This paper presents a rational model of active portfolio management that explains the observed relationship between mutual fund flows and performance. The model shows that active managers do not outperform passive benchmarks due to competitive capital markets and decreasing returns to scale in active management. This implies that past performance cannot predict future returns or infer the average skill of active managers. The lack of persistence in performance does not mean that differential ability is nonexistent or unrewarded, that information gathering is socially wasteful, or that chasing performance is pointless. Instead, the strong relationship between past performance and fund flows is the mechanism that ensures no predictability in performance. Calibrating the model to fund flows and survivorship rates, we find that 80% of active managers have enough skill to cover their fees. The model also shows that fund flows are driven by past performance, and that the lack of persistence in performance is due to the competitive nature of the market. The model is consistent with the existence of skilled managers and the observed behaviors in the mutual fund industry.This paper presents a rational model of active portfolio management that explains the observed relationship between mutual fund flows and performance. The model shows that active managers do not outperform passive benchmarks due to competitive capital markets and decreasing returns to scale in active management. This implies that past performance cannot predict future returns or infer the average skill of active managers. The lack of persistence in performance does not mean that differential ability is nonexistent or unrewarded, that information gathering is socially wasteful, or that chasing performance is pointless. Instead, the strong relationship between past performance and fund flows is the mechanism that ensures no predictability in performance. Calibrating the model to fund flows and survivorship rates, we find that 80% of active managers have enough skill to cover their fees. The model also shows that fund flows are driven by past performance, and that the lack of persistence in performance is due to the competitive nature of the market. The model is consistent with the existence of skilled managers and the observed behaviors in the mutual fund industry.