Global Outlook

Market participants can consider contra and arbitrage funds in present market conditions.

Contributed by Nirmal Bang

By Nirmal Bang

The performance of equity markets have forced investors to look at  different types of mutual fund schemes instead of blindly putting money in conventional equity schemes. Equity markets have been under pressure since the past few months and if experts are to be believed, then in the coming months, the markets may remain range-bound.

In such a scenario, retail investors can invest a part of their allocated money  in contra funds or arbitrage funds as these have outdone the benchmark indices in the last one year.

CONTRA FUNDS

Currently, over seven fund houses provide investors with the option to T invest in contra schemes. Typically, in contra style of investing fund managers consciously do not invest in stocks that are popular at that point in time. They look for stocks that are out of favour and stay invested for longer duration in those stocks.

The key reason to invest in such stocks is that they come at cheap valuations and strong fundamentals. Fund managers also witness value, especially over the long-term that  most others do not.

The company may be having trouble in the short term, but fund managers believe that it is fundamentally strong and over the long-term it will overcome its problems and provide better returns in line with the markets.

However, in India, contra funds are not popular among investors as they generate returns in line with benchmark indices. Contra funds have been around for a while in the  Indian mutual fund industry.

The first contra fund was launched by SBI Mutual Fund 12 years ago. Due to solid performance since it started, several fund houses lined up to start contra funds and over the years, it has become a niche category for investors with high knowledge of equity markets. SBI Magnum has a corpus of Rs.3,000 crore and since its launch it has given returns of over 22%.

There are other funds too that have given better returns. If we look at statistics, in the last one year, the BSE Sensex has been down by over 16%.

Few contra funds like Tata Contra, Kotak Contra, L&T Contra and Religare Contra have been able to beat the benchmark indices.

Most fund managers adopt the strategy of investing in stocks that are a bit risky but also offer value even when the markets neglect them. The performance of few schemes over the long-term have proved that contra strategy have paid off quite well compared with other equity schemes.

In simple words, a contra fund is based on a contrarian approach to investing. Fund managers look for mispriced investments and buy those that appear to be undervalued and possibly sell those that are overvalued. However, there are schemes that have given below average returns and investors have lost money by investing in them.

At present, consumer and pharma stocks are in demand and market players are on a buying spree, pushing its prices to new highs. A contrarian fund manager does not follow the herd and will not buy this overpriced stock. Instead, he looks for stocks that the markets have ignored completely.

At such times, contra funds buy into companies that have strong fundamentals but are discounted due to short-term performance issues. So, even though the portfolio has blue-chip stocks, they were bought when the stocks were struggling.

Fund managers are of the opinion that this is a contrarian strategy and works mostly in all market phases.

In the contrarian theme, fund managers always try and get reward-risk balance in their favour. So, it is best for retail investors with  ow risk appetite and a suitable investment horizon of at least 3-5 years, as advised for any diversified equity fund, to get better returns.

However, some participants argue that in order to generate better returns, some funds deviate from their investment mandate and haven’t helped the investor create wealth.

However, a major portion of the investment should be in large-cap or multi-cap funds. A contra fund should comprise of only a small portion of your equity portfolio so as to give it added diversity in the portfolio.

Investors must have patience when it comes to contra funds. This is because contra funds invest in stocks which are out of market and many a times the general market may take longer to realize a stock’s potential.

The contra fund will be loaded with a low value stock for a longer period. Also there is always the risk of a fund manager’s call going wrong.

A dip in the recent performance of contra funds has raised concern among investors. But an investor should note that contrarian investing usually takes more time to generate returns. Those investing in such funds should not seek quick returns. Instead, they should be patient and allow their contra investments to play out in the long run.

ARBITRAGE FUNDS

If one is looking at a fund with low risk profile, which can also generate positive returns in volatile markets, then arbitrage funds might be the one  for you. These funds try to capitalize on the arbitrage opportunities arising out of pricing mismatch of stocks in the equity and derivative segments.

In the last one year, this is one of the few categories that has given positive returns. Currently, there are over 18 schemes in this category and all of them have given better returns then their benchmarks. In the last one year, on an average, arbitrage funds have given returns of 7.5% against the benchmark indices, which are down by over 16% for the corresponding time frame.

These funds usually take advantage of the arbitrage opportunities between the cash and the futures market to generate better returns. The arbitrage is sought by taking advantage of the mispricing between the cash and the derivatives market.

Let us understand how this works. Suppose the stock price of ABC Ltd is Rs.100. Let us say the stock is trading in the derivatives segment, where its future price is Rs.110. In such a case, one can make a risk-free profit by selling a futures contract of ABC Ltd at Rs.110 and buy an equivalent number of shares in the equity market at Rs.100.

So during the expiry, the fund manager pockets a net of Rs.10 irrespective of stock prices, which might be higher or lower.

Investors can enter into arbitrage funds anytime and not worry where the markets are headed. Since these funds invest predominantly in  equities, they are treated like equity-oriented mutual funds and have an identical tax treatment.

Arbitrage funds may be classified as equity or non-equity funds for the purpose of taxation. For instance, if the fund house maintains an average equity component of over 65%, the arbitrage fund will be counted as an equity fund and be entitled to taxation benefits like equity schemes.

Here the short-term gains will be clubbed with the income and taxed at normal rates, while the long-term gains will be taxed at 10% without indexation and 20% with indexation. Investors should note that by definition such schemes will always yield limited returns and not fully  invest their entire corpus in such mutual fund schemes.