Every individual aims to protect their hard-earned money from taxes. Out of the various instruments available for tax-saving needs, Equity-linked Saving Schemes (ELSS)also known as a tax-saving mutual fund, have emerged as a popular option for many individual investors.

SEBI defines ELSS as equity-oriented mutual funds that invest a minimum of 80% of its total assets in equity and equity-related instruments and come with a mandatory lock-in period of 3 years along with tax benefits.

Investing in ELSS offers you the triple advantage of tax-saving (under Section 80C of the Income Tax), wealth creation through equities, and the lowest lock-in period compared to other tax-saving instruments.

At present, there are 37 ELSS or tax-saving mutual funds in India offered by different mutual fund houses. Now the question arises — How should you select the best ELSS given the plethora of options available?

Many individuals prefer to take an easy way out and select the scheme based on its popularity, while others pick the one with the lowest NAV. Few others, simply select the top-performing ELSS of the previous year.

[Read: How to Select Top Equity Mutual Funds for Your Portfolio]

In my view, these are imprudent approaches to selecting the best ELSS that may fail to payoff in the long run. Remember that ELSS comes with a mandatory lock-in period of 3 years. So, if you decide on a not-so-worthy fund, you will have to bear the cost of underperformance for the entire period. What you need is to thoroughly assess the schemes on various quantitative and qualitative parameters to be able to zero-in on the best ELSS for your tax-saving needs that have the potential to create superior long-term wealth.

In this article, we will discuss in detail how you should select the best ELSS for your portfolio in 2022…

I. Quantitative parameters

1) Past Performance

The core objective of investing in ELSS is to maximize wealth by investing in a diversified basket of stocks spread across sectors and market caps. Accordingly, it makes sense to analyse the past performance of the scheme, which will help you set realistic expectations of its future performance.

However, when you evaluate a fund’s past performance, ensure that you do not give undue importance to this aspect while shortlisting schemes for selection because past performance is not indicative of how the fund will perform in the future. Instead, you should use past performance as a tool to determine how consistently the scheme has performed. Here is how you can do it:

  • Compare performance against the category peers and the benchmark index: Assess the performance of the scheme relative to its benchmark and the category peers across various time frames such as 1-year, 3-year, 5-year, 7-year, since inception, etc. Do note that no ELSS can turn out to be a top performer year after year because each fund follows a unique investment strategy/style, which may or may not be in favour during a certain market phase. However, evaluating past performance will help you determine whether the fund has performed reasonably across time frames. If a particular fund does not have a long-term track record or has generated a one-off superior performance, it may be better to ignore it.
  • Evaluate the fund’s Performance Across Market Cycles: Most ELSS perform well during market uptrends. However, when the market conditions look bleak, such as the one we are witnessing now, many funds fail to contain the downside. Therefore, it is vital to select schemes that perform consistently well in most bear and bull market phases relative to its benchmark and the category peers.

2) Risk-adjusted returns

Since ELSS invest predominantly in equities, they are susceptible to market volatility. However, the impact of volatility can be mitigated if the fund manager deploys efficient risk-management techniques. The point is that the fund must be able to reward investors by undertaking a reasonable level of risk consistent with its investment style and strategy. To determine a scheme’s ability to reward investors adequately for the level of risk taken, you should evaluate the scheme’s Standard Deviation; a higher standard deviation means that the scheme is more volatile compared to the benchmark and its peers. Additionally, evaluate the scheme’s Sharpe Ratio (a measure of risk-adjusted returns) and Sortino Ratio (that denotes the fund’s ability to contain the downside risk); the higher the ratio, the better it is.

3) Portfolio quality

The performance of an ELSS is extensively dependent on the quality of its underlying portfolio, i.e. stocks, sectors, and market cap allocation. If the underlying securities do well, your mutual fund scheme is likely to reward you with superior returns. Therefore, ensure that the scheme is well-diversified across stocks and sectors to avoid concentration risk. To assess this, analyse the schemes top-10 holdings, the top-5 sector exposure, the market capitalisation bias, the style of investing followed – value, growth, etc.

In addition, ensure that the fund manager does not frequently churn its portfolio and holds each stock with conviction until its full potential is realized. If the fund manager constantly buys or sells stocks (as denoted by the higher Turnover ratio), it leads to a higher expense ratio which is eventually borne by you, the investor. So when you decide to select an ELSS for investment, pay special attention to its portfolio quality.

II. Qualitative parameters

Qualitative parameters are often overlooked, but they play an equally important part in selecting the right ELSS for tax-saving.

Quantitative factors are easy to find and analyse while selecting mutual funds. But the real art is to discover and analyse the qualitative factors. It involves determining the quality and efficiency of the fund house and the fund management team because only process-driven funds can be expected to generate consistent returns for investors.

Analyse the below factors to determine if the fund scores high on qualitative parameters:

1) Efficiency of the mutual fund house

When you select ELSS for your portfolio, always give higher importance to fund houses that follow sound risk management techniques and have robust investment systems and processes in place. It is crucial that you understand the overall philosophy of the fund house, whether they aim to create wealth for investors or are they in a race to garner more AUM by showcasing higher returns generated by chasing higher yields and taking higher risk.

2) Experience of the fund manager

The performance of ELSS is directly dependent on the ability of its fund manager to timely identify various opportunities available in the market. This makes it crucial to check the qualification and experience of the fund manager and the track record of the other schemes they manage. Apart from knowledge and market experience, assess the number of schemes that they manage. When the same fund manager is over-burdened and manages multiple schemes, inefficiency is likely to kick in. Therefore, ensure that a single fund manager does not manage more than five schemes at the same time.

To conclude…

Following the above-mentioned steps and parameters will surely help you to narrow down on a winning ELSS or tax-saving mutual fund. After you have carefully selected an ELSS for your portfolio in the endeavour to save tax and grow wealth, be patient and give your investments some time to grow and generate meaningful returns. Ideally, if the ELSS you have invested in performs well, it would be sensible to stay invested even beyond the lock-in period of three years to maximise the return potential and accomplish the envisioned financial goals.

When you invest in ELSS for your tax-saving and wealth creation needs avoid timing the market. Even though market conditions may not be favourable in the short term it can reward you over the long run. You can opt for the SIP route to invest in ELSS, that will reduce the impact of volatility on the portfolio vide its inherent rupee-cost averaging feature and, at the same time, allow your wealth to grow and benefit from the power of compounding.

This article first appeared on PersonalFN here

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