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SEBI's move to save ELSS
August, 23rd 2010

Last week, I wrote about how tax-saving investments need to be investments first, and tax-savers later. Investors tend to choose their tax-saving investments carelessly. They invest in types of investments that are not really suitable for them solely because theyll save on taxes. Of course, the tax-saving landscape of the country is set for sweeping changes from next year onwards. The new Direct Tax Code severely limits the types of investments on which complete tax exemption will be available.

One of the tax-saving investments that will no longer exist after the new code comes into effect are ELSS mutual funds. While this fits into what is supposed to be the theory of the DTC, it isnt by itself a great idea. Interestingly, just a couple of days ago, Sebi, somewhat uncharacteristically, asked the Central Board of Direct Taxes to keep the tax-saving status of ELSS funds unchanged. According to reports, Sebi has written to the CBDT that these are a product that is especially beneficial to small investors.

For investors as well as the mutual fund industry, ELSS funds are a very useful product. There are two reasons for this. One is that ELSS funds are unique in being the only tax-saving investment which brings the benefits of equity returns. Sure, there are two other options that give equity-linked returns Ulips and the New Pension System.

However, Ulips have a long lock-in at least ten years-coupled with high costs and poor transparency. The NPS is a great product but its a retirement solution rather than a savings one with a lock-in that effectively extends till retirement age. ELSS funds actually have the best combination of much lower cost than Ulips, 100% equity as well as a reasonable lock-in period of just three years.

Beyond this, ELSS funds have another hidden benefit. For many retail investors, it tends to be a gateway product in which they get the first taste of equity investing and of mutual funds. The tax-savings attract people to these funds and the three year lock-in ensures (most of the time) that investors get the good returns even if their timing and choice of funds is less than optimal.

This experience converts a certain proportion of these investors to investing in equity mutual funds over and above their tax-saving needs. The demise of ELSS funds will definitely be negative development in the Indian small investors savings and investment landscape.

As such, it is good to see that SEBI is trying to prevent this from happening although one would have doubts about the timing. If SEBI has been trying to do so for a while and it has come to light only now then thats great. However, if this effort has commenced only now, then one would have to wonder if it hasnt been left till too late. I hope Im wrong but as things stand, the changes in the DTC seem to be a done deal.

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