Is a contrarian fund necessary?

DEBATE

Cholamandalam AMC Ltd

The consummate investor is one who has the ability to anticipate the market and not react to it. And therein lies the biggest pitfall of the "contrarian fund" proposed by the capital market regulator. It's likely that such a fund will react to the market rather than anticipate it.

The capital market regulator has sought advice from the government on the creation of a contrarian fund to counter the rising inflow of foreign institutional investor (FII) funds. The proposal, it appears, stems from the perceived risk to the equity markets, if the FIIs exit the market. There is little doubt that the Indian markets lack depth.

Moreover, the market lacks players who can take a long-term view, like pension funds, hedge funds and so on. Speculators, retail investors and domestic institutions are often momentum players rather than long-term investors. However, the setting up of a contrarian fund can hardly be the solution to provide a natural hedge to the market.

Besides the fact that such a fund will take time to set up, the concept needs to be examined in greater detail at an intuitive level. A contrarian investor is not one who is in disagreement with the majority. He is an investor who is interested in the extremes in the market.

A contrarian's point of view is, to a great extent, an entry and exit technique. Once the contrarian fund has taken a position it obviously wants the market to come around to its point of view. It cannot be forgotten that only the majority can push up the market and allow the contrarian to make money on his investments!

Contrarians operate on the inherent premise that there is substantial irrationality in the assumptions that the majority of investors use to form their investment opinions. They work on the understanding that the majority of the players would put too much emphasis on short-term market events rather than adopt a long-term strategy.

These assumptions of irrationality and short-term outlook would work in big markets with a large number of players. The opinion of the "crowd" that the contrarian wants to play against, are those of speculators, individual margin traders, retail investors, hedge funds and so on.

Unfortunately, the Indian market is bereft of such investors. At times, one would tend to believe that many FIIs are themselves contrarian investors as they have entered when few domestic players dared to enter. A contrarian fund would actually provide an opportunity to the FIIs to exit when the markets enter a phase of extreme exuberance.

It is important to realise that the essence of contrarian investing is to buy when other investors are not buying and not buying when other investors are selling. It is unrealistic to believe that the majority of investors would sell only on "bad news" or when everyone predicts the coming of doomsday.

The danger then would be that such a contrarian fund would do nothing but provide an exit route to the FIIs while possibly continuing to fuel the speculative mania in the market.

A contrarian fund that is centred on protecting the markets from any big fall on account of the exit of FII money from the market flies in the face of the concept that every fund needs a well-rounded, well-reasoned long-term strategy. An added pitfall would be that such a fund would not be able to cut losses, as it would be constantly averaging down in a bear market.

Finally, contrarians need to be born sceptics. Not optimists. Not pessimists. But sceptics. Therefore, a contrarian fund would need to be driven by a strong independent streak. This would mean that the contrarian fund might, at times, have to take seemingly contrapositive, incongruous positions.

Such a fund, therefore, cannot, by its very nature, be an offshoot of the government, as it is the government's policy that, to a great extent, determines trends in the equity market.

The best alternative would be to put in place incentives for long-term players to invest in the equity markets. If the big banks, mutual funds and pension funds are able to deploy larger funds in the equity markets, it would act as a natural balance in the markets.

Strengthening of these institutions as well as policy measures aimed at making equity investment through these vehicles more attractive to individual investors, could by far be a better alternative.

(The views expressed here are personal and may not be endorsed by the writer's organisation)

S K Mitra
Director, Financial Services,
Aditya Birla Group

It is reported that the Securities and Exchange Board of India (Sebi) has sought the government's advice on the creation of a contrarian fund to counter the rising inflow of FII funds.

The FIIs surprised the domestic market players when they took an early lead with their faith in the neglected old-economy stocks. Most of the major old-economy companies in the past few years have gotten their acts together and strengthened management and corporate governance: the FIIs were quick to appreciate the good work. However, during the first part of the current financial year, the net investment by mutual funds, including the Unit Trust of India, was nominal.

This was substantially due to the continuous redemption pressure from weak investors in equity funds in a gradually improving but volatile equity market. The Life Insurance Corporation of India, with a relatively huge investment portfolio of over Rs 29,000 crore, regularly bought shares during the preceding two years in the depressed state of the market, but turned a seller as prices shot up.

On the other hand, during the current financial year, up to November 2003, the FIIs invested nearly Rs 29,000 crore in equity, which is almost 50 per cent of the total FII inflow between 1992-93 and 2002-03.

Even in December "" the traditionally slow holiday season "" they have remained hyperactive. Further, investments by promoter groups and management through creeping acquisitions and share buy-backs has been substantial, while retail investors have just started entering the market through both primary and secondary markets.

Management or promoters do behave like typical contrarians, when they find their company shares are sharply undervalued. Thus, we see built-in contrarian behaviour among various players in the market.

There have been concerns that under the FII umbrella there has been substantial non-institutional investments by way of pro-notes. Investment by hedge funds has also been increasing.

The concern also arises due to the herd mentality in the market. FIIs as a group stayed out of the equity market for a long time. FIIs of all varieties are now increasing exposure on India. The concern is that at some stage the bullish sentiment may turn negative. This can arise due to easy opportunities elsewhere, profit booking and political or economic issues "" external or internal.

In the foreign exchange market, most central banks take positions from time to time as contrarians. In such cases, the country's reserves are used to fund such contrarian operations. The forex market does provide a reasonable idea on roles, responsibilities, cost and effectiveness of such operations. Should the regulators adopt a similar role in the equity market as well?

It should be appreciated that the true meaning of a contrarian fund is not always to buy against the tide. The contrarian is one who thinks and acts differently. To be successful, a contrarian fund must have a strong research team comprising economists who can identify prospective sectors, both on the upside and down, and analysts who have the mind of a venture capitalist with an eye for the potential.

For any market to operate efficiently, there is always need for contrarians. There would never be a trade otherwise. For every buyer, there is a seller to complete a trade.

Extraordinary situations, however, may need extraordinary measures. The Hong Kong government had bought shares worth several billion dollars during the last meltdown. There was criticism against such a role and the contrarian buying did not stop the market slide.

However, the patience paid off and the government did exit later at a good profit, which at that stage helped in cooling down a booming market.

The need for contrarians is, thus, well appreciated. The first option should be to strengthen natural contrarians in the market so as to provide balance. The second should be to proactively deal with potential negative sentiments that may result in large-scale exit by FIIs.

However, a contrarian fund promoted or supported by the government or the regulator will have to be dealt with great caution. First, as mentioned earlier, the team will have to be savvy, experienced and reliable.

Second, both the fund size and contributors to the fund should be considered sensitive information. The fund may be treated as a safety net by speculators. In conclusion, the concept of contrarian funds is well-accepted, but the structure of the funds will need greater consideration.

(The views are personal)