Your Questions Answered: I want to diversify my portfolio. Please elaborate on contra mutual funds and how do they work? | Mint

Q. I am a nurse working with a multispeciality hospital in Ghaziabad. My husband is a tailor, and he has his own boutique in Delhi. We have been investing in large-cap index mutual funds for the past 3 years. We intend to diversify our portfolio, and many of our acquaintances have suggested that we invest in contra mutual funds. However, we have limited knowledge about the contra mutual funds. Please elaborate on contra mutual funds, how they function and what are the pros and cons of investing in contra mutual funds. Additionally, please let us know the top-performing contra mutual funds.

Sumedha Saini, Ghaziabad, Uttar Pradesh.

Contra mutual funds are a type of equity mutual fund that follows a contrarian investment strategy. This means that the fund manager invests in stocks that are currently out of favour in the market but have the potential for significant appreciation in the long term. The idea is to buy low and sell high, capitalising on market inefficiencies and investor sentiment. The Securities and Exchange Board of India (SEBI) has classified mutual funds into five broad categories to make investments simpler and more transparent. Contra mutual funds fall under the equity-oriented schemes category, specifically under the sub-category of contra funds.

Contrarian investment strategy

The contrarian investment strategy is based on the belief that markets often overreact to news, leading to the mispricing of stocks. This overreaction can create opportunities for investors to buy undervalued stocks at a discount. The fund manager of a contra mutual fund looks for these opportunities by identifying stocks that are currently out of favour but have strong fundamentals and growth potential. The stock selection process for contra mutual funds involves several steps:

Identifying undervalued stocks: The fund manager uses various financial metrics and analysis techniques to identify stocks that are undervalued. This may include analysing the company’s financial statements, management quality, industry position, and future growth prospects.

Assessing market sentiment: The fund manager also considers market sentiment and investor behaviour. Stocks that are currently out of favour may be experiencing negative sentiment due to temporary issues or market trends. The fund manager looks for stocks where the negative sentiment is likely to reverse in the future.

Building a diversified portfolio: Once the undervalued stocks are identified, the fund manager builds a diversified portfolio. This helps to spread the risk and increase the potential for returns. The portfolio may include stocks from various sectors and industries to ensure diversification.

Advantages of investing in a contra mutual fund

There are several advantages associated with investing in contra mutual funds and why they might be a valuable addition to your investment strategy.

Potential for high returns: One of the primary benefits of contra mutual funds is the potential for high returns. By investing in undervalued stocks, these funds can deliver substantial returns when the market eventually recognises the true value of these stocks. The contrarian approach allows investors to capitalise on market inefficiencies and investor sentiment, leading to significant gains over time.

Diversification: Contra mutual funds often invest in a diverse range of sectors and companies, providing investors with a well-diversified portfolio. This diversification helps to spread risk and reduce the impact of any single stock or sector’s poor performance on the overall portfolio. A well-diversified portfolio can provide more stable returns and reduce the overall risk for investors.

Long-term growth: These funds are suitable for long-term investors who are willing to wait for the market to recognise the true value of the stocks in the portfolio. The contrarian investment strategy requires patience, as it may take time for the market to correct its mispricing of the undervalued stocks. However, for investors with a long-term horizon, contra mutual funds can provide significant growth potential.

Capitalising on market cycles: Contra mutual funds can also benefit from market cycles. During periods of market downturns or corrections, many stocks may become undervalued due to negative sentiment or temporary issues. Contra mutual funds can take advantage of these opportunities by investing in these undervalued stocks, positioning themselves for substantial gains when the market recovers.

Professional management: Investing in contra mutual funds provides investors with access to professional fund management. The fund managers have the expertise and experience to identify undervalued stocks and make informed investment decisions. This professional management can help investors achieve better returns than they might be able to achieve on their own.

Risk mitigation: While contra mutual funds do carry some level of risk, the contrarian investment strategy can help mitigate certain risks. By investing in undervalued stocks, the fund manager aims to reduce the downside risk associated with overvalued stocks. Additionally, the diversification within the fund helps to spread risk across different sectors and companies, further reducing the overall risk for investors.

Cons of investing in contra funds

One should be aware of the cons associated with investing in contra funds before one makes:

Market risk: Like all equity mutual funds, contra mutual funds are subject to market risk. The value of the investments can fluctuate based on market conditions. If the market continues to favour certain sectors or stocks that are not part of the contra fund’s portfolio, the fund’s performance may suffer. Additionally, if the market does not recognise the value of the undervalued stocks in the portfolio, the expected returns may not materialise.

Stock selection risk: The success of a contra mutual fund heavily depends on the fund manager’s ability to identify undervalued stocks. If the selected stocks do not perform as expected, the fund’s returns may be adversely affected. The contrarian approach requires a deep understanding of the market and the ability to make accurate predictions about future stock performance. Any misjudgment in stock selection can lead to suboptimal returns.

Longer time horizon: Contra mutual funds may require a longer time horizon to realise their potential returns. It may take time for the market to recognise the value of the undervalued stocks in the portfolio. Investors need to be patient and willing to wait for the market to correct its mispricing. This longer time horizon may not be suitable for investors with short-term financial goals or those who need liquidity in the near term.

Volatility: Investing in contra mutual funds can be volatile, especially in the short term. The stocks in the portfolio may experience significant price fluctuations due to market sentiment and external factors. This volatility can be challenging for investors who are not comfortable with short-term market swings. It requires a strong stomach and the ability to stay invested during periods of market turbulence.

Who should invest in contra funds?

Contra funds are suitable for a variety of investors. We have mentioned below a few categories of investors who can benefit from investing in contra funds.

Long-term investors: Contra mutual funds are best suited for long-term investors. The contrarian investment strategy requires patience, as it may take time for the market to recognise the true value of the undervalued stocks in the portfolio. Investors with a long-term horizon, typically five years or more, are more likely to benefit from the potential high returns that contra mutual funds can offer.

Risk-tolerant investors: Investing in contra mutual funds involves a certain level of risk, as the fund manager is betting on stocks that are currently out of favour. Therefore, these funds are suitable for investors who have a higher risk tolerance and are comfortable with the possibility of short-term volatility in their investment portfolio. Risk-tolerant investors are more likely to stay invested during market fluctuations and reap the rewards when the market eventually corrects itself.

Value-oriented investors: Contra mutual funds are ideal for value-oriented investors who believe in the potential of undervalued stocks. These investors are willing to invest in companies that may be facing temporary challenges but have strong fundamentals and growth potential. Value-oriented investors are typically more focused on the intrinsic value of a stock rather than short-term market trends.

Diversification seekers: Investors looking to diversify their investment portfolio can benefit from adding contra mutual funds to their mix. These funds often invest in a diverse range of sectors and companies, providing a well-diversified portfolio. Diversification helps to spread risk and reduce the impact of any single stock or sector’s poor performance on the overall portfolio.

Investors seeking professional management: Contra mutual funds provide investors with access to professional fund management. The fund managers have the expertise and experience to identify undervalued stocks and make informed investment decisions. Investors who prefer to rely on professional management rather than making individual stock picks themselves can benefit from investing in contra mutual funds.

Investors with a contrarian mindset: Contra mutual funds are well-suited for investors with a contrarian mindset. These investors are willing to go against the crowd and invest in stocks that are currently out of favor. They believe in the potential of these stocks to recover and provide substantial returns in the long term. Investors with a contrarian mindset are typically more patient and disciplined, willing to wait for the market to recognize the true value of their investments.

Performance and returns

There are only 3 mutual fund houses in India offering contra mutual funds at present. Below we have listed the 3 mutual fund schemes based on their past 5-year return (CAGR). All three mutual fund schemes have given an annual return north of 23%.

Source: AMFI; data as of 30 December 2024.

Note: Past returns are not indicative of future returns.

Taxation of contra funds

As mentioned earlier, contra mutual funds in India are typically a sub-category of equity mutual funds. They are therefore taxed as equity mutual funds. Below we have mentioned in detail how contra mutual funds are taxed.

Taxation rules for contra mutual funds

The taxation of contra mutual funds is primarily governed by the rules applicable to equity-oriented mutual funds. Here are the key points to consider:

Short-term capital gains (STCG): If you hold your investment in a contra mutual fund for less than 12 months, any gains realised will be considered short-term capital gains. As per the Budget 2024, short-term capital gains on equity-oriented mutual funds, including contra funds, are taxed at a rate of 20%.

Long-term capital gains (LTCG): If you hold your investment in a contra mutual fund for more than 12 months, any gains realised will be considered long-term capital gains. The Budget 2024 has increased the tax rate on long-term capital gains from 10% to 12.5% for equity-oriented mutual funds. Additionally, the capital gains exemption limit has been increased to ₹1.25 lakh per year.

Conclusion

Contra mutual funds offer a unique investment opportunity for those willing to take a contrarian approach to investing. By focusing on undervalued stocks, these funds have the potential to deliver high returns over the long term. The benefits of diversification, long-term growth potential, capitalising on market cycles, professional management, and risk mitigation make contra mutual funds an attractive option for investors looking to achieve substantial returns while managing risk.

Disclaimer: Investing in mutual funds involves risks, including potential loss of principal. Please consult with a financial advisor before making any investment decisions.

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