Contrary to popular belief, contrarian funds don't bet against the stock market. They bet against mainstream trends and look for undervalued areas with strong potential.
"It's hard to generalize them because by definition, contrarian funds don't act like other contrarian funds," said Russel Kinnel, director of mutual fund research for Morningstar.
A successful contrarian mutual fund manager will avoid areas that are becoming overheated, and they usually prefer long-term investments to short-term fads, Kinnel said.
Sometimes this pays off.
For example, a contrarian fund invested in healthy, non-tech stocks in 2000 while the rest of the market was tech heavy would have profited when the dot-com market's bubble popped and panicked investors sought alternatives. But it also would have missed out on huge profits during the climb to the peak.
"The general concept of contrarian funds is to focus on sectors that are out of favor and to go against what the market is doing," said Bruce Harrington, managing director of Cogent Research. "People like them as a small percentage of their portfolio because of the higher risk. It's part of the I'm going to do something different than everybody else' mentality."
"Contrarian funds do different things during rising markets - when there are all sorts of hidden risks - so they can survive a downturn," Kinnel said. "There are so many different contrarian strategies. The challenge is to find an area that is temporarily beaten down and not beaten down for a good reason."
FPA Capital's Playbook
Robert Rodriguez, CEO of First Pacific Capital and portfolio manager for FPA Capital and FPA New Income, is regarded as one of the top contrarian fund managers, Kinnel said.
Rodriguez is a bargain hunter who looks for beaten-down stocks that have the potential to turn around. He favors stocks that are trading below their five-year average prices or at 12-month lows and considers price/earning ratios.
FPA Capital's top holdings include off-shore drilling company Ensco International, electronics distributor Avnet and contract driller Rowan Companies, none of which are doing spectacularly well right now, but all of which have great potential in Rodriguez's eyes.
It's difficult to post a profit when the whole market is suffering a downturn, and sometimes success is measured by minimizing loss.
When Rodriguez is considering a stock, he asks himself if he's being compensated for perceived risks, and if he isn't, he looks elsewhere, including cash and money market securities. He said he is skeptical of long-running consensus trends.
FPA Capital currently has 34% invested in cash or cash equivalents, which is not unusual for the fund, according to the fund's website.
FPA Capital's turnover averages 20% a year or less, compared to more than 100% for a typical domestic stock fund. He has been named the Morningstar Manager of the Year twice, once in 1994 and again in 2001.
Another star fund manager known for his contrarian standings is Bill Miller, manager of Legg Mason Value Trust. For 15 years, Miller's value-oriented fund outperformed the Standard & Poor's 500 index, but his luck has run out recently. Value Trust trailed the S&P by 10 percentage points in 2006 and by 12 last year.
Miller is famous for taking chances like buying high-multiple stocks such as Amazon, eBay, Google and other Internet stocks, but his exposure to mortgage lender Countrywide Financial has recently hurt the fund and scared away investors.
When Countrywide's stock began to fall late last year, Miller doubled down, hoping to get Countrywide at a bargain before the price shot back up. The stock continued to drop, from $40 a share to $4 a share.
Nobody can predict what the market will do, however, and if Miller's choices start gaining instead of losing, his Value Trust fund will be back on top.
Stock markets often experience extreme booms and busts that aren't always justified by the underlying economic situation, and experts say these market swings are often magnified by the erratic and irrational behavior of traders and amateur investors.
Berkshire Hathaway's Warren Buffett is famous for saying, "Be fearful when others are greedy and greedy when others are fearful," meaning seasoned investors should look at a down market as an opportunity to buy low and should sell high during booming times.
The record-setting performance of crude oil is a prime example. Many contrarian funds, such as Rodriguez's FPA Capital, are betting that oil has peaked and that prices will drop. The Organization of the Petroleum Exporting Countries (OPEC) says the world's supply of oil is right where it should be, and has resisted calls to increase the supply.
As long as oil continues to climb in price, a contrarian who bets against oil will suffer and miss out on profits, but if the commodity is indeed overvalued and the price falls, the hedge will have paid off over the long run.
Even if an investor is weary of taking big risks, contrarian funds offer another way to further diversify a well-balanced portfolio.
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