Tax Saving Mutual Funds: Who Should Invest, How to Invest, and the Best Ones to Invest
July 26, 2023 Mutual Fund
“In this world nothing can be said to be certain, except death and taxes.” — Benjamin Franklin (the founding father of the United States of America, statesman, diplomat, polymath, philosopher, author, printer, publisher, inventor, and scientist)
As regards taxes, a penny legitimately saved from tax is money earned. And for this purpose, tax planning is pivotal. A galore of provisions exist under the Income Tax Act 1961, enabling you to save tax. Besides, there are tax-saving instruments that help complement tax planning with investment planning. One such instrument is Tax Saving Mutual Funds.
What are Tax Saving Mutual Funds?
Tax Saving Mutual Funds are also known as Equity Linked Saving Schemes (ELSS). Deploying the investible surplus in Tax Saving Mutual Funds or ELSS entitles you to a deduction (from the Gross Total Income) of up to Rs 1.50 lakh in the financial year in which the investment is made as per Section 80C of the Income Tax Act, 1961.
The capital market regulator, the Securities and Exchange Board of India (SEBI), Tax Saving Mutual Funds or ELSS are categorised as open-ended equity mutual funds that invest a minimum of 80% of their total assets in equity and equity-related instruments (in accordance with the equity-linked savings scheme, 2005, as notified by the Ministry of Finance).
Broadly, the investment objective of an ELSS is to achieve long-term capital appreciation or growth. In the endeavour to achieve this, the total assets of an ELSS are usually allocated by the fund manager across market capitalisation segments (largecaps, midcaps, and smallcaps) and sectors.
Further, to pick stocks for its portfolio, the fund manager may go top-down or bottom-up, and as regards style of investing, it may be of any genre –growth style, value style, or even a mix of both, depending on its investment mandate and strategy.
Is there are lock-in Tax Saving Mutual Funds?
Yes, there is.
A distinguishing trait of a Tax Saving Mutual Fund or ELSS is that although it is an open-ended scheme, your investment in it is subject to a 3-year lock-in period. So, you cannot withdraw until the completion of 3 years from the date of your investment.
Table 1: Lock-in period of tax-saving instruments
| Tax-Saving Instrument |
Lock-in period |
| Equity-Linked Saving Scheme |
3 years |
| Unit-Linked Insurance Plan |
5 years |
| National Saving Certificate |
5 years |
| Tax Saver Bank FD |
5 years |
| Senior Citizens Savings Scheme |
5 years |
| Public Provident Fund |
15 years |
| Sukanya Samriddhi Yojana |
21 years |
| National Pension Scheme |
Till 60 years of age |
Note: The list is not exhaustive.
However, when compared to other tax-saving instruments, the lock-in for Tax Saving Mutual Funds or ELSS is the least, thus offering better liquidity. When it comes to equities, a lock-in period instils the discipline of staying invested for the long term, so that you can potentially grow wealth, i.e., compound your hard-earned money.
So, investing in a Tax Saving Fund or ELSS kills two birds with one stone–tax saving (at the time of investment) and wealth creation (over 3 years or more).
[Read: 5 Reasons to Invest in ELSS (Tax Saving Mutual Funds)]
Who Should Consider Investing in Tax Saving Mutual Funds or ELSS?
By and large, if you are a risk-taker and do not mind market-linked returns that could potentially beat inflation, ELSS mutual funds may be apt for your tax-saving portfolio.
In times when inflation is eroding the purchasing power of hard-earned money, even senior citizens considering their personal risk profile, liquidity needs, and tax outgo, by taking a calculated risk, could allocate a small portion to Tax Saving Mutual Funds or ELSS, which is tax-efficient investment avenue compared to fixed-income instruments (where the interest earned in most cases is taxable).
Strategically, in my view, for the tax-saving portfolio, a retiree, may follow an 80:20 or 75:25 allocation–between ELSS (a market-linked tax-saving instrument) and the non-market-linked tax-saving instruments to save tax under Section 80C. This shall potentially help you make up for the rising cost of living.
How to select the best Tax Saving Mutual Funds or ELSS?
Care needs to be taken to select Tax Saving Mutual Funds or ELSS. One cannot solely rely on past returns, as it is in no way indicative of future returns. Similarly, one can’t count on the ratings that are given only based on returns.
Here are a few guidelines to pick the best Tax Saving Mutual Funds or ELSS for the investment portfolio:
- Evaluate the Past Performance:In this case consider the performance across longer periods (such as 3 years, 5 years, 7 years, since inception, etc.) and market cycles (bulls and bears). Check for the consistency with which the ELSS is performing and how it has fared relative to its benchmark index.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. Likewise, when the market conditions look bleak systemically, some ELSS could fail to contain the downside.
- Assess the Risk-adjusted Returns:Lone returns are not the best way to evaluate a Tax Saving Mutual Fund or ELSS. This is because, being an equity-oriented mutual fund scheme, the returns are susceptible to market volatility.To select among the best Tax Saving Mutual Funds or ELSS, it is vital to assess the risk the fund has exposed its investors to as denoted by the Standard Deviation. A higher Standard Deviation means that the scheme is more volatile or risky compared to the benchmark and its peers.An ELSS must demonstrate its ability to adequately compensate investors for the level of risk taken. This can be well understood by the Sharpe Ratio, which tells how much return an investor is earning in correlation to the level of risk being undertaken. It’s calculated by taking the difference between the returns of the investment and the risk-free return, divided by the Standard Deviation of the asset.Similarly, the Sortino Ratio is a useful measure to determine a fund’s ability to contain the downside risk, especially during depressed market conditions. It is calculated by taking the difference in the fund returns and risk-free return, divided by only the downside deviation. Unlike the Sharpe Ratio, Sortino uses only downside deviation for calculating the risk instead of the total volatility of the portfolio. The downside risk denotes returns that fall below a minimum threshold, such as risk-free returns and/or negative returns.[Read: 3 Important Ratios to Consider Before Investing in Mutual Funds]Also, watch this video:https://www.youtube.com/embed/X-wNklmXnpc The higher these ratios are, the better is for the mutual fund scheme. Note, when the fund manager deploys efficient risk-management techniques, the downside risk is mitigated.
- Study the Portfolio Characteristics:The performance of an ELSS is closely linked to the underlying stocks or other equity-related instruments held in the portfolio. Therefore, in this respect, it is important to judge the portfolio characteristics, i.e. the market capitalisation, top-10 holdings, the kind of sectors it has exposure to, and the fund management style followed (value, growth, or blend).A Tax Saving Fund or ELSS must be well-diversified across stocks and sectors to avoid concentration risk. If the underlying securities do well, the ELSS is likely to reward you with superior returns. At times to generate higher returns, certain fund managers tend to churn the portfolio often. However, keep in mind that this also weighs on the expense ratio, which is borne by you, the investor.
- The Credentials of the Fund Manager:The fund manager is the one responsible for the performance of the mutual fund scheme. How a fund fare directly or indirectly depends on the ability of its fund manager/s (to timely identify various investment opportunities in the market) and therein credentials, i.e., experience and qualifications, play a crucial role. One also needs to evaluate the track record of the other schemes managed by him/her.Ideally, a fund manager should not be actively overseeing more than 5 schemes. This is because when a fund manager is overburdened with the task of managing multiple schemes, inefficiency is likely to kick in.
- Check the investment ideologies, processes and systems followed at the mutual fund houseIn addition to the above, to select a Tax Saving Mutual Fund or ELSS for your investment portfolio, it would be worthwhile to understand the ideologies/philosophy of the fund house, its forte in managing a respective asset class, alongside the investment processes and systems.Always give higher importance to fund houses that follow sound risk management measures and have robust investment systems and processes in place rather than going with a Tax Saving Mutual Fund or ELSS managed by a star fund manager. When the star fund manager moves out, it may have a bearing on the performance. Note, usually, the process-driven fund houses hold the potential to generate consistent returns for investors.It would also do well to check the efficiency of the fund house in managing its Assets Under Management (AUM) by evaluating the proportion of AUM of the fund house actually performing to judge whether it is an asset manager or a mere asset gatherer.
And when you zero in on the best Tax Saving Mutual Funds as per the aforesaid quantitative and qualitative parameters, choose the Direct Plan and Growth Option to maximise wealth creation rather than going with the Regular Plan and IDCW Option.
Which are the best Tax Saving Mutual Funds or ELSS to Invest in 2023?
Well, currently, there are several ELSS mutual funds. But not all have been able to beat their respective benchmark Total Return Index (TRI).
Table 2: Number of ELSS Outperforming and Underperforming the benchmark indices
|
1-year |
3-year |
5-year |
| Total no. of schemes |
34 |
34 |
31 |
| No. of schemes outperformed |
23 |
19 |
15 |
| Outperformance rate (%) |
67.6 |
55.9 |
48.4 |
| Underperformance rate (%) |
32.4 |
44.1 |
51.6 |
Data as of July 21, 2023
Past performance is not an indicator of future returns.
Returns considered are point-to-point.
Direct Plan-Growth option considered.
Mutual Fund investments are subject to market risks. Read all scheme-related documents carefully.
(Source: ACE, data collated by PersonalFN)
Over a 3-year horizon, 19 schemes (out of 34) managed to outperform the benchmark TRI, while over a 5-year horizon, 15 schemes (out of 31 that completed a 5-year performance track record) outperformed the TRI.
Over a 3-year and 5-year period, Quant Tax Plan tops the list with a CAGR of 42.02% and 25.85%, respectively. A few other Tax Saving Mutual Funds or ELSS too have fared better than the category average returns and outperformed their respective benchmark index.
Table 3: Performance of Tax Saving Mutual Funds or ELSS
Data as of July 21, 2023
The list above is not exhaustive.
The securities quoted are for illustration only and are not recommendatory.
Direct Plan-Growth option considered.
Returns considered are point-to-point and expressed in %.
Returns over 1 year are compounded annualised; else absolute.
Standard Deviation indicates Total Risk, while Sharpe and Sortino Ratios measure the Risk-Adjusted Return. They are calculated over a 3-Yr period assuming a risk-free rate of 6% p.a
Past performance is not an indicator of future returns.
The table above is NOT a recommendation as such. Speak to your investment advisor for further assistance before investing.
Mutual Fund investments are subject to market risks. Read all scheme-related documents carefully.
(Source: ACE MF; Data collated by PersonalFN Research)
The table above also makes it evident that a few schemes haven’t been able to outperform the category average and benchmark returns. Hence enough care and a scientific approach need to be followed to pick the best Tax Saving Mutual Funds or ELSS. In the current market scenario, where valuations are not cheap and the margin of investing is low in growth stocks [commanding ridiculous Price-to-Equity (P/E) and Price-to-Book Value (P/B) multiples], you need to zero in on the right ELSS. The fund manager should be mainly investing in undervalued stocks commanding lower P/E, P/B, offering higher dividend yield, and in well-established companies that have an advantage in terms of the moat, market share, lower debt, etc. Such companies when the market is volatile in the interim or witnesses a downturn, could remain afloat and prove rewarding for you, the investor, in the long run. Don’t just go by the recommendations of your friend, colleague, relative, or neighbour.
This article first appeared on PersonalFN here
Related
Related Posts
