In a rational market for investment management, active investment should outperform passive investment.
Still, much evidence suggests index funds have outperformed actively managed ones after fees and expenses. Any such outperformance is peculiar.
In a rational market for investment management, securities prices should be inaccurate enough to compensate clients who invest actively for:
(1) management costs and fees;
(2) the costs of selecting managers;
(3) the difficulty in identifying superior managers, including adjusting for risk and separating skill from luck; and
(4) the possibility of underperforming (or outperforming) the index.
With too many active managers, passive would outperform active. With too few active managers, active would outperform passive by too much. Equilibrium would involve just the right combination of active and passive and the correct outperformance by active.
If active managers differ in skill, the marginal active manager should outperform the index just enough to compensate for the four factors mentioned earlier: costs, fees, difficulty of identifying skill and the risk of underperforming (or outperforming) the index. Cleverer managers would do better (unless they increased fees to capture completely the results of their superior talent). Less able managers should tend to disappear eventually.
People would continue to invest in index funds, but would incur a penalty for doing so. Otherwise, too many would invest passively.