Contra Mutual Funds: Benefits and Taxation
Posted on 18-Dec-2024
6 min read
Get a clear understanding of what contra mutual funds are, their features and benefits, and how to invest in them in this blog post by Shriram AMC.
Table of Content
Mutual fund managers employ various types of investing strategies to meet their scheme's investment goals. The contra mutual fund, which uses the contrarian approach holds particular appeal to investors. These funds defy conventional wisdom and invest in stocks that are currently out of favour with the market. Despite its inherent risks, there is a potential to achieve exceptional returns. In this detailed blog post, we will walk you through the features and benefits of a contra fund and how it works.
Here, the basic concept is that the high-priced assets will gradually become normal after the underlying factors are resolved. A contra mutual fund manager buys stocks at a lower price compared to the long-term estimated price. Some sectors might experience downturns and contra mutual funds invest in stocks from such sectors, retaining them till there is a rise in the demand. Investors who prefer investing for short-term might not benefit from contra mutual funds as these deliver strong performance in the long run.
Given that contra mutual funds primarily invest in listed securities (stocks), the new tax regime will impact them as follows:
Here are some factors to consider before you invest in contra funds:
Experienced fund managers who can identify underperforming funds with potential for growth in the future manage your contra funds.
Yes, contra funds have the potential to offer significant returns if you can stay invested for a long period and are willing to handle the short-term risks.
Seasoned investors who are expert in analysing the market and making informed decisions are suited for contra mutual funds. Ideally, an investor should have more than 5 years of experience in investing before considering contra funds.
Yes, there are many restrictions on asset allocation for contra funds set by the Securities Exchange Board of India (SEBI). Contra funds should invest at least 65% of the total value in equity & equity related instruments . For this reason, these funds are classified as equity funds due to their predominant investment in equity instruments.
A contra mutual fund must be held for a minimum of 5 years. However, the assets within the fund can become steady further, generating improved returns. Holding these funds for another year or two could yield even better earnings. The returns will depend on how long you hold the funds.
Yes, management fees, performance fees, etc., are some of the charges associated with contra mutual funds.
What are Contra Mutual Funds?
A contra mutual fund goes against the current market trends by buying stocks that are not performing well. With a contrarian approach, the fund manager invests in stocks that investors overlook even during high demand. Thus, the fund manager achieves capitalisation from fluctuations in asset values due to over-performance or under-performance.Here, the basic concept is that the high-priced assets will gradually become normal after the underlying factors are resolved. A contra mutual fund manager buys stocks at a lower price compared to the long-term estimated price. Some sectors might experience downturns and contra mutual funds invest in stocks from such sectors, retaining them till there is a rise in the demand. Investors who prefer investing for short-term might not benefit from contra mutual funds as these deliver strong performance in the long run.
How Does a Contra Mutual Fund Work?
Contra mutual funds follow the contrarian method by investing against the prevailing market conditions. The working of a contra mutual fund is outlined below:- The fund manager looks for stocks that are unfavoured in the market because of negative news cycles and temporary challenges.
- The stocks trading at a value lower than their expected value are purchased. The industry’s potential is represented by these expected values, by considering factors such as competitive advantage, anticipated returns, and assets.
- The fund invests in devalued stocks and attains profits by anticipating the price recovery to align with their actual value. This can happen as the fundamentals of the company improves, market conditions get better, or the issues related to negative news are fixed.
- Long-term investors can get the most out of contra mutual funds. The approach followed by these funds might deliver weaker performance during bullish market conditions. However, if the underperforming stocks witness upward price trends over a longer duration, contra mutual funds can provide substantial returns.
Features of Contra Mutual Funds
The features of contra mutual funds are mentioned below:- Investment Strategy: Contra mutual funds employ the contrarian strategy by investing in unfavoured stocks that may achieve capital appreciation in the future.
- Risk-Reward Profile: While these funds are highly risky, they have the potential to generate excellent returns. However, if the stocks fail to recover, contra mutual funds will underperform.
- Minimum Investment Amount: The minimum amount to be invested can differ based on a particular fund.
- Volatile Nature: Since the investments are done in stocks that are currently undervalued, contra mutual funds exhibit more volatility compared to traditional mutual funds.
- Long-Term Investment: Contra mutual funds are ideal if you can invest for a long period (above 5 years) with the purpose of wealth creation and withstand fluctuations in the market.
Benefits of Contra Mutual Funds
The benefits associated with contra mutual funds are as follows:- The contra fund returns are high when the stocks deliver good performance, and their value rises.
- The profit potential is high because contra mutual funds invest in underperforming stocks.
- The fund managers evaluate low-performing stocks and invest in those with high growth potential. Thus, in the event of market turmoil, your investment will remain stable.
- Since the minimum investment in contra mutual funds is low, they attract all types of investors.
Taxation Rules of Contra Mutual Funds
According to the recent changes announced in Budget 2024, this is what you need to know about taxation of contra mutual funds:Given that contra mutual funds primarily invest in listed securities (stocks), the new tax regime will impact them as follows:
Short-Term Capital Gains (STCG)
- If you sell your contra mutual fund units within 12 months of purchase, the profit you make will be considered STCG.
- This STCG will be taxed at your marginal income tax rate.
Long-Term Capital Gains (LTCG)
- If you hold your units for more than 12 months, any profit you make will be considered LTCG.
- This LTCG will be taxed at a flat rate of 12.5%.
Key Points to Remember
- Indexation Benefit Removed: The earlier benefit of reducing your taxable gains by adjusting them for inflation (indexation) has been removed.
- Higher Tax Burden: The uniform 12.5% LTCG tax rate is generally higher than the previous rates for certain asset classes.
- Investment Horizon: A longer investment horizon can help you benefit from the lower LTCG tax rate.
- Consult a Tax Professional: For specific tax advice, it's recommended to consult a tax professional.
Who Should Invest in Contra Mutual Funds
Investors with high-risk appetite and the ability to invest for long-term should consider investing in contra mutual funds. These funds invest in stocks that are not performing well currently. Therefore, such stocks come with the risk of volatility and fluctuations till they become steady. All in all, contra mutual funds might not work for you if you wish to invest in safe financial instruments.
Factors to Consider before Investing in Contra Mutual Funds
Here are some factors to consider before you invest in contra funds:
- Contra mutual funds will require you to stay invested for a longer duration as these funds assure high returns in the future.
- Even the best performing stocks are volatile and fluctuate frequently. So, there is no need to worry in case of price fluctuations. · Keep in mind that you will be charged expense ratio by the managing company. Therefore, ensure that you understand the charges for management of your funds.
How to Invest in Contra Funds
To invest in contra funds, follow the steps mentioned below:- Step 1: Visit the mutual fund website/app of your choice.
- Step 2: Complete the registration.
- Step 3: Select your preferred contra mutual fund.
- Step 4: Click on the ‘Invest’ option and select the amount.
- Step 5: Select one from SIP and lump sum investment.
- Step 6: Finish the process by entering your KYC information.
FAQs
Here are a few frequently asked questions about contra mutual funds:1. Can I redeem my contra fund investment at any time?
Yes, contra mutual funds are open-ended schemes so you can redeem them whenever you want. However, the tax implications and exit load must be considered before you redeem your investment.
2. Who will manage my contra fund?
Experienced fund managers who can identify underperforming funds with potential for growth in the future manage your contra funds.
3. Do contra funds offer high returns?
Yes, contra funds have the potential to offer significant returns if you can stay invested for a long period and are willing to handle the short-term risks.
4. Can a beginner invest in contra funds?
Seasoned investors who are expert in analysing the market and making informed decisions are suited for contra mutual funds. Ideally, an investor should have more than 5 years of experience in investing before considering contra funds.
5. Are there any particular regulations related to asset allocation for contra funds?
Yes, there are many restrictions on asset allocation for contra funds set by the Securities Exchange Board of India (SEBI). Contra funds should invest at least 65% of the total value in equity & equity related instruments . For this reason, these funds are classified as equity funds due to their predominant investment in equity instruments.
6. What is the best investment horizon to invest in a contra mutual fund?
A contra mutual fund must be held for a minimum of 5 years. However, the assets within the fund can become steady further, generating improved returns. Holding these funds for another year or two could yield even better earnings. The returns will depend on how long you hold the funds.
7. Are there any charges associated with contra mutual funds?
Yes, management fees, performance fees, etc., are some of the charges associated with contra mutual funds.
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