How To Invest In The Right Tax-Saver Fund?

Written on Wednesday, January 17, 2018
By Sudipta Mitu

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It is the time when your company is likely to demand proof of your tax saving investments for the year. If you have still not made those investments, you should do so now. For investors with a long investment horizon - say, those saving for their children’s education or marriage, or for their own retirement--an attractive tax saving option is the Equity Linked Saving Schemes (ELSS) of mutual fund houses. Since these funds invest in equities, they are likely to give you higher returns over the long term (five years or more) than other tax-saving options like Public Provident Fund (PPF) or tax-saver bank fixed deposits. Here is how to choose the right tax-saver fund.


Burgeoning AUM size, great returns: 


Ten years ago, the number of funds in this category stood at 22 and the total assets under management (AUM) at Rs. 10,955.28 crores. At the end of September this year, the number of funds stood at 41 and the total AUM had burgeoned to Rs. 65,642.14 crores. The category has rewarded investors richly in the past. One-year average trailing return for the category has been 41.71 percent three-year average trailing return has been 12.54 percent, and five-year average trailing return has been 18.97 percent. The median SIP return for the category over the five-year horizon is 19.34 percent.


The three-year lock-in that is allowed in these funds means that fund managers know that the money cannot go out before this time-period. Therefore, they can invest even in those stocks where it may take some time for value to emerge. Next, let us turn to how you should go about selecting the right fund for yourself.


Consistency in performance:


Trailing returns are important, but they are also very much affected by near-term performance. If a fund’s performance has been good over the past one year, it will also lift its performance over the three-year and five-year horizons. What an investor should ideally look for is a fund that has been consistent from year to year. The fund should not only outperform in a bull market but should also fall less than its benchmark in bear markets. It is easier for an investor to stick to such a consistent fund. Otherwise, in bearish market conditions, investors tend to turn despondent and exit a fund that is performing worse than its benchmark.


One simple way to gauge performance consistency is to look at the fund’s calendar year wise performance over a five- or seven-year horizon. In the table given alongside, we have provided a list of 15 funds that have beaten their benchmark at least six or seven times over the past seven calendar years. This could be the basic list from which you select a fund (by looking up other additional criteria as well.


Concentrated or diversified portfolio: 


When choosing a fund from the ELSS category, you should also know whether the fund that you are opting for is a diversified or concentrated fund. A concentrated fund tends to invest in fewer stocks. If the fund manager’s stock selection turns out to be right, the fund can outperform its peers in a big way. But if the fund selection goes wrong, the performance of these funds can also be hit in a big way. More aggressive investors may opt for concentrated funds while more conservative investors should opt for funds with a diversified portfolio. Whether a fund’s portfolio is diversified or concentrated can be known by looking at the number of stocks it holds, and how concentrated its portfolio is in the top five sectors and top five stock holdings. The average number of stock holdings for the ELSS category is 51. A fund having a lower number of stocks than this in its portfolio is likely to be more concentrated, while one having a higher number is likely to be more diversified. For the ELSS category, the average concentration of funds in the top five sectors is 43.16 percent. The average concentration of funds in the top five companies is 26.10 percent. A fund having a higher concentration than these levels is likely to be a more concentrated fund, while one having a lower concentration than these numbers is likely to be more diversified in nature. Choose a concentrated or diversified fund depending on your risk appetite.


Risk-adjusted return:


Conservative investors, in particular, may not want to invest with a fund manager who gives high returns but also takes high risks. Such funds may have a more volatile performance: up one year, down the next. For a smoother experience, you should go with a fund manager who gives you the highest return for each unit of risk taken. Hence, looking up measures of risk-adjusted return like Sharpe ratio and Treynor ratio becomes important. For the ELSS category, the average Sharpe ratio for the three-year horizon is 0.0524, while the average Treynor ratio for the same period is 0.0494 (Source: Ace MF). Go with a fund with a higher number than these.


Risk: Most investors would also like to invest in funds that have a lower-than-average level of risk. Hence it becomes important to consider measures of risk like standard deviation and beta. For the ELSS category, the average over the three-year period for standard deviation and beta is 0.8673 and 0.9039 respectively. Go with a fund that has a lower level of risk than these numbers.


Expense ratio: This is the fee that you pay annually to the fund house. The average for this category is 2.48 per cent. A lower expense ratio adds to the investor’s returns. You should ideally select a fund that has an expense ratio lower than the average.
Turnover ratio: This is an indicator of how much the fund manager churns his portfolio. A turnover ratio of 100 per cent indicates that the fund manager has churned his entire portfolio once in a year. A turnover ratio of 50 per cent, on the other hand, indicates that the fund manager has churned his entire portfolio once in two years, while a turnover ratio of 200 per cent indicates that the fund manager has churned his portfolio once in six months. A high turnover ratio is not a desirable feature in a fund since it adds to the trading costs incurred by a fund. A high turnover ratio also indicates the fund manager’s lack of conviction in his stock selection. The median turnover ratio for the ELSS category is 54.5 per cent. It would be ideal to select a fund with a turnover ratio lower than this number.
AUM size: The AUM size does not per se affect performance. Most fund managers contend that the size of their funds has not has not grown so much yet as to impede performance. Since most ELSS funds have a multi-cap mandate, they do not have any market cap-related restrictions. However, it would be prudent not to invest in a fund that is very small in size. Very small-sized funds are likely to be new, have a higher expense ratio, and they may not have the kind of performance track record (at least three or five years) that you would like to see before opting for a fund. If they are old and have a small size, their track record is likely to be unattractive. Another risk in a very small-sized fund is that the fund house may not find it very remunerative to run it and may close-down the fund. Ideally, invest in a fund having an AUM of at least Rs. 300 crores (certainly do not go below an AUM size of Rs. 100 crores).
Fund manager: 
Go with a fund whose fund manager hasn’t been changed frequently. Once the fund manager changes, past track record becomes irrelevant, since a new fund manager brings a new level of skills and fund management style. Ideally, you want consistency at the top. 
Watch out for fund mergers: Many fund houses have multiple funds in this category. As soon as SEBI’s guidelines on classification of funds become operational, these fund houses will have to merge their multiple funds into one. If you are investing with a fund house that has multiple funds, it would be a good idea to invest with the flagship fund having the highest AUM. It is most likely that the smaller funds of the fund house will get merged into the largest one. That way you will be saved from the trouble of seeing your fund merged into another or go with a fund house that has only one fund in the category. 
So  this can be your road map for selecting the right ELSS fund. Go to the websites of rating agencies like Morning star India and Value Research and try to search for a fund that meets most of the criteria suggested above. Remember that any choice that you make is based on past performance. A fund may or may not live up to its past performance. That is a risk you have to take. Hence, once you have made the selection, check the performance of your fund at least once every year o see that it is not severely underperforming its benchmark or category average. If it is, switch to another fund. 


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