I'll be honest. What you said is so oversimplified that it cannot be possibly the only factor. Sure there might be a misallocation factor but as others have said, active traders benefit from this.
How do active traders make money? Easy, they make money off of volatility and volatility increases as the market size increases. So greater passive share means more profit potential for active traders.
What is even the function of a trader? A trader is providing liquidity so that buyers and sellers can get fair prices for the thing they want to buy. Who are buyers and sellers? People who believe in the company or in the case of an index fund, people who believe in the index and expect it to net a return in the future. If there are not enough active traders then index funds will pay unfair prices and that is a loss for the index fund.
Now lets get to the meat of your post, zombie companies or rather low productivity companies are a function of interest rates and interest rates are set by the market and usually they are set based on inflation + desired margin. Inflation is low, or at least not high enough, so interest rates are relatively low. The Fed does control the interest rates to some extent but it does so for inflation targeting. However most of the time the Fed rate is slightly above the actual market rate, this is especially the case with negative interest rates where a lot of central banks want to stay above 0% if it is feasible. If inflation goes up the Fed will normalize the interest rates.
High interest rates are a barrier to companies with low returns. If your company makes a 2% return every year and your interest is 3% you will go out of business. If your company makes losses and obtains a 0%-1%% loan then it can stay afloat thanks to the debt.
Now the obvious problem is, if the Fed is doing everything it can to increase inflation and subsequently raise interest rates then why on earth do we see very low inflation? If interest rates are lower than inflation it means everyone (including foreign entities) is putting their money into savings. After all, if people spent it on consumer goods it would drive up prices and therefore inflation. So it isn't going there.
Actually, there is a way for consumer spending to increase savings. China is running a trade deficit by pegging their currency to the yuan. This means the government just outright buys USD so you can exchange them for yuan and the government stockpiles the USD in US treasury bonds. In my opinion they do this because China has an aging population, it's basically a retirement fund, when China is doing poorly they are hoping the US economy is doing well.
Ok, China (and pretty much everyone exporting in USD) is saving. Who else is saving? Retirement funds. The US has an aging population that puts money aside for retirement. It also has a retirement motto that everyone is supposed to save for themselves so even the working population is putting money aside. Rich people save a disproportionate percentage of their salary. They simply cannot spend all of it because they are simply that rich. Think of Bill Gates. A lesser effect also applies to city dwellers in top cities. They get paid a lot more than the countryside. Think of all the people on HN with stock compensation or people on HN who put their excess money into stocks. This portion is growing bigger over time. Automation plays into savings as well. Higher productivity means you can put more money into capital via machines that merely consume electricity instead of spending your money on workers who must consume food and water.
If everyone is saving and nobody is spending then how are workers supposed to get paid for their work? It's clearly impossible, unless that money is being invested and new jobs are being created. This is why people shouldn't put money under a mattress or why we don't want deflation. It will cause unemployment. Give it to your bank and your bank will give it to a company that creates jobs. But since interest is so low or in theory negative (banks don't pass negative interest on) the banks are basically telling you that they don't want your money and you should put it elsewhere.
Enter the stock market and housing market. Low yields in conventional markets (bank accounts, treasury bonds, mortgage bonds, etc) cause investors to flee these markets and enter riskier markets. They will spend it on stocks instead, they will also spend it on housing directly. That's where all those speculators that don't want to rent the house out come from. They aren't looking for a good investment, they are looking for an investment that isn't worse than conventional assets.
It's almost as if we have run out of good investments.
How do active traders make money? Easy, they make money off of volatility and volatility increases as the market size increases. So greater passive share means more profit potential for active traders.
What is even the function of a trader? A trader is providing liquidity so that buyers and sellers can get fair prices for the thing they want to buy. Who are buyers and sellers? People who believe in the company or in the case of an index fund, people who believe in the index and expect it to net a return in the future. If there are not enough active traders then index funds will pay unfair prices and that is a loss for the index fund.
Now lets get to the meat of your post, zombie companies or rather low productivity companies are a function of interest rates and interest rates are set by the market and usually they are set based on inflation + desired margin. Inflation is low, or at least not high enough, so interest rates are relatively low. The Fed does control the interest rates to some extent but it does so for inflation targeting. However most of the time the Fed rate is slightly above the actual market rate, this is especially the case with negative interest rates where a lot of central banks want to stay above 0% if it is feasible. If inflation goes up the Fed will normalize the interest rates.
High interest rates are a barrier to companies with low returns. If your company makes a 2% return every year and your interest is 3% you will go out of business. If your company makes losses and obtains a 0%-1%% loan then it can stay afloat thanks to the debt.
Now the obvious problem is, if the Fed is doing everything it can to increase inflation and subsequently raise interest rates then why on earth do we see very low inflation? If interest rates are lower than inflation it means everyone (including foreign entities) is putting their money into savings. After all, if people spent it on consumer goods it would drive up prices and therefore inflation. So it isn't going there.
Actually, there is a way for consumer spending to increase savings. China is running a trade deficit by pegging their currency to the yuan. This means the government just outright buys USD so you can exchange them for yuan and the government stockpiles the USD in US treasury bonds. In my opinion they do this because China has an aging population, it's basically a retirement fund, when China is doing poorly they are hoping the US economy is doing well.
Ok, China (and pretty much everyone exporting in USD) is saving. Who else is saving? Retirement funds. The US has an aging population that puts money aside for retirement. It also has a retirement motto that everyone is supposed to save for themselves so even the working population is putting money aside. Rich people save a disproportionate percentage of their salary. They simply cannot spend all of it because they are simply that rich. Think of Bill Gates. A lesser effect also applies to city dwellers in top cities. They get paid a lot more than the countryside. Think of all the people on HN with stock compensation or people on HN who put their excess money into stocks. This portion is growing bigger over time. Automation plays into savings as well. Higher productivity means you can put more money into capital via machines that merely consume electricity instead of spending your money on workers who must consume food and water.
If everyone is saving and nobody is spending then how are workers supposed to get paid for their work? It's clearly impossible, unless that money is being invested and new jobs are being created. This is why people shouldn't put money under a mattress or why we don't want deflation. It will cause unemployment. Give it to your bank and your bank will give it to a company that creates jobs. But since interest is so low or in theory negative (banks don't pass negative interest on) the banks are basically telling you that they don't want your money and you should put it elsewhere.
Enter the stock market and housing market. Low yields in conventional markets (bank accounts, treasury bonds, mortgage bonds, etc) cause investors to flee these markets and enter riskier markets. They will spend it on stocks instead, they will also spend it on housing directly. That's where all those speculators that don't want to rent the house out come from. They aren't looking for a good investment, they are looking for an investment that isn't worse than conventional assets.
It's almost as if we have run out of good investments.