Mutual funds: Why contra funds bet against market trends and who should invest in them

When markets are chasing momentum and popular stocks are hitting new highs, contra funds take a very different route. These funds deliberately invest in sectors or companies that are currently out of favour, overlooked, or temporarily beaten down by the market, with the belief that their true value will emerge over time. The strategy is built on the idea that market sentiment often overreacts in the short term, creating opportunities for patient investors.

But while contra investing can potentially deliver strong long-term gains, it also comes with higher volatility and requires a long investment horizon. So, who should consider investing in contra funds, and how do they work during different market cycles?

Funds strategy

Contra funds are a type of mutual fund that follow a contrarian investment strategy. In simple terms, they look for opportunities in stocks or sectors that are currently unpopular, undervalued, or overlooked by the broader market.

According to a recent report by Motilal Oswal Mutual Fund, sector leadership tends to shift across phases of the market cycle, with sectors such as metals, real estate, banking, and auto moving in and out of favour over time.

The fund house said its newly launched Motilal Oswal Contra Fund aims to tap these changing trends by identifying undervalued opportunities early and investing in companies with strong fundamentals and turnaround potential.

How it works

Instead of chasing stocks that have already rallied, contra fund managers focus on companies that may be facing short-term challenges or negative sentiment but still have strong fundamentals for the long run. The thinking here is that markets often overreact in the short term, which can open the door to buying quality businesses at lower valuations.

“A good example of this approach was seen during the COVID-19 market crash in 2020. Between January and March, the Nifty 50 dropped nearly 38 percent. Sectors like banking, hospitality, and automobiles were hit hard as investors rushed to sell,” said Gaurav Maheshwari, CFO, Alankit Limited.

“While many exited these sectors out of fear, contrarian-style investors took the opposite view. They accumulated shares of fundamentally strong companies, such as large private banks and auto manufacturers, at discounted prices. Over the next two to three years, as economic activity picked up again, many of these stocks staged a sharp recovery,” said Maheshwari.

What investors must understand

When evaluating opportunities, contra fund managers typically look at metrics like price-to-earnings (P/E) ratios, cash flows, debt levels, management quality, and sector cycles. For instance, if a company that usually trades at a P/E of 25 falls to around 14–15 because of temporary concerns, it could become attractive for a contra investor.

This strategy requires patience, since market sentiment can stay negative for quite some time before turning around.

“These funds are best suited for investors with a long-term horizon of at least 5–7 years and the ability to handle volatility. They may underperform during momentum-driven rallies, when popular sectors dominate returns. That’s why they work better as part of a diversified portfolio, with around 10–15 percent of equity investments allocated to higher-risk strategies,” said Maheshwari.

It’s important to note, though, that contra investing carries its own risks. Sometimes stocks remain cheap because the underlying business has serious structural problems, turning them into ‘value traps.’ This is why the success of a contra fund depends heavily on the fund manager’s research, patience, and ability to pick the right stocks.

Disclaimer: The views and investment tips expressed by experts on Moneycontrol.com are their own and not those of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions.