Contra funds are a type of equity mutual funds that invest mainly in stocks. These funds follow a contrarian approach to the market. In other words, Contra fund managers go against the current market trends. They look for undervalued stocks that have strong fundamentals yet are not favoured by the market. These stocks are often available at lower prices and therefore contra funds can gain from sharp increases in the prices of these stocks when the market recognises their value.
This guide will explain what Contra Funds are, how they work, and their main features. We will also talk about investing in Contra Mutual Funds, why people choose them, and the tax rules for these funds.
What are contra mutual funds?
A contra fund is a type of mutual fund that focuses on investing in stocks that are currently out of favour with the market. Instead of following market trends, these funds target undervalued stocks, anticipating future growth potential. The fund manager takes a contrarian approach, believing that these overlooked stocks, which may be performing poorly at present, are likely to experience substantial price appreciation over time. By identifying opportunities in less popular stocks, contra funds aim to capitalise on the long-term gains when these assets rebound in value.
The core principle behind contra funds lies in exploiting temporary market inefficiencies. When investor sentiment sours on a particular stock or sector, its price may fall below its intrinsic value. Contra fund managers identify these opportunities, buying stocks with the expectation that their prices will eventually recover as market conditions improve or the company's fundamentals strengthen.
Contra funds are geared towards long-term investors. These funds may underperform the broader market in the short term, especially during periods of strong market rallies. However, over a longer timeframe, they have the potential to deliver superior returns if their contrarian bets pay off.
How does a contra mutual fund work?
Contra mutual funds operate with a contrarian investment philosophy, essentially betting against the current market sentiment. Here's a breakdown of their process:
- Identifying undervalued stocks: The fund manager actively seeks stocks that are currently out of favor with the market. This could be due to temporary setbacks, negative news cycles, or a general market correction in a particular sector.
- Value investing: The core principle is to buy stocks believed to be trading below their intrinsic value. This intrinsic value represents the company's long-term potential, taking into account factors like future earnings, assets, and competitive advantage.
- Capitalising on market inefficiencies: By buying undervalued stocks, the fund aims to profit when their prices eventually recover and reflect their true worth. This correction can occur when market sentiment improves, company fundamentals strengthen, or negative news events are resolved.
- Long-term perspective: Contra funds are designed for long-term investors. Their strategy may underperform the broader market in the short term, especially during bull markets. However, over a longer timeframe (5+ years), their contrarian bets have the potential to generate significant returns if undervalued stocks experience price appreciation.
Features of contra mutual funds
- Investment philosophy: Contrarian approach, focusing on out-of-favor stocks with potential for future growth.
- Volatility: Can be more volatile than traditional mutual funds due to investments in companies facing temporary challenges.
- Risk-reward profile: High-risk, high-reward potential. Offers the possibility of significant returns if contrarian bets pay off, but also carries the risk of underperformance if the chosen stocks don't recover.
- Long-term investment horizon: Best suited for investors with a long-term investment timeframe (5+ years) who can tolerate market fluctuations.
- Minimum investment: The minimum investment amount varies depending on the specific fund.
Advantages of contra funds
Here are some advantages of investing in contra funds:
- Has higher chances of gaining positive returns since selected stocks have sound fundamentals and are purchased at a lower cost.
- Comes with lower downside risk in comparison to large cap, multi-cap, mid-cap and other equity funds. This is because the stocks in a contra fund trade at discounts relative to their historical valuations.
- This Contra Fund has a very low minimum investment requirement, making it easy for retail traders to invest.
Thus, contra mutual funds are a great way to invest in undervalued stocks that have the potential to grow over time. However, it is important to consider the risk factors associated with them carefully, and consider your appetite for the same, before investing.
How to invest in contra funds?
Here are a few steps to follow:
- Register online on your preferred mutual fund website or app.
- Choose the contra fund you want to invest in.
- Click on invest and choose the amount and mode of investment (SIP or lumpsum).
- Provide your KYC details (PAN and bank details) and complete your investment.
Who should invest in contra mutual funds?
Contra mutual funds are suitable for:
- High risk investors: It is suitable for investors with a high-risk appetite since all these funds are underperforming stocks but have the potential to grow over time. Since these funds are based on a possibility, they can be vulnerable and face fluctuations.
- Long term investors: It is best suited for investors who can invest for the long term. Since it is a fund that looks forward to the future, it can do well for those who remain invested for a long tenure.
Secret Mantra to Investing in Contra Funds?
The key to successful investing in Contra Funds lies in understanding their unique approach and having patience. These funds invest in stocks that are currently undervalued but have the potential to perform well in the future.
- Long-term Vision: Contra Funds require a long-term investment horizon as they focus on undervalued stocks that may take time to realise their true potential.
- Risk Tolerance: These funds are best suited for investors with a higher risk appetite, as they involve investing in out-of-favour sectors and companies.
- Market Contrarian Approach: A contra fund strategy often goes against the prevailing market trends, investing in assets that others may be avoiding.
By investing in Contra Funds, you are betting on the market's tendency to correct itself over time. Patience and a strong understanding of market cycles are essential for reaping the rewards of this strategy.
Recommended contra mutual funds to invest in 2024
Risks of investing in contra mutual funds
The major risks associated with the contra funds category are:
- They are based on estimations: These funds invest in undervalued stocks , anticipating they will do well in the future.
- It is for expert investors: Investors new to the investing environment need more expertise to invest in these stocks; they are most suitable for experienced investors skilled in research and analysis.
- It is based on the fund manager’s expertise: The fund manager used to make investment decisions. You may experience losses if the fund underperforms against predictions.
Taxation on contra funds
Contra funds invest in equities and hence , they are taxed like any other equity mutual funds. Investors have to pay taxes on the dividends they receive from mutual funds at their respective slab rates. Short-term capital gains earned on selling fund units are taxed at a rate of 15% irrespective of investors’ income tax slab rate. Long-term capital gains (realised on selling fund units after one year of holding) of up to Rs. 1 Lakh a year are made tax-free. Any gains exceeding this are taxed at 10%, and there is no benefit of indexation provided.
Factors to consider before investing in contra funds
Before choosing the best contra funds for your portfolio, it's essential to evaluate the following key factors:
- Investment tenure: Contra funds typically require a long-term commitment to realise their full potential. These funds invest in undervalued stocks that may take time to appreciate. Therefore, you must be prepared to stay invested for an extended period, often 5-7 years or more, to maximise returns.
- Risk and volatility: Contra funds are inherently volatile due to their contrarian strategy, investing in stocks that are not currently performing well. Price fluctuations are common, and you may notice significant ups and downs over time. It is crucial to have a high-risk tolerance and a long-term perspective to ride out these short-term market swings.
- Expense ratio: Managing contra funds involves costs, including fund management fees, which are reflected in the expense ratio. A higher expense ratio can eat into your overall returns. Therefore, carefully evaluate the fund’s expense ratio to ensure that the management costs are reasonable and won’t significantly affect your investment returns in the long run.
- Fund manager's expertise: The success of contra funds depends largely on the skills and experience of the fund manager. A competent manager can identify undervalued stocks with high potential for future growth. It’s essential to review the track record and performance history of the fund manager before selecting a contra fund, as this can greatly influence the fund’s success.
Conclusion
In conclusion, selecting the right contra fund for your portfolio requires careful consideration of key factors. A long-term investment horizon is essential due to the nature of these funds, which focus on undervalued stocks. Investors must also be prepared for high volatility and fluctuating prices. Additionally, the expense ratio plays a significant role in determining your net returns, so understanding the associated fees is crucial. Lastly, the expertise of the fund manager is vital for identifying potential growth opportunities in underperforming stocks, making it important to assess their track record before making a decision.
