Mutual Funds

How to choose the right ELSS fund

Kumar Shankar Roy BL Research Bureau | Updated on January 23, 2021

Hasty decisions may save tax in the short term, but can prove to be damaging in the long run

If you choose the old tax regime, it is ideal to start your tax planning investments at the beginning of the financial year. But most take it easy until the last one-two months of the year.

This results in spur-of-the-moment decisions such as investing in equity-linked savings schemes (ELSS) when it may not suit your risk profile or, even when it does suit, choosing the scheme without doing any homework.

ELSS funds are equity MF schemes that provide tax benefits for investments of up to ₹1.5 lakh a year under Section 80C of the Income Tax Act. The schemes have a three- year lock-in.

Therefore, deciding whether you want to invest, and if so, selecting the right scheme, becomes very important as you cannot break the investment.

Suitability

There are several tax-saving instruments such as Public Provident Fund (PPF, 15- year tenure), National Savings Certificate (NSC) and tax-saving FD (five-year tenure).

Unlike most of these, ELSS invests in equities fully and so there is risk of loss of capital. You should not choose ELSS because it is one which has the lowest lock-in of three years among 80C instruments.

A three-year tenure which matches the lock-in may not be enough for any equity instrument. Since ELSS are by nature diversified mutual funds, one should give 5-7 years at least. So, don’t put money in ELSS if you need the corpus immediately after three years.

If you do SIPs in ELSS funds, every SIP will be locked in for three years. Fund houses don’t allow withdrawal in ELSS before three years whether you invest in lump sums or SIPs.

Return stability

Many investors looking at ELSS for last-minute tax savings tend to choose the top-performing fund of the past one year. Select funds carefully after examining the consistency of their performance in different phases of market cycles.

Did you know that the best ELSS of 2017 became the second-worst in 2018? Evaluate returns for a few calendar- or financial-year returns. Select funds that figure in the top performers list consistently.

Another way to assess good fund management skills is by looking at rolling returns, which remove any bias towards periods under review, and are suitable for a SIP investor.

Rolling returns take several blocks of three-, five- or 10-year periods at various intervals, and the return consistency of the fund can be better analysed as it considers both upside and downside market trends.

If we compare the five large ELSS funds on three-year rolling returns for the past five years, Axis Long Term Equity will be on the top based on reporting at least 10 per cent returns over 81 per cent of the time, followed by Aditya Birla Sun Life Tax Relief 96 (77 per cent), ICICI Prudential Long Term Equity (59 per cent), SBI Long Term Equity (50 per cent) and Nippon India Tax Saver (48 per cent).

Don’t view a fund’s returns in isolation; compare it with the benchmark and peers.

Portfolio tilt and diversification

ELSS funds have the flexibility to invest across large-, mid- and small-cap stocks. Large-cap stocks are dominant in the portfolios of Axis Long Term Equity and HDFC TaxSaver.

But funds such as Aditya Birla Sun Life Tax Relief 96 and IDFC Tax Advantage usually have decent allocation to mid- and small-caps.

Curiously enough, in the new risk-o-meter, most ELSS funds, irrespective of their portfolio tilt, are given ‘very high’ risk grade. But if you like to take relatively low risk, you can choose a fund which has a large-cap tilt.

Like in other equity funds, diversification in an ELSS portfolio is an important factor to consider. Diversification can be gauged by the number of stocks in the portfolio. To assess concentration risk, look at the percentage of the portfolio in the top five stocks.

Finally, pay attention to ELSS fund costs. The Total Expense Ratio (TER) is critical for schemes with similar attributes. Big funds may be cheaper but that is no surety of future performance.

The TER range for tax-saving funds (regular plan) is 1.6-2.5 per cent, but if you buy direct plans, the costs can drop by up to 80 per cent.

Published on January 23, 2021

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