Contra funds vs value funds: Key differences for investors

When building an investment portfolio, investors have a diverse range of mutual funds to choose from based on their financial goals, risk tolerance and investment style.

Two categories of equity funds that can sometimes seem confusing are contra funds and value funds. On the surface, the two follow a somewhat similar investing approach. However, when it comes to the nuances, there are some key differences between the two in terms of strategy, portfolio, risk profile and suitability.

Understanding these differences is essential for investors to make an informed choice between contra and value funds. This article helps you identify these so that you can potentially make a choice aligned to your investment objectives.

• Table of contents

• What is a contra fund?
• What is a value fund?
• Differences between contra and value funds
• Contra fund vs value fund: Which is more suitable?
• How to choose between contra and value funds

What is a contra fund?

A contra fund is a type of equity mutual fund that follows a contrarian investing approach by taking positions that run contrary to the prevailing market sentiment. This may involve selecting stocks or sectors that are currently out of favour but are expected to do well in the future. By taking a contrarian view, these funds aim to benefit from the potential upswing in the prices of such stocks in the future.

To assess this, fund managers consider company fundamentals as well as behavioural finance insights on market underreactions and overreactions to determine the stocks’ prospects for future growth.

The underlying premise is that lower valuations provide an opportunity to accumulate stocks that could be primed for a turnaround once market sentiments improve. Contra funds require patience to stay invested during the phase of negative or low returns but have the potential to deliver high returns when the tide turns.

What is a value fund?

Value funds are equity funds that invest in stocks trading below their intrinsic or true value due to market inefficiencies or temporary negative investor perception. This may not entail a contrarian position – these stocks are undervalued but may not be falling in value or considered unpopular by the market. Value funds rely on fundamental analysis to identify undervalued stocks based on financial parameters such as low price to earnings or price to book value ratios.

The fund managers believe these stocks are underpriced relative to their earnings potential and long-term growth prospects. By investing in such undervalued stocks, value funds aim to generate a higher return potential when the stock price rises to its fair value in line with the company’s fundamentals over the long run.

As per SEBI guidelines on Scheme categorisation of mutual funds, a Mutual Fund can either launch a contra fund or a value fund – not both.

Differences between contra and value funds

Here are some of the key differences between contra and value funds:

Investment approach

• Contra funds adopt a contrarian approach by investing in stocks or sectors that are underperforming and maybe even declining in prices owing to market sentiment
• Value funds use fundamental analysis to identify undervalued stocks with strong financials selling below intrinsic value.

Risk profile

• Contra funds can carry significantly higher risks as they contrary to current market trends. A prolonged downturn can impact returns.
• Value funds carry high risks as undervalued stocks may remain undiscovered for long periods.

Time horizon

• Contra funds require a long-term investment horizon of 5-7 years to ride out downturn phases.
• Value funds also demand a long-term horizon of 5+ years for the value unlocking to play out.

Liquidity risk

• Contra funds may have relatively higher liquidity risks as they often invest in stocks that currently are out of favour.
• Value funds also have liquidity risk, though it may be somewhat lower than a pure contrarian approach.

Contra fund vs value fund: Which is more suitable?

For aggressive investors

Contra funds are more appropriate for aggressive investors with a high-risk appetite looking for potentially higher returns through contrarian investing. The ability to remain invested during prolonged underperformance of out-of-favour stocks is vital.

For high risk investors

Value funds suit investors willing to tolerate high risks in return for long-term capital appreciation potential through undervalued stocks. Discipline to stay invested until value realisation is required.

Investment goals

Contra funds are ideal for investors specifically looking for potentially higher returns through contrarian investing. Value funds fit those seeking undervalued stocks rather than out-of-favour stories.

How to choose between contra and value funds

• Assess your risk tolerance and return expectations. Contra funds can be more risky because they take a position that is opposite to general market sentiment.
• Evaluate your investment horizon. Both demand long-term commitment of 5+ years.
• Check portfolio liquidity. Contra funds may have higher liquidity risks.
• Compare historical returns* and analyse performance across market cycles. *Past performance may or may not be sustained in the future.
• Assess fund managers’ expertise and the fund’s investment strategy.
• Consider the expense ratios to optimise the return potential.
• Consider portfolio overlap with your existing mutual funds to optimise overall diversification.

Conclusion

Contra and value funds adopt different investment philosophies for stock selection, but both target market-beating return potential over the long run. Contra funds carry higher risks given their contrarian approach, while value funds are relatively less volatile but still carry a high level of risk. Assessing parameters like risk appetite, investment horizon, liquidity needs, and portfolio diversification it is important for investors to decide between contra and value funds.

FAQs:

Is it advisable to invest in a contra fund?

Contra funds suit very aggressive investors with a high-risk appetite and patience to remain invested for 5+ years to ride out volatility

What are the disadvantages of contra funds?

Key risks in contra funds are significant market risk, liquidity issues and short-term underperformance.

Are value funds a good long-term investment?

Value funds require a long investment horizon and are suitable for patient investors looking for undervalued picks that have the potential to deliver high returns over time. The long tenure may potentially allow the price-value gap to converge and fundamentals to be realised.

Which is more suitable - value fund or growth fund?

The choice between the two depends upon several factors, including risk appetite and investing style. Both strategies are high risk, but contra funds could be riskier because they go against the prevailing tide, whereas value funds focus on stocks that are trading below their intrinsic value. For an investor, the strategy that they have more conviction in could be a deciding factor between the two.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully. This document should not be treated as endorsement of the views/opinions or as investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.