Managers of mutual funds adopt various styles of investments that help them fetch the objectives of investment of the scheme. Out of these, the contrarian style, or the contra fund, is an investment style that attracts multiple investors.
Contra funds are highly risky but are the ultimate opportunity to get superlative returns.
A contra fund is an equity fund that bets against the prevalent market teens and sentiments. The key concept is to capitalize on twisted valuations and purchase stocks at a price that is lower than their elemental value.
“A contra fund is defined by its against-the-wind kind of investing style. The manager of a contra fund bets against the prevailing market trends by buying assets that are either under-performing or depressed at that point in time. This is done with the belief that the herd mentality followed by investors on the Street will lead to mispricing of assets, which will pick up steam in the long run, creating opportunities for investors to generate superlative returns.”- The Economic Times.
In this article, we shall explore a Contra Fund, which follows the traditional contrarian style of investment, and discuss some of the essential factors that you must be aware of before investing in these funds.
What Is A Contra Fund?
A contra fund is an investment that goes against the predominant trends of the market and invests in stocks that are not performing impressively at the time of investment.
The fund manager gets a contrarian picture of the stocks when they are rejected by investors and also when there is a high demand for the same.
Both underperformance and overperformance of the stocks result in a distorted value of the assets, which the fund manager will capitalize on.
The fundamental concept of this process is that if there is any excessive price of an asset, it will gradually normalize in the near future as soon as the triggers are cooled down.
For instance, steel may not be performing well ahead of the lowering of the steel cycle. However, a flip-back is just around the corner. That means steel here is a contra fund to invest in.
Typically, a contra fund goes against the conventional wisdom of any investor.
The critical focus here is on the stock of the companies that may not be performing well in the short term. However, when the current issues that are prohibiting the stocks from performing well get solved in the near future, the same stock is anticipated to be an outperformer.
This is how you usually bet on a contra fund. This is the reason why a contra fund is also known as the out-of-the-box approach or the contrarian approach in investing.
Who Can Invest In A Contra Fund?
While every investment is all about patience, an investor who invests in contra funds is expected to have more patience than a typical investor.
The reason is simple. A contra fund invests in stocks that are underperforming for multiple reasons. Therefore, investors are expected to wait till all the issues are eliminated and the stocks start performing again to earn profits.
Also, it must be remembered that the risks of investing in a contra fund are comparatively much higher than investing in other companies that are performing well and operating in the same sector.
A contra fund will not be chasing any momentum of the market or bet on the recent favorites. In contrast, it does the exact opposite. It bets on the underdog.
Therefore, you must only be thinking about investing in a contra fund if you have immense risk tolerance, an investment threshold of at least more than five years, and, of course, a pool full of patience.
Considering Factors To Invest In A Contra Fund
It is always feasible for investors to look at the previous performance of the stock before investing in it. In addition to it, here is a list of some of the factors that you may consider before you invest in a contra fund:
Irrelevance Of The Market Performance
Contrary to investing in growth stocks where the returns depend on the overall performance of the market, contra funds operate on the performance of specific stocks and the mitigation of the factors that have been responsible for their underperformance.
Therefore, you may make profits from contra funds even when the overall performance of the market is low and book losses even after the markets are high at all times.
It is necessary that you keep yourself aware of such performances of the stocks that you have made an investment in.
There Is A Possibility Of Loss
It is necessary that you understand that investing in a contra fund is entirely based on betting on the stock that is underperforming with the slightest amount of hope that it may show a better performance in the long run.
While there’s a possibility of higher returns if the stocks live up to the expectations, you must be prepared for the losses in case they disappoint you. Therefore, it is safe to invest only 10% of your portfolio in Contra Funds.
Research Well About The Fund Manager
The fund manager of any contra fund is vital in determining the performance of the scheme, as the choice of the stocks depends on the assessment of the stocks made by the fund manager.
Therefore, as an investor, one must always make sure that you have done proper research on the performance of the fund manager before you invest.
Advantages Of A Contra Fund
- Makes profit on the overlooked or undervalued opportunities.
- Investors experience diversification by investing in stocks with the help of the against-the-wind strategy.
- The chances of a fall are less if the industry undergoes correction.
The Bottom Line
A contra fund is a great investment choice if you are looking to get better profits compared to a usual stock. However, there are many risks that are associated with it.
Because you are investing in stocks that have been underperforming, there is no guarantee that they will improve in the near future. Also, you have to be extremely patient and make sure that the investments are made for long-term goals, which should be at least five years or more.