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Time to save tax

Despite a dip in their popularity, are tax-saving funds, or equity-linked savings schemes (ELSS funds), still the best 80C avenue? Let us find out.

Time to save tax

The category of tax-saving funds, also called equity linked savings schemes (ELSS), comes into focus in the last quarter of a financial year as investors rush to make their tax-saving investments. Here we take a look at the various facets of this category.

The AUM story
As of December 2021, the AUM of tax-saving funds stood at Rs 1.49 lakh crore as against Rs 1.18 lakh crore at the end of 2020. Though the AUM has grown, the category's relative share among the other open-end equity fund categories has dropped. In terms of assets, ELSS now stands at the fourth position among all open-end equity fund categories, with an AUM share of little more than 11 per cent. As of December 2020, it stood at the third position, with an AUM share of 13 per cent. This fall is despite the relentless bull run witnessed during 2021.

The category saw a significant spike in redemptions, which started during the second half of 2020, when the markets started recovering after the COVID crash. Need based redemptions appear to be the primary reason behind this. Another reason could be the fear of the market crashing again that made investors exit equity funds, including tax-saving ones.

However, the trend of net outflows from the category is likely to reverse as markets become resilient to the impact of successive COVID waves and investors make their tax-saving investments in equity to profit from the ongoing rally. As can be seen in the chart 'Tax-saving funds: Inflows and outflows', category inflows usually peak in March, as investors rush to make their tax saving investment.

The best of all worlds
ELSS is the best tax-saving alternative and among the Section 80C basket of investments. Being an all-equity fund, they have a high return potential. The average return of the ELSS category for any seven-year period during the last five years has been 12.90 per cent. This is way-more than the return of any other tax-saving investment, specifically the popular Public Provident Fund (PPF), which currently returns 7.1 per cent.

Tax-saving funds have the shortest lock-in period of just three years among 80C investment options. However, it is recommended to stay invested in equity for a longer term, five to seven years, for favourable investment outcomes. Equities can be extremely volatile over the short term and this is one reason why many investors shy away from investing in them. But if one stays invested for a longer term, the impact of volatility gets reduced. The least category-average return from tax-saving funds was 7.24 per cent over a seven-year period. On the other hand, if we look at the three-year category average during the last five years, the least was -7.20 per cent. So, outcomes are more fruitful on staying invested for a longer term.

Volatility, as measured by standard deviation, reduces as the investment period increases. Across investment periods of three, five and seven years, it is lowest for seven years and highest when for three years.

The inherent transparency of mutual funds in terms of disclosures and strict regulation further strengthen the case of tax-saving funds. Also, competition in the industry keeps fund houses on their toes to deliver, which ultimately helps investors.

In terms of asset allocation, tax-saving funds have the flexibility to invest in companies of all sizes across sectors, making them a suitable investment avenue for your long-term goals. The average exposure of the category to large caps is usually around 70 per cent, with 20 per cent in mid caps and the remaining in small caps.

Picking the best tax saver
The category of tax-saving funds has 37 schemes. It can be a Herculean task to choose a good fund that matches your needs. While doing so, one should be mindful of the expense ratio, which varies widely across the category. As of December 31, 2021, the cheapest direct plan in the category had an expense ratio of just 0.38 per cent, while the most expensive direct plan charges 1.85 per cent!

That said, expense ratio should not be the only factor that one must look at while choosing an ELSS. One should also look at how the fund has historically performed across different market phases - whether it falls more than its peers when the market crashes and vice versa? What is the investment style of the fund manager? Does he believe in 'buy and hold' or does he prefer making tactical, momentum-based bets? Does the fund invest more in large caps or mid/small caps? The level of diversification shouldn't be ignored either. One must look at all these factors and pick the fund that aligns with one's needs, risk profile, experience in the market and temperament.

Is it too much work? Worry not. Access our 'Analysts Choice' section. It has our hand-picked tax-savers, along with all the vital information that you may need to entrust your hard-earned money this tax saving season.