Mutual funds: Have a 3-year investment horizon while considering ELSS investments

By: | Published: January 12, 2016 12:02 AM

Besides tax planning, the other important aspects about investing in equity-linked saving schemes you should consider are your risk appetite and investment horizon

In a balanced fund, is there any way I can increase my debt portfolio as equities are giving poor return now?
Anirudh Singhal

Balanced funds typically maintain an allocation of between 65% to 75% to equity and the rest in debt. The minimum 65% allocation to equity is to ensure that the fund qualifies for equity taxation. Further, the discretion to vary the allocation lies with the fund manager based on her market views. As an investor, in case you would like to manage the asset allocation you could invest in a mix equity funds or shares or ETFs, debt, etc. and rebalance the portfolio according to your views. But you should also consider the cost-benefit implications including transaction costs, taxation, etc. of frequent re-balancing. An annual review and re-balancing (if required) of one’s portfolio is normally considered adequate.

Can I do one time payment in equity savings scheme for tax savings before March and do I have have to pay for another year. Also what kind of returns can I expect after five years?
Pramod Saxena

Investments in equity-linked savings scheme (or ELSS) can be made in lump sum or SIP mode depending on the investor’s choice. A couple of points to be noted about the modes of investment are: Tax benefits would be available only in the financial year in which the investment is made and only on amount invested in that financial year.

Further, since ELSS investments are locked-in for 3 years, investments made through the SIP mode would result in each SIP getting locked in for a 3-year period starting from the date of respective SIP. Therefore, one should have a minimum investment horizon of 3 years while considering investments into ELSS funds.

Additionally, the investment amount is deductible from your gross total income under Section 80C of Income tax Act (up to a limit of R1.5 lakh per annum). Since ELSS are classified as equity schemes for taxation purposes, dividends as well as long term capital gains (since they are locked-in for 3 years) are tax free.

Besides tax planning, the other important aspects about investing in ELSS you should consider are your risk appetite and investment horizon. ELSS funds invest in equities, which tend to generate attractive returns over the longer term (3 to 5 years and above) but these returns can fluctuate over the short term. For example, ELSS funds have generated annualised returns of 17% and 10% over the last 3 years and 5 years respectively, on an average.

But this has been accompanied by a few periods of negative returns. Historically, the probability of generating negative returns from ELSS funds has been 6.2%, 0.83% and 0% over 3-year, 5-year and 7-year holding periods respectively over the last 15 years. In other words, out of a total of 145 periods of 3 years each, over the last 15 years there were 9 periods in which the category on an average generated a negative return. As the investment horizon increased to 5 years, the number of periods with negative returns reduced to 1 out of 121 periods. Hence, one should have at least a moderate risk appetite while considering investments into any equity fund including ELSS funds.

What are the various risks in investing in liquid funds and is it better to invest in liquid funds than keeping money in savings account?
Archit Gangahar

Liquid funds invest in short term debt instruments i.e. with maturities of up to 91 days. Bond investments are typically subject to two key risk factors, namely interest rate risk and credit risk. Interest rate risk relates to the effect of changes in market interest rates on the price of a bond. Bond prices and interest rates share an inverse relationship i.e. if market interest rates move up, bond prices would move down and vice versa. Further, longer the tenor of a bond the more sensitive is its price to interest rate movements. Credit risk is the risk of default, on either interest or principal payment, by the issuer of the bond.

Since liquid funds invest in short term debt instruments, interest rate risk is negligible and typically only very sharp movements in interest rates (movements of more than 2% to 3% over short periods of time like a few days) would affect NAVs of such funds. Further, the debt instruments, particularly those issued by corporates and other non-government entities, that liquid funds invest in, are subject to credit risk. AMCs mitigate credit risk by investing in instruments with superior / good credit quality and holding a diversified portfolio of securities. Historically, incidents of defaults in holdings of debt mutual funds have been minimal.

In terms of returns, liquid funds typically generate returns that are close to the prevailing inter-bank money market rates and/or the repo rate, which is the interest rate at which RBI lends money to banks.

Currently, the repo rate is at 6.75%. In terms of taxation, liquid funds and savings accounts are broadly on par. Liquid funds also fulfil redemption requests either on the same day or subsequent day depending on the time of submission of the request. Overall, as long as the prevailing interest rates and hence returns on liquid funds are higher than interest rates available on savings accounts, one can consider investing in liquid funds holding good credit quality portfolios.

The writer is director, Investment Advisory, Morningstar Investment Adviser (India)

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