The Negative Externalities of Index Funds

Steve Waldman doesn't like it when I defend passive investing. If everybody moved to a passive-investment style, he asks, then where would we be? We need active investors to make efficient markets and set prices. Passive investors, he says quite rightly, are free-riders:

Passive investors pay none of the costs of generating good investment decisions, but enjoy the benefits by free-riding on the work of others...
Advising people to buy index funds rather than select investments is akin to advising people not to vote, since the cost of voting far exceeds any individual benefit. Those who don't vote get the same government everyone else does, but at lower cost!

Steve goes even further in the comments:

It's a lot like greenhouse gasses, really. Tallying the aggregate "costs" of active investing is like enumerating the costs of reducing CO2 emissions without figuring in any kind of benefit. Advising people to go passive is like telling people to ignore their carbon footprint, because by doing so you'll come out ahead of those who conserve (you'll live in the same world, but bear fewer costs).
Scolding people not to go passive may be a fool's errand, so long as the individual cost/benefit looks good. But broad encouragement of behavior that has clear (if hard to quantify) external costs as though it were a virtue, because, hey, it won't cost you anything, strikes me as a bad idea.

Except the amount of active investing has been going up even as the amount of passive investing has been going up. When John Bogle started the Vanguard Group, the amount of active investing was a fraction of what it is today. And in most cases it makes perfect sense for small retail investors to go the passive route anyway, just because those investors don't have the kind of risk appetite needed to be an active investor.

My feeling is that we're a very, very long way from the point at which passive investments carry significant negative externalities. Already we've reached the point at which active investors front-run index changes and do all manner of year-end index arbitrage, seeking to profit from passive investors' passivity. All power to them, I say. Passive investors will always underperform the market as a whole by a little bit: they have to pay some management fees, after all. So the market as a whole actually outperforms passive investors. As long as that money's on the table, I'm not going to lose any sleep about free-riding on hedge funds doing price discovery.