Contra funds a good bet to diversify portfolio, but keep the risks in mind

After underperforming during 2018 and 2019, value investing came back in style over the past one year, beating returns of many major categories such as large-cap or multi-cap funds.

Value investing is a strategy, which involves picking stocks or sectors that appear to be trading for less than their intrinsic or book value. This is theme is essentially captured by value and contra funds.

In India, as per the Securities and Exchange Board of India (Sebi) guidelines on scheme categorization of mutual funds, value and contra categories are clubbed together, meaning a fund house can either offer a contra fund or a value fund, not both.

While there are around 15 value funds available in the market, only three fund houses—Invesco Asset Management (India) Pvt. Ltd, SBI Funds Management Pvt. Ltd and Kotak Mutual Fund—offer contra funds in India.

Essentially, contra funds are equity mutual funds that take a contrarian view on the market. Underperforming stocks and sectors are picked at low price points with a view that they will perform in the long run.

While both value and contra funds pick themes that are currently unpopular, a value fund invests in undervalued stocks, while a contra fund picks underperforming stocks.

According to experts, value is a subset of contra strategy in a sense that companies or sectors that are available at cheap valuations become a contrarian play.

“To me, it is just one aspect of the contrarian strategy or a contra fund, other key aspect is to essentially buy even good-quality companies which might not be trading at absolute cheap valuations. They may be trading at a valuation, which is at a discount to that company’s long-term historical average, but in absolute terms it can still be expensive,” said Dinesh Balachandran, fund manager, SBI MF.

For SBI MF, pharma in 2019 and industrial sector in 2020 are good examples of contra bets. “Over the last six months, another sector, which has given us this opportunity, is the power space,” said Balachandran.

Contra funds over the past year have outperformed some of the large-cap funds. According to experts, the nature of these funds is that when the markets are falling, they do much better.

“There is a possibility that these can go through underperformance for years. In a running market, investors may find that these funds tend to go slow, but when the correction happens and there is opportunity to invest into underperforming stocks, and when the cycle turns back, they tend to do well,” said Harshad Chetanwala, a Sebi-registered investment adviser and co-founder of MyWealthGrowth.

According to Balachandran, the contra strategy at this point is inherently more attractive in terms of where the economy is right now. “Themes that have done well over the past 10 years are all consumption themes, and the old economy sectors such as industrial and capex-heavy sectors were in a big slump. I think the next decade would be favourable for the capex-heavy, high operating leverage, real estate or old economy sectors,” he said.

There are two ways to build a contra fund. In the top-down approach, a fund manager considers neglected sectors that have been going through a significant earnings downgrade for a while but are primed for a comeback. The second approach—bottom-up perspective—looks at good-quality companies that are going through a tough phase, but here fund manager thinks that the problem won’t last much longer, or it is a solvable problem.

However, when the selected sectors and companies do see a turnaround, the contra funds act more like any other fund. In many contra funds you will find IT, big private banks and pharma as major holdings.

“The real contra bets in the fund are ones below the top five-seven holdings, where we have a mix of PSU names, energy names, industrial and real estate stocks, which are very contrarian ideas,” said Balachandran.

On exiting these top holdings, Balachandran said he doesn’t want to exit early just because a particular stock is a contra idea and other funds also own it. “The exit part has two components: one, whether the investment thesis has fully played out, and two, whether we find a better risk-reward,” he added.

Inherently, contra funds go against the market tide, meaning they have poor correlation to how the market is doing. However, usually, contra funds currently have a beta ratio of close to 1.

For example, if the beta ratio of a specific fund is 1.10, it means the fund is 10% more volatile than the benchmark index.

“Beta will keep changing depending on what time period you take. I would not take beta as an indicator for contra funds because depending on the market conditions, contra, or value, can have a low beta,” said Vidya Bala, co-founder, Prime Investor.

“I would rather look at the downside containment, whether these funds are able to restrict downside better than growth-focused funds or not. That would be a better measure, and in that, we have often seen that value and contra funds try to do better if it is a good fund,” she added.

Contra funds have to invest at least 65% in stocks, meaning they fall under the equity mutual funds category and are taxed according to the short-term capital gains tax rate of 15%. After one year, investors are required to pay long-term capital gains tax of 10% on returns of ₹1 lakh in a financial year.

A portfolio needs a mix of different strategies at all points in time because there is never a time when anyone can predict which theme will outperform, or which will underperform.

Instead of timing a particular strategy, investors having growth-oriented aggressive funds can supplement this strategy with contra funds.

Investors should keep in mind that as this theme is very contrarian, these funds sometimes underperform for long, simply because the stock or sectoral selection hasn’t taken off in the market. “Investors may find years of underperformance before these funds work well, so they need a very long-term investment horizon even more than a regular growth-oriented diversified funds,” Bala added.

According to financial advisers, from an investor’s perspective, these funds can be a good hedge against market corrections.

“However, the core portfolio has to be growth-oriented. An investor can have 5-10% allocation to contra funds as a diversification tool,” said Chetanwala.

Experts say contra funds can be a part of a diverse strategy of investors provided they know that these funds can underperform for many years.