If you don't want inflation to munch out a big part of your savings as you invest to cut your tax burden, you should look at equity investment. Equity-linked savings schemes (ELSS), whose returns are far ahead of that from traditional tax-saving instruments like Public Provident Fund (PPF) and National Savings Certificate (NSC), is what you need.

Three-year returns from most ELSS funds have been around 30-50 per cent over the last five years, and the 8 per cent returns from guaranteed return products look paltry in front of them.

An ELSS is a diversified equity fund that comes with a 3-year lock-in period and offers tax benefits under Section 80C of the Income Tax Act.

Before selecting an ELSS, ensure that your investment takes into account your risk profile and the overall asset allocation of your portfolio.

Remember that the higher returns from ELSS come with higher risk as they are market-linked. These schemes are suitable for investors willing to trade lower risk for better returns from their tax saving investments.

How to evaluate an ELSS?

ELSS funds should be evaluated on the same parameters that are applied to other equity funds. Funds with a longer performance history should be preferred over newer funds.

The longer the performance history, the longer time a fund has to test its mettle in various market situations. It would be easier for the investor, too, to evaluate consistency in the fund's performance. The performance of the fund should be compared with that of its benchmark and peers.

An investor should also assess the risk and return strategy of the fund and take a call on whether he is comfortable with it. Fund houses with strong and established processes and the ones that focus on fund management teams rather than the individual are better.

Choosing the fund

The biggest advantage of an ELSS is that it allows investors to choose products according to their risk appetite. The suitability of a fund depends upon the compatibility of the fund's strategy with the risk appetite of the investor.

The focus of the fund's portfolio to different segments of the market, such as large-, mid- and small-cap, gives an indication of the volatility that an investor can expect in a fund.

Moreover, the 3-year lock-in reduces the risk in equity investing to a great extent and allows the fund manager to choose stocks with long-term potential without liquidity concerns.

We have picked seven schemes for you, and categorised them as conservative and aggressive. The schemes taken here have at least three years of performance history.

Apart from that, they are well diversified funds and would form part of any selection process based on their past performance and robust portfolio strategy.

Less aggressive funds

SBI [Get Quote] Magnum Taxgain: The top performing fund in the 3- and 5-year time frame, SBI Magnum Taxgain retains the flexibility to move into whichever market segment it sees opportunities in. Its mid- and small-cap focus in 2003, 2004 and 2005 reaped huge returns.

The fund's 3-year and 5-year returns of 59.93 per cent and 69.43 per cent, respectively, make it one of the top performers in this space. Since the mid-2006 market crash, it has slowly shifted focus to large-caps. At Rs 3,782 crore (Rs 37.82 billion), it is one of the largest funds in the category and may make it difficult for the fund to take substantial exposure in the mid and small cap segments of the market.

The past performance of the fund and its ability to move into various segments of the market makes it an attractive proposition for investors willing to put up with a degree of uncertainty for higher returns.

Sundaram BNP Paribas TaxSaver: A top performing fund in the category with returns of more than 45 per cent over a 3-year period, this fund again has the flexibility to invest across market segments and has done so successfully in the past.

The fund has always maintained a well-diversified portfolio with 55-60 stocks. So, even if one, or few stocks underperform, the overall performance won't be much at risk.

The fund has reduced its large-cap exposure in the last quarter of 2007 unlike most funds that increased holdings in large-cap stocks during the period. As a fund that can shift across segments, the ability of the fund manager to identify trends early enough would be crucial in the fund's performance and is suitable for investors willing to take this risk.

HDFC [Get Quote] Tax Saver: This is another fund for investors, who would prefer a large-cap orientation in their investment portfolio. Though the fund had benefitted by moving into the mid- and small-cap space in 2003 and 2004, it has focused on large-cap stocks in the last two years.

The fund is among the top funds in the 3- and 5-year time frames though it fell in the 1-year stakes. The 1-year rolling return of the fund at 40.55 per cent still keeps it among the top schemes with more than three years of performance track record.

Franklin India Tax Shield: This scheme is suitable for investors who like steady returns with no surprises. Its biggest advantage has been its ability to negotiate market downturns.

The fund has given negative returns in only four of the 20 quarters. It finds a place on this list on the back of its consistent large-cap focus in its portfolio.

The returns from the fund at 29.17 per cent, 38.65 per cent and 45.95 per cent over one, three and five years, respectively, have been steady rather than spectacular. Investors willing to trade return for the comfort and lower risk of a large-cap portfolio can consider this scheme.

Aggressive funds

Principal Tax Savings Fund: This is another candidate for investors willing to take greater exposure to the mid- and small-cap segments. The fund has been among the top five schemes over one, three and five years and has consistently beaten the benchmark and the category average.

The fund is suitable for investors who are willing to take a higher exposure to the more volatile small-cap segment since the fund has a substantial exposure to it. The 3-year lock-in gives the fund manager the leeway to take such calls. Nevertheless, the fund is not for the faint-hearted.

Birla Sun Life Tax Relief '96: This is another multi-cap fund that has been a steady performer. It has consistently outperformed both the benchmark and the category average. It took a large-cap tilt in its portfolio after the mid-2006 market crash.

The fund has taken concentrated exposure to the financial services segment and has benefited from it as is evident from its 1-year return--41.66 per cent. The fund is suitable for investors willing to take greater risk associated with a higher degree of concentration both in sector and stocks.

Birla Equity Plan: For investors who are willing to take an extra dose of risk to benefit from better returns can invest in this fund that has always maintained a majority of its assets in mid- and small-cap stocks.

With returns of 40.94 per cent in the 3-year time period and 52.51 per cent in the 5-year period, the fund has done well to reward its investors. From a concentrated portfolio of 32-35 stocks, the fund has gone to a more diversified portfolio of 45-50 stocks in the last six months.

While this reduces the risk in the fund, it also limits the gains from good stock picks. With a fund size of Rs 196 crore (Rs 1.96 billion), the fund is still small enough to be nimble while moving in and out of sectors and stocks. The fund is a good pick for an investor with a higher risk appetite.

How to make most of your ELSS investments?

ELSS should be treated as part of the overall portfolio, and not merely as a tax-saving instrument. By keeping a few strategies in mind, an investor can make the most of his investment.

Keep financial goals in mind: Every ELSS adopts different stock picking strategies. Some schemes such as Franklin India Tax Shield maintain a large-cap focus and are suitable for investors who have a lower risk profile.

On the other hand, funds that have greater exposure to small- and mid-cap stocks, such as Principal Tax Savings Fund, fit the portfolio of an investor willing to take a higher degree of risk. Ignoring this aspect would lead to a mismatch between the fund and the investor's profile.

Diversify among styles: The role of the ELSS in a portfolio is restricted to providing tax benefits without compromising on the return. It cannot form the core of a portfolio. A portfolio should ideally stick to at best two schemes with varying investment styles and market focus.

Periodic investments: Identifying the scheme and starting a systematic investment plan (SIP) would ensure that the investor benefits from lower acquisition costs through rupee cost averaging in a volatile market. Investing periodically also spreads the burden.

However, remember that each installment will be subject to a 3-year lock-in. So, if you enroll in a 3-year SIP and invest systematically every month for three years, you will get your entire proceeds only after six years, after your last installment (at the end of the third year) completes three years.

Growth or dividend option: Choosing the growth option ensures compounding and capital appreciation in a mutual fund investment. However, in case of an ELSS, the dividend payout option provides a degree of liquidity even during the lock-in period.

The dividend paid out can be invested in other investment options, whether equity or debt, depending upon the rebalancing needs of the investor's portfolio and, thereby, reduce the risk in the overall investment plan. From the tax perspective, both options are equally efficient.

Don't chase NFOs: A new fund does not offer a track record to bank on. Populating their portfolio with ELSS NFOs every year is a mistake that many investors commit.

Buy from the company: Why pay Rs 2.25 entry load on every Rs 100 you invest to the agent, now that we have identified the schemes for you. Go to the fund office and buy.