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> So when these 10 people decides to sell stock of some company, that stock will fall by some minor amount but immediately all index funds would need to react to this minor drop and sell their holdings.

That's not how it would work.

1) When one of the 10 sells they must be selling to another of the 10 who is buying. There's no such thing as just selling. Instead the way that the price would drop would be that the 10 start trading that stock between themselves at a lower price than it had been before.

2) If the price dropped then that wouldn't mean that the index fund had to sell. The index fund aims to own a fixed proportion of each company. If they own $98 million of a $100 million company and then the share price drops in half then they now own $49 million of a $50 million company. There's no need for them to do anything.

1) few parties can collude to sell or buy at the price they desire.

2) Index fund must balance their portfolio. If stock A goes down and B goes up then they must sell off A and buy more of B to re-balance. At least that has been my understanding.

Above two in combination means that you can cause chain reaction which is to be expected because much larger dollars is simply trying to imitate much smaller dollars. So later gets to control the former.

Index fund must balance their portfolio.

They must balance to the underlying index, not so that they hold the same value of each stock. If A goes down and B goes up they don't have to do anything unless the change is so dramatic that it causes the people who compile the index to update which stocks are in the index.

What can happen is that a stock being added/removed from a major index can cause a large amount of buying/selling by index funds as they are 'forced' to add or remove that stock in their portfolio. However that is a fairly rare occurrence.

Let's try an example. Suppose company A has 1000000 shares in total, each with market value of $100. Then its market cap is $100 million. Suppose company B has 2000000 shares total, each with market value of $150. Then its market cap is $300 million.

Index funds own shares in proportion to the market cap. So an index fund will own shares of B worth three times as much as their shares in A. Lets say we're looking at a fund that owns $6 million of B and $2 million of A.

Now suppose A's share price doubles to $200 and B's share price falls to $125. Then the value of the index funds shares will now be $2 million × ($200/$100) = $4 million of A, and $6 million × ($125/$150) = $5 million of B. Meanwhile A's market cap has changed to 1000000 × $200 = $200 million, and B's market cap has changed to 2000000 × $125 = $250 million.

Then B's market cap is 1.25 of A's market cap, so the index fund wants to be holding shares in B worth 1.25 the value of its shares in A. It currently has $4 million of A, so it wants to be holding 1.25 × $4 million = $5 million of B, which in fact is the amount that it is already holding.

I imagine the worry that "everything will be an index fund" a bit like discussing a Savannah ecology and worrying that "everything will evolve into grazing herbivores."

Seems a little hyperbolic.

As active investors are basing their decisions on p/e ratios and EBITDA then algorithmic choices can substitute for the lack of human traders.

In fact, traders are the ones who should be worried about AI, not taxi drivers. We're going to need a lot less traders and more data scientists.

Clearly there are equilibrium effects here which would stop the extreme scenario you describe from arising.

As the proportion of active investors in the market falls, those that remain enjoy a greater advantage. There will therefore always be some minimum threshold of actively managed assets (due to the marginal returns from active management eventually exceeding the marginal fees).

It's an open question as to what this threshold might be, but it will certainly be orders of magnitude above what you describe.

Where would those returns for active investors come from? They're still playing a zero-sum game amongst themselves.

Seems like it's more complicated than that? Index funds do buy and sell sometimes, as some investors move money into and out of index funds. There are also dividends and stock buybacks.

I see, indeed IIUC index funds can stagnate and do not provide movement (up or down) on the market. So they are basically neutral when it comes to influencing trends. On the other hand, if the lack of active actors on the market means that the market is only going down, it would be inconsistent.