Contra Mutual Funds - What They Are & How They Work

In India, there are 43 mutual fund houses that manage public money via about 1,400 mutual fund schemes. Each scheme has its own investment style, philosophy and strategy, however, all of them have been broadly categorised into certain categories.

These categories have been defined by the market regulator Securities and Exchange Board of India (SEBI). Each mutual fund house is allowed to have just one scheme under one category. One such category is contra fund.   

What Is a Contra Fund and How Does It Work?

A contra mutual fund is a type of mutual fund that takes a contrarian approach to investment. Instead of investing in stocks that are popular and performing well, a contra fund manager will look for opportunities to invest in stocks that are currently out of favour or undervalued.

The idea is that by taking a contrarian approach, the fund manager can identify stocks that have the potential to perform well in the future, but that may be overlooked by other investors.

As per SEBI guidelines, a contra fund needs to invest 65% of the funds in equity. The rest can be invested elsewhere. SEBI mandates that a fund house can either offer a contra fund or a value fund. As of January 2023, there are 22 schemes offering products following either contra strategy or value investing strategy.

Usually, in a contra fund, underperforming but quality stocks and sectors are bought at low price points with an expectation that they will perform in the long run. Typically, contra fund portfolios include beaten-down stocks and defensive stocks that performed poorly or gave negative returns during bear markets.

Industry body Association of Mutual Funds in India (AMFI) warns that contra funds carry the risk of getting calls wrong as catching a trend before the herd is not possible in every market cycle and these funds typically underperform in a bull market.

Key Benefits of Investing in Contra Mutual Funds

• Potential for High Returns: Since Contra funds buy undervalued stocks, they can deliver substantial profits if the stocks rebound.

• Market Downturn Resilience: By holding stocks out of favour, Contra funds may decline less during market corrections compared to traditional equity funds.

• Uncovering Hidden Gems: Contra fund managers seek fundamentally strong companies experiencing temporary setbacks, offering the potential to invest in future leaders.

• Portfolio Diversification: Adding Contra funds to your portfolio can provide diversification beyond traditional stocks, reducing overall risk.

Who Should Invest in Contra Funds? 

Contra mutual funds can be a good option for investors who are willing to take on a higher level of risk in exchange for the potential for optimised returns. Many times, investors have to remain invested for a long time before their investment bear fruits. Thus, contra mutual funds are not for those that have no patience.

It is also important to keep in mind that the performance of contra funds can be volatile, and there is no guarantee that they will outperform the market over the long term.

Additionally, one should also note that contra funds typically have higher expense ratios than other types of mutual funds. Thus, if the fund is not performing in a cycle, your losses will continue to widen over time.

Important Factors to Consider Before Choosing a Contra Mutual Fund

High gestation period

If you are investing in a contra fund, you should be patient. Moreover, you should be investing for the long term as the fund can continue to underperform for the long term. Hence, invest only that capital that you do not need in the near term.

High risk

Contra funds are inherently riskier. Since the fund bets on underperforming stocks, there is no guarantee that they will start to perform. There is always a risk that such stocks continue to bleed money. Thus, only those investors who can tolerate losses should invest in contra funds.

High risk is also the reason that one should not invest a large chunk of the capital in contra funds. The fund should never be part of your core portfolio.

Fund manager

In high-risk strategies, it is important to research the fund manager as a lot depends on the prowess of the person managing money. If the fund manager has the reputation to pick winners from a pile of garbage, they can perform relatively better than other peers. One should always research the fund manager before investing in contra funds.

Market performance

The overall market’s performance does not determine the expected returns in the contrarian style of investing. The returns here mostly depend upon the selected stocks and their performance. Hence, the broader market performance has no relevance in the performance of a contra mutual fund scheme. Rather than gauging the overall market strength, it is essential to assess the performance of the stocks in the contra mutual fund scheme.

How to Invest in Contra Funds Step-by-Step

Contra funds offer potential for growth, but require careful planning:

1. Assess Your Risk Tolerance: These funds are high-risk, so only invest if you're comfortable with potential losses.

2. Long-Term Vision: Contra funds target undervalued stocks that might take time to recover. Be prepared for a multi-year investment horizon.

3. Research Fund Options: Compare Contra funds offered by different Asset Management Companies (AMCs). Look at past performance, fees, and investment philosophy.

4. Investment Method: Invest a lump sum or go for a Systematic Investment Plan (SIP) to average out costs over time.

5. Start Investing: Once you've completed the process mentioned above, invest through the AMC's website or a trusted online platform.

Taxation Rules of Contra Mutual Funds

Contra funds, like other equity funds, are taxed based on how long you hold them: 

1. Short-Term Capital Gains (STCG): Sell within 1 year - taxed at a flat 15%.

2. Long-Term Capital Gains (LTCG): Sell after 1 year - benefits apply:
1. First ₹1 lakh exempt each year.
2. Remaining LTCG taxed at 10% (no indexation benefit to adjust for inflation).

What are The Contra Funds Available in India?

Conclusion

In conclusion, it is critical to note that the contra mutual fund scheme should be preferred by those with a higher risk appetite. Investors must do their research, understand the risks involved and consult with a financial advisor before investing in a contra mutual fund scheme.

Contra Fund FAQs

Is Contra Fund Risk-Free?

No, Contra Funds are not completely risk-free. They do take positions in out-of-favour stocks, which often can be quite volatile. While they offer the opportunity for high returns, they run the risk of underperformance if the market never turns in their favour.

What is the Minimum Amount to Invest in a Contra Fund?

The minimum amount of investment in Contra Funds varies, though it can be as small as ₹ 500 with some of the AMCs in India if availed through SIP.

How Long Should You Invest in a Contra Fund?

Contra Funds are for long-term investors (5+ years). They target undervalued stocks that take time to recover. Patience is key to potentially benefit from their turnaround.

Can we Redeem a Contra Fund Anytime?

Yes, Contra Funds (open-ended) can be redeemed anytime. However, there might be an exit load (fee) if you redeem within a short period (usually 1 year).

Is There any Tax on Contra Fund?

Yes, gains on Contra Funds are taxed like other equity funds. You apply the rates according to the period you hold them, whether they are short term or long term, with some exemptions and lower rates for long-term holdings.

What kind of returns can I earn from contra funds?

Contra funds offer the potential for high returns if out-of-favour stocks rebound. But there's no guarantee. Past performance isn't necessarily indicative of future results.

Are there any restrictions on asset allocation for contra funds?

Yes, contra funds in India must mandatorily invest at least 65% of their assets in equity and equity-linked instruments following a contrarian strategy.