Contrary to the popular action, contra fund aims to go against the market and target out of the favour sectors in the hope of investing in them at lower prices.
The recent re-categorisation of mutual funds has created a new type of equity mutual fund, called contra fund. A contra fund does not invest in popular sectors or the stars of the day. Contrary to the popular action, it aims to go against the market and target out of the favour sectors in the hope of investing in them at lower prices. The underlying theory behind the action is that the herd mentality followed by investors leads to mispricing of assets. Consequently, it causes the market to pick up in the longer run, creating opportunities for investors by rewarding with alpha. In order words, the basic idea is to buy businesses that are valued lower than their intrinsic value and watch these businesses grow.
A contra fund exhibits a very different pattern of demand from the investors. At a time, it witnesses exuberant demand from investors or is discarded completely at a particular point of time. The short-term hiccup is the cause of asset’s poor performance and outperformance. The fund managers try to capitalise on this pattern with a belief that the asset will stabilise and come to its real value in the long term.
“Buying into contra ideas entails an in-depth research and understanding of the market and the companies that the manager seeks to invest in. Given that the idea is to invest against the consensus, there is an element of added risk as distressed stocks could perform against expectations,” says Kavitha Krishnan, Senior Research Analyst, Morningstar.
These assets do not perform in the short term. However, this fund can provide higher returns than other multi-cap stocks in the long haul. It gives a natural hedge in times of market crash. However, many investors may shy from investing in this fund owing to the uncertainty. The experts reveal that the genesis of the growth stories of some companies have been in their being contra companies at some stage in the life cycle. The mega returns from these stocks are not a pure gameplay and what investors get could be a recovery in earnings and potential re-earnings.
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According to Navin Chandani, Chief Business Development Officer, BankBazaar.com, contra funds show results over a longer period of time. The correlation of contrarian returns with growth funds has been low to negative. He further adds, “This fund acts as diversifiers in the investor’s portfolio. This fund type is more popular in evolved markets like the US. As and when investors in India evolve and become more mature, contra funds will gain popularity.”
Experts believe that investing constantly in this fund averages out returns in the long term. Long-term investing and maintaining a financial discipline is more important than timing the market. Investments based on return expectations, goals and risk appetite are the right strategy. Contra funds work as a hedging and diversification tool in this regard.
The level of patience and optimism required is a little higher in this kind of fund. This category of fund has grown over the past 5 years, but not at the same magnitude as other categories mostly because the current market favours growth stocks. Only if the fortune of the contrarian stocks spans out in the same direction as what was thought out, then it can lead to potentially bumper returns in the long run.