Saving tax: Avoid these 3 ELSS mistakes

While ELSS is a smart way to get equity exposure combined with tax savings, you need to pick your fund wisely.

Equity Linked Savings Schemes, or ELSS, are diversified equity funds that provide a tax benefit under Section 80C of the Income Tax Act.

Here's what you need to be aware of.

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1. Don't fall for the latest chart topper

This is an error many investors are prone to make. Despite the bold disclaimers about past performance not necessarily being sustained in the future, investors have a hard time resisting that lure. And when that is employed as a sole parameter, it's not uncommon for disillusionment to set in rapidly.

A look at the 1-year returns of the ELSS category, Escorts Tax Plan features with a return of 13.81 and a 3-year annualised return of 26.32 per cent.

But if one look at the annual performance, the fund underperformed the category average for 6 consecutive years (2009–2013). Over the last few years it had delivered impressively which skews the latest numbers.

Or, let's look at Taurus Tax Shield. Let's say in 2008 investors rushed to invest in the fund as it was the best performer in its category in 2007 with a return of 112 per cent, way ahead of the average 57 per cent. Had investors done their homework, they would have noticed the fund's abysmal performance in 2006.

That year, the category average was 30.33 per cent but the fund returned -10.13 per cent. Over the past 5 years (2012-2016) it has underperformed the category average.

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On the other hand, you have a fund such as Axis Long Term Equity which underperformed the category average in 2016. However, over the past 6 years (2010-2015), it has outperformed every single calendar year.

When looking at performance, don't get swayed by a sporadic burst in numbers. Either positive or negative.

Some investors may find that consistency does not really matter and they are willing to ride it rough. Reliance Tax Saver put up some amazing numbers in 2012 and 2014 but underperformed the category average in 2011, 2013 and 2015. However, the 3- and 5-year annualised returns are very impressive. Investors who were willing to stick on have been well rewarded.

2. Don't assume all funds have similar portfolios

Once you get past performance, take a good look at the fund's portfolio.

Do remember, these are actively managed diversified equity funds with a tax break. That gives the fund manager complete leeway on what must comprise his portfolio. One fund's mandate will not be the same as the other.

Canara Robeco Equity Tax Saver has 71 per cent of its portfolio in large caps.

Quantum Tax Saving has around 10 per cent in cash with 87 per cent of the portfolio in large caps.

IDFC Tax Advantage has 47 per cent allocated to mid-, small- and micro-caps with cash cornering 5 per cent of the portfolio.

You need to figure out the kind of exposure you are looking for.

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If you are looking for a mid-cap fund, then search for a tax-saving fund which has such exposure to smaller fare. If you prefer playing it safe with large caps, then search for such portfolios accordingly.

On similar lines, check whether the fund manager takes big bets or prefers going with a diversified portfolio, and see where your comfort level lies.

Edelweiss ELSS and JM Tax Gain are both fully invested (minimal cash) and have no exposure to micro caps. Edelweiss has a 37 per cent exposure to mid- and small-caps while the figure is 20 per cent for JM Tax Gain.

However, Edelweiss ELSS has a very diversified portfolio of 71 stocks. The top 10 corner just 27 per cent of the portfolio. JM Tax Gain has just 33 stocks with the top 10 cornering 46 per cent of the portfolio.

3. Don't be rigid about the 3-year deadline

As with any equity investment, don't look at a short-term horizon, specially if you have invested a lumpsum. Agreed, such funds have a mandatory lock-in period of 3 years.

Though this minimum time horizon is forced upon you, it does not mean you have to exit when the lock-in is over and done with.

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If the market dynamic favours you and you need the money, then do so.

But if the market is down at that time, hold on and don't be too eager to sell. Exit only when the market picks up. Remember, there is no pressing need for redemption once you complete the mandatory lock-in period.

Important Note

None of the funds mentioned are recommendations or suggestions. They have been used for the sole purpose of illustration.

The funds mentioned refer to the Growth Schemes of Regular Plans.

The portfolio references are to the latest disclosed ones as on January 4, 2016.

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