Are tax-saving investments optimal?

March is a month for tax savers. Investors typically take exposure to equity linked savings scheme (ELSS) to lower their tax liability.

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Some, of course, invest in public provident fund (PPF) and other such savings scheme to gain tax advantage. But are tax-advantaged investments optimal in the overall portfolio context?

However, investors’ compelling urge to save taxes may a time forces them to lose sight of how such investments sit with other assets in the portfolio.

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The article suggests that investors should look at tax-advantaged investments within the core-satellite framework.

Tax saving optimal?

That ELSS is fairly popular as a tax-advantaged investment is clear from the fact that assets under management for this fund class was Rs 11,130 crore as of February 2009.

Investors typically invest in tax-advantaged investments with the primary objective of saving taxes.

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And that could turn out to be sub-optimal, for the primary objective should be to optimise post-tax returns, not to save taxes.

Consider an investor wanting to buy a tax-exempt bond that carries 8 per cent interest.

If this investor has another investment avenue that can fetch risk-adjusted returns of 15 per cent, the post-tax returns will be 10.5 per cent, assuming 30 per cent tax rate. It would then be sub-optimal to invest in the tax-exempt bond just to save taxes.

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Tax-advantaged equity

The case with ELSS is different. This investment can generate higher returns due to equity exposure.

The problem, however, is that such an investment may not be optimal within the core-satellite portfolio framework. Why?

ELSS is essentially a tax-advantaged active fund. The problem then is two-fold. One, active funds may not sit well within the core portfolio. A core portfolio is optimal when it carries low-cost beta (market) exposure.

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It is primarily set-up to achieve specified investment objectives such as buying a house or funding higher education.

Active funds do not provide such low-cost exposure. Index funds do.

Can ELSS form part of the satellite portfolio? It can, but only if the fund carries an investment style. And this is the second problem.

Most tax-advantaged funds do not carry a distinct investment style. Franklin India Taxshield is a case in point.

The portfolio manager is within his mandate to load stocks ranging from large-caps to small caps.

Such a diversified fund may interfere with other structures in the investor’s satellite portfolio.

If the portfolio has an aggressive mid-cap fund and ELSS also carries sizable exposure to mid-caps, the investor will be over-exposed to that sector.

Fixed-income exposure

All portfolios have exposure to fixed-income securities as part of the strategic asset allocation policy. What if investors take tax-advantaged exposure to this asset class? That way, the investor can save taxes and also fulfil the requirements under the asset allocation policy.

Employees already carry such exposure through provident fund (PF).

They can also invest in PPF. Besides, investing in PPF or PF carries a longer lock-in period. This feature enables the investment to sit well inside the core portfolio alongside index funds.

It is important to remember that a fixed-income exposure is not about generating high returns.

Rather, this asset class helps investors’ lower portfolio volatility.

This is does not mean that tax-advantaged mutual funds with bond exposure are optimal.

The problem is that such mutual funds carry price risk- risk that bond prices may decline when investor redeems the units.

Investors who prefer shorter lock-in periods can consider tax-advantaged fixed deposits — five-year deposits with commercial banks. The problem, however, is that the interest on investment is taxable. Another alternative is the National Savings Certificate, where interest is tax-exempt.

Conclusion

Investors buy ELSS with a primary objective of saving taxes.

The objective instead should be to exhaust the investment deductions under the Income-tax Act in such a way that they sit well within the overall investment objectives. Compared with ELSS, a tax-advantaged fixed-income investment serves the purpose well.