That's great but now you have to determine if the actual number of active participants is getting smaller. We can determine that more folks are passively investing but that does not necessarily mean that the number of active investors is getting smaller. If your claim that having more knowledgeable participants in the market makes for better pricing and having fewer makes for less accurate pricing you'll need to determine if there are less knowledgeable participants not that there are more passive. The pool of people investing in the market isn't some static number that can only be cut one way or another.
No what I said is that there probably will still be a large number of active participants, but they will control less money and hence have less of ability to affect markets price. Index fund will still trade among themselves. Joe may have keen insights on automotive industry which allows him to make good money but if only starts with $100,000 he isn't going to have much influence on the market compared to Fidelity total market fund and Vanguard Total Market fund trading GM, or TSLA . Joe decides he wants to get into in the money management business today he can compete for the 67% of money but if 75% of the money is indexed he is going to competing for the remaining 25%.
What you just said is a nuanced way to say what I said. Entities sold investments that were labeled as safe and they weren't. I don't really want to get into the 2008 financial crisis because it's irrelevant, since the only reason you've brought it up to begin with was to use it as a comparison to what would happen if more and more people use index funds and there was nothing linking the two. It was used a scare tactic common in rhetoric, a sort of ghosts of the past as there is no connection between index funds and the 2008 financial crisis.
But you're not answering my question. How do the mechanics of index funds generate this tipping point? How does the tipping point work? What exactly happens if more and more people use index funds? And answering bubble and walking away is not an answer but a guess.
No you are missing the point entities were trading mortgage back securities that were badly mispriced. When evidence of this overvaluation become more obvious to more participant prices quickly crashed, and caused a huge amount of collateral damage. The root cause was because not enough people were evaluating the individual mortgage inside the securities. The reason there weren't enough people doing this is because people trusted the rating agency that AAA mortgage backed security would behave just like any other AAA rated security.
VTI today closed at $97.64 why is it worth that price? Do you think it is because the last folks who traded VTI, carefully got out their spreadsheet plugged in all the price of 3692 securities that it holds, multiply the price by the number of shares, and divided by the total number of shares outstanding or do you think it was simple a bid and ask transaction?
We are dependent on traders armed with computers to calculate on any given second keep the price of VTI vs all of appropriately weighted component aligned to within tenths of a percent.
We are also dependent on small smart guys pouring over VTI 10K listing, and double checking that Vanguard algorithm for market weighting the index, calculating NAV etc. are all correct. It is better to have more of these folks looking than not and money acts as a big incentive.
I never said the index fund mechanics were going cause the problems. (It is possible that there might be bug in Vanguard computer program that says overstates the NAV and that would be a bigger issue if VTSMX was trillion dollar fund instead of a 330 billion but that is just a size thing). My concern is the ratio of active investors to passive investor, I think I showed at the extreme if there are only a few active investor and they are delusional (Tesla, Netflix) that would be a bad thing. All bubbles are different, so it is pretty pointless for me to make prediction. But during a crash, it is clear that the indiscriminate selling by index funds will make the situation worse. Most years ~75% index funds out perform active managers, but during 2008 active managers outperformed the index fund, in no small part because index funds were forced to sell everything (even companies little effected by the financial crisis) to handle redemption.
TL:DR More smart active participants in a market are good thing, because it leads to more accurate pricing. As the ratio of smart money to dumb money decreases it increase the chance of a bubble. This isn't something we need to worry about for quite sometime and possibly never.