What Is Contra Funds And Which Are The Best Ones

September 3, 2024 Mutual Fund

In recent years, contra funds have gained significant traction among investors, driven by a combination of market dynamics, investor sentiment shifts, and the increasing appeal of alternative investment strategies.

One of the primary reasons for the rising popularity of contra funds is the ongoing market volatility and uncertainty. The global economic landscape has been characterized by fluctuations due to geopolitical tensions, inflationary pressures, and interest rate hikes by central banks.

Investors are increasingly looking for investment avenues that can hedge against such volatility. Contra mutual funds, which invest in undervalued stocks that are out of favour in the market but have solid fundamentals, present an attractive option. These funds are often less correlated with broader market trends, making them a potential safeguard during turbulent times.

Graph: Increasing Inflows into Value/Contra Mutual Funds Over the Past Year

Data as of August 31, 2024
(Source: ACE MF, data collated by PersonalFN Research) 

What is Contra Fund?

Contra funds are a type of equity mutual fund that adopts a contrarian approach to investing. This strategy involves investing in stocks that are currently underperforming or out of favour in the market but have strong fundamentals and potential for future growth. The idea is to buy these undervalued stocks at low prices and hold onto them until their value is realized when the market turns in their favour.

As per the regulatory guidelines, Contra 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.

According to SEBI’s mutual fund categorization and rationalization norms, a mutual fund house is permitted to offer either a Contra Fund or a Value Fund, but not both. This restriction exists because contra investing is considered a subset of value investing. In simpler terms, the contra investing strategy incorporates aspects of value investing, such as analysing valuation metrics like the P/E ratio, P/B ratio, EBIT, EBITDA, cash flows, and profitability ratios like ROCE, ROE, and ROA.

How Does the Contra Investing Strategy Work?

The contrarian investing strategy is based on the principle of ‘buying low and selling high.” Fund managers who manage contra funds actively look for stocks that are currently undervalued or are going through a rough patch due to temporary issues. These stocks are often overlooked by most investors, leading to a lower price.

The fund manager analyses the stock’s fundamentals, such as its financial health, management quality, and future growth potential. If these factors are sound, the manager will invest in the stock, expecting that the market will eventually recognize its true value, leading to an increase in the stock’s price.

The strategy requires patience, as it may take some time for the market sentiment to change. However, once it does, contra funds can potentially deliver significant returns. By investing in undervalued stocks, contra funds have the potential to generate high returns when the market corrects its valuation of these stocks.

Benefits of Investing In Contra Mutual Funds

• Potential for High Returns: Contra funds invest in undervalued or out-of-favour stocks with strong fundamentals. When the market sentiment shifts, these stocks often see significant appreciation, potentially leading to high returns for investors.
• Diversification: Contra funds typically have a diversified portfolio across sectors and market capitalizations. This diversification helps mitigate risk and reduces the impact of poor performance by any single stock or sector.
• Hedge Against Market Volatility: Because contra funds invest in stocks that are currently undervalued or overlooked, they can perform well during periods of market downturns or volatility, providing a hedge against broader market fluctuations.
• Long-Term Growth Potential: Contra funds are generally suited for long-term investors. The strategy focuses on stocks with the potential for value appreciation over time, making them an attractive option for investors with a longer investment horizon.
• Exposure to Underperforming Sectors: Contra funds often invest in sectors or stocks that are currently underperforming but have the potential for recovery. This provides investors exposure to potential turnaround opportunities in the market.
• Behavioural Advantage: The contrarian approach helps avoid herd mentality, where investors typically follow market trends. By investing against market sentiment, contra funds can capitalize on opportunities that others might overlook, potentially leading to better returns.

However, one needs to understand that Contra investing is more complex than value investing as it involves selecting stocks that are currently out of favour or overlooked by the market. These contrarian bets may temporarily underperform, requiring investor patience.

Despite the potential benefits, there is a risk that if these stocks or sectors fail to perform as expected, the fund may struggle to generate returns. A contra fund’s success in consistently delivering market-beating returns largely depends on effective portfolio management and sound risk management strategies.

Table: Performance of Contra Mutual Funds Across Various Periods

Data as of September 02, 2024
Do note past performance is not an indicator of future returns
The securities quoted are for illustration only and are not recommendatory.
(Source: ACE MF, data collated by PersonalFN Research) 

When the market recovers, contra funds have the potential to deliver strong returns. The stocks they hold, which were initially out of favour, may experience significant price appreciation as investor sentiment improves and the market recognizes their underlying value. This can lead to outperformance compared to more growth-oriented funds during recovery phases.

In strong bull markets, contra funds may underperform compared to growth or momentum-based funds. This is because their focus on undervalued or out-of-favour stocks may not align with the prevailing market trend, which typically favours high-growth stocks and sectors. However, over the long term, contra funds can still provide competitive returns if their underlying stocks eventually gain market favour.

Overall, the performance of contra mutual funds is highly dependent on market conditions and investor sentiment. They tend to perform best when there is a shift in market dynamics, rewarding their contrarian approach.

Below, we have outlined some contra funds along with their key characteristics. Investors may consider investing in any of these three available contra funds based on their suitability.

1. SBI Contra Fund

SBI Contra Fund the oldest Contra Fund launched in the year 1999, is an open-ended equity mutual fund scheme that follows a contrarian investment strategy and currently holds an AUM of Rs 37,845.69 crores. The fund aims to invest in stocks that are currently undervalued or out of favour in the market but have strong fundamentals and the potential for future growth.

The SBI Contra Fund is known for its strong long-term performance due to its contrarian investment approach. Over various market periods, the fund has demonstrated the ability to deliver competitive returns, particularly benefiting from market recoveries when the stocks it holds gain recognition. When compared with other contra funds, the SBI Contra Fund’s returns are competitive.

As of the latest data, the top holdings of the SBI Contra Fund typically include a mix of large-cap and mid-cap stocks across various sectors. Commonly held stocks are those with strong financial health and growth potential, which may include companies in sectors such as financial services, technology, and consumer goods. Specific top holdings can vary over time based on the fund manager’s investment decisions.

2. Kotak India EQ Contra Fund

Kotak India EQ Contra Fund was launched in July 2005 and currently holds an AUM of Rs 3,760.40 crores. The scheme has demonstrated strong performance relative to its peers in the contra fund category. When compared to its benchmark, the NIFTY 500 TRI, the Kotak India EQ Contra Fund has generally outperformed over shorter and medium-term periods.

The Kotak India EQ Contra Fund’s performance across various time frames demonstrates its effectiveness in leveraging contrarian opportunities and managing risk, making it a compelling choice for investors looking for a strategy that capitalizes on undervalued stocks.

The scheme holds high allocation to the financial services and IT sector, the portfolio is designed to capitalize on undervalued opportunities that may offer significant upside potential as market conditions evolve.

3. Invesco India Contra Fund

Invesco India Contra Fund is an open-ended equity mutual fund scheme launched in April 2007 and currently holds an AUM of Rs 17,268.79 crores. The fund has demonstrated strong performance over various market cycles, historically, it has provided competitive returns, particularly during market recoveries when undervalued stocks rebound.

The top holdings of Invesco India Contra Fund typically include a mix of large-cap and mid-cap stocks across various sectors like financial services, pharmaceuticals, and technology, among others, depending on the fund’s current strategy and market outlook.

The fund continues to focus on undervalued stocks with strong fundamentals, aiming to capitalize on potential market corrections and recoveries. Despite facing challenges in outperforming growth-focused peers during strong bull markets, the fund’s contrarian strategy positions it well for long-term gains, especially as undervalued stocks gain favour.

[Read: Investing in High-Risk Mutual Funds: A Bold Approach]

Who Should Consider Investing In Contra Mutual Funds?

Contra mutual funds are well-suited for long-term investors who have a higher risk tolerance and are looking to capitalize on value opportunities. Given the current market volatility and uncertainty, investors with a long-term horizon can benefit from the contrarian approach of these funds. They can potentially buy into quality companies at lower prices, positioning themselves for substantial gains when the market sentiment shifts and these undervalued stocks rebound.

In times of market uncertainty, diversification becomes even more critical. Contra funds provide a unique opportunity to diversify a portfolio by investing in stocks that other mutual funds might overlook. This strategy helps in balancing the portfolio, especially during periods when growth and momentum-driven stocks are underperforming.

As the current market environment is marked by frequent fluctuations and unpredictable movements, contra funds can offer a defensive layer, protecting against market downturns by focusing on value rather than short-term market trends.

However, for investors who are comfortable with a high level of risk and understand the potential for short-term underperformance, contra funds may be an attractive option. The current market volatility makes it challenging to predict short-term movements, but contrarian investors who are patient and can withstand periods of market pessimism may find these funds align with their investment goals.

To conclude…

By focusing on undervalued or out-of-favour stocks, contra funds provide a chance to benefit from potential turnarounds and market recoveries. Contra Funds could be a part of the satellite portion of your investment portfolio for alpha generation. Currently, there are only 3 contra mutual funds available in the market, Invesco India Contra Fund, SBI Contra Fund, and Kotak India EQ Contra Fund, each offering a slightly different take on the contrarian strategy while maintaining a focus on value investing principles.

Ultimately, the best contra fund for an investor will depend on their individual financial goals, risk appetite, and market outlook. With a well-chosen contra fund, investors can potentially enhance their portfolio’s diversification and gain from long-term value creation, especially in times of market turbulence.

This article first appeared on PersonalFN here