n the last few years Equity Linked Saving Schemes or ELSS Mutual Funds have become popular investment choice for saving taxes under Section 80C of The Income Tax Act 1961. However, people who are still living under the rock, here is what ELSS is all about- Equity Linked Savings Scheme or ELSS is a diversified equity mutual fund scheme that comes with a lock-in period of 3 years and investors get the benefit of tax saving under Section 80C of the Income Tax Act of India, 1961.

It has been a challenge for investors to choose a good scheme when investing in ELSS. Investors should be extra careful and due diligence is required when selecting the best ELSS schemes in order to get the maximum benefits from investments.

In this article, we cover some of the key parameters that an investor should follow while choosing the same. So let the learning begin!

AUM and Fund House (AMC)

One of the most important things an investor should consider when picking up an ELSS fund is to choose a scheme which has a decent asset under management (AUM). The investor should consider an ELSS scheme from an established AMC which has a good fund management team and the fund managers have established track record of managing equity mutual funds.

Return of the ELSS Fund

Investors, especially the first-timers, should analyze the trailing returns of past 1, 3 and 5 years whenever planning to invest in this category of funds. Investors shouldn’t just decide on an ELSS fund based on its recent performance.

Over and above the returns of 1, 3 and 5 years, the investor should also check if the ELSS fund being considered by them has been able to beat the category average returns and benchmark returns compared to its peers. A good long term track record of an ELSS fund is also a good measure to understand the scheme’s ability to perform in varying market situations.

Risk-Adjusted Returns

Generally, people only take a note of the historical returns of the schemes in order to determine the nature of providing returns; but it may not represent the actual picture. Investors can use the past performance of the ELSS scheme that can be adjusted for risks.

The significance of Risk-adjusted returns lies in the excess return that the fund manager generates by taking one unit of risk, and an investor can measure the same using the ‘alpha’ of the fund. This fund’s alpha is also the excess return of a fund relative to the return of a benchmark index. By analyzing the alpha of any fund, investors can ensure that the fund is a good investment choice or not.

Among several parameters, there is also the Information Ratio that can be used by investors to gauge the risk-adjusted returns. People can use the tracking error which is measured as standard deviation of active returns to determine the Information Ratio. The expertise of the fund manager can also be analyzed based on the deviation of the returns from the benchmark indices.

Risks

A smart investor should also analyze the ELSS fund’s risk besides the performance of the fund. Investing in mutual funds is prone to market risks and one can’t predict the market uncertainties since it can show its volatile nature anytime. An investor should, therefore, take the values of variance, standard deviation, and the beta of the portfolio into consideration.

The risk taken by the fund manager is broadly measured by a metric called beta. Higher the beta, above 1, more is the risk taken by the fund manager. Lower the beta, below 1, less is the risk. However, just because a fund’s beta is high, it is not a bad fund or vice-a-versa.

If you are desirous of very high returns from your ELSS investments compared to the benchmark and the peer schemes in the category, you can invest in high beta funds. On the other hand, if you want to protect downside risks, you should invest in low beta funds. Beta of the fund is generally available on the scheme fact sheet or mutual fund research websites.

Selecting a fund with suitable risk profile

While ELSS funds as a category are pure equity mutual funds, each scheme has a defined style. Some ELSS funds are large cap oriented, some are mid and small cap oriented and some may be more diversified in nature.

As you may be aware, mid and small cap oriented funds can be more risky than large cap funds but mid and small cap funds can give higher return too. Therefore, you should select an ELSS scheme suiting your risk profile. For example – if you are a high risk taker, select an ELSS scheme which is more diversified in nature. In case you can tolerate even higher risk in anticipation of high returns, mid and small cap funds can be a good option. However, if you are shy of taking much risk, then you should select an ELSS fund which is large cap oriented.

Conclusion:

Investors should therefore, choose an ELSS scheme ideally on the basis of one’s own risk profile, and not purely on a fund’s recent performance. An investor should read the scheme related documents carefully and identify the nature of underlying exposure of the ELSS funds in order to understand the scheme’s objectives are in-line with the investors’ requirement.