KRF: We analyze a general version of this question in "Disagreement, Tastes, and Asset Pricing" (Journal of Financial Economics, 2007). Suppose index fund investors hold a passive market portfolio. Then from a pricing perspective they are sitting on the sideline. They are not overweighting or underweighting any securities, so they do not affect (relative) prices. As a result, it is hard to argue that they contribute to mispricing.
Would prices be more accurate if investors did not buy index funds? It depends on what they would do instead. Suppose for example, that all index fund investors abandon their market portfolios and randomly overweight some stocks and underweight others in the mistaken belief that they can identify and exploit pricing errors. Barring a remarkable coincidence in which their collective portfolio offsets the over- and underweighted positions held by the combination of all other uninformed investors, the former index investors make prices less accurate when they switch to active portfolios.
The answer might be different if the former index fund investors decide to spend lots of time and money trying to identify undervalued and overvalued securities. If their efforts are not totally futile, their attempts to beat the market will improve prices. This does not imply, however, that the switch from passive to active was a good investment decision. Because of the higher fees and expenses of active investing, most of the formerly passive investors would have been better off with their index portfolios.
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