That diversification is a bit of a smoke-screen though. The most popular index funds are cap-weighted. This causes the allocation of capital within the fund to become increasingly dominated by those few winner-take-all companies.

When index funds grow to huge levels of assets under management, their own asset allocations come to make up a significant portion of the market cap of the stocks in the portfolio. Thus the cap-weighted investment strategy becomes a self-fulfilling prophecy.

> Thus the cap-weighted investment strategy becomes a self-fulfilling prophecy.

Either you’re doing the math wrong or you’ve skipped some steps.

Let’s say you have companies X and Y, each with 50% of the market. X is a winner, and the stock price goes from $10 to $45. Y is a loser, and the stock price drops from $10 to $5. The new weight is X=90% and Y=10%.

But this cannot be a self-fulfilling prophecy for index funds, because the index funds do not have to buy or sell any shares of X or Y to keep up (I mean rebalance, specifically). In this scenario, the index funds are just holding. (By “holding” I mean “not rebalancing”.)

This is… an oversimplified scenario. But it illustrates the problem here with the “index funds cause a small number of stocks to be winners” theory. There are alternative theories that make sense, but not this one.

(What makes the scenario more complicated is when you think of buybacks, dividends, delisting, etc.)

Don't index funds trail market changes though? I thought their allocations are reactive. In other words, the Mag 7 are being bid up by people trying to beat the market. I don't see how index funds could move prices.

I do understand how they can stabilize allocations where they are, which I think is the concern. Zombification rather than a positive feedback loop.