How to Select Top Tax Saving Mutual Funds

The Modi 3.0 budget, introduced in July 2024, brought significant changes to the tax regime, providing taxpayers with more options and opportunities to save on taxes. This budget not only revised certain tax slabs but also introduced new incentives for investments in specified financial instruments. As a result, exploring suitable tax-saving options has become crucial.

Tax planning has always been an essential aspect of financial management, but the dynamics have shifted with the introduction of the new tax regime. The option to choose between the old and new tax regimes allows investors to tailor their tax-saving strategies according to their financial goals. However, this flexibility also requires a deeper understanding of available investment options, particularly tax-saving mutual funds.

Investors need to understand how these funds align with the latest tax policies to maximize their benefits. Recent developments in the financial market have further emphasized the importance of choosing the right tax-saving instruments.

With market volatility affecting returns, investors must be cautious and strategic in their approach. Selecting the right tax-saving mutual funds can not only provide substantial tax benefits but also ensure long-term wealth creation.

This article elucidates the critical factors to consider when selecting top tax-saving mutual funds for FY 2024-25. We will explore the various aspects that influence the performance and suitability of these funds, helping you make informed decisions that align with your tax planning objectives.

[Read: Top 6 ELSS That Gained Up To 25% CAGR In Past 3 Years: Invest Wisely For FY 2024-25]

Understanding Tax-Saving Mutual Funds

For individuals looking to reduce their tax liability under Section 80C of the Income Tax Act, 1961 - Tax-saving mutual funds, also known as Equity Linked Savings Schemes (ELSS), are a popular investment choice. These funds invest primarily in equities across market capitalisation, offering both tax benefits and the potential for high returns.

Investments in ELSS funds are eligible for tax deductions up to Rs 1.5 lacs under Section 80C, providing a balance between liquidity and long-term investment. The mandatory three-year lock-in period is the shortest among other tax-saving options like Public Provident Fund (PPF) and National Savings Certificate (NSC), providing a balance between liquidity and long-term investment.

Given their equity exposure, ELSS funds have the potential to offer higher returns compared to other tax-saving instruments, though they also come with higher volatility.

[Read: Tax Saving Mutual Funds: Who Should Invest...]

Factors to Consider When Selecting ELSS or Tax-Saving Mutual Funds

• Fund Performance: The historical performance of the fund is one of the factors one may consider when selecting an ELSS fund. Look at the fund's performance over different time horizons, such as 1 year, 3 years, 5 years, and 10 years. Compare the fund's returns with its benchmark index and peer funds. One may consider ELSS that exhibits consistent performance over the long term.

• Fund Manager's Track Record: The expertise and experience of the fund manager play a significant role in the fund's performance. A seasoned fund manager with a proven track record of managing equity funds can make informed investment decisions that enhance the fund's returns. It is essential to research the fund manager's background, investment philosophy, and the performance of other funds managed by them.

• Expense Ratio: The expense ratio is the annual fee charged by the mutual fund company to manage the fund. A lower expense ratio means that a larger portion of the fund's returns is passed on to the investors. Compare the expense ratios of different ELSS funds and choose a fund with a competitive expense ratio.

• Portfolio Composition: Analyze the fund's portfolio to understand the sectors and companies in which it has invested. A well-diversified portfolio that includes a mix of large-cap, mid-cap, and small-cap stocks across sectors could help in mitigating risks and maximizing returns. Avoid funds with a concentrated portfolio or those that are heavily invested in a single sector, as they may carry higher risks.

• Lock-in Period: While the lock-in period for all ELSS funds is three years, it is essential to consider your investment horizon. If you plan to stay invested for more than three years, you can choose a fund with a higher exposure to mid-cap and small-cap stocks, as they have the potential to deliver higher returns over the long term. However, if you have a shorter investment horizon, it is advisable to select a fund with a higher allocation to large-cap stocks, which are generally less volatile.

• Tax Efficiency: ELSS mutual funds are subject to capital gains tax. Long-term capital gains (LTCG) above Rs 1.25 lacs from ELSS are taxed at the rate 12.5% with effect from July 23, 2024 (post Modi 3.0 budget). While selecting a fund, consider its tax efficiency by analysing the turnover ratio, which indicates how frequently the fund manager churns the portfolio. A lower turnover ratio can lead to lower capital gains tax liability.

  [Read: Mutual Fund Taxation: Here Are the Key Changes After the Union Budget 2024-25]

• Investment Style: Different ELSS funds follow different investment styles, such as value investing, growth investing, or a blend of both. Value investing focuses on investing in undervalued stocks with strong fundamentals, while growth investing targets stocks with high growth potential. Understanding the fund's investment style and aligning it with your risk appetite and investment goals is crucial for selecting the right ELSS fund.

• AUM (Assets Under Management): The size of the fund, measured by its Assets Under Management (AUM), can also influence its performance. A large AUM may indicate the fund's popularity, but it can also lead to challenges in managing the portfolio, especially in small-cap stocks. On the other hand, a very small AUM may suggest that the fund has not gained investor confidence. It is advisable to choose a fund with a moderate AUM that aligns with your investment goals.

[Read: The Top Blunder in Mutual Fund Investing and How to Sidestep Them]

Steps to Select the top tax-saving mutual fund or ELSS

Step #1 - Define Your Investment Goals:

Before selecting an ELSS fund, it is essential to define your investment goals. Are you investing primarily for tax savings, or are you also looking to create wealth over the long term? Understanding your goals will help you choose a fund that aligns with your risk tolerance and investment horizon.

Step #2 - Research and Shortlist Funds:

Use online tools and resources to research and shortlist ELSS funds based on the factors mentioned above. Compare the shortlisted funds' performance, expense ratios, portfolio composition, and other metrics to narrow down your options.

Note: I have covered a comprehensive analysis of the few Best ELSS Mutual Funds for 2024; you may consider reading -

Top ELSS Mutual Funds: HDFC ELSS Tax Saver Fund vs Quant ELSS Tax Saver Fund

Choosing the Right ELSS: SBI Long Term Equity Fund vs Mirae Asset ELSS Tax Saver Fund

Parag Parikh ELSS Tax Saver Fund vs Kotak ELSS Tax Saver Fund: Pick Your Tax-Saving Option

Best ELSS Mutual Funds: DSP ELSS Tax Saver Fund vs Nippon India ELSS Tax Saver Fund

Step #3 - Analyse Fund's Performance:

Once you have shortlisted a few funds, analyse their performance in detail. Look at the fund's returns during different market cycles, its risk-adjusted returns, and its consistency in performance. Check if the fund has outperformed its benchmark and peers over the long term.

Do note, relying on past returns could be misleading, as many investors mistakenly assume that a fund's previous success will continue. However, financial markets are unpredictable, and past performance doesn't guarantee future results; the factors that drove a fund's success in the past may not hold, and market conditions may shift rapidly.

Another common mistake is selecting mutual funds based on publicly available star ratings, which reflect past performance but fail to consider future risks, management changes, or shifting market conditions. A highly-rated fund today could underperform tomorrow if its investment strategy no longer aligns with evolving market dynamics.

[Read: Beyond the Star Ratings: Your Guide to Comparing Mutual Funds]

Step #4 - Consider Portfolio Diversification:

Analyse the fund's portfolio to understand its sectoral and stock allocation. A well-diversified portfolio with exposure to different sectors and market capitalizations could help reduce risks. Avoid funds with a high concentration in a single sector or stock.

Step #5 - Check the Expense Ratio:

Compare the expense ratios of the shortlisted funds. A lower expense ratio means higher take-home returns for the investor. However, do not compromise on the fund's quality for the sake of a lower expense ratio.

While ELSS funds are popular for tax-saving, it's important to compare them with other tax-saving instruments like PPF, NSC, and tax-saving fixed deposits. Understanding the pros and cons of each option will help you make a more informed decision.

To conclude...

As you plan your tax-saving investments for FY 2024-25, take a comprehensive approach that balances tax benefits with financial goals. By carefully evaluating and selecting top tax-saving mutual funds, you can ensure that your investments contribute to your financial growth while also providing the necessary tax relief.

Remember, tax planning is not a one-time activity but an ongoing process. Regularly review your investments, stay updated with market trends, and make informed decisions to stay ahead in the ever-changing financial landscape.

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MITALI DHOKE is a Research Analyst at PersonalFN. She is an MBA (Finance) and a post-graduate in commerce (M. Com). She focuses primarily on covering articles around mutual funds including NFOs, financial planning and fixed-income products. Mitali holds an overall experience of 4 years in the financial services industry.
She also actively contributes towards content creation for PersonalFN’s social media platforms in the endeavour to educate investors and enhance their financial knowledge.
 

Disclaimer: Investment in securities market are subject to market risks, read all the related documents carefully before investing.
This article is for information purposes only and is not meant to influence your investment decisions. It should not be treated as a mutual fund recommendation or advice to make an investment decision in the above-mentioned schemes.