Tax-saving funds: Low on assets, high on performance

THE idea of locking into an investment for three years in a volatile equity market is surely not too appealing to the average investor. Equally, the tax benefits from the investment may not be attractive enough for the really big-ticket investors. Whatever the reason, `tax-saving' funds, or `equity-linked savings schemes', , have never really found many takers, as their average fund size indicates. At a time when some diversified equity funds are coping with corpuses exceeding Rs 1,000 crore, the tax-saving funds still have a small asset base — usually Rs 50-100 crore.

Tax-saving funds have, however, fared well in recent years, easing concerns over investing in them. These funds gained prominence over the past year, topping the mutual fund performance charts almost every quarter. During this period, they recorded average returns of 35-40 per cent.

As an investment up to Rs 10,000 in a tax-saving fund entitles one to a rebate under Section 88 of the IT Act, it is attractive for the small investor. And investor interest does appear to be picking up. Between June and December 2004, the asset base of HDFC Long Term Advantage (formerly HDFC Tax Plan 2000) more than doubled to Rs 71 crore, while the net asset value edged up just 55 per cent, indicating the inflows the fund attracted during the period.

Outperforming the diversified funds

But that most of these funds even outperformed their diversified equity-fund counterparts is what may make even investors not seeking tax benefits sit up and take notice. For instance, over one-year and three-year periods, HDFC TaxSaver and HDFC Long Term Advantage bettered the performance of HDFC Equity.

Funds such as PruICICI Tax Plan, SBI Magnum Tax Gain, Sundaram Tax Saver and Birla Equity have outperformed the regular diversified equity funds of their respective fund houses over the past year. These funds are also beginning to have a better three-year track record than the regular diversified equity fund. For instance, on an annualised basis, PruICICI Tax Plan generated returns of over 50 per cent over a three-year period, while PruICICI Growth recorded 30 per cent.

Aided by stable asset base

So what makes these funds race ahead? If it is the lock-in period that puts you off, think again. In fact, the lock-in period is the advantage that tax-saving funds have over their peers. Because of the lock-in, fund managers of tax-saving schemes are guaranteed a relatively stable asset base compared to those of regular, open-end diversified equity funds.

Fund inflows or outflows have a bearing on the performance of a typical diversified equity fund. For instance, if there is a sudden pullout by investors, managers may be forced to book profits prematurely on some of the fund's holdings, in order to meet redemption pressures.

As the asset base is more volatile, they may be forced to churn their portfolios more often thana manager of a tax-saving fund has to, as the half-yearly portfolio statements of funds such as PruICICI Mutual Fund reveal. According to the statement, the portfolio turnover ratio (a measure of the fund's buying and selling activity) of PruICICI Growth is about 67 per cent, against about 15 per cent in PruICICI Tax Plan.

To avoid such frequent churning (which also involves higher expenses), some managers may be inclined to hold a small portion of their portfolios in cash to cope with outflows during volatile periods. Again, not being fully invested may act as a drag on performance during a market rally.

Flexible fund management

Large corporate and institutional investors often bypass tax-saving funds as they are not eligible for tax benefits. As such funds cater broadly to the retail investor, they are not vulnerable to volatile fund inflows or outflows, or lock-in periods.

In addition, the fund size remains small and is, therefore, easier to manage. Most tax-saving funds have a small portfolio of stocks, which reduces the number of right calls the manager has to make.

The small asset base also has a bearing on the kind of stocks in the portfolio. These funds typically have a mid-cap bias, unlike their diversified fund counterparts.

For instance, HDFC Long Term Advantage has a distinctly mid-cap and small-cap tilt. HDFC Equity, on the other hand, with its asset base of more than Rs 1,000 crore, has few options in the mid-cap space to invest in without significantly affecting the stock price, given the liquidity constraints associated with mid-cap stocks.

Stocks such as Orient Abrasives, Vesuvius India and Balkrishna Industries make a rare appearance in the portfolios of Long Term Advantage and HDFC TaxSaver.

With mid-cap stocks hogging the limelight in the past year or two, it is not surprising that tax-saving funds, with their mid-cap heavy portfolios, have raced ahead of larger, diversified equity funds.

Long-term orientation

With fund performance closely tracked these days, managers of regular diversified funds often tend to ride sector themes, rather than pick offbeat sectors, lest a lag in performance makes investors jump to another fund.

A tax-saving fund, on the other hand, caters to those who are invested for the long term. With the three-year lock-in period, fund managers are, therefore, better placed to pick stocks that would deliver value over the long term. That these funds tend to have a long-term orientation is also reflected partly by their lower portfolio turnover. They are thus, more likely to pick contrarian themes that would pay off over time.

HDFC Long Term Advantage, among the top-performing tax-saving funds, did begin with a rather unconventional approach, picking up mid-cap stocks in the chemicals and industrial machinery sectors earlier than its peers. Even now, while HDFC Equity has holdings in conventional sectors such as banking, IT and engineering, HDFC TaxSaver and HDFC Tax Plan have among their top sector holdings sectors such as paper products and paints.

Typically, tax-saving funds, having been early-movers into unconventional sectors, are seen as sporting more distinctive portfolios than regular diversified equity funds. But with the latter now packing their portfolios with mid-caps, previously "offbeat" sectors such as chemicals and fertilisers — which have seen much mid-cap action — are now figuring in their portfolios as well, blurring the distinctions between tax-saving and diversified funds somewhat.

Good investment option

The tax-saving fund is a good option for the small investor with an appetite for the equity market. The lock-in period of three years is lower than that required by other tax-saving options.

Investors who are not seeking tax-benefits need not view such funds as strictly tax-saving options.

Given their superior performance and the unique advantages they enjoy over the average diversified fund, investors can consider including such funds in their portfolio. Here are a few points to consider before adding a tax-saving fund to your portfolio.

# As always, pick a fund with a good long-term track record. HDFC TaxSaver, HDFC Long Term Advantage, Birla Equity Plan, Sundaram TaxSaver, Franklin India Taxshield, PruICICI Tax Plan and Alliance Capital Tax Relief boast of good track records in this category.

Preferred picks from this shortlist would be HDFC Long Term Advantage and HDFC TaxSaver. Birla Equity Plan and Alliance Capital Tax Relief may also be considered, although the last mentioned has turned in a rather indifferent performance over the past year.

# Invest in small lots through a systematic investment plan (SIP).

Most tax-saving plans ask for a minimum investment amount of Rs 500, which is lower than the Rs 5,000 usually stipulated by most diversified equity funds. By investing small sums every month, you can avoid exposing a large investment to the downside risks that could arise from a badly-timed investment.

Sourced from Business Line