select tax-saving funds (also called equity-linked saving schemes – ELSS) for
the Section 88 (of the Income Tax Act) benefit.
As blunt as that may sound, it is the main reason why tax-saving funds find
their way into investor portfolios.
We are not saying there is anything wrong with that, but equities are too
risky an investment to let tax breaks dictate your
Once investors appreciate that the tax benefit is just an add-on, they will
treat tax-saving funds at par with regular diversified equity funds.
In other words, they will use the same yardstick to select a tax-saving fund
as they would any diversified equity fund.
Which means that performance, investment style, expenses and other critical
parameters come into play and ‘tax benefit’ takes a back seat. We have tried to
outline some of the key parameters that need evaluation before you select the
right tax-saving fund.
Among other things, investors must evaluate the tax-saving fund on NAV
returns. While performance isn’t everything, it is nonetheless a critical
parameter on which a fund must redeem itself before you can consider investing
The fund must have put in a solid performance vis-à-vis the benchmark index
(Sensex, Nifty, BSE 200, as the case maybe) as also
its peer group. And since tax-saving funds have a 3-year lock-in, this performance
must stand out over longer time frames 3-year, 5-year.
In reality, all equity-linked investments need to be considered with a 3-5
year investment horizon, but ironically it takes a lock-in in a tax-saving fund
for investors to evaluate equity funds over that ‘extended’ a timeframe.
While evaluating performance, you need to put a premium on consistency
across market phases. Most, if not all, funds do well during a bull run, and
most funds do just as poorly during a market slump. Choose tax-saving funds
that have put in a reasonable show during the upturns and the downturns.
For this you need to look at calendar year returns, not just compounded
annual growth returns (CAGR).
2. Investment approach
Equally important, if not more important than NAV returns, is the investment
style and approach of the fund manager. Typically, mutual funds are either
managed through strong systems and processes or they are managed with a strong
individualistic trait, wherein the fund manager has sufficient leeway to make
Of the two styles, the first one is preferable as there is greater emphasis
on an investment team that follows a well-defined process that is known to the
investor before hand and does not come as a shock to him at a later stage.
To cite an example, Sundaram Tax Saver has a
well-defined investment process that does not allow the fund manager to invest
more than 5 per cent of net assets in a single stock.
While this may be a defensive investment strategy, it also gives a lot of
comfort to the investor who knows well in advance the risk levels associated
with the fund.
Given that you invest in a tax-saving fund with a minimum 3-year commitment,
there is merit in selecting conservatively managed funds that look for
undervalued stocks as the fund manager has the luxury of taking longish
3. Volatility and risk-return
Great NAV (net asset value) returns in isolation do not amount to much. A
fund could have done exceedingly well during a bull run by pursuing an aggressive
investment strategy and could have slumped as hard during the bear phase after
What this means to the investor is that his fund’s NAV is up sharply one
month and down even more sharply the next month. This is the kind of turbulence
that most investors can do without.
Admittedly, equity funds cannot really eliminate turbulence in their
performance given the nature of equities. But it can be kept under control by
pursuing a disciplined investment approach. You need to identify funds that
have a lower ‘standard deviation’ — a measure used to gauge volatility in NAV
Likewise, look for tax-saving funds that have rewarded investors more per
unit of risk taken by them. This is calculated by the Sharpe Ratio; a higher
Sharpe Ratio indicates that the risk-return trade off has worked in the
So a lower standard deviation and a higher Sharpe Ratio make for an ideal
mutual fund investment.
Managing a fund entails costs like fund manager’s salary, marketing/advertising
costs and administration costs. The cost of investing in a mutual fund is
measured by the expense ratio. The ratio represents the percentage of the
fund’s assets that go purely towards the cost of running the fund.
Typically, tax-saving funds have expense ratios in the region of 2.25-2.50
per cent. A lower expense ratio has a positive impact on the returns of the
fund as the NAV (net asset value) is calculated after deducting the expenses.
5. Other parameters
Some other parameters that you must look at are entry load and track record
of the asset management company. Most tax-saving funds have an entry load of
2.00-2.25 per cent. Some fund houses waive off the entry load on investments
made through SIPs (systematic investment plans).
Likewise track record and asset management pedigree also need to be given
due weightage. A fund house that has been embroiled
in a controversy in the past can be given the miss. Likewise, a fund house that
has just been launched can be considered only after you have exhausted other
Remember, with a tax-saving fund, the fund house needs to have a minimum
3-year track record over which it should have witnessed market upturns and
Investing in tax-saving funds must be given its due research and planning. By
only playing the tax benefit angle, you run the risk of settling for a
compromise and forfeiting the opportunity of making a great equity investment.
Your tax-saving fund shopping list:
- 1. Less than 40% of net
assets in the top 10 stocks of the portfolio.
- 2. Expense ratio less than
- 3. Standard deviation of less
- 4. Sharpe Ratio higher than
- 5. Compounded growth of over
25% over 5-year.
Table 1: Leading Tax-Saving Mutual Funds
Assets (Rs cr)
HDFC Tax Plan 2000
Birla Equity Plan
Pru ICICI Tax Plan
Magnum Tax Gain
HDFC Tax Saver
Principal Tax Savings
Tata Tax Saving Fund
Sundaram Tax Saver
Alliance Tax Relief
(Source: Credence Analytics. NAV data as on Nov 9, 2004. Growth over 1-Yr is compounded annualised. The Sharpe Ratio is a measure of the returns
offered by the fund vis-à-vis those offered by a risk-free instrument. Standard
deviation highlights the element of risk associated with the fund.)
This article forms a part of the latest issue of Money Simplified – The
Definitive Guide to Tax Panning. Click here to download, for FREE, the complete guide.