One way mutual fund managers achieve a four to five-star Morningstar rating is by taking advantage of the Law of Large Numbers. A manager who actively or passively manages a large number of mutual funds has a very high chance of obtaining one or more funds that outperform the stock market across the two-, three-, or five-year period that is used to determine a mutual fund’s rating. If you only have one mutual fund, then the chance that that fund will outperform the market for five years in a row is very small. However, if you have 100 mutual funds, the chance that at least one will outperform the market is higher. All a mutual fund manager needs to do is create enough funds to increase the statistical likelihood that at least one will beat the market for five straight years, and then aggressively publicize that fund’s performance. By dissolving the unsuccessful funds and pointing to the successful fund(s), a fund manager can profit handsomely from pretending to know what the future holds.
