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In your hypothetical 99.9% passive scenario that doesn't work either because passive funds have long ago disallowed borrowing their stocks to short. If you start with a ~100% passive premise the reality is so different to what a normal market looks like you can't just propose a normal strategy and expect any of it to work.

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Hi, I'm not sure I follow this idea that passive investors don't lend their shares. Is that meant to describe the hypothetical world of no active traders, as discussed above, or is it meant to describe the present situation in the investing world today?

In the world as it stands today, passive ETFs and index mutual funds are a huge source of shares to lend. It's one of the ways they can lower the cost of the passive fund (or slightly increase returns above the passive benchmark), as the proceeds from lending shares are returned to investors in the fund. (Not always, but the good ETF operators do this.)

If passive funds made this tradeoff then how would they be influenced by a company going bankrupt? They would just change the tradeoff when that becomes a problem since this is not part of the passive investment strategy.

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