5 Steps to Select the Perfect ELSS for Tax-Saving in 2022

Equity-linked Saving Schemes (ELSS), also known as tax-saving mutual fund schemes, have emerged as a popular option for tax-saving needs for individual investors.

The capital market regulator, SEBI, defines ELSS as equity-oriented mutual funds that invest a minimum of 80% of its total assets in equity and equity-related instruments. They 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 Act), 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?

Should you take an easy way out and judge the scheme based on its popularity? Or pick the one with the lowest NAV? Or say, simply select the top-performing ELSS of the previous year?

In our view, these are imprudent approaches to selecting the best ELSS that may fail to pay off in the long run.

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.

Therefore, you need to thoroughly assess the schemes on various quantitative and qualitative parameters. This will help you zero in on the best ELSS for your tax-saving needs that have the potential to create superior long-term wealth.

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So, here are the definitive steps to select the best ELSS for your tax-saving portfolio...

Step #1: Evaluate the past performance

The core objective of investing in ELSS, or any equity mutual fund, is to maximize wealth by investing in a diversified basket of stocks spread across sectors.

It makes sense to first analyse the past performance of the scheme. This will help you set realistic expectations of its future performance.

However, when you evaluate a fund's past performance, ensure you do not give too much importance to past performance for selection. This is because past performance is not indicative of how the fund will perform in the future.

Instead, use past performance as an indicative parameter to determine how consistently the scheme has performed.

Here is how you can do it...

To determine how consistently a scheme has performed, assess the returns generated by the scheme relative to its benchmark and its category peers across various time frames such as 1-year, 3-year, 5-year, since inception, etc.

It is important to 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 certain market conditions.

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 avoid investing in such an ELSS.

In addition, evaluate the scheme's performance across various market phases and cycles. Most ELSS perform well during market uptrends.

However, when the market conditions look bleak, many funds fail to contain the downside. Therefore, it is vital to select schemes that perform consistently well across bear and bull market phases relative to the benchmark and the category peers.

Step #2: Assess the 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.

Therefore, the next step in selecting the best tax-saving fund is to assess whether the fund is capable of rewarding investors by taking on a reasonable level of risk. This should be consistent with its investment style and strategy.

To determine a scheme's ability to reward investors adequately for the level of risk taken, evaluate the scheme's Standard Deviation.

A higher standard deviation means that the scheme is more volatile or risky compared to the benchmark and its peers.

Also, assess the risk-adjusted returns denoted by the Sharpe Ratio as well as the Sortino Ratio which denotes the fund's ability to contain the downside. The higher these ratios are, the better is the fund.

Step #3: Check the quality of the fund's portfolio

The performance of an ELSS depends on the quality of its underlying portfolio, i.e. stocks, sectors, and market-cap allocation.

If the underlying securities do well, your ELSS is likely to reward you with superior returns.

An ELSS must be well-diversified across stocks and sectors to avoid concentration risk. To check this, analyse the scheme's top-10 holdings, the top-5 sector exposure, the market capitalisation bias, the style of investing followed - value, growth, etc.

Ensure the fund manager does not frequently churn its portfolio and holds each stock with conviction until its full potential is realised.

If the fund manager constantly buys or sells stocks (as denoted by the higher Turnover ratio), it leads to a higher expense ratio. This expense is eventually borne by you, the investor. So when you zero in on an ELSS to make a tax-saving investment, pay special attention to the portfolio and how it's managed.

Other than these quantitative parameters that are easy to find and analyse, you also need to analyse the qualitative factors. This is essentially where the art of picking the perfect mutual fund is.

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

So, the next steps in selecting the best ELSS or tax saving fund are the qualitative aspects. These will help us understand how well the fund house and the fund management team manage their mutual fund schemes.

Step #4: Determine the quality of the mutual fund house

When you select ELSS, 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. Do they aim to create wealth for investors or are they in a race to garner more AUM by showcasing higher returns generated by taking a higher risk?

Keep in mind that it is only the process-driven funds that can generate consistent returns for investors.

Step #5: Check the experience of the fund manager/s

The performance of ELSS depends directly on the ability of its fund manager/s to timely identify various opportunities available in the market.

Thus it is 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 they manage. When the same fund manager is over-burdened with the task of managing multiple schemes, inefficiency is likely to kick in.

This is why you must ensure that a single fund manager does not manage more than five schemes at the same time.

To Conclude...

Evaluating the above-mentioned parameters will surely help you to select the perfect ELSS for your tax-saving portfolio in 2022.

After you have carefully selected an ELSS, be patient with it. 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. This way one could maximise returns and accomplish the envisioned financial goals.

If you are looking to invest in ELSS for your tax-saving and wealth creation needs, do not wait for the market conditions to turn favourable.

You can opt for the SIP route to invest in ELSS. That will reduce the impact of volatility on the portfolio with its inherent rupee-cost averaging feature.

At the same time, it will allow your wealth to grow and benefit from the power of compounding.

Happy Investing!

Disclaimer: This article has been authored by PersonalFN exclusively for Equitymaster. PersonalFN is a Mumbai-based Financial Planning and Mutual Fund research firm known for offering unbiased and honest opinions on investing.