Tax Saving Mutual Funds

How to select a tax-saving mutual fund

Selecting the best tax-saving mutual fund (also referred to as equity linked saving scheme - ELSS) is never an easy task. For one, there are just too many funds, which only confuses the investor. Add to this the sometimes misrepresentative mutual fund advertisements that paint a rosier than warranted picture. At the end of the day, often investors end up being invested in the wrong tax-saving mutual fund.

To reverse the effect of the misrepresentative advertisements and help investors take the decision-making in their own hands, we have drawn up a list of 5 parameters that they must consider before investing in a tax-saving mutual fund.

1. Evaluate the fund house
    
   Too often investors are so enamoured by the performance of the tax-saving mutual fund that it's all they consider before investing in it. Among other points, they ignore the fund house and its investment style and philosophy. In our view, this is a serious oversight. Ignoring the fund house can prove to be a costly mistake over the long-term. This is because a tax-saving fund mutual is only as good as the fund house and its investment processes. Fund houses that do not have well-defined investment systems and processes in place can never serve the long-term interests of investors effectively. In the short-term, some factors like a star fund manager may mask the poor quality investment processes, but take away these factors (i.e. when the star fund manager quits) and the fund house stands exposed. We recommend that investors first evaluate the fund house; only when it makes the grade on high quality investment processes and philosophy should investors look at its tax-saving offering.



 
2. Give restrictive mandates a miss
    
   Building a tax-saving portfolio is a lot different from building a regular, diversified equity fund portfolio. While constructing a diversified equity fund portfolio, there is scope to include a variety of mutual funds - large caps, mid caps, flexi cap/opportunity style funds, growth style funds, value style funds, among others. However, it's a little different while building a tax-saving portfolio, which typically must have no more than 2-3 mutual funds to make it manageable for investors. Since investors usually have a limited corpus for tax-saving (maximum limit of Rs 100,000 per annum), having too many tax-saving mutual funds can be self-defeating considering the time and effort that will go behind monitoring a large portfolio. Therefore it's best to go for 2-3 tax-saving mutual funds that have very broad investment mandates in terms of stocks (large caps, small/mid caps) and investment style (growth and value). That way you will be able to make the most of opportunities across the market.



 
3. Insist on diversification
    
   Since investing in tax-saving mutual funds is no different from investing in regular diversified equity funds, the same yardsticks apply for selection. An important point to consider while evaluating equity funds is the level of diversification. At Personalfn we like diversified equity funds (including tax-saving mutual funds) to be truly diversified i.e. maintain diversified portfolios. This is particularly important during choppy markets when being over-exposed to a particular stock/sector can prove fatal. Investors should short-list tax-saving mutual funds that have well-diversified stock and sector portfolios. We have noticed that while many funds have well-diversified stock portfolios, they tend to hold concentrated sectoral portfolios. A concentrated sectoral portfolio can reverse all the good work done by a well-diversified stock portfolio; hence the need to diversify across both stocks and sectors. At Personalfn, we maintain that diversified equity funds should aim at investing no more than 40% of assets in the top 10 stocks; this can serve as a benchmark for investors while evaluating the level of diversification in tax-saving mutual funds.



 
4. Check NAV returns
    
   Another evaluation parameter that is common across regular diversified equity funds and tax-saving mutual funds is performance on the NAV (Net Asset Value) returns. While the NAV return in isolation is incomplete (the risk-adjusted return which is the other factor to be considered is discussed in the next point), it is nonetheless a parameter worth considering. While evaluating the NAV returns consider three points - how the fund has performed vis-a-vis the benchmark index and comparable peers. Also apart from the compounded annualised growth rate (CAGR), it is important to note the fund's performance over the calendar year and over specific market phases like the downturns. Finally, ensure that comparisons are made over longer time frames like at least 3-5 years; this is pertinent given the 3-Yr lock-in that accompanies tax-saving mutual funds.



 
5. Check risk-return
    
   While performance over NAV returns is important, equally significant is the fund's showing on the risk-return parameters. Simply put, this means that while generating a return is critical it is important to note the 'price' investors have paid for that performance. The price that investors pay (apart from the fund's recurring expenses) is the risk the fund manager has exposed the fund to, in pursuit of NAV returns. The risk is reflected mainly through volatility in the NAV returns (which is measured through the Standard Deviation) and the risk-adjusted return (captured by the Sharpe Ratio). While evaluating the Standard Deviation, look for equity funds with a lower figure (which underlines lower volatility). It's the opposite with the Sharpe Ratio where a higher figure shows that the fund has given a higher return per unit of risk borne. The best tax-saving mutual fund would be the one that has given a high NAV return at lower volatility (Standard Deviation) and higher Sharpe Ratio (risk-adjusted return).

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