The public provident fund may still be the most courted tax-saving instrument, but equity linked savings schemes - or tax-planning mutual funds - are a more dashing alternative.

The lure of these funds can be traced back to Budget 2005, when Finance Minister P Chidambaram ensured that taxpayers change their attitude towards this investment.

The hike in the investment limit in the equity linked savings scheme from Rs 10,000 to Rs 100,000 threw open the possibility of building wealth through some tax planning. And the largely ignored category of tax-planning funds suddenly came alive.

Exponential growth

In one year, assets of tax-planning funds grew by leaps and bounds. From Rs 684.01 crore (Rs 6.84 billion) in March 2005, it steadily rose to touch Rs 5,089.90 crore (Rs 50.9 billion) in March 2006. As on October 2006, it had reached Rs 6,214.28 crore (Rs 62.14 billion).

The launch of Reliance [Get Quote] Tax Saver in August last year made everybody sit up. The fund raised Rs 670 crore (Rs 6.7 billion) at a time when the largest existing ELSS had assets of just over Rs 200 crore (RS 2 billion). Subsequently, 11 more tax-planning funds have been launched in the last year-and-a-half (the NFO period for two of them is currently on).

The lure of ELSS

Among tax-saving investments, ELSS has the maximum return potential. The average annual return over the past five years has varied from 16 per cent to 108 per cent. A far cry when compared with the 8 per cent from National Savings Scheme and PPF.

Moreover, the lock-in of three years is considerably less compared with other tax-saving avenues such as PPF (15 years) and NSC (six years).

Vis-a-vis diversified equity funds

Equity-linked savings schemes are quite similar to diversified equity funds in terms of investment style. Just like the latter, they have the 'go anywhere' approach, as they invest in diverse sectors and across market capitalisation.

But they tend to have an edge in terms of cash flow management. Since the money gets locked in for three years, the fund manager does not have to worry too much about sudden outflows, and therefore can place bigger bets on promising but relatively less liquid stocks.

However, tax-saving funds do not necessarily outdo diversified funds in terms of returns. As on December 19, 2006, the year-to-date return of the tax-saving funds category was 25.53 per cent while that of the diversified equity fund category was higher at 29.85 per cent. But the three- and five-year returns were almost the same.

Playing it smart