The problem with that interpretation is the following:
Each active investor gets some return and contributes some movement to the market. If there are enough active investors, the aggregate move of the market matches the actual value movement of the stock in a company. Then, on the sidelines, over some time period the market's moves are copied by the index (a balancing of the index). If, however, there are too few active investors, the index funds will be causing feedback into the system by being the only source of liquidity in a stock. If active investors then attempt to capitalize on this "failure", they will be the movements of the market. Then the index funds will copy them in the next round of balancing. In the end, there is a level where the market is not something the active investors can get a good return in because all the momentum is in the index and nowhere else. If the active investors are all doing way better than the indexes, the indexes will just copy that and suddenly be doing as well... Right?
> If the active investors are all doing way better than the indexes, the indexes will just copy that and suddenly be doing as well.
Passive investors are copying the average of the active investors. Just as you would never have a situation where all active investors are outperforming passive investors, you would always expect there to be some active investors outperforming the average. The big question is the extent to which individual managers can keep it up over time (and as more AUM flows into their funds) and the magnitude of their out-performance.
And you're right - as active investors find new opportunities and make money out of them, they will improve the average and hence the performance of the passive investors.
You can add up the performance of all active funds and see how they are doing as a whole. My understanding is that at the moment, the sector as a whole is doing OK, but almost all of the returns are from the top performing funds, so an active fund chosen at random is likely to be destroying value. However, this could change as more mispricing opportunities arise in the market.
Each active investor gets some return and contributes some movement to the market. If there are enough active investors, the aggregate move of the market matches the actual value movement of the stock in a company. Then, on the sidelines, over some time period the market's moves are copied by the index (a balancing of the index). If, however, there are too few active investors, the index funds will be causing feedback into the system by being the only source of liquidity in a stock. If active investors then attempt to capitalize on this "failure", they will be the movements of the market. Then the index funds will copy them in the next round of balancing. In the end, there is a level where the market is not something the active investors can get a good return in because all the momentum is in the index and nowhere else. If the active investors are all doing way better than the indexes, the indexes will just copy that and suddenly be doing as well... Right?