In active investing the investor aims to outperform an index. In passive investing the investor aims to match or track the performance of an index.
Now imagine if God was the only active investor in a theoretical market.
God is all knowing, so he knows all the future cash flows of all the investments available in the market. Since he is the only active investor and all other investors mimic him, all the investments in the market will be priced based on their discounted future cash flows. As such, all the investments will have exactly the same expected return.
There are two fundamental problems with this thought exercise:
- If God knows the future cash flows, then he’s not taking any risk. If God isn’t taking any risk, what discount factor should God use? The rate of inflation?
- If God is the only active investor, then who is he buying from? If God is the only investor that sets prices and all other investors are trying to mimic his returns, then all the other investors would want to buy when God buys and sell when God sells. Does this mean that no orders will be matched?