 3000 = 15,000
• Net profit: 15,000 – 10000 = 5000 or 50% on 10K investment
• Simple Average for each year: 50%/3 = 16.66%

Best of ELSS:
• Exposure to Equity market
• Tax benefit

Worst of ELSS:
• Risks of Equity Market
• Professional Money management (I’d call it Inefficient Money management – that costs money)
• Commissions that you pay is high
• No guarantee of returns : Everything is subject to market risk
• Basically, all the drawback of a Mutual fund – as described in my previous post about MF

Now let’s have a look at the performance of some of the BEST performing ELSS in past few years:
The HDFC tax saver fund has been the best performing ELSS scheme available (Source ValueResearchOnline :http://www.valueresearchonline.com/funds/typecomp.asp?type=1&objective=20)
Digging deeper into the details of this best performing ELSS scheme (http://www.valueresearchonline.com/funds/newsnapshot.asp?schemecode=854), we observe that the 3 year returns have been 55.03% -annualized returns, as on August 2nd 2007. If we look at the historical data for this tax saving ELSS scheme on Association of Mutual Funds of India website, we will see that the NAV price of this fund on 2nd August 2004 was 43 Rs, while on 2nd August 2007, it was 158.21. This means that over the 3 year long horizon, this fund has given a return of (158.21-43)/43 = 268%. However, we also need to take into account the one time tax saving that we’ll get on ELSS. Suppose we invested 10,000 in ELSS on 2nd August 2004, and suppose we are in the maximum 30% tax bracket. So we will be able to save 3K on our investment. In 3 years time, this is how our investment will grow in the best performing ELSS:
• Invested amount: 10,000
• Tenure: 3 years
• Maturity Amount: 10K * (1 + 268%) = 36818
• Tax benefit (One time only): 3000 (Maximum if in 30% tax bracket)
• Total gain over 3 year: 36818 + 3000 = 39,818
• Net profit: 39,818 – 10000 = 29,818 or 298.2% on 10K investment
Simple Average for each year: 298.8%/3 = 99.4%

Continue to Part II of this article