Introducing tax saving ELSS funds

Now the first question, what is ELSS? and why do I need to know about it? Well, I assure you that after reading this post you will find that it was worth your time and attention!

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What is ELSS?

ELSS stands for Equity Linked Savings Scheme and it is a tax-saving equity mutual fund. Yes you heard it right, it’s a mutual fund which also helps in tax saving purpose by saving upto Rs. 1.5 lacs from your taxable income under section 80C of the Income Tax Act. It has a mandatory lock-in period of only 3 years and hence will be considered as LCTG (Long Term Capital Gain) and will be taxed at 10% if the income is above Rs. 1 lac. The advantage of ELSS funds is not only its lower lock-in period but also its capacity to give higher returns when compared with other normal tax saving schemes.

Some Quick Facts about ELSS

• There is no maximum tenure of investment.
• You can start investing in different ELSS schemes with amount as low as Rs 500.
• Both lump sum and SIP method is available while investing in ELSS.
• No need to commit for multi-year investment, even an initial investment of only Rs 500 can be held till perpetuity.
• Both growth and dividend fund options are available.
• Minimum 80 percent of the total fund’s assets is invested in equity and equity related instruments.
• All the ELSS funds are managed by the finance industry and not by SEBI.

Now we have some basic idea about ELSS funds, let’s dive into how to choose ELSS funds for ourselves. Since there are so many funds it’s important to understand various factors & parameters which measures the volatility, risk and returns of these funds.

Parameters to consider while choosing any mutual fund

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1. Alpha — Let say an alpha of a fund XYZ is 5 then it means that it has outperform it’s benchmark index by 5% and if the alpha is -5 then it has underperformed its benchmark index by 5%. Every fund has a benchmark index with which these funds are compared. So if the index fund has given a return of 10% over a year & the ELSS fund has given a return of 15% over a year then its alpha would be 5%.
   Alpha is a measure of the investment’s performance compared to its benchmark index. Higher alpha is always a good indicator.
2. Beta — Beta is a measurement of the volatility or a systematic risk of an investment or portfolio as compared to the whole market. By definition, market has a beta of 1.0 so if a beta of the XYZ fund is more than 1.0, it means it’s more volatile than the whole market and vice versa. If investors are looking for more returns by taking more risk, they should find funds with higher beta value but if the investment strategy is more conservative then low beta funds must be considered.
3. Standard Deviation — It measures the deviation of a data from its mean. It tells how much return from the mutual fund is drifting away from the expected return based on its previous performance. Let’s suppose a fund XYZ has standard deviation of 5% and its average return is 15% for a year then that fund can deviate from its average return by 5% so it could either give 20% return or fall to 10% return. It measures the volatility of the portfolio.
4. Sharpe ratio — It measures risk-adjusted performance. It will tell how well any mutual fund has performed in terms of excess of risk-free return (usually government securities are considered as risk-free instruments). It tells if the returns are due to smart investment strategy or excessive risk. Higher the sharpe ratio, better is your mutual fund portfolio performance.
   Sharpe ratio = ( Expected Return — Risk free return ) / Standard Deviation of the fund
   Let’s say a fund XYZ has an average return of 16% with a standard deviation of 8% and a fund ABC has an average return of 14% with a standard deviation of 5%. The risk free returns in both the cases could be taken as 8% since usually government securities gives a fixed return of 8%. So now, SR of XYZ = (16- 8)/8 = 1 & SR of ABC fund = (14–8)/5 = 1.2 So even if fund XYZ gives more return, it also takes more risk.
5. Sortino ratio — It’s a variation of sharpe ratio. It uses downside deviation instead of standard deviation since standard deviation also consists of upside volatility which is beneficial for every investors. Downside deviation is a measure of downside risk which explains how much maximum an investor can lose. Like Sharpe ratio, higher the sortino ratio better is the mutual fund performance .
   Sortino ratio = (Expected or Actual Return — Risk free return)/Standard Deviation of the downside.
6. R-squared — Its value ranges between 0 to 100. It compares the fund’s performance with respect to its benchmark index. A mutual fund with R-squared between 1–40 has very low correlation with its benchmark index which indicates that changes in its benchmark index don’t explain about the fund movements while a mutual fund with R-squared value from 70–100 matches the performance of its benchmark precisely.

Final Thoughts

So these are some of the most important parameters which should always be considered when selecting any fund, be it ELSS or any normal mutual fund. Selecting any fund for investment purpose by calculating only the rate of return is the biggest mistake many newcomers do which creates a negative impact on the overall performance of the fund. The good news is all these risk measures are already calculated for every fund and is present on number of financial websites like https://www.etmoney.com/mutual-funds/equity/elss/38, https://www.moneycontrol.com/mutual-funds/performance-tracker/returns/elss.html, etc. Therefore, always due your due diligence before investing your money in any fund.

Let me know if you have any doubts regarding any of the ratios mentioned above or interested in knowing more about any specific ELSS fund, mutual funds or stock market in general.

Till then, keep learning ✌️