What Are Contra Funds?

What is a Contra Fund?

A Contra Mutual Fund is an equity mutual fund that targets fundamentally strong companies that are undervalued or overlooked by the market. The objective is to benefit from their potential growth when market sentiment changes and these stocks gain recognition. These mutual funds are generally suitable for long-term investors, as the contrarian approach requires time to deliver results. 

Key Features of Contra Mutual Funds

The following features of contra mutual funds help investors decide whether they align with their investment objectives:

• Volatility: Typically more volatile than conventional funds, as investments are made in companies facing temporary challenges.

• Equity-Oriented: Primarily invests in equity and equity-related instruments, with diversification across sectors and market capitalisations.

• High Risk–High Reward Potential: Offers the possibility of significant returns if contrarian bets succeed, but carries the risk of underperformance if selected stocks fail to recover.

• Active Fund Management: Requires highly skilled fund managers with expertise in identifying undervalued opportunities and managing market fluctuations.

How Does a Contra Mutual Fund Work?

Contra mutual funds process typically works as follows:

• Selection of Undervalued Stocks: Fund managers look for companies that are fundamentally strong but currently out of favour due to setbacks, negative news cycles, or temporary market corrections.

• Value Investing Approach: Investments are made in stocks trading below their intrinsic value, which is assessed by analysing a company’s future earnings potential, assets, and competitive advantages.

• Exploiting Market Inefficiencies: Contra funds take advantage of market inefficiencies where quality stocks are underpriced. As the market corrects itself and recognises the true worth of these companies, their prices tend to rise, generating returns.

• Long-Term Perspective: These funds are designed for long-term investors. They may underperform in the short term, especially during bull markets when momentum stocks dominate. However, over a horizon of five years or more, contrarian bets can generate substantial profits if undervalued companies bounce back.

How to Invest in a Contra Mutual Fund?

Investing in Contra Mutual Funds requires careful planning and is best suited for investors with higher risk tolerance and a long-term outlook. The steps below provide a structured approach:

• Understand the Investment Philosophy: Learn how the contrarian approach works and assess whether it aligns with your financial goals. Be prepared for short-term volatility as these funds generally perform better over the long term.

• Assess Your Risk Profile: Evaluate your risk tolerance to decide how much of your portfolio can be allocated to contra funds.

• Complete Regulatory Requirements: Fulfil the mandatory Know Your Customer (KYC) process as SEBI prescribes before investing.

• Select the Right Fund: Choose schemes from reputed Asset Management Companies (AMCs) with a proven track record. Review past performance and analyse risk-adjusted measures such as the Sharpe ratio and standard deviation.

• Open an Investment Account: Create an account directly with the AMC or through a reliable online investment platform.

• Decide Your Investment Mode: Opt for a Lump Sum investment during market corrections or a Systematic Investment Plan (SIP) for disciplined, long-term investing.

• Seek Professional Guidance: Consult a financial advisor to align the investment with your financial objectives and risk profile.

Factors to Consider Before Investing in Contra Mutual Funds

Before you select the contra funds to add to your portfolio, take into consideration the following main aspects:

• Investment Tenure: Contra funds are designed for long-term wealth creation. Since they invest in undervalued stocks that may take time to recover and grow, investors should be prepared to hold their investment for at least 5–7 years or more to optimise returns.

• Risk and Volatility: Contra funds are volatile because they adopt a contrarian strategy, investing in stocks currently out of favour. Prices may fluctuate significantly in the short term, making these funds suitable only for investors with high risk tolerance and a long-term outlook.

• Expense Ratio: Managing contra funds involves costs, reflected in the fund’s expense ratio. A higher expense ratio can eat into returns over time, so choosing funds with a competitive fee structure is important to ensure costs do not outweigh potential gains.

• Fund Manager’s Expertise: The success of a contra fund depends heavily on the skills and experience of the fund manager. Identifying undervalued stocks with future growth potential requires strong market knowledge. Before investing, reviewing the fund manager’s track record and performance history is essential.

Risks of Investing in a Contra Mutual Fund

While contra mutual funds can deliver attractive returns, they also carry distinct risks that you must carefully evaluate before investing. These are:

Tax Implications for Contra Mutual Fund Investors

Contra funds are taxed under the same framework as other equity mutual funds. Gains from units sold within 12 months are treated as short-term capital gains (STCG) and taxed at 20% plus cess. Units held for more than 12 months attract long-term capital gains (LTCG) tax, where gains exceeding ₹1.25 lakh in a financial year are taxed at 12.5% without indexation benefits. Dividends distributed by contra funds are added to the investor’s total income and taxed as per the applicable income tax slab, with a 10% TDS deducted if dividend income exceeds ₹10,000 in a year (from FY 2025-26 onward).

Key Takeaways

Contra funds are suitable for investors with a long-term horizon, as they invest in undervalued stocks that may take time to deliver returns. These funds are volatile, so investors should be prepared for short-term fluctuations. While they may not perform well in the short term, they have the potential to create value over longer periods when market cycles shift. Review the expense ratio as it affects net returns, and assess the fund manager’s track record, as expertise drives turnaround opportunities. Careful consideration of these factors can help investors make informed choices. You can begin a SIP in Best Mutual Funds in India to start mutual fund investing.