The Benefits and Risks of Contra Mutual Funds: Should You Invest?

Investing in mutual funds is not necessarily just about determining which way the market is headed; it can also be about investing smartly in situations where other investors see risk. Contra mutual funds follow a contrarian investment style that aims to invest in fundamentally sound stocks but out of favor with the overall market. The contra funds capture this alternative thinking about where the market is wrong and the inefficiency of the corrective process in an undervalued price for these stocks. In a volatile stock market like India’s, funds like SBI Contra Fund are a solid opportunity for long-term investors.

What Are Contra Mutual Funds?

Contra funds belong to the family of equity mutual funds, which use a contrarian approach toward investments in financial securities. They involve investing in underperforming stocks and sectors at a low valuation, hoping that they will recover, and earn a return over the long term. The portfolio of contra funds often contains defensive or downtrodden stocks that have performed poorly in bear markets.

However, these funds are prone to making a mistake in the direction of the market, as predicting a change in direction ahead of the market is notoriously difficult. Contra funds typically have an underwhelming performance in bullish markets, where growth stocks are the darlings of the market rally. According to SEBI’s mutual fund categorization, a fund house can only have a Contra Fund or a Value Fund, but not both!

Advantages of Investing in Contra Mutual Funds:

1. Taking Advantage of Market Inefficiencies: 

   In the Indian stock market, stocks are often mispriced due to fears of macroeconomic uncertainty, whims in investor sentiment, or sector-specific issues. Contra funds thrive in this environment by identifying stocks and sectors that are trading below what they should be valued at. This process acts as a means for investors to gain upside from stock mispricing when their genuine value comes into the market.The classic example is during the 2020 market crash where market sentiment cyclically reacted to the pandemic origins. Many profit-making companies saw their stock prices crash due to investor panic during the economic lockdown.

   Contra Fund investors paired with the SBI Contra Fund found proven financial gain in 2021 when the stock was deemed as a recovery stock. The return potential showed shape, as stocks in different sectors like the infrastructure, banking, and energy sectors increased fourfold.

2. Portfolio Diversification:
   
   Historically, contra funds provide opportunities to investors, essentially by increasing portfolio diversification in sectors and stock opportunities, typically later by most traditional equity funds.Many funds focus exclusively on investing capabilities in certain high-growth sectors or momentum stocks in industries like banking, technology, or FMCG. Contra funds enable funds to purely take into account portions of sectors that might not yet deserve to be effective.

   The SBI Contra Fund, as a matter of fact, as of mid-2024, does present a well-put-together diversified fund including sectors; I believe they are distinguished from sectors like

   1. Private sector bank
   2. Gas transmission/marketing
   3. Computers – software & consulting
   4. Private sector bank
   5. Telecom – infrastructure
   6. Household appliances
   7. Refineries & marketing
   8. Diversified FMCG
   9. Public sector bank
   10. Personal care

The property benefited directly can also create a safety net against increased and even deteriorating economic climates.

3. The Ability for Outperformance over Long Time Horizons:
   
   Alpha generation is an established track record for contra funds, especially in recoveries. The literature supports that contrarian strategies generally outperform in recovery mode following market declines. The SBI Contra Fund, for example, has an impressive 5-year CAGR of 31.89% and a 3-year CAGR of 27.85%.

4. Value-based Investing Framework

Many contra funds apply a value investing philosophy, as with the SBI Contra Fund. The general modus operandi of a value-based investing approach is to maintain ownership of undervalued securities through to when their price reflects their intrinsic value. This long-term, value-oriented investing methodology fits well in the Indian market, where extended periods of volatility are common due to national political and economic conditions.

Risks Associated with Contra Mutual Funds

1. Poor Relative Returns in Bull Markets

An important risk of contra funds is their potential to produce poor relative returns during bull markets. Given that these funds will purposely not invest in growth stock holdings that primarily drive a bull market, when the market sentiment is high and positive, contra funds will produce less attractive performance compared to their active equity mutual fund peers.

2. Significantly High Volatility in the Near Term

While contra funds have good long-term potential, in the near term, they tend to exhibit high levels of volatility. Being that contra funds will invest in sectors that are currently under heavy market sentiment, weaker periods will exist for these segments. Given that a large portion of Indian equity investing has short-term sentiment behavior, short-term changes will impact performance hurdles.

3. Depending too much on the Expertise of the Fund Manager

Contra mutual funds are very reliant on the experience and judgment of the fund manager. The fund must find and review stocks with truer values and expectations of identifiable recovery. Picking a weak stock, relating to market cycle timing, can impact overall fund performance.

Should You Invest in Contra Mutual Funds?

Aside from SBI Contra Fund, contra mutual funds have huge potential for wealth creation in the long term through a value-based investment strategy that is a little contrarian. These funds are for long-term investors who are looking to take a reasonably high level of risk and have the patience to withstand short-term rough patches.

If you are the type of investor who buys into the value-investing methodology and does not mind the occasional period of underperformance in pursuit of what would be considered from a more analytical viewpoint, these funds can be very good opportunities.  If you are more of a short-term gain type of investor – and not specifically phased by industry or sector weightings, contra mutual funds likely are not your best opportunity for returns.

Conclusion

The SBI Contra Fund and the collection of contra mutual funds in India present a possible investment in undervalued stocks or stock sectors, so they provide a solid long-term capital appreciation option. If necessary, risks inherent to fund-type investments, like underperformance in stock market run-ups and reliance on a fund manager’s capabilities to manage a value-oriented portfolio, are all acceptable risks, and therefore, the opportunity is strong for the patient, long-term investor looking for diversification in an equity portfolio.