50% returns in select funds: skill or market cycle

The stock market is a very exciting place. When a few equity funds achieve 50% or higher returns in one year, the industry rejoices. However, before running to top-performing funds, the real question is whether the fund manager beat the market or if everyone rode the tide up.

The headline numbers and what drove them

It has been an extraordinary performance in India's equity markets in the fiscal year 2023-24, with the small-cap and midcap indices outperforming. Some of the theme-based equity schemes, including manufacturing, defence, infrastructure and PSU funds, have managed to generate in excess of 50% returns, while a few even crossed the 70-80% mark during this period. Both the Nifty Smallcap 250 index and the BSE Midcap index rose by 50-60% in the said period, which formed the base for such strong returns.

Macro environment too was very conducive with high government capital expenditure beyond ₹10 lakh crore, earnings recovery from the COVID pandemic, healthy flow of FII investment in mid-2023, along with retail SIP contributions acting as a constant support base.

The case for skill: what active managers actually did right

All outperformance isn’t created equal, and to write off fund managers entirely would be an intellectual cop-out. Several well-made bets distinguished the top-performing funds. Early exposure to capital goods and defence PSUs prior to becoming consensus picks was evidence of good sectoral foresight. Funds like Quant, Nippon, and HDFC, which favoured domestic cyclical stocks against export-oriented IT stocks, took several conviction bets that served them well.

Portfolio construction was another key differentiator. Top-decile funds maintained concentrated portfolios of 25-35 stocks compared to the industry average of over 50 stocks. Such portfolio construction results in higher gains when correct, requiring conviction in one’s investment thesis. Sectoral stock picking, such as selecting BHEL over its smaller rival or spotting Mazagon Dock’s booking trends, differentiated some managers from benchmark huggers.

Tactical cash management was also notable. During the foreign institutional investor (FII) selling in October 2023, top-performing funds bought heavily, whereas other funds sold.

The case for the cycle: when the market does the heavy lifting

Quantitative evidence is sobering. When you regress top-performing fund returns against their respective category indices, the R² values are frequently above 0.85 — meaning market beta explains 85% or more of the variance in returns. The fund manager, on this reading, was essentially leveraging a category tailwind and adding marginal value on top.

The structural argument is even starker: in a bull market, almost any fully-invested equity fund will produce strong absolute returns. The key test is whether the same managers outperform on a risk-adjusted basis over full market cycles — including the inevitable drawdown. Historical data from SEBI's mutual fund performance records shows that fewer than 20% of large-cap active funds consistently beat their benchmarks over rolling 10-year periods. In small and midcap categories, the number improves modestly, but persistence of alpha remains elusive.

Survivorship bias further distorts the picture. The fund that posted 60% last year is celebrated; the category peer that blew up or was quietly merged is forgotten. When you include the full distribution of outcomes, the average manager's alpha diminishes significantly.

How to think about sustainability

Ultimately, the sustainability question boils down to three key questions that investors must ask about the portfolio of a recent winner. Firstly, is the portfolio strategy scalable to higher levels of AUM? Small funds have managed to achieve great returns with sub-Rs. 500 crore AUM. However, after gaining popularity, the level of their AUM expanded 5-10 times. Thus, making the same nimble small-cap bets became structurally difficult for them since they would need to move the markets against themselves.

Secondly, does the thesis still stand? Defence order books, capex cycle, and infrastructure budgets are multi-year stories. However, current valuations reflect considerable optimism regarding these factors. While the same fund that earned 50% last year needs a timeframe of 3-5 years to earn even 15%, the only reason is that the starting point is no longer the same.

Thirdly, and most importantly, can the manager repeat his success? The manager who was “right for the right reasons” – who identified the earnings inflexion, knew about the policy catalyst, and was appropriately positioned – is bound to create greater value in the subsequent cycles than an overweighted sector manager.

What history says about chasing top performers

As per the findings of international and national fund research, there seems to be an agreement regarding how performance chasing hurts returns. In a SEBI analysis in 2022 on returns of Indian mutual fund investors, it was found that real returns for investors (accounting for timing and flow of cash into and out of the investment) fell behind the reported NAV return by an average of 2-4 percentage points yearly due to their behaviour of flocking in during good times and exiting during corrections.

The proverb remains true: Driving through the rearview mirror. The fund, which would be the best performer in FY24, had been established in FY22-FY23 when its idea was out of fashion and its valuation was not too much.

Conclusion

The impressive 50% returns from certain equity funds during the recent bull market were neither sheer luck nor genius; it was a multi-layered phenomenon. The structural backdrop came from the market cycle itself; the added value was the alpha generated by savvy managers through sector timing, concentration, and sound execution. This is true at both ends of the spectrum.

As an investor, what does it mean? These returns are neither beta nor sheer luck. It would be naive to overlook the fact that certain managers did earn their fees in the year. But it would be equally foolish to extrapolate from this single year's performance without taking a holistic view of the portfolio's valuation, scalability of its strategy, and its manager's track record throughout the market cycle.

Market cycles offer unique opportunities to distinguish skill from luck. In most cases, a fund manager who earns 14% per annum over the course of a decade will add more net value to his investors than one who earns 50% in one year and 8% each for the next nine years. Ultimately, the numbers will speak.

Invest in a manager's process, not returns. The latter will follow suit.