Should investors avoid all actively managed mutual funds? A study in Bayesian performance evaluation

This paper analyzes mutual-fund performance from an investor's perspective. We study the portfolio-choice problem for a mean-variance investor choosin g among a risk-free asset, index funds, and actively managed mutual funds. To solve this problem, we employ a Bayesian method of performance evaluatio n; a key innovation in our approach is the development of a flexible set of prior beliefs about managerial skill. We then apply our methodology to a s ample of 1,437 mutual funds. We find that some extremely skeptical prior be liefs nevertheless lead to economically significant allocations to active m anagers.