The flaw in this argument is that one can be well diversified by investing passively in capital-weighted indexes.

By their nature, capital-weighted indexes can become concentrated in a handful of industries pretty easily. In 2000, for example, TMT stocks--technology, media and telecom--the champions of the dot com era, grew to over 40% of the theoretically diversified S&P 500 index. When TMT stocks infamously imploded, they took the index down with them. Peak-to-trough losses for that index were almost 51% (excluding dividends). The results for the NASDAQ were worse.

The problem exists because the most popular positions, the ones for which no price is too high, become the largest by market capitalization as the underlying shares rise in price. So, yes, equity indexes are difficult for an active manager to beat when markets rise. But, they can be hugely disappointing in declining markets when one needs the benefits of diversification the most.