In order to correctly answer this question, let’s analyse what is the fair holding period for equity investments.
Equity investing is meant for the long term. That’s because equity markets tend to be extremely volatile in the short term – that is share prices jump around a lot. However in the longer terms the fundamentals win out and the long term equity returns are remarkable stable. In fact it has been said that in the markets resemble a beauty contest in the short term and a weighing scale in the long term. This dissonance tends to disorient investors and causes them to make sub-optimal choices.
Therefore investors have to be really cautious and ideally avoid allocating money to equity markets in the short term.
However what is the correct definition of long and short term? It is linked to the earnings and economic cycle as well as sentiment changes in the market. Businesses typically do not grow in a straight line but the growth tends to be more erratic linked to various internal and external reasons – such as seasonality, product launch cycles etc. These trends tend to establish themselves over time only. In the short term the analysts looking at these companies can only work with best estimates. However different analysts can have different estimates. Also as new data comes, these estimates can change. As a result, there is a great margin of error when valuing a stock for the short term. This is the reason for the volatility in the underlying price in the short term from a fundamental perspective.
This volatility is further compounded due to changes in investor sentiment. When we are in a bullish environment, for the same stock, a higher valuation seems ok whereas bearish times call for much lower valuations.
In light of all this, the long term for equity investing is anything that takes away the uncertainty from growth cycles and sentiment cycles. And looking at the history this happens only when you invest for much longer than 5 years – maybe even 7 to 10 years. Yes you can get lucky and get good returns in the short term, but you need to make sure that you are allocating for the long term in order to consistently participate in the potential of the market.
With reference to this, we get the answer to our question. Clearly it is not optimal to exit ELSS after the expiry of the 3 year lock-in. Ultimately ELSS funds invest in equity markets and to do justice to these, the investors should be prepare to remain invested for much longer.
It should also be noted that once the lock in gets over, ELSS funds operate just like any other open ended fund in the sense that the investorsare free to redeem on any day of their choice. Hence there is no special advance to redeeming at the end of the lock-in and rather the investor can pay a big price in terms of missing out on the potential for equity market participation.