You must have heard experts chiming that contra funds take a contrarian investing view on the market. So, what does this mean? In simple terms, these are equity mutual funds that invest their corpus in stocks that are presently not doing well.
Not sure why fund managers invest in funds seemingly shunned by other investors? To answer this, we will have to get into the nitty gritty of funds that take a contrarian view.
As mentioned above, through contra mutual funds (MFs), investors can invest in low-demand stocks. This is a contrarian investing strategy, where fund managers purchase low-performing stocks, but only when they speculate a demand for them in the coming days, months, or years.
A contra fund investor, be it an individual or an AMC, tries to assess the true value of the underlying asset linked to the fund. Sometimes both over-performance and under-performance of a fund lead to value distortion. This distortion is precisely what a fund manager, individual or AMC tries to capitalise on.
The basic idea is that a stock's inflated or deflated value will normalise in the long term or as soon as the triggers causing value distortion are managed.
For example, suppose you invested in a contra fund that invests in aviation stocks online. You purchased these low-valued stocks during the pandemic when only a few investors were interested in them. Today, the pandemic is behind us, and your aviation-linked contra funds have jumped in value.
Typically, investors hold on to their contra mutual funds until the slump is over and the underlying asset's demand increases again. Now that you know what is a contra fund, let’s understand the type of investors it is ideal for.
Key features of a contra mutual fund include:
- Risk-reward ratio: Contra funds often involve a higher risk-reward ratio, as they target stocks that may be undervalued for a reason, but also have the potential for significant long-term gains if the market sentiment changes.
- Equity investments: These funds primarily invest in equity, focusing on companies with strong fundamentals, providing opportunities for capital appreciation.
A contra mutual fund uses a contrarian investment strategy, where the fund manager invests in stocks that are currently underperforming or out of favour in the market. Here's how it works:
- Contrarian strategy: The fund identifies and invests in undervalued stocks, betting that they will eventually outperform once the market corrects its sentiment.
- Research and analysis: Fund managers conduct in-depth research to identify companies with strong fundamentals, even if their current stock prices are low due to negative market sentiment.
- Long-term focus: Contra funds typically have a long-term investment horizon, as the strategy relies on the market recognizing the true value of the selected stocks over time.
- Diversification: To manage risk, contra funds often diversify their portfolio across different sectors and industries.
- Potential for high returns: While risky, the approach can lead to substantial returns if the market eventually revalues the stocks in the portfolio.
Investing in a contra mutual fund can offer substantial benefits like:
- High returns: Contra mutual funds aim for high returns by focusing on undervalued stocks with growth potential.
- Long-term growth: They often invest with a long-term perspective, benefiting from market corrections and eventual stock appreciation.
- Diversification: By investing across various sectors, contra funds offer diversification, reducing risk and balancing potential rewards.
Short-Term Capital Gains (STCG): Taxed at 15% if sold within 1 year.Long-Term Capital Gains (LTCG): Gains over 1 year are tax-free up to Rs. 1.25 lakh annually. If your gains exceed this amount, you'll be taxed at 12.5% without indexation.
Gaining knowledge of what is a contra fund is only helpful if you know who should invest in them. Of course, these funds are open to all, but they work best for investors with a long investment horizon.
Since contra funds tend to perform better over time, investing in them is not recommended for short-term gains. While some contra mutual funds may earn you quick returns, the probability is lower than, say, short-term equity funds.
So, investing in this type of fund requires some patience from your end. Remember that these stocks are only presently underperforming for various reasons like environmental factors, political policies, wars, etc. The minute these factors fade away, the stocks will rise and provide excellent returns.
Safe to say, if you wish to chase the market’s momentum, contra funds may not be your first choice. However, bear in mind these stocks promise some of the highest returns from mutual funds in the long run.
Now that you know what is a contra fund and who should invest in them, let’s move on to the factors you must consider before investing.
Intrigued by contrarian philosophy? If you wish to invest in these mutual funds, here are the four most important things to keep in mind.
Since the selection of assets that make up contra MFs requires deep knowledge of the market, you need the right AMC. A credible AMC will never compromise on the quality of their fund managers, who are central to selecting the stocks that go in contra funds, meaning you’re always in safe hands.
Now, many investors invest in contra and other types of mutual funds through online portals that feature different AMCs. So, you must choose these portals after checking out the AMCs listed on their website.
Market performance does not play a significant role in contra funds, meaning the overall market performance does not determine expected returns in this case. This is unlike investing in growth stocks whose returns are directly linked to the market's performance.
For contrarian funds, what matters is the performance of individual stocks and the rectification of problems within a sector or industry. No wonder, often, contrarian investors earn high returns, even when the market is down, and vice versa.
What is contra mutual fund investing? It is putting money on underperforming stocks in the calculated hope that they will normalise or over-perform in due time. And, when they do, the profits you book can be limitless.
However, if the underlying assets in these stocks don't take off, your mutual fund will book losses. You can categorise this instrument as moderate to high risk and return. Since losses are possible in contra fund investments, you must first assess your risk appetite.
Even if you have the stomach for risk, invest only a part of your entire corpus in these funds. If you are a beginner with a decent risk appetite, experts suggest investing only 10% of your corpus in contra MFs.
As mentioned earlier, these funds have the highest chance of posting returns in the long run. Therefore, patience is vital when investing in contra funds, meaning you must have a long investment horizon.
This is necessary to earn sizable returns. Many experts remark that to maximise returns on contra MFs, you must stay invested for five years. This is primarily because underperforming assets can take a substantial amount of time to get out of the slump.
Looking for a web portal that features AMCs with a lot of experience? If so, create an account on the Tata Capital Moneyfy website or download the Moneyfy's mutual fund app. Through our web portal, you can compare and invest in different types of contra funds featured by AMCs that boast highly-experienced fund managers. The experience of fund managers is critical, especially in the case of contra MFs.
Through us, you can also invest in a wealth of different types of mutual funds, SIPs, insurance, NPS, fixed deposits, and more.
For more details, visit the Moneyfy website today!
Yes, contra funds can be risky. They typically invest in undervalued stocks, which might be volatile or have uncertain prospects. Their performance can fluctuate based on market conditions and the success of their contrarian strategies.
Contra funds can be rewarding investments, particularly for those with a higher risk tolerance. Their contrarian approach can lead to significant gains if the market eventually recognizes the value of these stocks.
Contra funds are primarily invested in undervalued stocks. These funds focus on companies that are perceived to have strong growth potential but are currently underperforming.
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11 September 2024
8 mins read
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