Tax-saving instruments usually sound boring, don’t they? Speak of one and you think of long lock-ins and modest returns. But how about an instrument that combines equity returns and a comparatively shorter lock-in period? Enter equity-linked saving scheme (ELSS).

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The bad news is that ELSS will go extinct from April 2012 as per the proposed direct taxes code (DTC). The good news is that you can still invest in ELSS even though DTC proposes to do away with them. So if you haven’t invested already, now is the time to hurry up and get an equity kicker to your tax-saving portfolio by putting money in an ELSS.

Equity with tax savings

Illustration by Jayachandran/graphic by Yogesh Kumar/Mint

There is a small price that you pay for saving tax: your money gets locked in for three years. After three years, you are free to exit or stay invested and enjoy equity returns over a long period of time.

There are four reasons why you should allocate a portion of your tax-saving pie to ELSS:

Only pure equity vehicle: Among the tax-saving options on offer, ELSS is the only pure equity vehicle. Options such as Employees’ Provident Fund (EPF), Public Provident Fund (PPF) and five-year tax-saving bank fixed deposits are all debt instruments that give modest returns. The National Pension Scheme (NPS) offers an option to invest up to 50% of your annual contribution in equities. The remaining 50% of your investment gets invested in government securities and other fixed income instruments approved by NPS. Unit-linked insurance plans bundle in insurance for which there’s a charge.

Shorter lock-in: ELSS comes with the shortest lock-in among all tax-saving instruments. For instance, PPF locks your money for 15 years and National Savings Certificate has a lock-in of six years.

A lock-in comes in handy during troubled times. Says Surya Bhatia, certified financial planner and principal consultant, Asset Managers, a financial planning firm: “In volatile markets such as the one we’re looking at these days, you would usually panic and take your money out. That would not be a wise thing to do in the long run. ELSS lock-in compels you to stay invested."

Good performance: Well-managed ELSSs have given good returns in the long run. Of the 49 ELSSs, 19 are at least 10-year-old and have returned 20% compounded returns, on average, in the past 10 years. If you had invested Rs1,000 every month for the past 10 years in, say, HDFC TaxSaver Fund, you would have ended up with Rs6.75 lakh or a return of 32.58% at the end of 2010. The same contribution in Fidelity Tax Advantage three years back would have become Rs57,530 by the end of 2010, a return of 33.5%.

Soon to be extinct: Once DTC kicks in April 2012, ELSS would lose its attractiveness as the draft DTC has removed it from the list of tax-saving instruments. “If the government has removed ELSS from the tax deduction ambit, it should act as a motivator rather than a deterrent to make the most of it while the sun shines," says Dhruva Raj Chatterji, senior research analyst, Morningstar India, a mutual fund tracker. The current fiscal (ending March 2011) and the next (ending March 2012) are your last two chances to invest in ELSS and claim tax deduction.

Our picks

Fidelity Tax Advantage: The scheme will turn five in February and it has had a glorious run so far. With returns of 7.88% and 50.93% in the past three and two years, respectively, it has always been a part of Mint50, our chosen set of 50 schemes that we recommend for fresh investments.

What sets the fund apart is consistency in its portfolio—its top 10 scrips and sectors have been consistent throughout 2010. Fund manager Sandeep Kothari does not churn the portfolio much. Though Kothari invests in scrips across market capitalization, of late he has veered more towards large-cap scrips. “Long-term attractiveness of the market has not changed, so we don’t see much reason to shift our portfolios rapidly," he says. His investments in the consumer discretionary, information technology and healthcare sectors have worked well for the fund; at the same time Kothari avoided infrastructure stocks last year.

An over-diversified portfolio (at least 60 scrips throughout 2010 and about 50 scrips less than 1% holding, each) hasn’t slowed this fund down. “We do not construct a portfolio with the number of stocks in mind. There are typically five-seven stocks in the portfolio which we are either building positions in or trying to exit from and the price has run away. Else, we are comfortable with the stocks in our portfolio," adds Kothari.

HDFC Taxsaver: At Rs2,969.8 crore, it is the second largest ELSS in the industry. With the exception of 2007, the fund has done well in falling as well as rising markets. In keeping with its large size, fund manager Vinay Kulkarni prefers to diversify the portfolio, perhaps a bit much. As per its December-ending portfolio, the fund has invested in banks (16.7%), pharmaceuticals (12.3%) and software (9.3%) sectors. Kulkarni aggressively manages the portfolio and goes into cash up to 10% of the portfolio.

Unlike HDFC Long-Term Advantage Fund—the fund’s other ELSS that focuses on mid-cap scrips—HDFC Taxsaver focuses more on large-cap scrips, though it invests between 30% and 50% in mid- and small- cap scrips.

Religare Tax Plan: Owing to the three-year lock-in, fund manager Vetri M. Subramaniam feels that it makes sense tilting the portfolio towards the mid-cap scrips. “Since investors stay with us for a long period of time, it enables us to stick to companies for slightly longer," he says. That also gives him to invest in mid-caps; typically, he invests about 35-50% in them. That is also one reason why his portfolio may seem a bit too diversified; it has consistently held around 50 stocks with multiple individual holdings below 2%.

With a corpus size of Rs110 crore, Religare Tax Plan is one of the smallest schemes in its category, but it packs in quite a punch. It has done well across market cycles. In 2010, its bias has been towards companies in the domestic consumption space. Its investments in companies such as Eicher Motors Ltd, Manappuram General Finance and Leasing Ltd, Page Industries Ltd and Lupin Ltd worked well.

First principles

SIP it up: Instead of a lump sum investment that most investors do, typically, towards the end of the year, financial planners suggest systematic investment plans (SIPs) throughout the year.

Avoid dividend reinvestment plan: Although many ELSSs offer dividend reinvestment option (dividend and growth are the other options), avoid it because you get locked in forever. Dividends get reinvested and locked in for three years. These units will further declare dividends which again get reinvested and locked in for three more years. Since all ELSSs declare dividends at least once in three years, you get sucked in the cycle.

Don’t get lured by dividends: Historical evidence shows that more tax-saving schemes declare dividends between January and March compared with other periods (see graph). These dividend figures are advertised aggressively. Avoid the noise and stick to ELSSs that come with a good track record since dividends are paid out of your own pocket and a higher dividend amount does not necessarily mean good performance.

Do your KYC quickly: Thanks to the new regime of mandatory know-your-customer (KYC) norms, effective 1 January, many distributors claim that the KYC process has become slow and it takes about two weeks to get the KYC done. “Since many investors have to submit their tax proof to their employers, a delay in KYC delays their investments. It’s a challenge that we face daily, these days," says Surajit Misra, national head (mutual funds), Bajaj Capital Ltd, one of India’s largest MF distributors. So you better hurry up.