How to choose a tax-saving fund

By Morningstar Analysts |  07-02-19 | 

Choosing a fund to invest in can be a bit overwhelming, simply because of the immense choice available. So it’s not surprising to have individuals often make an apparently simple request: Tell me which is the best fund.

The issue is not what the best fund is, but what’s the best fund for your risk tolerance, your goals and your portfolio. The recommendation made by your friend or family member could be completely ill suited for your portfolio.

We touched the basics in, 5 things to note about ELSS. Here we seek to tell you why hearsay is dangerous and suggest you look at these criteria when selecting a fund.

(The fund names mentioned below are purely for illustrative purposes and not recommendations.)

A year of great returns does not mean you have a winner in hand.

When it comes to investing, it is amazing how nearsighted individuals are. The latest chart topper has an irresistible pull. Despite the bold disclaimers about past performance not necessarily being sustained in the future, investors have a hard time resisting that lure.

At Morningstar, we have been crying hoarse that the star rating, which is based on performance numbers, should be just one of the steps in the fund evaluation process. A high rating alone is an insufficient and dangerous basis for investment decisions.

All funds go through hot and cold spells, ups and downs, highs and lows. To base a decision solely on how they fared temporarily is an excellent way to lose money and get disillusioned.

Take Principal Tax Savings. After underperforming the category average for four consecutive calendar years, it put up an outstanding performance in 2012; a return of 46%. It once again had an excellent round in 2017, only to find itself in the bottom quartile last year.

Or consider BOI AXA Tax Advantage Eco. The fund was bottom quartile in 2016, topped the charts in 2017 at 60%, and was bottom quartile again in 2018.

Don’t get carried away by a sporadic burst in numbers.

View performance in conjunction with the fund’s investment style.

You cannot expect a large-cap oriented fund to do well during a mid- or small-cap rally. Or vice versa. Or expect a value-oriented fund to do well as its peers during an aggressive bull run.

When viewed through this lens, you will realize that no fund can always be a chart topper. But by and large, how does it perform? How has the fund held up on the downside? Does it fall hard in down markets but screams ahead during rallies? Or is there no rhyme nor reason behind when the fund does well and when it does not? Are its fortunes highly dependent on its top holdings?

Don’t kick a fund to the curb just because of underperformance. It could be that the investment style is currently out of favour and not a reflection of bad fund management. For instance, Franklin India Taxshield underperformed the category average in 2012 and 2013, only to bounce back and reward investors. In 2016, the fund went through some fundamental changes in terms of change in the manager and investment strategy, and had a period of underperformance. But that did not make it a bad offering.

The ELSS umbrella covers all diversified equity funds that offer a tax benefit under Section 80C. It does not imply that all the funds are identical or even similar in their investing approach.

A look at various portfolios will reveal different levels of concentration.

Axis Long Term Equity has around 34 stocks with the top 10 cornering 59% of the portfolio.

Two years ago, Edelweiss Long Term Equity had a very diversified portfolio of 72 stocks with the top 10 accounting for just 27% of the portfolio. It now has 58 stocks with the top 10 garnering 44% of the portfolio.

Quantum Tax Saving has a tight portfolio of around 25 stocks with the top 10 cornering more than 50%. High cash calls are also a mark of this fund when they find no value in the market. Around 85% of the stock portfolio is in large caps.

IDFC Tax Advantage over the past year has reduced its exposure to mid, small and micro caps from around 50% to 40%.

Do your homework.

Here are the views of Morningstar's analysts on various ELSS.

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