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Diversified Equity Vs Tax Saving Funds

I have observed that tax-saving equity funds have provided superior returns as compared to equity diversified funds due to the lock-in period. Am I right?
-Mukesh Patel

I intend to create true wealth by investing in funds through SIPs for a period of 5 to 10 years. I will not need to redeem these investments during this period. While I don't need tax benefits, I want to invest in tax-saving equity funds as I have observed that they have provided superior returns as compared to equity diversified funds due to the lock-in period. The funds I have short-listed are Alliance Capital Tax Relief '96, Birla Equity Plan, HDFC Taxsaver and Franklin India Taxshield. Is this strategy advisable? What kind of a portfolio will this result in?
—Mukesh Patel

It's good to see investors researching and planning long-term investment strategies. Let us start by examining your hypothesis that tax-saving funds have performed better than diversified equity funds. According to our calculations, this is not true. As you can see in the table, SIP returns from diversified funds have been better than those from the tax-savers.

Of course, the issue needs some subjective evaluation too. It is true that since tax-saving funds have a lock-in period of three years, their fund managers can plan their investments better than other funds. Fund managers can take somewhat higher risks and also invest in relatively illiquid stocks like mid-caps without fear of sudden redemptions forcing them to sell stocks at the wrong time. In practice, this does not seem to have given them a big advantage.

The lock-in period is also another minus point. Of course, you have said that you will not need the money in a hurry but you also have to consider the fact that if one fund starts performing poorly you may want to switch to another one. With your investments locked in a tax saver, you can just sit and watch.

However, if you do invest in these funds, here's what your portfolio will look like. Assuming equal investment in all four, around 42 per cent of your money will be in large-cap companies, 41 per cent in mid-caps and the rest in small caps. Exposure to individual companies is well-balanced with Infosys leading the table at 3.8 per cent. Among the sectors, technology comes in a little heavy at 17.7 per cent but then this is not really worrisome as many top-performing funds have similar exposures to tech.

Given that their performance is not better than diversified equity funds and keeping all these other factors in mind, we feel that there is no strong recommendation for this strategy. A set of well-chosen diversified equity funds could be a better choice.

SIP Returns
Equity: Tax Planning  Launch Date  3-year  4-year  5-year  6-year  7-year
Alliance Capital Tax Relief ’96 29/03/96 47.11 38.19 28.93 32.71 37.70
Birla Equity Plan 13/02/99 59.23 46.91 33.32  -  -
HDFC Taxsaver 31/03/96 56.75 46.04 36.97 40.42 44.76
Franklin India Taxshield 10/04/99 46.77 37.77 29.76  -  -
Equity: Diversified            
Franklin India Bluechip 30/11/93 50.86 41.27 32.32 31.83 33.13
Franklin India Prima 30/11/93 71.91 63.23 48.81 43.98 42.47
HDFC Equity 24/12/94 55.10 47.17 37.06 35.26 36.40
Reliance Growth 07/10/95 75.56 62.93 47.48 42.38 39.73
Reliance Vision 07/10/95 67.59 60.80 47.16 42.31 38.63
As on October 8, 2004
Assuming SIP Investment on the 10th of every month

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