Doesn't it seem self-limiting? At some point, if prices become totally irrational, wouldn't active investors profit by taking advantage of predictable index fund transactions?
This is an under-appreciated point... if 99 people leave money on the table, and the 100th person picks it up, we're back to efficiency in the aggregate.
Yeah, it's a bit like saying: "But what if all the animals in the ecosystem became helpless herbivores?"
What your saying sounds like the Grossman-Stiglitz paradox.