Contra Funds: Are They Right for You?

August 3, 2023 Mutual Fund

Over the last couple of months, exuding confidence in India’s growth story (termed as a ‘bright spot’ by the International Monetary Fund), the Indian equity markets scaled new highs and generated wealth for investors.

However, not all stocks and sectors have participated or done well in the rally. For example, the IT & software sector and certain stocks therein, have been laggards over the last few months. That doesn’t mean that this sector lacks potential. On the contrary, in this day and age of digitisation and information at the fingertip, the outlook for this sector looks positive. Similarly, there are other sectors like pharma, energy, and metals and stocks therein that haven’t rewarded investors very well but, on their fundamentals, still make them a value proposition. In other words, these stocks and sectors, are yet to participate in the market rally.

Contra investing is one sphere that focuses on investing in beaten-down, ignored stocks and/or out-of-favour stocks of the respective sectors even though their fundamentals make a good long-term investment proposition.

As per SEBI’s mutual fund categorisation and rationalisation norms, a mutual fund house is allowed to offer Contra Funds. However, it cannot offer a Contra Fund as well as a Value Fund. This is because Contra Style Investing is essentially a subset of value investing. Simply put, the approach followed in contra investing has certain elements of value investing (wherein valuation metrics are used such as P/E ratio, P/B ratio, EBIT, EBITDA, cash flows, etc., along with profitability ratios such as ROCE, ROE, and ROA, among others, to judge the future potential of the stocks along with a bunch of qualitative aspects of the company, viz. economic moat, circle of competence, economies of scale, the market in which it operates, brand value, management quality, corporate governance and culture, amongst a host of others).

Contra Funds

As per the regulatory guidelines, Contra Funds (open-ended mutual funds) are required to strictly follow a contrarian investment strategy and invest a minimum of 65% of the total assets in equity and equity-related instruments.

A Contra Fund looks to find untapped opportunities in distorted valuations, and out-of-favour stocks. In doing so it may approach bottom-up and top-down in its stock-picking picking approach and invest across market capitalisations, i.e. largecaps, midcaps, and smallcaps, and sectors, wherever it perceives value. So, there is a good amount of diversification across while following a contrarian style.

The focus is also on undervalued stocks trading at a significant discount to their fair valuation to hold them in the portfolio until their intrinsic value is achieved. The aim is to have a first-mover advantage by investing in out-of-favour sectors/stocks thus increasing outperformance prospects.

The three key benefits of investing in Contra Funds are:

1. Helps diversify while going against the tide with a professional fund management team.
2. The exposure to undervalued and ignored companies gives the opportunity to realise attractive returns.
3. Plausibly reduces the risk amidst the market correction if the value proposition holds true (margin of safety).

But do note that Contra Investing is far more complex than value investing. This is because the objective is to pick stocks that are dumped or out-of-favour or ignored by the market. Contra bets may temporarily underperform and hence deserve patience. Hence, along with the advantages remember that, despite taking contra bets with all conviction if those stocks and sectors do not perform in reality, a Contra Fund may falter in generating returns. A Contra Fund’s ability to consistently generate market-beating returns is hinged on how effective the portfolio management and sound risk management strategies are.

How have Contra Funds Performed?

Out of a total of 3 Contra Funds available to invest in the Indian mutual fund industry, not all Contra Funds have generated market-beating performance across time periods.

Table 1: Number of Contra Funds Outperforming and Underperforming the benchmark indices

Data as of August 1, 2023
Past performance is not an indicator of future returns.
Returns considered are point-to-point.
Direct Plan-Growth option considered.
Mutual Fund investments are subject to market risks. Read all scheme-related documents carefully.
(Source: ACE, data collated by PersonalFN) 

Over a 3-year horizon, 2 schemes (out of 3) managed to outperform the benchmark TRI, while over a 5-year horizon, all 3 schemes managed to outperform the TRI.

Table 2: Performance of Contra Funds

Data as of August 1, 2023
The securities quoted are for illustration only and are not recommendatory.
Direct Plan-Growth option considered.
Returns considered are point-to-point and expressed in %.
Returns over 1 year are compounded annualised; else absolute.
Past performance is not an indicator of future returns.
The table above is NOT a recommendation as such. Speak to your investment advisor for further assistance before investing.
Mutual Fund investments are subject to market risks. Read all scheme-related documents carefully.
(Source: ACE MF; Data collated by PersonalFN Research)

SBI Contra Fund (the oldest Contra Fund launched way back in the year 1999) by taking high conviction bets has topped the list generating a stellar CAGR of 41.09% over 3 years, 20.38% over 5 years, and 17.10% over 7 years (as of August 1, 2023) by following a combination of top-down and bottom-up approach to stock picking. SBI Contra Fund has shown a turnaround performance in the last couple of years which has helped it to generate a significant lead over the benchmark and category peers. It has adequately compensated investors well for the risk taken.

Who should invest in Contra Funds?

Given the investment mandate, wherein the fund manager goes against the tide (i.e., invests in unpopular, out-of-favour, or ignored stocks), he/she waits for stock re-rating to happen to generate alpha. So, Contra Funds aren’t for the faint-hearted. Contra Funds are a high-risk-high returns investment proposition, and you must be willing to assume high risk and have an investment time horizon of 7-8 years.

[Read: 5 High-Risk Mutual Funds That Can Reward You]

How to Invest in Contra Funds?

Given the investment mandate, Contra Funds could be a part of the satellite portion of the investment portfolio for alpha generation. The satellite portion of the overall investment portion should be a small portion of the overall investment portfolio that pushes up the overall portfolio returns. And by keeping a longer investment horizon (of 7-8 years), possibly the downside risk is possibly reduced.

Currently, while the Indian equity markets have scaled new highs and some correction is probably owing to various macroeconomic and geopolitical risks, it would prove sensible to invest in a staggered lump sum manner, or even better take the SIP (Systematic Investment Plan) route wherein the inherent rupee-cost averaging feature shall help deal with interim volatility while you endeavour to compound wealth.

[Read: 7 Top Performing Mutual Funds Based on 10-Year SIP Returns]

If you do not possess the skills or the knowledge to pick the best and most suitable Contra Fund (or any other mutual fund schemes for that matter), seek the services of a SEBI-registered investment adviser.

You see, the world of investing also has cynics. “The cynic knows the price of everything and the value of nothing,” said Oscar Wilde, the famous Irish Poet and playwright. But at times if you take bold moves and a contrarian approach, it could be worth the risk taken.

Happy Investing!

This article first appeared on PersonalFN here