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The authors argue that the popularity of active management is not puzzling despite the industry's poor track record. The model features decreasing returns to scale: as the industries size increases, every manager's ability to outperform passive benchmarks declines. They find that the active management industry can remain large even after significantly negative underperformance. Given the observed performance of active mutual funds, investors' proportional allocation to active management should have shrunk only modestly since 1962. They also find investors face endogeneity that limits their learning about returns to scale and allows prolonged departures of the industry's size from its optimal level.
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