[mruts]

This is not exactly true. Many (most?) indices are market cap weighted, so if a company’s stock is tanking (i.e, their market cap proportional to other tickers in the index is going down), the index will sell the shares.

In my view, index funds aren’t really passive at all, they are crowdsourcing the best ideas of active management. This is why many indices (like S&P 500) produce pretty good returns.

If you created an index held every US equity in equal proportions, regardless of price movement, that would be like what you’re talking.

If you compared the returns of the S&P 500 against this theoretical index (let’s make it an ETF and call it “DUMB”), you would find that the S&P 500 would have much better returns.

The takeaway from this is that many indices produce stellar returns and aren’t as “passive” as one might think. Think of factor indices or whatever.

[nostrademons]

The point is that the stock won't always tank when they're doing something that'll negatively affect fundamentals, because too few people are actively researching & investing in the stock to affect the price. And then when a tipping point is reached and the stock price starts to go down, index funds will exacerbate the slide as they rebalance out of the falling stock and sell off its shares.

Normally markets remain efficient because they provide an incentive for people to actively research & surface all available information on a company's future prospects. If most people aren't doing this, then a.) the market price will be slower to react to bad information about the company and b.) people who do actively react will make larger profits, as they can trade on their information before the majority of the market takes it into account.

There's an equilibrium level of disequilibrium - as more people pursue passive investing, returns to active investors rise, until some of those passive investors realize they can make large profits as active investors, restore market efficiency, and destroy the profit potential of active investing. I'm not sure exactly where we are in that cycle, but there's some evidence that stock prices have become less volatile overall except for major news-related panics, which would be expected if a large proportion of people are passively investing.