How the tax advantages of the ELSS work out?
To understand the tax benefit of an ELSS and its impact on yield, let us compare a pure equity fund with an ELSS fund. Both are structurally the same except that the ELSS has a 3-year mandatory lock-in and offers exemption under the overall limit of Rs150,000 under Section 80C of the Income Tax Act.
|Equity Fund||Amount||ELSS Fund||Amount|
|Initial investment||Rs100,000||Initial investment||Rs100,000|
|Value at the end of 3 yrs||Rs155,000||Value at the end of 3 yrs||Rs155,000|
|Tenure of holding||3 years||Tenure of holding||3 years|
|CAGR Yield||15.73%||CAGR Yield||15.73%|
|Section 80C Benefit||Nil||Section 80C Benefit||20%|
|Effective Investment||Rs100,000||Effective Investment||Rs80,000|
|Post tax yield CAGR||15.73%||Post tax yield CAGR||24.67%|
The above illustration best captures the impact of the tax benefit on the ELSS fund. In the above case we have only considered 20% tax impact and that has given an advantage of nearly 900 bps in CAGR yield to the ELSS fund. If the individual is at 30% tax bracket then the difference will be still higher. The moral of the story is that the tax benefit reduces your effective initial investment and enhances yield. But this yield is subject to the cap of Rs150,000 for all Section 80C investments put together.
Should you try timing the entry into ELSS funds?
That is a common question that a lot of us contend with. Should you just follow a passive ELSS SIP approach or should you start a SIP at the bottom of the market or should you invest lump sum at the bottom of the market. Optically, buying lump sum at the bottom should be the best choice but that leaves you with two additional questions. How do you identify the bottom of the market, when the best of experts find it hard? Secondly, if you buy after a sharp correction and the NAV goes lower by 20% then you are stuck for the next 3 years. That way the SIP should be a better choice compared to lump sum investing as it gives the benefit of rupee cost averaging.
That brings us to the second part of the problem; should you try and time your entry into an ELSS fund. Let us look at 3 distinct scenarios to answer this question:
- Investor starts ELSS SIP at the previous top in Jan-07 and continues till date
- Investor starts ELSS SIP at the long term bottom in Mar-09 and continues till date
- Investor starts ELSS SIP at the recent bottom of Sep 2013 and held till date
We have simulated these 3 scenarios for ICICI Pru Long Term Equity (Tax Saving) Fund and the findings are fairly interesting.
|Scenario 1||Details||Scenario 2||Details||Scenario 3||Details|
|Start Date||Jan-07||Start Date||Mar-09||Start Date||Sep-13|
|End Date||Aug-19||End Date||Aug-19||End Date||Aug-19|
|Monthly SIP||Rs10,000||Monthly SIP||Rs10,000||Monthly SIP||Rs10,000|
|Investment||Rs15.20 lakhs||Investment||Rs.2.60 lakhs||Investment||Rs7.20 lakhs|
|Final Value||Rs36.07 lakhs||Final Value||Rs25.19 lakhs||Final Value||Rs9.37 lakhs|
|CAGR Returns||12.77%||CAGR Returns||12.56%||CAGR Returns||8.63%|
The findings of the above table are quite surprising to say the least. Here are the key takeaways.
- Over longer time frame, timing the SIP hardly makes any difference. Over the last 12 years, you would have done slightly better if you had started at the top than at the bottom. This is despite the fact that between Jan 2007 and March 2009, the Nifty had corrected more than 50%. That goes to show that timing hardly makes an impact in the long run.
- More than timing the market, it is time in the market that matters. That becomes clear when you consider Scenario 3. In this case, even though you started the SIP at the recent bottom of September 2013, you end up with just 8.63% annualized returns. You would have been better of just letting time work for you.