If you wish to combine tax savings with wealth creation, start an SIP in an ELSS fund early in the financial year.

One instrument he is keen to invest in is Equity-Linked Saving Schemes (ELSS), also known as Tax-Saver Funds. But before he takes the plunge.

Why Invest In ELSS Funds

When investors put their money in a Tax-Saving Product, they are usually concerned only with the amount of tax they will save. Ideally, they should also pay attention to the returns that these tax-saving investments will yield. ELSS funds score highly on this count. ELSS is one of the instruments under Section 80C that takes 100% exposure to equities. Hence, along with tax saving, it also offers the benefit of wealth creation. The ELSS category has given an average return of 43.48% over the past one year and 22.99% over three years. Fixed-income schemes like PPF, EPF and NSC pay an interest rate of 8-9% while Sukanya Samriddhi Scheme pays slightly more at 9.2%. The returns from NPS tend to be lower than from ELSS funds as the former allows a maximum of only 50% investment in equities, and that too only in Nifty stocks. Traditional insurance plans give a return of barely 5-6%. And while Ulips do invest in equities, a part of the premium goes into offering insurance cover. The higher returns in ELSS funds will, of course, come with higher volatility.

Conservative investors should, however, remember that the risk in equities declines as your investment horizon increases. If you are anyway going to have your money locked up for three years, you may as well invest at least a part of your tax-saving portfolio in an equity-based instrument like ELSS. The returns will be higher, and the interim volatility won't matter due to the lock-in. Investors keen on wealth creation should leave their money invested in an ELSS fund even after the mandatory three-year lock-in so as to earn optimal returns from it. The risk of making a loss in equities becomes very small if you stay invested for 5-7 years.

The three-year lock-in also allows fund managers do a better job. To deliver steady returns, a fund manager needs a steady and predictable inflow of AUM. The three-year lock-in period in ELSS funds gives Fund Managers the leeway to thoroughly analyse companies and invest with a longer time horizon. They can do so because they know that the money is going to stay with them for at least three years.

Choose the right fund

Before investing in an ELSS fund, check its track record. Compare its returns over the short (six-month and one-year), medium (three-year) and long-term (five-year) horizons vis-a-vis its benchmark and the category average. Ensure that the fund has been ahead over all or most of these time horizons.

Besides high returns, look for consistency. Not only should the fund have beaten its benchmark in rising markets, it should also have fallen less than its benchmark in declining markets. Investors should pay heed to a fund's risk-adjusted return rather than just the return. The fund's expense ratio, level of churn, and level of risk should also be lower than the category average. Look up the websites of rating agencies like Morningstar and Value Research for these data.

There should also be consistency at the helm. The fund manager who was responsible for creating the fund's fine track record should still be managing it.

What should you avoid?

Avoid making a lump sum investment in ELSS funds. If the market is at a high level and it falls right after you invest--the sort of conditions that prevail today--you will see massive erosion in your portfolio value. Instead, use the SIP approach and take advantage of rupee-cost averaging to garner good returns from these funds.

When selecting an ELSS fund, take into consideration your own risk appetite. Conservative investors should avoid ELSS funds that take large exposure to mid and small-cap stocks. They should stick to funds that invest primarily in large-cap stocks. Aggressive investors may opt for funds with a higher mid and small-cap exposure.

Finally, since in all likelihood your purpose is to build up a corpus to meet various financial goals, avoid the dividend option and go for growth.