Contra Mutual Funds

A contra fund is a form of mutual fund that invests in the opposite direction of the market. Explore more in the article.
Contra Mutual Funds
4 mins
29-April-2024

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.

What are contra mutual funds?

Contra mutual funds take an unconventional approach, aiming to profit by investing in stocks that are currently out of favour with the market. The fund manager adopts a contrarian view, believing that these undervalued stocks have the potential for significant price appreciation in the long run.

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.

While contra funds offer the potential for high returns, they also carry inherent risks. Investing in out-of-favour companies can be volatile, and it may take time for the fund's strategy to bear fruit. Investors considering contra funds should have a long-term investment horizon and a high tolerance for risk.

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:

  1. 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.
  2. 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.
  3. 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.
  4. 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.

How to invest in contra funds?

Here are a few steps to follow:

  1. Register online on your preferred mutual fund website or app.
  2. Choose the contra fund you want to invest in.
  3. Click on invest and choose the amount and mode of investment (SIP or lumpsum).
  4. 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.

Factors to consider before investing in contra funds.

You must consider these factors before you choose the best contra funds for your portfolio:

  1. Tenure of the investment: These funds are estimated to perform well in the future, which means you will have to be invested in this investment for the long term.
  2. Risks: Even the best contra funds come with high volatility. It is known to see frequent price fluctuations. Therefore, do not worry when you notice fluctuations in the price.
  3. Expense ratio: The managing company will levy you with a certain amount of fees and charges to manage the fund effectively. You will have to be aware of these fees to estimate the correct returns you will make.

Risks of investing in contra mutual funds

The major risks associated with the contra funds category are:

  1. They are based on estimations: These funds invest in undervalued stocks , anticipating they will do well in the future.
  2. 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.
  3. 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.

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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.

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.

Frequently asked questions

What kind of returns can I earn from contra funds?

Contra funds are equity funds that invest in stocks that are undervalued. They aim to generate higher returns than the benchmark index by buying low and selling high. The returns from contra funds depend on the fund manager’s ability to identify and invest in such stocks, and the market conditions that affect their performance. Contra funds can offer high returns in the long term, but they may also underperform in the short term.

How long do I need to stay invested in a contra fund?

Contra funds are suitable for long-term investors who have a high-risk appetite and a lot of patience. Contra funds invest in stocks that are currently unpopular or ignored by the market and wait for them to increase in value over time. This may take several years, depending on the market cycles and the fund manager’s strategy. Therefore, investors may have to hold their investment in contra funds for at least 5 to 7 years to reap the benefits of this contrarian approach.

Can I redeem a contra fund investment at any time?

Yes, you can redeem a contra fund investment at any time, as they are open-ended schemes that allow investors to buy and sell units daily. However, you should be aware of the exit load and the tax implications of redeeming a contra fund investment.

Are contra funds a safe investment?

Contra funds are not a safe investment, as they involve a high degree of risk and volatility. Contra funds invest in stocks that are of low value, which means they may have low liquidity, poor financial performance, or negative market sentiment. These stocks may take a long time to recover or may never recover at all, resulting in losses.
Contra funds also depend greatly on the fund manager’s ability to identify such stocks, which may not always hit the mark.

Are there any restrictions on asset allocation for contra funds?

Yes, there are some restrictions on asset allocation for contra funds, as per the SEBI guidelines. Contra funds are a type of equity funds, which means they have to invest at least 65% of their assets in equity and equity-related instruments which follow the contrarian investment theme.

What are the disadvantages of contra funds?
  • High Volatility: Investments in out-of-favor companies can be volatile, and it may take time for the fund's strategy to show results.
  • Short-Term Underperformance: Contra funds may underperform the broader market in the short term, especially during bull runs.
  • Requires Patience: Investors need a long-term horizon (5+ years) to ride out market fluctuations and potentially benefit from the contrarian approach.
Who manages contra funds?

Contra funds are managed by experienced portfolio managers skilled in:

  • Identifying undervalued stocks with strong long-term potential.
  • Employing fundamental and technical analysis to uncover investment opportunities.
  • Maintaining a contrarian perspective and making independent investment decisions.
What does a contra fund invest in?

Contra funds invest in stocks that are currently out of favor with the market. This could be due to:

  • Temporary setbacks for the company.
  • Negative news cycles affecting the stock price.
  • A general market correction in a particular sector.
What is the value of a contra fund?

The value of a contra fund lies in its potential to deliver high returns over the long term. By buying undervalued stocks, the fund aims to profit when their prices recover and reflect their true worth. This strategy can be particularly valuable during market downturns when quality stocks may be trading at a discount.

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