Fenil's Library

Given the reasonable valuations going, capital appreciation can be huge

ICRA Online Research Desk

It’s that time of the year again. Everyone is scurrying to save tax before March 31. But, the only difference this time is that the confidence levels of the average investor are low.

There are many investors who are hesitant to invest in any type of equity instrument, even if it amounts to saving a large sum in taxes. Until recently, very few investors looked beyond insurance and equity linked savings schemes (ELSS), but today the average investor wants to know whether there are safer alternatives to tax planning. 

To some extent, this is also ironical, because before January 2008, all we heard was that Indian markets were overpriced; we were floating in a five-year long inflated bubble (which commenced in 2002), which could burst anytime. In spite of such noise, investors pooled in money in ELSS without batting an eyelid.

However, today when the markets look more reasonably priced with possibilities of gaining phenomenally from capital appreciation, we are thinking twice. 

While this is human tendency, as better informed investors, we must not fall prey to such predispositions. If you are a disciplined and regular investor who has a minimum investment horizon of three to five years, then you stand to gain much from investing in equity tax planning mutual funds. 

ELSS funds have been positioned essentially as diversified equity schemes, and very few of them have a style bias towards a particular market segment.

There is one open-ended index-based ELSS fund floated by Franklin Investments.

Apart from this, there are a few theme-based ELSS funds floated by asset management companies. However, these are closed-ended in nature and hence do not accept fresh applications.

There is no doubt that the figures for the past year have been very discouraging. The average 48% loss for the one-year period ending March 3, 2009 is enough to scare investors. But, what we were interested in assessing was the performance of the average tax planning scheme in the two different bear phases. 

The pertinent question is whether fund management has matured at all or are we back in the same scenario of under performing the large indices. A look at the table shows that in a bull phase asset management companies manage to comfortably out-perform the key benchmarks, but in bear phases they very clearly leave much to be desired. 

Having said that, there have been about six schemes that have lost less than the Nifty over 2008. However, this still amounts to a minimum 47% loss through the year. 

But a quick analysis reveals that one way to reduce these losses is possible through a systematic investment plan. For the period — January 1, 2008 to January 1, 2009 — possibly the worst phase of the current crisis, a systematic investment in an average performing plan would limit your losses to 34%.

So, what has the average equity tax planning scheme done to combat the current slump?

Many have reduced their equity allocation, much like the average diversified equity fund. Schemes, which are not yet three years old and hence do not face a redemption pressure, are also playing it safe and keeping more money in cash. 

In the current scenario one can easily divide the universe of open-ended ELSS schemes amongst those that have decided to stick to their primary mandate of staying invested in equities and those which are currently holding large amounts in cash. 

The immediate question that crops up is whether a low equity allocation shields you from losses. Well, the answer to this is no. 

While some schemes such as Sundaram BNP Paribas Taxsaver have managed to limit losses to 40% (for a one-year period ending January 31, 2009 on the back of an average 78% exposure to equity schemes for a 12-month period ending January 31, 2009) there are others such as Escorts Tax Plan which have lost as much as 55% in spite of a low 51% average exposure to equity instruments.

A low equity holding is not the way out to contain losses and this has been exemplified by the fund management at Franklin India Taxshield and Fidelity Tax Advantage. These funds have lost 43% on the base of a 90-94% allocation to equity instruments over the one year period ending January 31, 2009. 

In addition to this the strategy of an index-based ELSS fund has also worked in the current slump where Franklin India Index Fund has managed to emerge amongst the best performing ELSS funds.

Other than this, there has been a discernible reduction in the exposure to the mid- and small-cap companies. During the current bearish phase, ELSS schemes have on an average allocated 19.50% of their net assets for mid cap stocks. 

In the bullish phase, ELSS schemes on an average have invested 25% of the net assets into mid-cap stocks.

Also the fallout of the slump has been that the concentration to top holdings has gone up and not down. Fund managers prefer sticking to safer options, by investing large sums in seemingly robust companies such as Reliance Industries. 

Till about February 2008 it was not unusual to find companies such as Areva T&D, Jaiprakash Associates being held as top holdings. In addition to this, there has been a drastic change in the allocation to different sectors over the past year. While the banking and oil & gas sectors continue to remain the most popular amongst fund managers, the allocations to realty, engineering, industrial machinery and auto sectors have given way to pharmaceuticals, technology and financial services.

There is one caveat to the three-year lock-in period. An investor can hope to receive some cash flow in the form of dividends, which again are tax free. This is true only for the dividend payout option and not the re-investment option. 

Schemes have not restricted dividend payouts only to their dividend options, but have declared dividends even under growth plans. Until recently, the dividend history of some of the schemes has been quite robust. 

Investors who are uncomfortable with the strict three-year lock in can consider the dividend payout option under the ELSS category. 

Also to limit losses and to capture the bottom of the current slump, systematic investments are highly recommended.