What Are Contra Funds? Potential Rewards & Risks

In the world of investing, it's easy to get caught up in the prevailing sentiment and follow the crowd. We have all done that. Buying a stock when a lot of people are and selling when the market sentiment towards the stock turns negative

But what if there was a way to capitalise on market inefficiencies and go against the herd? This is where a contrarian mindset comes in. 

Contrarian investing involves going against the market sentiment and taking a different approach. Remember the 2008 financial crisis in the USA? Michael Burry was one of the few with a contrarian view and went against the market sentiment. He bet on something the entire market thought could never fail and made substantial profits from it.

On the other hand, in the mid-2010s, contrarian investors who invested in stocks like Blockbuster and Blackberry, even though the companies showed clear signs of being technologically far behind their competitors, lost a lot of money. Contrarian investing can be a double-edged sword, but there are mutual funds that want to capitalise on this mindset with Contra funds.

Contra funds follow the contrarian strategy and focus on investing in stocks that are not performing well. They look for stocks that the market is not paying attention to but have the potential to rebound in the future.

But does the contrarian strategy work? In this blog, we will look into how contra funds work, their advantages and disadvantages and who should invest in these funds.

What are Contra Funds?

According to SEBI, Contra funds are equity mutual funds that take a contrarian view on the market. Contra Funds offer a structured approach to contrarian investing. 

They invest in stocks that are underperforming with the potential for future growth. They diversify across sectors and market caps to reduce the risk of going against the market sentiment.

How does contrarian investing work?

1. Understanding market sentiment: Contrarian investing starts by understanding how people feel about the market. Are they overly optimistic or excessively pessimistic? By figuring out what most investors are thinking and feeling, contrarian investors can find opportunities that others might not see and can lead to potential gains.

2. Finding overlooked stocks: Contrarian investing involves finding stocks that are being ignored because of the current market sentiment. These stocks have the potential to grow in the future, but not many investors are interested in them right now. Contrarian investors do careful research to uncover the hidden gems that others have missed.

3. Doing thorough research: Contrarian investing requires doing a lot of research on the stocks you want to invest in. Investors look at several factors, like how much money they can make, the company's management, what makes them better than their competitors, and what's happening in their industry. By doing this careful analysis, investors can determine the real value of the stocks and if they can give returns in the future. 

Advantages of investing in Contra Funds

1. Potential returns from market inefficiencies: Contra funds capitalise on market inefficiencies and invest where there is an obvious gap between the potential of a stock and the markets' view on it. If the fund managers' judgement is correct, contra funds have the ability to give high returns.

2. Diversification benefits: Contra funds bring a greater variety to an investment portfolio. They don't just follow popular choices like large-cap, mid-cap, or small-cap stocks. Instead, they select different stocks that others overlook. By going against market sentiment, contra funds make investments more diverse. This helps reduce risks and could help with portfolio performance.

3. Outperformance during market downturns: Contra funds can outperform in bearish markets. Holding stocks that the market has a negative sentiment towards or are undervalued has an advantage. It reduces the overall risk during market downturns as the already negative stocks will fall to a lesser degree than popular stocks, thus limiting investor losses.

Disadvantages of investing in Contra Funds

1. Short-term volatility: Contra Funds can be subject to short-term price fluctuations and market volatility. Their contrarian approach of investing against the prevailing sentiment can lead to uncertainty and volatility, which is not suitable for investors seeking stability and consistent returns.

2. Requires patience and a long-term horizon: When investing in contra funds, it's important to have a long-term perspective, ideally at least 5 years. These funds include companies that are facing temporary challenges. A contrarian investor needs to be patient and understand that it may take time for undervalued stocks to reach their actual value or for market sentiment to change in favour of the fund's holdings to have a chance at achieving the expected returns.

Who should invest in Contra Funds?

Although contra funds can potentially give you high returns, they also come with their own risks. Before investing in these funds, make sure you check all the following points-

-You are seeking long-term growth opportunities through market inefficiencies.

-You have a contrarian mindset and the ability to withstand short-term volatility.

-You understand the risks of investing in contra funds and are comfortable with ups and downs.

Conclusion

Contra Funds offer the potential for significant growth by capitalising on market inefficiencies and investing against the herd. However, it is essential to carefully consider your investment objectives and risk appetite before investing in Contra Funds. 

Contra funds are a bet against the market sentiment, which, if gone wrong, can significantly affect your portfolio returns. A contrarian investment strategy has worked for some investors over the years and gone completely wrong for others. 

If you decide to invest in Contra funds, remember that they are not like other equity funds, so don't try to time them. When it comes to contra funds, it's best to take a long-term approach. 

Trying to predict the lowest point to invest in these funds is not a good idea and you're likely to miss out on potential gains by trying to time the market. So, it's better to focus on staying invested long-term and not worry too much about finding the perfect moment to invest.

Contra Funds: Frequently Asked Questions (FAQs)

Are value funds and contra funds the same?

Contrary to popular belief, contra funds are not the same as value funds, although they share some similarities. Value funds aim to buy stocks at prices lower than their true worth, focusing on a safety cushion. On the other hand, contra funds focus on stocks that are currently performing poorly but are expected to improve and outperform the market in the future. In simpler terms, value funds look for undervalued stocks, while contra funds target stocks that are currently down but expected to bounce back.

Note- According to SEBI (Securities and Exchange Board of India), a fund house can only offer a contra fund or a value fund, but not both. In simpler terms, an AMC can choose to have either a contra fund or a value fund, but they cannot have both types of funds in their offerings.

How will my investment in contra funds be taxed?

Contra funds are equity funds and are hence taxed in the same manner. If you hold your investments for more than one year, and gains are over Rs. 1 lakh, then you are taxed at 10%. If you hold it for less than one year, you will be taxed at a flat rate of 15%

What is the right time to invest in a contra fund?

There's no perfect "right time" for contra funds, as they aim to capitalise on undervalued stocks regardless of market conditions. However, times with broad market downturns or when specific sectors are out of favour can offer more opportunities for contra funds to find deeply discounted stocks with high rebound potential.

What is the ideal investment horizon for contra funds?

Contra funds require a long-term investment horizon, ideally a minimum of 5 years or more. This extended time frame allows undervalued stocks to potentially recover, market cycles to shift, and the contrarian investment philosophy to reap potential rewards.

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