scorecardresearchYour Questions Answered: Should I invest in contra-mutual funds when most other funds are overvalued?

Your Questions Answered: Should I invest in contra-mutual funds when most other funds are overvalued?

Updated: 14 Jan 2023, 09:29 AM IST
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Contra Funds concentrate on stocks that are now underperforming but are anticipated to turn around and outperform the market in the future.

Contra Funds concentrate on stocks that are now underperforming but are anticipated to turn around and outperform the market in the future.

Q. I am a young professional working with a big 4 auditing firm. I have been planning to invest in mutual funds for a long time, however, I believe that currently, most stocks are overvalued, based on my analysis of their PE Ratio. I have heard from numerous friends and acquaintances that contra mutual funds are well suited for investors looking to avoid investment in an overpriced market. Can you please let me know what a contra-mutual fund is and how it operates and what should an investor keep in mind while investing in a contra-mutual fund.

Archit Modi, Ahmedabad, Gujarat

Due to the Indian financial markets' recent recovery and notable gains, investors are ecstatic to witness a positive increase in the value of their portfolios. Despite the unfavourable global backdrop, rising USD against the Indian Rupee, persistently high inflation rate, and the RBI's hawkish posture, the Indian markets have exhibited signals of confidence.

There are a lot of challenges which are currently a cause of worry for the stock market investors. There are still worries about rising inflationary trends globally and the upcoming recession in the US and most of Europe which could make the present recovery fleeting.

Several fundamentally good stocks and sectors are still available at a considerable discount to their fair value despite the fact that there has been a rally across most market cap segments, which has resulted in the majority of the equities and sectors moving up significantly. The trick, however, is to spot these stocks and sectors in good time and to stick with them until their full potential is realised by the broader stock market.

Contra mutual funds attempt to achieve precisely this, they invest in stocks and underappreciated industries that have the potential to grow greatly but are accessible at large discounts to their fair value. Such equities have a greater margin of safety during market peaks, which provides them the ability to produce respectable returns over the long term.

Contra vs value funds

Contra funds are frequently mistaken for value funds. While they certainly have some things in common, there is a fundamental distinction between them. Value investment funds concentrate on acquiring stocks at prices substantially below their intrinsic value. They seek a margin of safety. Contra funds, on the other hand, concentrate on stocks that are now underperforming but are anticipated to turn around and outperform the market in the future.

As we previously mentioned, there is a propensity to lump value funds and contra funds together and treat them as interchangeable. But that would ignore the key distinction between the two. We will adhere to the Securities and Exchange Board of India (SEBI) definition. In accordance with the SEBI definition, there are at present only three contra mutual funds schemes in India: SBI Contra Fund, Kotak India Contra Fund, and Invesco India Contra Fund.

Risks related to contra funds

Following are the major risks associated with contra-mutual funds:

Low earnings if the exit is made early - Contra funds should be bought with a long time horizon, at least with a 5 years horizon, because they contain companies that are currently experiencing transitory problems. However, when such issues are not resolved in the allotted time, fund managers leave their positions to pursue better prospects, which results in the exit of some assets at a loss and a loss of opportunity cost.

Bearing losses as a result of the issue's persistence - The ostensibly manageable business issue could balloon in size. As a result, in order to safeguard the capital and prevent additional losses, the position on that stock must be closed off at a loss.

Limited options: The number of these contra stocks available to a contra fund management might be constrained.

Investors do, however, see a number of significant advantages with contra-mutual funds. Here are a few examples of these advantages.

  • Contra funds deploy contrarian strategies, and if properly calibrated, they can provide investors with returns that are above the market. Of course, there is always a risk, but the rewards can make it worthwhile.
  • Contra funds concentrate on businesses that are typically ignored by analysts and investors. Since the target companies do not attract much attention from the institutional investor, consequently the effect of institutional trading on these companies will also be limited. For example, if Foreign Institutional Investors start selling stocks in India in order to off-set their loss from other markets, there is a very low probability that it will impact the stock price of companies in which contra mutual funds invest.
  • Contra funds typically invest in companies during periods of underperformance, therefore in these circumstances, the price is typically low. Investors in contra funds consequently benefit indirectly from buying these companies on a discount.
  • It has been noted that high-beta stocks typically decline the most during market crashes or extended market downturns. The contra funds typically retain the principal amount invested better than other classes of funds in a bear market.

The majority of contrarian stocks have a lot of untapped potential but owing to their perceived issues, the stock price does not reflect this potential. When these problems are resolved, the stock typically rises as it catches up.

What to check when investing in contra mutual funds?

There are a few things which you should keep in mind if you are investing in contra funds in order to maximise your probability of making a decent return. Below is a short list of things which you should know/check prior to making your next contra mutual fund investment.

  • Contra funds are not the right choice for someone without patience. It often takes time for contra stocks to recover from problems and begin to perform. It would be unrealistic to anticipate being able to profit from contra funds unless you had a time horizon of 4-5 years.
  • The majority of the contra fund follows a long-term strategy. Therefore, avoid attempting to predict the bottom of these funds in simpler terms - do not try to time your investment in these funds. There is a high probability that you will lose out on potential gains in your attempt to time the market.
  • When you own contra funds, don't freak out if they are not providing stellar returns from day one. They take longer to produce worthwhile results than many other equity mutual funds. After you invest, there may be a period during which your investment is in the red, however, you should not panic in these situations.
  • You must maintain your conviction, perseverance, and patience. Long-term returns from contra funds could be strong, but it takes perseverance and determination to win.

Contra funds' taxability

Since equities make up a sizable portion of contra funds (65% minimum), these funds are classified as equity funds. Contra funds are consequently taxed as an equity funds and the capital gains tax application on these funds is as follows:

  • Regardless of the investor's tax bracket, short-term capital gains (gains realised within a year of investing) are taxed at 15%.
  • Up to Rs. 1 lakh of long-term capital gains (gains realised after a year of investment) are tax-free, and any gains over this amount are subject to a 10% tax rate with no indexation benefit.
  • Any dividends provided by the contra mutual funds are taxed in the investor's hands according to his or her tax bracket.

Conclusion

A lot of investors avoid investing in the stock market during a bull run. However, certain categories of mutual funds stay more or less unaffected from the bull run because of their investment strategy, chief amongst them being: contra-mutual funds and value mutual funds.

At present in India there are only three contra mutual funds, however, given their above stellar performance in the past 3 years, more fund houses may launch new contra funds. However, given that these funds are active funds, investors should closely study the offer document prior to making any investment decision.

Kuvera is a free direct mutual fund investing platform.

Note: This story is for informational purposes. Please speak to a financial advisor for detailed solutions to your questions.
 

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Investors often prefer to invest in mutual funds that consistently beat the benchmark indices.
First Published: 14 Jan 2023, 09:29 AM IST