Tax-saving funds: Where to invest?

Being in the last quarter of the financial year, tax-planning is a top priority for most investors. Investments in designated avenues are eligible for a deduction (of up to Rs 100,000) from gross total income under Section 80C of the Income Tax Act.

Some of the popular investment avenues are National Savings Certificate (NSC), Public Provident Fund (PPF) and tax-saving funds (also referred to as Equity-Linked Saving Schemes -- ELSS).

With various investment avenues on hand, where should you invest? Among all the "eligible" investment avenues, tax-saving funds are likely to emerge as favourites with investors with an appetite for risk.

Top performing tax-saving funds

Since investments in tax-saving funds are subject to a 3-year lock-in, the same is an appropriate time frame for evaluating tax-saving funds. Over the last 3 years, Magnum Tax Gain has clocked a compounded annual growth rate (CAGR) of 65.84% and is the top performer in the segment.

HDFC Tax Saver has posted an NAV appreciation of 53.00% CAGR, followed by Sundaram Tax Saver (48.44% CAGR) and PruICICI Tax (46.89% CAGR).

Standard Deviation (SD) is a measure of the volatility in a mutual fund's performance; a lower SD effectively implies lower risk.

HDFC Long Term Advantage (Standard Deviation 5.36%) pitches in a good performance on the volatility control front vis-à-vis its peers. Franklin India Tax Shield (6.15%) and Magnum Tax gain (6.51%) also deliver noteworthy performances. PruICICI Tax (8.68%) fares the worst in the peer group.

Sharpe Ratio (SR) is used to evaluate how well the mutual fund has compensated investors for the risk borne. For this purpose the mutual fund's returns are compared vis-à-vis those of a risk-free instrument (usually a government security). The higher a fund's Sharpe Ratio, the better is the fund's performance on the risk-adjusted return front.

Magnum Tax Gain (Sharpe Ratio 0.68%) leads the pack, followed by HDFC Tax Saver (0.51%). Tata Tax Saving (0.33%) languishes at the lowermost rung in the peer group.

Over longer time frames (3-year and 5-year), tax-saving funds have been successful in outperforming the benchmark indices, i.e. S&P CNX Nifty and BSE Sensex.

However, this does not imply that one can invest in any tax-saving fund. To select the right fund, investors need to first evaluate their risk profile and also assess the funds on parameters like the investment style, performance and risk, among others.

1. Assess your risk profile

Unlike other tax-saving avenues i.e. PPF and NSC which offer assured returns, tax-saving funds are market-linked in nature i.e. they don't offer assured returns. Investors would do well to assess their risk profile before investing in a tax-saving fund.

Secondly, mutual funds adhere to various investment styles. For example, some adhere to the growth style of investing (aggressively managed funds), while others follow the value style of investing (conservatively managed funds).

It is important for investors to select a fund that suits their investment objective. HDFC Tax Saver is an aggressively managed (growth styled) tax-saving fund; conversely, another tax-saving fund from the same fund house, i.e. HDFC Long Term Advantage, is a value styled fund and hence rather conservatively managed.

2. Evaluate the fund house

The fund house's investment philosophy plays a vital role in determining the long-term performance of the schemes. It is crucial for investors to evaluate the fund house on parameters like fund management philosophy, investment approach and processes (team-based or individualistic process), before making an investment decision.

Investors must avoid investing in fund houses that are over dependent on star fund managers. Because, when a star fund manager leaves, he could possibly "take the performance" with him.

Instead, invest in a fund house that pursues a process-driven (team approach) investment style where performances do not suffer, even if the fund manager leaves. E.g. Franklin Templeton Mutual Fund and HDFC Mutual Fund are some of the fund houses that adhere to a team-based investment approach.

3. Select right option

As mentioned earlier, investments in tax-saving funds are subject to a 3-year lock-in period; hence the investment tends to be rather illiquid vis-à-vis one made in an open-ended equity fund. Investors who need cash flows at periodic intervals (returns are not assured, it mainly depends on the fund's performance) can opt for the dividend option.

However, investors for whom liquidity is not a priority can select growth option. The advantage of selecting the growth option is that over the long-term, money taken out in the form of dividend works against the principal of compounding.

Irrespective of how attractive a given investment proposition seems, investors must consider investing in the same, only if it matches their risk profile and makes a fit in their portfolio.

Tax-saving funds are no different. While tax-saving funds should occupy a dominant portion of the risk-taking investor's tax-saving portfolio, investors with a low-moderate risk appetite should continue investing in conventional assured return schemes.

Tax-saving funds can occupy a smaller portion of the portfolio from a diversification perspective.