6 Parameters To Consider Before Choosing ELSS Fund

Selecting a Right Tax Saving Fund

Introduction

If you are planning to invest in ELSS fund to save taxes for the current financial year ie. FY2019-20, here are 6 parameters to consider before choosing ELSS fund.

As we are heading towards the end of financial year 2019-20, we have discussed the 8 important financial tasks to complete before March 31, 2020 in our earlier article.

6 Parameters To Consider Before Choosing ELSS Fund

Features of Equity Linked Saving Schemes (ELSS)

• ELSS is one of types of Equity Oriented Mutual Fund. Equity Linked Saving Schemes / Funds give dual benefit viz opportunity to invest in equity mutual funds and tax saving.
• These ELSS funds are diversified equity mutual fund schemes that provide tax benefits under Section 80C of the Income-tax Act, 1961, up to Rs.1.5 lakh.
• Being Tax Saver Fund, ELSS come up with a lock-in-period of 3 years. i.e. ELSS funds cannot be redeemed or switched before completion of 3 years from the date of investment. Therefore, selecting the right scheme becomes very important.
• ELSS funds can be redeemed after expiry of 3 years. LTCG is taxable @ 10% without indexation benefit.

6 Parameters To Consider Before Choosing ELSS Fund

1. Market cap composition

• As a general rule, ELSS fund requires at least 80% of its investment in equity instruments. However, there is no restriction on the % allocation in particular equity instrument.
• SEBI has given a full flexibility to fund manager to decide the % allocation in stocks (i.e. Large Cap / Mid Cap / Small Cap). Manager decides the allocation on the basis of the market conditions, objective of the fund, and his own risk-taking capability to achieve that objective.
  • Note: SEBI gives ranking to all the listed companies based on their market capitalization. According to the market capitalization, these companies are broadly categorized as Large Cap, Mid Cap and Small Cap Companies. SEBI reviews the market capitalization periodically and revises the categorization of the companies. Now, based on the above categorization –
    1. Large Cap companies are the top 100 companies as per SEBI Ranking based on market capitalization. These companies are the stable companies which give moderate returns with lower risk. One should invest in these companies for approximately. 5-7 years.
    2. Mid Cap Companies are next 150 companies i.e. companies from 101 to 250 as per SEBI ranking based on market capitalization. These companies give higher returns as compared to large companies. However, the risk involved is also higher than large cap companies. One should invest in these companies for minimum 7-10 years to get the desired returns.
    3. Small Cap Companies are the companies not categorized as Large Cap or Mid Cap Companies as per SEBI. These companies come up with Highest Return potential as well as involves highest risk factor amongst all the categories.
• Also, review the past trend of market cap allocation of the fund and stability of its investment patterns. One should prefer to choose the funds with steady investment pattern rather than frequently changing investment pattern as this involves the higher risk. You can get last 10 year market cap allocation trend at our MF Yadnya website.

2. Risk Involved and Expected Returns

• Risk and returns on investments are interlinked.  Mutual Funds delivering higher returns come up with higher risks and the mutual funds delivering lower returns involve lower risk as compared the others.
• Therefore, the key to decide your suitable Tax Saving Fund is to understand your risk profile first i.e. understand that how much risk you can take while investing in the mutual funds.
• If you are an aggressive investor, (i.e. if you are ready to take high risk) then you can keep choose a fund having higher allocation in mid-cap or small cap stocks. However, for achieving the desired rate of return, investor must keep his mutual fund investment intact for at least 7-10 years.
• If you are a conservative investor, (i.e. if you wish to play safe) then you can choose the ELSS fund having maximum of its investment in Large Cap Stocks which are quite stable and less risky than the other two categories. (i.e. Mid Cap and Small Cap). However, for achieving the desired rate of return, investor must keep his mutual fund investment intact for at least 5-7 years.
• Risk involved can also be understood from ratios like Standard deviation, Beta and Alpha.

3. Review of Returns of the ELSS Funds

• While investing in mutual fund, investor must review the trend of the fund in respect of rate of returns delivered. Also, he should consider the rate of return as well as the consistency with which those returns are delivered. While reviewing it is advisable to track the records for at least 8-10 years of the fund.
• This is an ideal duration, because by that time fund goes through the multiple cycles of ups and downs in the market. This helps the investor to track the performance of the fund in all the situation.
• While reviewing the performance of the fund, investor should focus more on the following types of mutual fund returns :
  1. Annualized Returns i.e. CAGR
  2. Trailing Returns
  3. Calendar Returns
  4. Rolling Returns

4 Types of Mutual Fund Returns :

1. Annualized Returns i.e. CAGR: Annualized Returns (CAGR) means the returns received by the investor on yearly basis for the given period of time.
2. Trailing Returns: Trailing Returns are the annualized returns for a specific period viz. for past 1 / 3 / 5 / 7 / 10 years. These returns can be utilized to understand the performance of the fund in the recent past. However, if a fund has performed exceptionally well in a particular year, then it can improve the % returns of the returns in 3 / 5 / 7 years. Therefore, one must not rely ONLY on the trailing return.
3. Calendar Returns: Calendar returns are the absolute returns from 1^st January to 31^st December each year. It gives you the rate of return of each year during the ups and downs in the market. Investor must compare the calendar returns with the benchmark and the category average.
4. Rolling Returns These are useful for reviewing the behavior of returns in the period of investment. It highlights the highest and lowest returns in the given period of time.
5. To summarize, A mutual fund with a strong and consistent track record of CAGR, Calendar and trailing returns along with the history of at least 8-10 years can be shortlisted while taking investment decision.

4. Expense Ratio of ELSS Funds

• While investing in Tax saving funds, investor should also consider the expense ratio of the fund. High expense ratio of the fund shows the high amount of expenses paid by the fund.
• Expense ratio in this category ranges between 1.46% to 2.99%. Investor should choose the fund with low or moderate expense ratio along with the higher rate of returns.
• Note: Expense ratio is the fees charged by the mutual funds for managing the money invested by the investors. This includes the following :
  • Registrar fee
  • Fund Management Fee
  • Distributors’ Commission
  • Advertising Expenses
  • Auditor’s and Custodians share  

5. Fund Manager

• Another important factor to understand the probability of return consistency in future.
• If a fund has a good and consistent fund manager who has given good performance in the past, then it can be safely assumed that fund will give good returns in the future too.
• Always check fund manager’s profile and his record not just in this fund but other funds he/she manages.

6. Fund House

• This is an important factor to select the Tax Saving fund. Investor shall consider an established fund house rather than new fund houses.
• It is because, when a fund house is established, it has an experience to handle the large amount of investments.
• Decision making processes are set, therefore, change in the fund manager does not impact the returns delivered by the fund too much.