The Public Provident Fund may still be the most courted tax-saving instrument, but tax-saving funds are increasingly being looked upon as a more dashing alternative.

The lure of these funds can be traced back to Budget 2005, when Finance Minister P Chidambaram ensured tax payers changed their attitude towards this investment. The hike in the investment limit in equity linked savings scheme -- or ELSS as these tax-planning mutual funds are more popularly known -- from Rs 10,000 to Rs 1 lakh threw open the possibility of building wealth even as you did some tax planning.

In one year, assets grew by leaps and bounds. From Rs 684.01 crore in March 2005, it steadily rose to touch Rs 5,089.90 crore in March 2006. As on October 2006, it had reached Rs 6,214.28 crore.

Another diversified equity fund?

In many ways, tax-saving funds are just diversified equity funds. They invest in stocks of various companies in different sectors. They are also open-ended in the sense that you can buy and sell these units from the mutual fund anytime you desire. 

Where it differs from other diversified equity funds is in the tax benefit. These funds give a tax benefit under Section 80C of the Income Tax Act. But, to get this benefit, your investment must stay with the fund for at least three years. This means the three-year lock-in period is mandatory.

The lure of ELSS

We are all in the money game. At the end of the day, investors want to know what they are getting in return for their investment. Over the years, the average return from tax-saving funds on the whole has far outweighed any fixed-income return.

The average annual return over the past five years has varied from 16% to 108%. Compare this to the National Savings Certificate, which gives you an interest rate of 8%, and the Employee Provident Fund which gives you 8.5%. Besides having the potential to deliver the most lucrative returns, the lock-in period of three years is considerably less when compared with other tax-saving avenues like PPF (15 years) and NSC (6 years).

As on November 10, 2006, the average year-to-date returns of tax-saving funds was 25.34 per cent.

The one-, three- and five-year returns of these funds average at 40.9 per cent, 43.29 per cent and 43.77 per cent.

Playing it smart

What we have listed above are some of the reasons why you should consider such funds. But -- and even though this sounds repetitive -- do consider investing in ELSS through a systematic investment plan so that you can fully exploit the potential of such funds. What this means is that you invest fixed amounts every single month.

Tax planning should never be left till the end of the financial year; it should be an ongoing process. If you commit your money at one go, you will be at the mercy of the market. But by distributing it over the months, you minimise your risk.

Let's say you invested Rs 8,000 every month over the past five years in an ELSS. That would mean an investment of Rs 4,80,000 over 60 months.

If you had invested in the one which gave the best return, you would have ended with Rs 23.95 lakh (Rs 2.3 million) at the end of five years. If you had picked the worst, you would still have ended up with Rs 9,82,000.

If we take a shorter time of three years, you would have invested Rs 2,88,000 over 36 months. The best fund would have given you Rs 6,97,000 and the worst, Rs 3,95,000.

Part II: Five best tax saving funds
Part III: New tax saving funds

Value Research is a mutual fund research organisation. This article appeared in the November issue of its magazine Mutual Fund Insight.