Contrarians track majority opinion and look for times when it may be wrong. This is psychologically difficult and requires a thick skin since it can often seem like a very stupid strategy. It takes courage to be selling when everybody is buying, and vice-versa. It is almost impossible for institutions to be contrarian. Internal reporting structures make it difficult for one thing, and so does the fact that clients find it frightening. An enlightening case-study from recent history is that of Scion Capital.
Scion, which is run by Michael Burry, was among the first hedge funds to figure out that US real estate was in trouble. Burry was also among the first to work out how to profit from a realty crash. By 2005, Scion owned a large portfolio of credit default swaps (CDS) on various subprime bonds.
CDS is like insurance. A CDS holder pays a premium to insure against blips in the cash-flow and market value of a given bond. As in most insurance contracts, the premium is a small percentage of value-at-risk. The insurer pays any losses that may arise from defaults or sliding market values.
There are two key differences between CDS and standard insurance. One is that the insurer puts up collateral - so the CDS holder is guaranteed a return in case of an adverse development. The second is that the CDS holder need not own the underlying bond.
In effect, a CDS is a cheap way to short real estate mortgages. If there are defaults, or the value of the loan portfolio is eroded by rising interest rates, the CDS owner gains. Scion eventually made returns of close to 600 per cent. But it lost most of its clients in the three years it took for the real estate sector to crash in slow motion. Scion's investors thought Burry was crazy to be betting against a sector that was apparently booming.
Uniformity in fund portfolios
If it is difficult for hedge fund investors to stomach contrarian strategies, it is practically impossible for mutual fund unit-holders. As a result, diversified equity fund portfolios tend to resemble each other quite closely. Fund managers all aim to generate performances yielding something slightly in excess of the benchmark without risking major downsides.
There are three sets of institutional investors actively operating in India - foreign institutional investors (FIIs), domestic funds and insurance companies. If we look at their consolidated top 10 holdings (March 31, 2010), we see that these closely resemble each other. If their views were completely divergent, there would be 30 different stocks. In fact, there are just 15. What is more, all 15 are drawn from the Nifty pool. In fact, if we look at the respective top 40 holdings of these three sets of institutions, over 30 stocks are in common. All of the top holdings are listed stocks drawn from the Nifty and Junior Nifty population, which comprises the top 100 shares by market-cap. Individual funds have different portfolios, of course. But there isn't that much to choose between the three sets of investors. This also implies that a fund of funds won't give noticeably better returns than a passive index fund.
Are contra funds truly contrarian?
However, a small set of Indian funds brand themselves as “contra”. These contra funds have a mandate to deliberately stay out of step with consensus. In theory, this should mean that they buy undervalued and under-performing stocks with a long-term perspective. This is a long-term strategy and it is not very different from that of a diehard value investor. A classic contrarian would also tend to divest equity when valuations are very rich, and funds can't really do that for various reasons. So they are buy-and-hold value investors rather than pure contrarians.
Are contra funds worth holding? Their performances are not bad both as a category and individually but they're not markedly better than that of other conservatively managed diversified equity (DE) funds. It's difficult to know how consistently they implement their mandate because they operate across the same universe (BSE 200 or BSE 500) as other DE funds. So a quick snapshot of portfolios tells you little about their consistency - they hold the same stocks as most other funds. The key is learning when the Contras bought, and at what valuations, and for that you need to track portfolios over long periods.
If the contra strategy is well-implemented it should cut down risk somewhat while generating decent returns. So this category is definitely worth looking at, if you're looking for a way to diversify your portfolio.
This article was originally published on July 03, 2010.
Ask Value Research 
New episodes every Friday 
New Process Alert 
Seems like you've uploaded a wrong QR code. Please upload the QR code downloaded from MF Central platform.
