How to Select the Best ELSS for Tax-saving in 2024

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 Tax Saving Mutual Funds, are a popular option for many individual investors opting for the old tax regime.

[Read: Why ELSS Is Your Best Choice to Build Wealth and Save Tax]

What are ELSS?

SEBI defines ELSS as equity-oriented mutual funds that invest a minimum of 80% of their total assets in equity and equity-related instruments and come with a mandatory lock-in period of 3 years, along with tax benefits. These funds have the flexibility to invest across market caps and sectors.

Investing in ELSS offers investors 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 traditional tax-saving instruments.

At present, there are around 40 ELSS, or Tax Saving Mutual Funds, in India offered by different mutual fund houses. Thus, it can be challenging to select the right scheme for the portfolio. Now the question that may arise here is -- How should one select the best ELSS for tax-saving given the plethora of options available?

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

In my view, these are imprudent approaches to selecting the best ELSS that may fail to pay off in the long run. Remember that ELSS comes with a mandatory lock-in period of 3 years. So, if an investor selects a not-so-worthy scheme, investors may have to bear the cost of underperformance for the entire period.

[Read: Tax Saving Mutual Funds: Who Should Invest, How to Invest, and the Best Ones to Invest]

In this article, we will discuss in detail how should investors select the best ELSS for their portfolio in 2024...

How to select the best ELSS for tax saving?

To narrow down the best ELSS for your tax-saving needs that have the potential to create superior long-term wealth, investors need to thoroughly assess the schemes on various quantitative and qualitative parameters as listed below.

You can also watch this video to learn about the key factors in choosing the best mutual funds:

https://www.youtube.com/watch?v=UjTymKScmms

I. Quantitative parameters

1) Past Performance

One of the core objectives 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 investors set realistic expectations of its future performance.

However, when evaluating a fund's past performance, one should avoid giving 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, one should use the historical returns as a tool to determine how consistently the scheme has performed in the past. Here is how to do it:

a. 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. Therefore, depending on the prevailing market conditions and the strategies adopted by the fund manager, a scheme may outperform or underperform.

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.

How ELSS fared in the last 5 years

Scheme	5 Yr Returns (CAGR %)
Top-performing scheme	30.36
Worst-performing scheme	10.47
Category Average	17.98
NIFTY 500 - TRI	17.16

Past performance is not an indicator of future returns
Data as of December 08, 2023. Direct plan - Growth option considered
(Source: ACE MF, data collated by PersonalFN)

b. Evaluate the fund's Performance Across Market Cycles:

Most ELSS perform well during market uptrends. However, when the market conditions turn bleak, some schemes may 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 their benchmark and the category peers.

2) Risk-adjusted returns

Since ELSS invest predominantly in equities, they are vulnerable to market volatility. However, the impact of volatility can be mitigated if the fund manager deploys efficient risk-management techniques. Thus, it is crucial to determine whether the fund has rewarded its investors suitably 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, investors 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 return) and Sortino ratio (that denotes the fund's ability to contain the downside risk); the higher the ratio, the better the scheme is.

[Read: 7 Ratios to Assess Mutual Fund Risk And Identify the Best Mutual Funds]

3) Portfolio characteristics

The performance of an ELSS is extensively dependent on the quality of its underlying portfolio, i.e. stocks, sectors, market cap exposure, and other securities that it holds. If the underlying securities do well, the mutual fund scheme is likely to reward investors with superior returns.

Therefore, ensure that the scheme is well-diversified across stocks, sectors, and market caps within its stated investment mandate to avoid concentration risk. To assess this, analyse the scheme's top-10 holdings, the top-5 sector exposure, the market capitalisation bias, the style of investing followed -- value, growth, portfolio turnover ratio, etc.

II. Qualitative parameters

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

While quantitative factors are easy to find and analyse while selecting mutual funds, the real test is to uncover and analyse the qualitative factors. Analysing qualitative parameters involves determining the quality and efficiency of the fund house and the fund management team. Remember that 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 selecting ELSS for the investment 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 investors 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 overburdened 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 can help investors narrow down on a winning ELSS or Tax Saving Mutual Fund. After carefully selecting an ELSS for the portfolio in the endeavour to save tax and grow wealth, be patient and give the investments some time to grow and generate meaningful returns.

Ideally, if the ELSS that 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.

Furthermore, when investing 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 investors reasonably over the long run. Individuals can opt for the SIP route to invest in ELSS, that will reduce the impact of volatility on the portfolio via its inherent rupee-cost averaging feature and, at the same time, allow the wealth to grow and benefit from the power of compounding.

This article first appeared on PersonalFN here.

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