Equity Linked Savings Scheme: The mastercard of tax saving season

One of the reasons we avoid Equity Linked Savings Scheme (ELSS) is that returns are linked to the stock markets and there is a lot of volatility. But have you realized that due to the tax break you receive on ELSS investments, your down-side risk in equity is automatically cushioned? And, on the other hand, your upside is also unlimited.

Here’s how that works. Let’s say you decide to invest Rs 1 lakh in an ELSS and claim a tax deduction on it. If you are in the 30% tax bracket, it means that effectively, instead of investing Rs 1 lakh, your actual investment is Rs 70,000 to get units worth Rs 1 lakh.

Now, let’s skip ahead to 3 years from the date of investment, when you have the option to disinvest. The return on your investment of Rs 1 lakh should actually be calculated on an investment of Rs 70,000, right?

So, at that time, even if the market had fallen and you get a negative return, thanks to the tax break you received at the time of your investment, your loss is minimized or even completely eliminated.

Let’s simplify that by considering a real-life example. To highlight the ‘ELSS cushion effect’, we have considered the worst return (on a 3-year rolling return basis) delivered by the fund house that has been one of the least-performing fund. Rolling returns reflects the returns from investing on any day and holding the investment for exactly 3 years. These returns are calculated for every day of every year during the period selected.

Let’s assume the most unfortunate (and highly improbable!) case that you invested Rs 1 lakh in the fund on 5th April 2017, three years later, on 5th April 2020, you would have a return of -14.85% per annum. We reiterate, this is the worst return that the fund has given over a three-year rolling period with investment dates starting in December 2012. By investing on any other day, you would have got a better three-year annualized return.

However, since you have availed a 30% tax break on the instrument, your effective loss is just 4.11%. That’s how ELSS cushions your fall!

Now, having considered the ‘worst-case’ scenario, let’s look at what happens to your investment when you make positive returns. Consider the same fund, if you were fortunate enough to invest on 3rd September, 2013, and disinvested three years later, on 3rd September, 2016, you would have made a return of 37.63% per annum.

That’s a mouthwatering amount by itself. But hold on; here again, let’s take into account the tax break you enjoyed when you invested. With a tax adjusted investment of Rs 70,000 to purchase units worth Rs 1 lakh on 3rd Sept 2013, you would actually have received a mind-blowing 54.99% per annum!! That’s the kind of power booster you receive from ELSS investing. This power booster is not available in any fixed income instrument.

Having said all that, here are some pointers, words of wisdom and concluding thoughts:

1. We do not advocate timing the markets; far from it. We have simply put out the highest and lowest 3-year returns of a medium-sized scheme, which has not done too well comparatively, to drive home the point that investing in ELSS schemes enhances your upside and curtails your downside, substantially.

2. While we have used a three-year investment horizon, it’s not an ideal investment time frame; again, far from it. The longer you invest, the better your returns will be, irrespective of the level at which you entered the market.

3. While every tax-saving investment has its advantages and limitations, ELSS is perhaps the only instrument that has a completely un-capped upside. And now that you are aware of how the tax break works to cushion the downside, it should change your perception of the risk it carries.

(By Juzer Gabajiwala, Director, Ventura Securities)

Disclaimer: These are the personal views of the author. Readers are advised to consult their financial planner before making any investment.