The downside of everyone piling into index funds isn't something systemic that'll bring down the financial system the way the real estate bubble did. Rather, it's that the capital market as a whole becomes less efficient. All the money parked in index funds is money whose owners did no due-diligence about where they put it; it means that if reality changes and the value of the underlying businesses goes up or down, the index fund will be the last to profit from it, and we can expect price changes in the stock market to lag fundamental changes in the businesses by a greater time period.

The effect of this is basically that returns for active smart-money investors go up, as there's less competition amongst folks actively trying to discover new relevant business facts. We see this already - a lot of the wealth-creation in Silicon Valley is because folks who have an information advantage can invest in new private businesses before the general public is willing or able to invest in them, creating large private fortunes. But because the price mechanism lags the business reality in this case, you don't have crises where a large number of people suddenly find out that they are poorer than they expected, like the 2008 housing bust and 2001 dot-com crash. Rather, you end up with chronic societal inequality where a small number of people end up with fortunes that everyone else thinks are implausibly large.

The problem is that Wall Street fund managers who beat the market almost never do so consistently, i.e. there is insufficient evidence to reject the null hypothesis "all actively managed funds have a roughly equal (low) chance of beating the market" in favor of "this fund knows how to beat the market consistently and will probably do so next year."

So a rational personal investor, who does not have insider information, is best off not trying to beat the market. Even though the market as a whole may be best off with everyone trying to beat it.

Yeah, I know the rationale behind why index funds exist. The majority of my wealth is in them, after all.

The parent poster, however, is asking "What's the catch? Where's the trade-off to investing in index funds, and what sort of new systemic risks does widespread adoption of them bring to the financial system?" He's right to ask that: there is always a catch, because the financial system is about distributing & incentivizing the wealth of society and doesn't directly produce any wealth itself.

I'm saying that the catch is in diminishing returns from the index itself. A well-subscribed index fund, by definition, will always give you the median return of the market it tracks. I'm saying that the effect of large amounts of capital pouring into index funds is that the mean and median returns will diverge. Market inefficiencies become more prevalent as fewer eyes are on each business; as a result, people who successfully exploit them become richer than they would otherwise. Wealth becomes increasingly more concentrated in the few people that actively invest (usually with insider information) and do so successfully. Passive investors continue to make the median return, but the median return falls further behind the mean return.

We're seeing exactly this phenomena right now. I haven't seen anyone else who has explicitly linked it to the rise of index funds & passive investing, but I wouldn't be surprised if it's related.

>funds are traditionally not FDIC insured

Index funds (whether exchange-traded or not) have exactly the volatility of the bundle of stocks they track; of course they aren't FDIC-insured, because they're investments and not savings accounts. But for index funds diverse enough and time horizons long enough they have really nice risk/reward characteristics that suit most people. If you go to Fidelity or Vanguard's website you can use automated tools to calculate the distribution of index funds, bonds, and cash equivalents that best suit your risk appetite and time horizon for growing a nest egg.