> Although indexing is predicated on efficient markets, the higher the percentage of all investors who index, the more inefficient the markets become as fewer and fewer investors would be performing research and fundamental analysis of equities.
Burton Malkiel (of "Random Walk Down Wall Street" fame) responds [1]:
FORTUNE: What if everyone owned index funds? What would happen to returns then?
MALKIEL: There's a paradox about this. It's actually the professionals' reacting immediately to news that makes the stock market efficient. So it's theoretically possible that if 99% of the market were indexed, indexing would stop working. There'd be no one left to make the market efficient. But only about 10% of money is indexed now. I'd say we could have half of the money in the market indexed, and there would still be plenty of people to make it efficient.
Stock markets are all about aggregating information about the state of the economy to discover its 'true' state at the current time. A trader makes money, on average, when they have knowledge that the market doesn't about a stock's valuation. By trading based on that information, they introduce it into the market, marginally changing the share price towards a value that incorporates their information.
When a trader's prediction is proven correct (assuming it is), they pocket an amount of money proportional to how incorrect the market was when they made their trade and how much of a risk they took (i.e, how much money they traded), thus being rewarded for the value of the new information.
Thus, the market is not efficient, but it asymptotically approaches perfect efficiency as the volume of trades increases. It's never 100% efficient but indexers assume it's close enough and that incentive of discovering the remaining inefficiencies is not worth the cost and risk. These days, that should be the case for most, if not all, individual traders.
If I understand things correctly, an index fund will end up reducing the efficiency of the market. But this is not necessarily a bad thing: it means that, as the portion of invested money that's in indexed funds increases, the value of new information that a non-index trader introduces to the market increases.
This creates a greater incentive for someone to discover and trade based on new information. The tension there will create an equilibrium point at some point below 100% indexed, meaning that the markets will never switch entirely to indexing.
>"A trader makes money, on average, when they have knowledge that the market doesn't about a stock's valuation"
That may be true for an investor, but it is completely false when speaking of a trader. A trader need not know the underlying stock to make a profit consistently. The uninformed continue to think trading and investing are the same. They are nothing alike.
The truth is we don't know at what point index funds will disturb the efficiency of the market. Malkiel makes a guess at 50% although I think he has an overtly optimistic view of how much rational professionals drive the market.
Regardless, let's suppose the mantra is "invest all your money in index funds until it breaks 50% after which bad things may happen". Do you think that if we manage to hit that 50% in the future, anyone will actually actively try to stop people from investing in index funds? Effectively there would be a lot of money very rich index fund managers who will be pushing to increase their fund sizes even further.
So it's possible for extreme irrational exuberance to cause even index funds to harm the market.
Burton Malkiel (of "Random Walk Down Wall Street" fame) responds [1]:
FORTUNE: What if everyone owned index funds? What would happen to returns then?
MALKIEL: There's a paradox about this. It's actually the professionals' reacting immediately to news that makes the stock market efficient. So it's theoretically possible that if 99% of the market were indexed, indexing would stop working. There'd be no one left to make the market efficient. But only about 10% of money is indexed now. I'd say we could have half of the money in the market indexed, and there would still be plenty of people to make it efficient.
[1] http://money.cnn.com/magazines/fortune/fortune_archive/1999/...