What are contra funds?

Warren Buffett once said, "Be fearful when others are greedy, and greedy when others are fearful." This timeless advice encapsulates the philosophy behind contra funds - a type of mutual fund that thrives on contrarian investing. But what exactly does this mean?

Contrarian investing is all about going against the grain of investor sentiment. While the masses flock to hyped-up stocks, these funds look elsewhere, investing in undervalued and overlooked opportunities. However, these funds are often misunderstood because there is no hard-and-fast rule of what contrarian investing truly is.

In this article, we'll explore the unique investment strategy of contra funds, highlight their benefits and limitations, and help you determine if they align with your financial goals as a long-term investor.

What makes contra funds unique?

Contra funds set themselves apart by following a simple yet unconventional strategy: they invest in distressed or undervalued stocks that the market has largely ignored. Here's how they work:

1. Investing in distressed stocks

Fund managers deliberately seek out stocks that have been shunned by the broader market. These stocks are often undervalued due to broad pessimism or temporary setbacks.

2. The belief in mispricing

Stocks are often mispriced due to some bad news or a sectoral downturn, presenting an opportunity to buy low. The manager bets that the market's sentiment will eventually change, leading to a price recovery. For instance, during the Covid-19 pandemic, the hospitality sector took a massive hit. But at the time, if you were to take a contrarian bet and invest in these stocks, you would have made a handsome fortune once the pandemic ended.

3. Avoiding the herd

Unlike many investors who chase trends, these funds avoid hyped-up stocks. Why? Because overhyped stocks often carry the risk of being overvalued, making them more susceptible to steep price corrections. In other words, there is a high likelihood that someone will overpay for such stocks and receive anaemic returns.

By focusing on these undervalued opportunities, these funds embrace the philosophy that long-term gains can come from ignoring market noise and betting on recovery.

Suggested read: How do I choose a value or a contra fund

Benefits offered in different market conditions

So what are the unique advantages that these funds offer over other equity funds? The answer lies in the inner workings of their investment strategy:

1. Upside potential

These funds target undervalued stocks with significant growth potential. Once the market recognizes these stocks' true value, their prices can surge, resulting in substantial returns for investors.

2. Margin of safety

By identifying mispriced opportunities, these funds ensure a margin of safety. This reduces the downside risk, ensuring that when there is a price correction, the returns won't be severely hampered.

These benefits make these funds particularly appealing to long-term investors who are patient and willing to wait for their bets to pay off.

Limitations of the contrarian investment strategy

While the benefits of these funds are compelling, their unconventional strategy can be a double-edged sword at times. Here are two major limitations:

1. Delayed returns

These funds often require significant time for their strategies to deliver results. In bearish markets, the stocks they hold may remain undervalued for extended periods which leads to periods of underperformance. This can test the patience of investors.

2. Underperformance in bullish phases

During bullish markets, these funds may underperform. Fund managers often sell stocks early to lock in gains, potentially missing out on the full benefits of a sustained market rally.

So, you should assess your investment horizon and risk tolerance before committing to these investments.

Is this fund right for you?

The nerve-wracking aspect of investing is picking a mutual fund and staying put for a long time. That's why it is crucial to know if these funds are right for you or not. Here is the ideal investor profile for contra funds:

1. Ideal for patient investors

They are best suited for those who can endure short-term volatility and wait for long-term rewards. The contrarian strategy requires time to bear fruit. People looking for immediate gains or those who frequently monitor short-term market movements may find these funds a challenging investment.

2. Risk tolerance matters

Since these funds invest in distressed stocks, they are a risky investment. However, when these stocks get recognised by the market, there is a massive surge. Ensure that your risk appetite aligns with the investment strategy and that you aren't just chasing profits.

Suggested read: A manifesto for equity investors

An aside

One important thing to note is that a mutual fund can only have either a value-oriented fund or a contra fund. SEBI doesn't allow a mutual fund company to have both types of funds. Therefore, there are only three contra funds. These are Invesco India Contra Fund, Kotak India Equity Contra Fund and SBI Contra Fund.

The contrarian edge

These funds offer a unique opportunity to capitalize on undervalued stocks and build wealth over time. However, they're not a one-size-fits-all solution. As with any investment, understanding your financial goals, risk tolerance, and investment horizon is key.

If you're ready to invest against the tide and embrace the contrarian edge, contra funds could be the perfect addition to your portfolio. However, there are very few such funds that make the cut.

If you are looking for a contra fund or any other kind of fund, you can give Value Research Fund Advisor a look. With expert fund recommendations, we ensure that you remain stress-free about your investment. Also, you'll achieve your financial goals without breaking a sweat.

Also read: What's your investing style?

This article was originally published on December 12, 2024.