If you have just filed your tax returns, then the resolve to do better this year to make the most of the opportunities available to save taxes must still be fresh in your mind. The equity-linked savings scheme (ELSS) is one product to consider as it can give the dual advantages of tax benefits and growth.

ELSS are diversified equity mutual fund schemes that provide tax benefits under Section 80C of the Income-tax Act, 1961, up to ₹1.5 lakh. The schemes have a three-year lock-in during which they cannot be redeemed or switched. Selecting the right scheme, therefore, becomes very important.

Here are five things to keep in mind while selecting an ELSS to ensure the right fit between what you want and the features of the scheme.

Portfolio tilt

ELSS is, typically, structured as a multi-cap scheme having the flexibility to invest in large-, mid- and small-cap stocks. Some funds like Invesco Tax Plan and Tata Tax Savings Scheme have a large-cap focus and invest predominantly in large-cap companies with greater stability in earnings and profitability.

Talking about the process of evaluating ELSS for recommendation to investors, Shyam Sekhar, founder, iThought, a Sebi-registered investment advisory firm, said, “ELSS, typically, takes exposure to the riskier segments of the market which has the potential to generate higher returns over a five-year holding period. A scheme must be evaluated for its portfolio stability, valuation of the portfolio as an aggregate, and attractiveness from a forward-looking return expectation."

The number of stocks in the portfolio and the percentage of the portfolio in the top five stocks give an idea of concentration risk. 

Too concentrated a portfolio means that the impact of underperformance of a few stocks can have a significant impact on the portfolio. Some funds hold portfolios of not more than 30 stocks as a strategy. On the other hand, a too diversified portfolio will dilute the performance of the individual components and the fund may not benefit much from a run-up in the price.

Return consistency

Selecting the previous year’s best performer is probably not the best way to select an ELSS. Different strategies and styles work in different market situations. Select the scheme based on your comfort with the portfolio strategy and not based on the historical returns alone.

Select funds carefully after examining the consistency of their performance in different phases of market cycles by evaluating the calendar year returns. A fund should demonstrate an ability to generate a return better than its benchmark in rising markets and fall less in a falling market. Look for funds that have remained in the top quartile among funds with similar portfolios and have a consistent approach to managing the portfolio.

Investment horizon

Even though the lower lock-in period for ELSS of three years is often touted as an advantage in comparison to other tax-saving products that have longer lock-in periods, investors should ideally look at a longer period of holding to benefit most from appreciation in equity investments.

Sometimes a three-year period may not be adequate for the markets, especially the mid- and small-cap segments, to reverse a downward trend and generate returns. For example, the steep fall that the mid- and small-cap segments have seen in the last one year has pulled down the three-year returns from the schemes that have a large exposure to these stocks.

Include in overall plan

The decision to invest in ELSS should not be an isolated one but taken in the context of the individual’s financial situation and goals. See whether there is room to accommodate an ELSS after considering expenses such as insurance premiums, school fees, repayment of mortgage, and contributions to Provident Fund and National Pension System, all of which are outflows that most household have and all of which form part of the 80C basket. Then check how additional equity investment fits into your asset allocation.

Compare the ELSS to the other equity funds held so that there is no duplication in style and portfolios. Also, remember that long-term capital gains from ELSS are now taxed at the rate of 10%.

The smooth ride that conventional debt-oriented tax products provide may not be available in an ELSS. But if investors reset their expectations on risk and do their homework in selecting the scheme that best suits their risk preference, then they will not only save taxes but benefit from growth by investing in ELSS.