Section 80C has come as a boon to investors who have an appetite for risk. Until the previous year, investment in tax-saving funds (otherwise known as Equity-Linked Savings Schemes) for the purpose of availing a tax benefit was restricted to Rs 10,000 per year.

In the current fiscal year all such restrictions have been done away with; an individual assessee now has the flexibility to invest the Rs 100,000 that is allowed under Section 80C in any proportion that he wishes (only in PPF is there an upper limit of Rs 70,000 p.a.) in specified instruments.

Naturally, those with a risk appetite should be looking at increasing their exposure to tax-saving funds.

Tax-saving funds are simply equity funds that have a mandatory lock-in of three years. The lock-in is one of the key strengths of such funds; it allows the fund manager to invest for the long-term and also saves him from the pressures of managing fund inflows and outflows on a day-to-day basis. In case of a tax-saving fund, the fund outflows are known relatively well in advance and therefore can be planned for.

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Before we delve further into understanding why tax-saving funds should be considered for your portfolio, let us first understand the risks associated with them.

Since tax-saving funds invest in the stock markets, they are prone to high volatility in the short to medium term. In the long-term (over three years), although it is generally stated that the investor will be compensated for the risk he is taking by way of a higher return.

It should be understood that there are no guarantees, i.e. there is always the possibility that at the end of the three-year period investors may lose part of their capital, let alone earn a return on it. This may seem like an extreme scenario, but it is not. There are several instances in stock market history where returns have been negative or very low not just for a year or two, but for decades.

The other risk pertains to selecting the wrong fund. Since there is a lock-in an investor cannot cut his losses by shifting to another fund. He has to be invested for three years at a stretch.

With respect to the risk of being invested in the stock markets, the best way to minimise the same is by ensuring that you are invested in line with your asset allocation. A well-planned asset allocation will ensure that you are adequately diversified; it will match your investments with your objectives in a manner that suits your risk profile.

So, if you are investing for say a period of three years, and are in a position to take risk, some allocation will be made to tax-saving funds (what better than an asset which not only earns an attractive return, but also offers tax incentives!).

One can dilute the risk of mistiming the market by investing not in a lump sum, but in small amounts at regular intervals (otherwise called a Systematic Investment Plan).

So, if your allocation for the Rs 100,000 Section 80C limit demands that you invest Rs 30,000 in a year, it is best that you break up the investment in twelve equal installments and invest in the selected fund.

Leading tax-saving funds

(Source: Credence Analytics; NAV data as on November 14, 2005. Returns are Compounded, Annualised.)

Over time, you will find that the risk adjusted return of such a plan compares well with other alternatives; especially when you factor in the time saved in trying to time the market!

Selecting the right fund presents its different set of challenges for the investor. The best option for you is to leave this decision to your financial planner. But, as we all know, credibility is in short supply and therefore a lot of homework will need to be done by the investor himself.

Here are five key things you should look at before investing in a tax-plan fund:

1. Take a call on the fund house

This is the first step in the process of selecting which tax-saving fund you should invest in. Look for fund houses which have strong processes and are led by teams as against individuals. This will ensure that in case a fund manager was to leave you will not suffer. Also look for fund houses that are committed to being there for the long-term.

2. Compare returns over various time horizons, with benchmark, peers

Although historical, returns logged in by a scheme are an important factor while taking a call on where to invest. The reason being that when compared to their benchmark and their peers, returns (over three years and more in this case) help investors take a call on whether or not a fund's strategy is working.

Some funds do not want to be the number one; they just want to be very consistent (say, among top 10 schemes). The return tables will help take a call on their success. But remember, at the end of the day, this is historical information. The future could be a lot different.

3. Look at other parameters

Looking at returns alone will not bring out the entire picture. It is important for an investor to study the 'risk' the fund has taken to earn the return (Sharpe Ratio, for the mathematically inclined). The fund which is able to generate the most return per unit risk, other points of comparison being the same, should ideally be a good investment opportunity.

Similarly the Standard Deviation figures can be studied to understand the degree of risk which the fund has exposed its investors to.

4. Know the fund manager

Another point to consider is that even though 'team driven' should be the preferred way to go, it is important to understand the person who manages the scheme on a day-to-day basis, i.e. the fund manager.

Some funds have been managed for long periods of time by the same fund manager; this provides the investor with an insight into the fund manager's working style, how he responds to market manias and crashes. Such information can be critical while deciding on which tax-plan fund to invest in.

Finally, our recommendation to you is that you invest in tax-plan funds only to the extent your asset allocation indicates you do. Do not put all your funds into a single scheme; have a mix of fund houses as well as schemes.

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