Tax-saving funds are a great way for risk-taking investors to invest their monies for the long term and earn tax benefits on the side. However, selecting the right tax-saving fund is not so simple.

There is a need, as with regular diversified equity funds, to evaluate tax-saving funds on critical parameters to ensure that you don't invest in the wrong scheme.

Remember, all tax-saving funds offer a tax benefit, so there isn't much to choose from over that parameter, but not all tax-saving funds make great investments, so there is plenty of evaluation to be done before you make a shortlist of the right tax-saving funds.

We have formulated a 5-step strategy for every investor looking at investing in tax-saving funds.

1. Assess your risk profile

Since investing to save tax is no different than investing for retirement or for child's education, investors need to consider the important principles of investing while selecting tax-saving funds. That is why it is important for you to have your eye on your risk profile at all times.

While, it is a given that a tax-saving fund investor has the requisite risk appetite, it still does not make his task any simple. The reason is that there are plenty of tax-saving funds out there that pursue varying investment styles. So you have to find the one that best suits your own risk profile.

For instance, HDFC TaxSaver is an aggressively managed, growth style, tax-saving fund. Another fund from the same fund house -- HDFC Long Term Advantage, is a value style fund and hence conservatively managed. As an investor you have to evaluate where you fit in -- with the aggressive fund or the conservative one.

2. Evaluate the fund house

Since the fund house plays a vital role in the performance of every scheme, it is crucial for investors to identify the right fund house while choosing a tax-saving fund. The sponsors, their investment philosophy and the systems and processes rank as extremely critical parameters at Personalfn. In fact, our research on a mutual fund scheme begins with these parameters.

Put briefly, investors must avoid fund houses that are overly dependent on star fund managers. Because when a star fund manager leaves, he takes the performance with him. And given that tax-saving funds that have a 3-year lock-in, you can't even chase the star fund manager (we don't recommend it anyways).

So it's important that you go for fund houses that are managed by teams. Teams are usually guided by well-documented processes and systems (like having investment caps on individuals stocks or sectors), which make individual fund managers dispensable. Over the long-term, it is best to be 'married' to a team than an individual.

Our research team has come across instances of both - fund houses run by teams as well as those run by star fund managers. Franklin Templeton Mutual Fund, HDFC Mutual Fund, DSP Merrill Lynch Mutual Fund are some of the fund houses that are by teams.

SBI Mutual Fund -- which owns the popular brand of Magnum funds -- for a long time had a star fund manager that propelled the fund house to great heights. But even the fund house has realised the perils of relying too much on one individual; they are now setting up processes to de-risk an individual fund manager's departure.

• Click here to download The 2007 Guide to Tax Planning

3. Compare returns over 3-year period

Once you have a fix on the fund house with processes, your scanner must now shift to the tax-saving fund's performance. Too many investors are obsessed with short-term performance (1-month, 6-month, 1-year) while evaluating equity funds.

Comparing returns over such short periods of time in an equity investment is unreasonable, even more so for tax-saving funds because of the mandatory 3-year lock-in period. Hence the 3-year period should be treated as the minimum time frame for evaluating the performance of a tax-saving fund (as also all other equity investments).

While evaluating performance, it is important to note how the fund has fared over varying time periods. Every equity fund has its day under the sun during a bull run; it's the bear phase that separates the experts from the punters. So your view on a tax-saving fund should not be based on its performance on the last rally, it should be dictated based on its performance on the last market downturn.

4. Compare performance on the risk parameters

The net asset value (NAV) performance is not the only parameter to be considered for evaluation in your quest for a well-managed tax-saving fund. Parameters like Standard Deviation and Sharpe Ratio must be given equal weightage.

How often have we seen a diversified equity fund deliver a brilliant performance on the 'NAV return' parameter by sacrificing all the rules of prudent investing and making aggressive investments across stocks and sectors and apportioning an above-average allocation to high risk investments like mid cap stocks or technology stocks for instance.

Therefore it's important for investors to keep an eye on the risk that the fund has taken to deliver that high-voltage performance.

Risk parameters like Standard Deviation and Sharpe Ratio are important indicators. Standard Deviation measures the degree of volatility that a fund exposes its investors to; similarly Sharpe Ratio is used to measure the returns delivered per unit of risk borne.

Find out how the fund measures up on these parameters vis-�-vis its peers from the tax-saving funds segment. The ideal combination for an equity/tax-saving fund is lower Standard Deviation (i.e. lower volatility) and higher Sharpe Ratio (i.e. higher return vis-�-vis the risk-free investment).

5. Select the right option

The 3-year lock-in makes tax-saving funds relatively illiquid. While all equity investments must be made with at least a 3-year investment time frame, with tax-saving funds, this is 'imposed' on the investor.

For investors who want to eke out some liquidity (over the lock-in period) from a tax-saving fund, there is the dividend option. Tax-saving funds like regular equity funds declare dividends (although this is not assured and depends mainly on the performance of the fund) at periodic intervals. Investors who want a cash flow (even if at infrequent intervals) can opt for the dividend option.

Investors not looking for a cash flow should opt for the growth option. Over the long-term, it is best to be invested with the growth option as taking out money from your investment (by way of dividends) works against the principle of compounding.

By Personalfn.com, a financial planning initiative. It can be reached at info@personalfn.com. Personalfn.com also publishes a free-to-download financial planning guide, Money Simplified. To get a copy of the latest issue - How ULIPs fit in - please click here.