Monday, January 26, 2009

Equity Linked Savings Scheme (ELSS)

With March just around the corner, people have started worrying about saving Income tax. Usually people throng investment options during February and March and try to save as much tax as possible. To know about the Indian taxation laws pls Click Here

As per our Indian IT laws every tax payer is eligible for savings under section 80C for amounts up to Rs. 1,00,000/- To know about the various options that we have to save tax under section 80C pls Click Here

This article is about Equity Linked Savings Scheme (ELSS). ELSS schemes are one the best tax saving instruments that have been offering great returns for our investor public over the years.

What are Equity Linked Savings Schemes?

An ELSS is a kind of Mutual Fund and is similar to any diversified equity mutual fund in many ways. An ELSS gives a tax benefit and comes with a lock in period of 3 years. Investment avenues of an ELSS are a mix of various asset classes such as equity, debt, gold and real estate.

Some advantages of ELSS are

* The 3 year lock in period prevents withdrawals and thus allows your money to grow over a period of time. Long term investment in equities gives better returns than any other investment instrument.
* It gives tax benefits (Up to 30% for people in the highest tax slab)
* Gives the flexibility to invest small amounts through a Systematic Investment Plan (SIP)

As an ELSS investor, your interests will be safeguarded by two separate market bodies. The Association of Mutual Funds in India (AMFI) and the Securities and Exchange Board of India (SEBI)

Let me explain the returns on an ELSS with an example:

Lets assume you invest Rs. 1 lakh this year in an ELSS scheme and you are in the highest tax bracket.

Invested Amount = Rs. 1,00,000/-
Income Tax saved = Rs. 30,000 (30% tax slab)

Net amount Invested = Rs. 70,000/- (I have deducted the 30,000 because you get it back up front after your investment as income tax benefit and you effectively invested only Rs. 70,000)

Let us assume your equity investment grows at the rate of 15% per annum.

Investment value at the end of the First year = 1,15,000/-
Investment value at the end of the Second year = 1,32,250/-
Investment value at the end of the Third year = 1,52,087/-

Assuming you encashed your investment at the end of the 3rd year you will get Rs. 1,52,087/-

Profit you realized = Rs. 82,087/- (You invested only Rs. 70000 effectively :) remember the tax saved)

Profit percentage = 117% (For 3 years together)

Returns % per year = 39%

A Returns of 39% per annum is something we cannot expect in any other form of investment. Thus ELSS schemes make one of the best investment options.

How is your ELSS Money Invested?

This is a very common question that people have. The asset allocation is pre-determined and is in accordance with SEBI guidelines. Between 60% to 100% is invested in equities, cumulative convertible preference shares and fully convertible debuntures and bonds of companies. Money market instruments account for anything between 0% to 20% The asset allocation shows a tilt towards equities which has the scope for providing good returns for us. The choice of industries and allocation to mid-cap and large-cap companies depends on the individual scheme & its fund manager. As an investor, we must first understand the objectives of the fund and also go through the offer document before investing.

Difference between an ELSS fund and a Equity Diversified Mutual Fund

Both ELSS and Diversified equity schemes have the same risk profile. Both are high risk - high return investment avenues. The major difference lies in the fact that an ELSS scheme has a lock in period if 3 years and a diversified equity scheme comes with no such conditions.

It is always advisable that Equity investments be made for the long term to help the fund outperform other asset classes. The lock in period for ELSS supports this view and also allows the fund managers to plan a strategy that would be beneficial in the long term. On the face of it, the 3 year lock in stipulation might be a deterent to investors, but it has its own advantages.

* By forcing us to wait 3 years, it makes us take a long term view of the market, which induces investing discipline to a certain extent
* The real potential for returns from equities can be realized only if we stay invested for at least a few years
* The fund manager knows that the investment would not be encashed in the next 3 years and hence they can plan and devise a strategy that can help us benefit. The manager can choose the sector and stock bets with freedom that he does not get in regular equity schemes

The performance of an ELSS and a diversified fund may also vary.

The difference in performance usually arises from the differences in managing styles and the market rewards for a particular style at a given time. ELSS schemes may have a small & mid cap bias. Fund managers may like to take advantage of the lock in period to exploit value stories in these sectors. Many diversified equity funds tend to have a large cap and growth bias. Therefore, during periods when growth stocks and large caps dominate, diversified equity funds would outperform ELSS Schemes.

But if we calculate the returns of ELSS schemes including the tax benefits we get out of it, they would outperform the diversified equity class.

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