Is It The Right Time To Bet On Contra Funds?

Following a succession of higher highs and higher lows, the market appears to be on its way to an all-time high set on October 18, 2022. Furthermore, the US Federal Reserve’s expected easing of its aggressive stance in raising interest rates is fuelling this move. That said, there are still areas that are underperforming the benchmark indices. These sectors may have lost favour owing to changes in macroeconomic conditions rather than worsening fundamentals. As a result, despite good fundamentals, companies in such sectors are likely to trade at lower prices.

Meanwhile, it appears to be a sensible strategy to amass fundamentally strong companies in a weaker sector and hold them for the long term in order to profit from a sector turnaround. This is the entire premise of contra funds. In this story, we will learn what contra funds are, how they function, how these funds perform, the risks associated with them, who should consider investing in them, and whether or not it is the right time to bet on them. So, without further ado, let us get started.

Understanding Contra Funds
Contra funds are equity mutual funds that invest primarily in equities and related securities. These funds take a contrarian approach to the market. Simply put, contra fund managers play against the current market moves. They invest in underperforming, fundamentally sound stocks that are not currently preferred by the market. Because these stocks are frequently accessible at cheaper prices, contra funds are likely to gain from substantial increases in their prices once the market takes notice of them. Contra funds are mandated by the Securities and Exchange Board of India (SEBI) to invest at least 65 per cent of their total assets in equity and equity-linked instruments.

Working of Contra Funds
Contra funds invest in companies that the market does not recognise. It expects these investments’ prices to rise when the markets recover. Contra funds are predicated on the assumption that little or no stock demand will result in market mispricing. They feel that investors frequently succumb to herd mentality and invest in trending stocks that are overvalued. Contra fund managers look for lagging stocks with excellent fundamentals to buy in. When the market realises its actual worth, contra funds capitalise on lagging stocks by generating larger returns.

Performance of Contra Funds
According to the SEBI’s re-categorisation norms, value and contra funds are clubbed into a single category. This means that the fund house can either have a value fund or a contra fund. At present, there are around 18 value funds and three contra funds. In this section, we would be looking at the performance of contra funds and also compare this to an appropriate benchmark index.

If we look at the trailing returns of these funds then indeed these funds have successfully beaten their benchmark even over the longer period. However, trailing returns does not tell the whole story. To understand the true performance of these funds, it makes more sense to check out its rolling returns against the benchmark.

The table above shows how contra funds perform in terms of rolling returns. On an average, Invesco India Contra Fund and Kotak India EQ Contra Fund performed better than SBI Contra Fund and S&P BSE 500. However, when it comes to maximum returns, SBI Contra Fund beats other two funds as well as the benchmark. That said, SBI Contra Fund seems to be riskier among others as it seems to have higher drawdown.

Risks Involved in Contra Funds
You are quite aware that every investment avenue comes with its own set of risks, be it equity or debt. In fact, even if we look at their respective sub-categories, the risk differs. Hence, before investing in any investment avenue, understanding the underlying risk is important. In this section, we would be looking at the risks involved while investing in contra funds. These funds are based on the underlying assumption that investments will reach their real value. However, there are chances of this being wrong as well. When you consider investing in contra funds it requires a lot of research and analysis. Therefore, those investors that are new to mutual funds or equity investing should certainly avoid them. The investment selection depends on the fund manager’s expertise. In case the stocks perform against the fund manager’s expectations, investors may also suffer losses.

Target Audience for Contra Funds
Investors who want to explore undervalued stocks that are often overlooked by the market can invest in contra funds. If you are someone who fits in the following criteria, then you can certainly invest in contra funds:
■ Investors who wish to limit their downside risk during overvalued market conditions
■ Investors who can remain invested till the stocks attain expected valuation
■ Ideal for long investment horizon of over seven years.

Timing the Investment
If you look at the present market valuations, the stocks are trading quite below their historical mean. To understand this, let us look at the price to earnings (PE) ratio of Nifty 500. As on October 31, 2022, the PE of Nifty 500 was 22.21 whereas its historical average is 26.37. It is to be noted that we have assumed the average PE for the last 10 years as the historical average.

As can be seen in the graph alongside, the PE of Nifty 500 is trading just above its March 2020 PE. This definitely makes a good opportunity to invest in contra funds. This is because as the markets would start to rise so will the valuation re-rating take place northwards so that the contra funds are likely to benefit from this rise. While investing in contra funds, having a longer investment horizon is advisable. Moreover, the right time to exit these funds is when the markets are trading at historically higher valuations. However, as an investor you should not ignore the risk part. Invest only if your risk profile is moderately aggressive to aggressive and are looking for diversification.