Most investors select tax-saving funds (also called equity-linked saving schemes - ELSS) for the Section 88 (of the Income Tax Act) benefit.

As blunt as that may sound, it is the main reason why tax-saving funds find their way into investor portfolios.

We are not saying there is anything wrong with that, but equities are too risky an investment to let tax breaks dictate your decision-making.

Once investors appreciate that the tax benefit is just an add-on, they will treat tax-saving funds at par with regular diversified equity funds.

In other words, they will use the same yardstick to select a tax-saving fund as they would any diversified equity fund.

Which means that performance, investment style, expenses and other critical parameters come into play and 'tax benefit' takes a back seat. We have tried to outline some of the key parameters that need evaluation before you select the right tax-saving fund.

1. Performance

Among other things, investors must evaluate the tax-saving fund on NAV returns. While performance isn't everything, it is nonetheless a critical parameter on which a fund must redeem itself before you can consider investing in it.

The fund must have put in a solid performance vis-�-vis the benchmark index (Sensex, Nifty, BSE 200, as the case maybe) as also its peer group. And since tax-saving funds have a 3-year lock-in, this performance must stand out over longer time frames 3-year, 5-year.

In reality, all equity-linked investments need to be considered with a 3-5 year investment horizon, but ironically it takes a lock-in in a tax-saving fund for investors to evaluate equity funds over that 'extended' a timeframe.

While evaluating performance, you need to put a premium on consistency across market phases. Most, if not all, funds do well during a bull run, and most funds do just as poorly during a market slump. Choose tax-saving funds that have put in a reasonable show during the upturns and the downturns.

For this you need to look at calendar year returns, not just compounded annual growth returns (CAGR).

2. Investment approach

Equally important, if not more important than NAV returns, is the investment style and approach of the fund manager. Typically, mutual funds are either managed through strong systems and processes or they are managed with a strong individualistic trait, wherein the fund manager has sufficient leeway to make investment decisions.

Of the two styles, the first one is preferable as there is greater emphasis on an investment team that follows a well-defined process that is known to the investor before hand and does not come as a shock to him at a later stage.

To cite an example, Sundaram Tax Saver has a well-defined investment process that does not allow the fund manager to invest more than 5 per cent of net assets in a single stock.

While this may be a defensive investment strategy, it also gives a lot of comfort to the investor who knows well in advance the risk levels associated with the fund.

Given that you invest in a tax-saving fund with a minimum 3-year commitment, there is merit in selecting conservatively managed funds that look for undervalued stocks as the fund manager has the luxury of taking longish investment calls.

3. Volatility and risk-return

Great NAV (net asset value) returns in isolation do not amount to much. A fund could have done exceedingly well during a bull run by pursuing an aggressive investment strategy and could have slumped as hard during the bear phase after that.

What this means to the investor is that his fund's NAV is up sharply one month and down even more sharply the next month. This is the kind of turbulence that most investors can do without.

Admittedly, equity funds cannot really eliminate turbulence in their performance given the nature of equities. But it can be kept under control by pursuing a disciplined investment approach. You need to identify funds that have a lower 'standard deviation' -- a measure used to gauge volatility in NAV performance.

Likewise, look for tax-saving funds that have rewarded investors more per unit of risk taken by them. This is calculated by the Sharpe Ratio; a higher Sharpe Ratio indicates that the risk-return trade off has worked in the investor's interest.

So a lower standard deviation and a higher Sharpe Ratio make for an ideal mutual fund investment.

4. Expenses

Managing a fund entails costs like fund manager's salary, marketing/advertising costs and administration costs. The cost of investing in a mutual fund is measured by the expense ratio. The ratio represents the percentage of the fund's assets that go purely towards the cost of running the fund.

Typically, tax-saving funds have expense ratios in the region of 2.25-2.50 per cent. A lower expense ratio has a positive impact on the returns of the fund as the NAV (net asset value) is calculated after deducting the expenses.

5. Other parameters

Some other parameters that you must look at are entry load and track record of the asset management company. Most tax-saving funds have an entry load of 2.00-2.25 per cent. Some fund houses waive off the entry load on investments made through SIPs (systematic investment plans).

Likewise track record and asset management pedigree also need to be given due weightage. A fund house that has been embroiled in a controversy in the past can be given the miss. Likewise, a fund house that has just been launched can be considered only after you have exhausted other options.

Remember, with a tax-saving fund, the fund house needs to have a minimum 3-year track record over which it should have witnessed market upturns and downturns.

Investing in tax-saving funds must be given its due research and planning. By only playing the tax benefit angle, you run the risk of settling for a compromise and forfeiting the opportunity of making a great equity investment.

Your tax-saving fund shopping list:

• 1. Less than 40% of net assets in the top 10 stocks of the portfolio.
• 2. Expense ratio less than 2.25%.
• 3. Standard deviation of less than 6.00%.
• 4. Sharpe Ratio higher than 0.60%.
• 5. Compounded growth of over 25% over 5-year.

Table 1: Leading Tax-Saving Mutual Funds

(Source: Credence Analytics. NAV data as on Nov 9, 2004. Growth over 1-Yr is compounded annualised. The Sharpe Ratio is a measure of the returns offered by the fund vis-�-vis those offered by a risk-free instrument. Standard deviation highlights the element of risk associated with the fund.)

This article forms a part of the latest issue of Money Simplified - The Definitive Guide to Tax Panning. Click here to download, for FREE, the complete guide.