It's a self-correcting problem: as more investors place money in passive funds, fewer eyeballs look for opportunities where the consensus price is wrong. That means that there's less competition for these opportunities, which both increases your chances of finding them and increases the returns to finding them. Eventually, active investing becomes fashionable again, because the returns are real and measurably higher, and the cycle repeats.
It may be contributing to greater wealth inequality, though: if you look at basically anyone who has become fabulously wealthy in the last couple decades, it's because they saw a profit opportunity that others were unwilling or unable to exploit. The primary form of unwillingness is "It's too risky..."
The fear is that prices won't correct because passive investors are the market. Also, there may not be anyone to take the other side of a trade because passive investors don't trade very often.
That just creates the conditions that lead to Warren Buffett's rise: a conservative market that often wildly mispriced securities. And you can trade against it the same way Mr. Buffett did: identify underpriced securities and buy & hold them until the market realizes their value, or if the market never realizes it, just end up owning a large fraction of American business and reinvest the profits from it.
Usually, once it's become apparent that some people are getting fabulously wealthy by breaking away from the herd, jealousy and Dunning-Krueger take over and you get a large number of people that are suddenly true believers in active investing.
3. Businesses are affected by the markets their shares trade in. Earnings can be depressed by increased costs of capital, sentiment and anti-competitive pressures from shareholders who hold the entire market.
The first one isn't even a real argument. That is claiming new initiatives just won't happen - if you stop being passive for exploiting this new market, not everyone is passive anymore. And about disposing, well, this is where the profits come into.
The third is mildly concerning. If a few companies are swimming in money, they may disturb every market around. Historically this don't last for long, every time the market gets like this, there comes a crisis and destroys those big players. Worth keeping an eye to a "this time is different" event.
With high-frequency and algorithmic market-makers, there is no such thing as low liquidity. Bid-ask spreads are at all-time lows as algo market makers try to one-up each other to squeeze spreads and provide liquidity.
Passively investing people still buy and sell. It's just that the triggers are based on their personal finances (got a windfall / need to buy new car...) rather than how the market is doing.
The second won't happen because there will always be a demand for market making traders, and at this point the cost of automated trading technology is low enough that it's worth making a market even in small/emerging exchanges.
The first can't happen because you can't answer what is the correct price of a stock. :) That's a bit glib, but the only reason passive investors are said to not correct is because there are plenty of active investors to move the prices of stocks.
It's more like HFT which wipes him out. He can't possibly react on the timescales involved, and the market is unlikely to reflect actual business realities compared to the current disposition of several automated financial instruments internal state.
The value of the stock is divorced from the underlying value of the business. HFT algorithms trade across the breadth of the market - I.e. whether they buy or sell a particular stock is correlated not to expectations of a businesse's books but things like Twitter, news, estimates of other firms positions and the like.
So if you're actually trading rather then just collecting dividends (and even then), then whether a stock moves is based less and less on the actual position of the business.
Holding them is fine, but index funds are the exact same thing: they're an exercise in cheaply diversifying to the broadest possible scale, which is the only way the little guy beats the algorithmic traders.
HFT algorithms trade across the breadth of the market - I.e. whether they buy or sell a particular stock is correlated not to expectations of a businesse's books but things like Twitter, news, estimates of other firms positions and the like.
That's the Castle-in-the-Air theory of investing, and it's been popular for much longer than even digital computers, let along HFT (Keynes is said to invest based on it, and as described the logic in his Beauty Contest analogy). It's why many thousands of investors over a century have been poring over stock price and volume charts, looking to predict where the other investors will put their money and beating them to it.
There are certainly algorithms nowadays doing this, but they are certainly not limit to HFTs, and have been around for much longer.
Many of them do, actually. When I had actively-managed funds the graph of their performance usually looked exactly like the graph of their benchmark, except minus a few basis points for fees.
No argument. I shifted over to passive investing by the time I was about 3 years out of college. (I worked in financial software for the first 2 of those years, so holding actively managed funds gave me an added benefit of helping to understand what my industry looked like and how end-consumers experience all the complicated algorithm/decision products we were working on.)
It may be contributing to greater wealth inequality, though: if you look at basically anyone who has become fabulously wealthy in the last couple decades, it's because they saw a profit opportunity that others were unwilling or unable to exploit. The primary form of unwillingness is "It's too risky..."