Firstly, yes the majority of passive funds are based on market cap. The majority, but not all. There has been a steady increase in smart beta and other non-market cap strategies for the past 5 years. However, from a purist perspective, then yes market cap is the dominant feature.
Secondly, your comment about when the market turns somehow the index will become less relevant doesn't make sense. It's the very basis of following the index. It goes where the market goes, it follows sentiment. Perhaps true hedge funds, that actually utilise shorting, may benefit from a downturn. But, then again, the vast majority of active managers do nothing but mimic the index and aren't hedge funds at all.
Also, I note the active management slogan "of when things turn" is not based on anything remotely factual. There are studies now going back to before the 80's dispelling this myth. Not just dispelling, showing it to be complete BS. Their performance downturn has shown to be in sync with the broader index. So, based on current evidence they will not mythically defy the great market downturn. They fall, when everyone else falls.
Thirdly, the above comments would appear, on face value, that I support passive investment. On the contrary, I think it is the most insidious invention ever to hit the markets. Like you said, it does nothing to aid in the efficiency of the market or price discovery. It relies solely on active investors making rational decisions on valuations and keeping the index in line. Ultimately, more and more people will leave active managers, because they simply can't achieve alpha, and their fees are egregious to say the least.
As more investors abandon active managers the market will become less and less efficient. Valuations will become stretched (just as we are seeing) and ultimately it will fail. This is not me saying this. The man himself, Jack Bogle freely admitted of the carnage that would be caused by a market dominated by passive investment. Like you said, a market doesn't operate on someone investing based on existing market cap.
Can you just imagine if it did? Company X with the biggest market cap on the market just releases its financials. It has just seen its earnings wiped out. Do you think the passive fund cares about the fact the company is in dire straits. The only reason it will decrease it's holding is because active investors, who actually care about valuations and what something is worth, will sell off. If it wasn't for this, the passive fund would just keep buying at the same rate, as if nothing had changed. Like I said, passive investment is the blood sucking leech of investing.
Sadly, every investor who puts their hard earned into active investment, or actually making any rational decision on the health of a company, is paying for the luxury which passive investors basque in. That is, every active investor/manager is ultimately a slave to passive investment. It's not fair, but that's life.
For the majority of people, they don't want to know why investing in the index has made them so much money at such little cost. They just think the system operates without, for a second, realising that their gain is down to someone else's hard work. Sounds familiar, right?
Like everything in the investment world, it's great until it all comes tumbling down. And it will come tumbling down.
How many people do you think are going to keep paying over 1 per cent management fees, performance fees for a manager that can't beat the index.
Slowly, but surely, those that keep the system in check will disappear. Valuations will continue to expand as passive money freely flows into companies with stagnant earnings and of poor quality.
Question is, do you take the easy money, put it all into passive and laugh all the way to the bank?
Or, do you continue to support true price discovery, yet know in the back of your head you are paving the way for the prick earning more than you and paying .07 of a percent.
If life or investing was fair, every passive investor would be paying every active investor for the luxury... and saying thank you everyday.
Based on current outflows from active and inflows into passive, index trackers. I would say you wont have to wait long for the carnage.
