What are contra mutual funds

Contra mutual funds, sometimes also referred to as contra funds, are mutual fund schemes where the investor invests mainly in undervalued stocks. Fund managers pick up stocks that are currently not performing well in the short term but are expected to outperform in the market in the future. This way they can get the assets at a lower price than their historical value and get potentially long-term growth.

Since contra mutual funds go against the market trends, they are characterised by relatively higher risk.

• Table of contents

• How does a contra mutual fund work?
• Features of contra mutual funds
• Advantages of contra funds
• How to invest in contra mutual funds?
• Who should invest in contra mutual funds?
• How can you benefit from investing in contra funds?
• Taxation on contra funds
• Things to consider before investing in contra mutual funds

How does a contra mutual fund work?

Contra mutual funds follow a contrarian investment approach, meaning they invest in stocks or sectors that are currently undervalued or not in favour in the market. Fund managers identify these potential opportunities with the expectation that they will yield potential returns if the market recognises their potential.

This strategy requires a long-term outlook and a high risk tolerance, as recoveries may take time, and success is not guaranteed. The investment approach is based on the belief that market sentiment can shift and recognise the intrinsic value of undervalued assets.

Features of contra mutual funds

Contra mutual funds have the following characteristics:

• Contrarian investment approach: They invest against prevailing market sentiment.
• Long-term perspective: These funds require patience and a commitment to long-term investing.
• High risk: They involve higher risk due to the nature of their investments.
• Potential for long-term returns: If the contrarian strategy succeeds, such funds can help build wealth in the long term.
• Focus on undervalued assets: They target companies and opportunities currently undervalued in the market.
• Active fund management: Fund managers actively research and select contrarian investment opportunities.

These funds require thorough research and strong conviction from the fund manager. Since they allocate a high proportion to equities, they are classified as high risk investments.

Also Read: What is an equity fund?

Advantages of contra funds

Contra funds offer several potential benefits for investors willing to take on higher risk.

Potential for higher returns: If the contrarian approach is successful, it can lead to significant returns if the market recognises the inherent value of these securities.

Diversification: They can provide diversification by investing in sectors or stocks that are not commonly included in mainstream portfolios.

Buying at relatively lower prices: They enable investors to acquire assets at lower valuations.

However, it is important to note that these potential benefits come with higher risk.

How to invest in contra mutual funds?

Investing in contra mutual funds follows the same process as investing in other equity mutual funds in India.

• Research and selection: Evaluate different contra funds based on factors like past performance*, fund manager expertise, and expense ratios. *Past performance may or may not be sustained in future.
• KYC compliance: Ensure completion of Know Your Customer (KYC) formalities.
• Investment options: Invest through direct plans (via the fund house’s website) or regular plans (through distributors).
• SIP or lumpsum investment: Choose between a Systematic Investment Plan (SIP) or a lumpsum investment based on financial goals and risk tolerance.
• Monitor your investment: Regularly review fund performance and adjust investment strategies if necessary.

Who should invest in contra mutual funds?

Contra mutual funds may be suitable for investors with a high risk appetite and a long-term investment approach. These funds are not appropriate for those looking for near-term potential returns or those who prefer lower-risk investments. Investors who recognize the potential in undervalued assets and can tolerate market fluctuations might find contra funds suitable.

• Investors comfortable with high risk.
• Those aiming for long-term growth potential.
• Individuals who understand and accept market fluctuations.
• Investors who align with contrarian investment principles.
• Those looking to diversify their portfolio with potentially high-growth assets.

It is important to note that these funds can be highly volatile and may not align with the preferences of conservative investors.

How can you benefit from investing in contra funds?

If the fund manager’s contrarian approach is successful, investing in contra funds can offer several potential benefits.

• Potential for higher returns: Undervalued assets may deliver potential returns if their value increases over time.
• Portfolio diversification: These funds add diversity by investing in sectors or stocks that may not be included in mainstream portfolios.
• Buying at relatively lower prices: They provide an opportunity to purchase assets at lower valuations, which may enhance future returns.
• Possibility of outperformance: When market corrections occur or previously overlooked sectors recover, contra funds may perform better than traditional funds.

Taxation on contra funds

Since contra funds fall under the equity mutual fund category, they are subject to equity taxation rules in India.

• Short-term capital gains (STCG): Gains from selling units within one year are taxed at 20%.
• Long-term capital gains (LTCG): Gains from selling units after one year are tax-free up to Rs. 1.25 lakh in a financial year. Any gains above this limit are taxed at 12.5% without indexation benefits.

Things to consider before investing in contra mutual funds

Before investing in contra mutual funds, it's crucial to understand their strategy of betting against market trends. Here are a few things you must know about contra-mutual funds.

• Diversification: Most investors acquire assets that are bound to perform well with the bull runs in the market. A contra mutual fund, meaning going against the market flow, helps in diversifying your portfolio by adding an investment that performs against the market trends. It is like betting on the underdog and giving the investors a chance to get above-market returns.
• Require a longer investment horizon: Contra funds are more suitable for a long-term investment horizon since they are likely to take longer than other stocks to show good results. With contra mutual funds, you need to exercise patience and hold the investment for the long term so that it can deliver potentially solid returns.
• Suited for seasoned investors: A contrarian investment scheme, used for contra mutual funds, is something that many novice investors may not be aware of, or are too afraid to adopt. It may be more suitable for experienced investors who are willing to take a relatively higher degree of risk by going against the market trend.
• Based on estimation: Contra mutual funds, by definition, are equity mutual funds that go against the flow of the market. This means that fund managers pick underperforming stocks based on estimations of which ones may outperform in the future. Essentially, the returns of investing in contra mutual funds depend on the expertise of the fund manager.

Also Read: Contra funds vs value funds: Key differences for investors

Conclusion

Contra mutual funds follow a unique investment strategy that seeks to capitalize on undervalued assets, offering the potential for higher returns. However, they come with higher risk and require a long-term perspective. Investors should evaluate their risk tolerance and financial goals before investing. A thorough understanding of the fund manager’s strategy is essential. While these funds can provide potential benefits, all equity investments involve high risk.

FAQs

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

Contra funds generally require a long-term commitment, typically five years or more. This duration allows enough time for the fund’s strategy—investing in out-of-favor stocks—to potentially generate returns. Short-term market fluctuations can significantly impact performance.

Can I redeem a contra fund investment at any time?

Yes, contra funds are open-ended equity mutual funds, allowing investors to redeem their investments at any time. However, selling before the recommended long-term period may lead to potential losses, especially in unfavorable market conditions. Some funds may also impose exit loads for early withdrawals.

Are contra funds a safe investment?

No mutual fund investments are completely safe. In particular, contra funds are equity mutual funds and are categorised as very high risk. Their strategy of investing in undervalued stocks can lead to significant volatility. Investors should have a high-risk tolerance and a long-term perspective.

What kind of returns can I earn from contra funds?

Contra funds have the potential to deliver higher returns if the fund manager successfully identifies undervalued stocks. However, they also carry the risk of higher losses during market downturns. Returns are market-dependent, and there are no guarantees of a specific outcome.

Are there any restrictions on asset allocation for contra funds?

As per SEBI regulations, contra funds must allocate at least 65% of their assets to equity and equity-related instruments. Beyond this requirement, fund managers have flexibility in asset allocation based on the fund’s contrarian investment strategy. Sector and market capitalization allocations may vary depending on the fund’s objectives.

Who manages contra funds?

Contra funds are managed by professional fund managers working for SEBI-registered Asset Management Companies (AMCs). These managers specialize in identifying undervalued or out-of-favor stocks, aligning investments with the fund’s contrarian strategy.

What does a contra fund invest in?

Contra funds primarily invest in equity and equity-related instruments of companies that are undervalued or currently out of favor in the market. These may include businesses facing temporary challenges or sectors undergoing a downturn, with the expectation of future recovery.

What is the value of a contra fund?

A contra fund’s value is measured by its Net Asset Value (NAV), which reflects the total market value of its underlying investments after deducting expenses. The NAV fluctuates based on the performance of the fund’s holdings.

Are contra funds risky?

Yes, contra funds carry a high level of risk. As equity mutual funds, they are subject to market volatility. Their contrarian approach, which focuses on out-of-favour stocks, can be risky. These funds are suitable for investors with a high risk tolerance and a long-term investment perspective.

Mutual Fund Investments are subject to market risks, read all scheme related documents carefully.
This document should not be treated as endorsement of the views / opinions or as an investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.