companies lucky enough to be listed in the S&P or whatever would get a huge influx of cash, but their actual quarterly performance wouldn't change whether people buy/sell their stock because people aren't picking and evaluating individual companies. so... what would determine their price?
But then it's no longer your theoretical market that is 100% passively invested.
and it's not even that the index fund is driving price discovery of the aggregate market because people using these funds just keep dumping money in on a schedule because they've internalized the message "time in market beats timing the market".
That would never happen, because the more a market tilts towards index investing, the larger the incentive and opportunity that active management has to exploit misspriced assets. The trick is that the very act of exploiting that opportunity updates the price and eliminates it long term, and the harder it becomes for active investors to find misspriced assets.
TLDR: Active managment effectively performs a service to the market, and gets rewarded for it, but the reward is small and fleeting
Because when you say a stock is undervalued, isn't what you're really saying is that you think it's value with increase at a higher rate than the rest of the index in future, because it will attract above-average rates of investment from other active investors? Or to put it another way, "in the future more people will want to buy this stock than other stocks, so its value will go up".
But if everyone else is the market is investing passively, where does disproportionate future demand come from?
Why does a share of a company have any value? Well, if you buy 10% of the stock of widget co, you presumably get 10% of it's earnings, be that through dividends, share buy backs, etc. It's stock price will reflect that. It also reflects the future potential growth.
For some companies, (utilities, etc) there isn't much future growth so the price is mostly a function of it's ability to pay out dividends. For a tech startup, they're not paying out dividends any time soon and the price reflects it's potential to someday be BigCo with massive earnings and massive dividends.
There will always be active investors trying to beat the market, and they aid in price discovery.
It's always interesting to read the frustrations of star fund managers and how difficult it becomes to sustain success just as they get popular.