Investing in ELSS to save tax? Diversify to balance out fluctuating returns over 3 years

When it comes to investing there's nothing called the best. This holds true even while choosing an equity-linked savings scheme (ELSS), a type of mutual fund that comes with a lock-in period of three years and helps you save tax under section 80C of the Income-tax Act, 1961.

With the tax saving season for this financial year coming to a close in less than a month, several tax payers zero-in on ELSSs due to its shorter lock-in and potential for high returns compared to most other tax savers which either have a longer tenure or are debt-oriented, and low returns over longer tenures.

However, give this a thought: when it comes to choosing the right ELSS, do most of us get it right or do we have duds sittings in our portfolios?

Many investors are led by the recency bias when choosing the right ELSS. What this means is that the fund which has shown the highest return over the past 1-3 years is picked advertently by investors in the belief that it will deliver equally good returns in the future as well. After all, who wouldn't want to invest in winner-funds?

However, the reality could be rather different and the manner in which one should select an ELSS is not as straight forward as it looks. Expecting an equally good performance by best performing schemes of today may not be the right approach. Selection of the right ELSS is not an easy task, especially when more than 40 schemes are available in the market.

Here are few things to consider while selecting the right tax saving mutual fund.

Performance: Look at the long term performance of the schemes. Funds that have consistently performed and generated benchmark beating returns over a longer time horizon should be preferred over the ones showing stellar returns only in the recent past.

Diversification: Instead of solely banking on one ELSS, choose 2-3 tax saving funds in your portfolio. Look at the portfolios of the schemes and ensure that the ones you have selected have varied allocation to different sectors and stocks. This will give you scheme-wise and portfolio-wise diversification.

Market-capitalisation: It is important to see what type of what scheme it is, i.e., if it is a mid-cap fund or a large-cap one. If you are an investor with moderate risk appetite, we suggest you to go for a large-cap tax-saving fund on the other side if you are willing to take some higher risk you can go for some mid-cap tax saving funds. Some funds follow a more balanced approach. Remember, the portfolio allocation (sector-related) may still change over time.

The lock in period of 3 years in the ELSS allows the fund manager to take long-term calls on the market without any redemption pressure, which is essential for any equity investment. ELSS funds are predominantly equity funds and do not have the option to move into debt assets. Bad market condition may erode all or majority of the returns of the previous years. Hence, holding on to the investment in depressed market conditions would be better than redeeming after the mandatory lock-in period.

The difference in the performance of an ELSS may also arise from the differences in the fund manager's investment style and the market's reward for a particular style at a given time. Some fund managers may like to take advantage of the three-year lock-in period to exploit value stories in various sectors. If your objective is to be invested for the long term and also save some tax along the way, ELSS could be a good bet. You should, however, be able to take short-term volatility in your stride.