Contra funds explained: How they work, key risks, benefits and top 3 options for investors

Among mutual fund categories, contra funds stand out for their distinctive investment strategy. Rather than following prevailing market trends, these funds look for opportunities in stocks or sectors that may be temporarily out of favour but have the potential for long-term growth.

Here’s a look at what are, how they operate, their potential benefits and risks, and the key factors investors should assess before investing.

What are contra funds?

A contra fund is a type of equity mutual fund that follows a contrarian investment strategy and is required to invest at least 65% of its assets in stocks. The fund looks for companies or sectors that are out of trend, with the expectation that they will grow over time.

However, contrarian investing is different from value investing. typically focus on fundamentally strong companies that are trading below their intrinsic value.

On the other hand, contra funds invest in stocks or sectors that the market is currently avoiding due to weak sentiment, temporary challenges, or poor recent performance.

In short, contrarian investing is about going against the crowd and identifying opportunities in areas where most investors are not willing to invest. Currently, there are only 4 contra funds actively operating in the market.

Advantages of investing in contra funds

Contra funds take the opposite view and benefit the investors through the expertise of a professional fund manager.

Going against the tide

These funds try to capture opportunities by investing in stocks or sectors that are currently viewed negatively by the broader market. For example, when the IT sector faces weak demand and stock prices decline, a contra fund may increase its exposure to quality IT companies in anticipation of a future recovery.

Buy low, sell high approach

While the buy low, sell high principle also applies to value investing, contra funds follow a different approach by investing in stocks and sectors that are out of favour and trading at lower prices. Buying when expectations are low means paying less for future earnings growth.

Different sort of diversification

Most investors already have exposure to popular sectors and market leaders through diversified equity funds. Contra funds can complement such portfolios by investing in areas that are currently being ignored by the broader market, such as crude-linked sectors.

Risks of investing in contra funds

While contra funds provide various benefits, they are not free from underlying risk.

Prolonged underperformance

Contra funds invest in stocks and sectors that are currently out of favour in the market. However, there might be a situation when these stocks would never recover, even in the long term.

Fundamental weakness

One of the biggest risks in contrarian investing is mistaking a weak business for an undervalued opportunity. A stock may appear attractive because of its low valuation, but the decline could be due to fundamental issues such as poor management, high debt, or negative cash flows.

Short-term fluctuation

Contra funds invest in stocks that are currently out of favour with the market. Because these investments are unpopular, their prices may continue to fall in the short term as other investors sell them. These funds are best suited for long-term investors who can stay invested for at least 5–7 years and remain patient through different market cycles.

Key factors you should consider before investing in contra funds:

Investment approach of the fund

Before investing, understand how the fund identifies contrarian opportunities. A genuine contra fund invests in stocks that are temporarily out of favour. Review the fund’s portfolio and check whether it has consistently followed a contrarian approach across market cycles.

Value trap and fund manager’s role

What may appear as a value stock by traditional ratios like P/E or P/B, could be undervalued for other reasons as well, like corporate governance, inefficient business model, and reducing market share, among many. So, distinguishing between a genuinely undervalued stock and a failing company can be a difficult task. The success of a contra fund heavily depends on the fund manager. Since contrarian investing requires patience and conviction, the experience of the fund manager plays a crucial role.

Portfolio construction

Review the fund’s sector allocation, top holdings, and position sizes before investing. If the fund’s holdings closely match those of popular growth-oriented equity funds, it may not be offering genuine contrarian exposure.

Rolling returns

Instead of focusing only on recent returns, check the fund’s 3-year, 5-year, and 7-year rolling returns. This helps you understand whether the fund has delivered consistent performance across different market cycles.

Downside capture

Downside capture measures how much a fund declines during market downturns compared to its benchmark. For contra funds, this metric can help investors assess how effectively the fund has managed risk during challenging market conditions.

Top 3 contra funds by 10-year returns

Here is the list of the top 3 contra funds by 10-year returns you can look at.

Disclaimer: This is purely for educational/ informational purposes and should not be taken as any sort of investment advice. Always consult a SEBI-registered advisor before making any investment decisions.