Nothing comes closer to heresy in financial circles than bad-mouthing index funds. Even managers of actively managed funds tend not to speak ill of the

Vanguard 500s

of the world. And really, why should they? Index funds beat the majority of investors, institutional or otherwise, year after year, have low expenses and are based soundly on a time-proven academic theory. What's not to love?

Well, I can keep silent and pretend nothing is amiss in my beloved fund world no longer. Somebody has to tell the emperor (the American investor in this case) that he is in fact, naked, and that somebody might as well be me.

Indexing giant Vanguard introduced its first index fund in 1976. Today, a cool $1 trillion -- about one in every 10 investment dollars -- is tied to indices, mostly through mutual funds. The growing proportion of assets tied to indices is changing the structure of the market -- and not in a good way. To understand why, a short history lesson is in order.

The spiritual father of indexing is Burton Malkiel, who popularized the Efficient Market Hypothesis -- the origins of which were cooked up in the 1950s -- in his 1973 book

A Random Walk Down Wall Street

. Oversimplifying, the theory claims that stocks are so carefully and thoroughly scrutinized by investors and their prices at all times efficiently reflect all information and news; therefore, an investor can randomly buy baskets of stocks and achieve the same returns as the market as a whole. As long as the costs to do so are low, investors can actually beat most professionals.

Prisoner's Dilemma

Another theory that has stood the test of time is the concept of a Prisoner's Dilemma, which describes a situation where one person can cheat to his own benefit, but to the overall system's detriment. In the example traditionally used, two prisoners are interrogated in separate cells without a chance to communicate with each other. Whether or not they are guilty is not important. They are offered the same deal: If both confess, each will get four years in prison. If neither confesses, the police can pin part of the crime on them and they'll each get two years. If one confesses and the other doesn't, the confessor will go free while the other goes to jail for five years.

If the goal is to minimize combined jail time for all parties, neither should confess. But in practice, one always does -- often both -- to the ruin of the system.

What does this have to do with index-fund investing? I will admit that Malkiel's efficient market hypothesis, or EMH, works, at least in the short run. If 99% of investors analyze investments the "traditional" way, why waste time or money doing the same? As an index investor, you can be an investment slacker of sorts and coast on the hard work of others. They already priced the securities for you with their analysis, and because you do not have the costs that these people incurred while figuring out what to pay for these stocks, you will outperform them.

The trouble starts when too many people start following your lead. Imagine a world in which everybody buys into indexing as a concept and all investable assets wind up in index funds. What would stock prices be like in this world? Completely insane, that's what. There would be bankrupt companies with billion-dollar market caps merely because they were in the index and nobody could sell it. If everyone did this, the markets would self-destruct. This is very different from a similarly extreme example of traditional investing: Everybody could give their money to

Warren Buffet

to manage without the very nature of market pricing going haywire because he could choose what to buy and sell.

Self-Fulfilling Prophecy

As if the prisoner's dilemma weren't enough, all funds tied to the

S&P 500

(and other major indices) have another scary detail to contend with: Because these indices are market-capitalization-weighted, they embody an element of self-fulfilling prophecy.

The process of investing pushes up prices, so when an index is market-cap-weighted (which means the bigger the company, the larger portion of the index it represents), the "manager" (read: computer program) has to buy more of the largest stocks in the index than the smallest. So for every dollar that goes into the

(VFINX) - Get Report

Vanguard 500 Index fund, the manager puts 1,145 times as much of it into No. 1

General Electric

(GE) - Get Report

(market cap: $519 billion) as in No. 500

Bethlehem Steel

(BS)

(market cap: $453 million).

The need to buy more of the big-cap stocks sends them up in price more than the stocks at the bottom (because the average trading volume of GE is not 1,100 times more than for Bethlehem Steel), and because they are such large components of the index, that pushes the index -- and the funds that track it -- ever higher.

Now, let's take this theory to the extreme, as we did with the prisoner's dilemma. Imagine what would happen if everybody put their money into a market-cap-weighted index fund. The index would grow ever more and more top-heavy until there was only one stock left, GE. (Until recently, it would have been

Microsoft

(MSFT) - Get Report

, and still would be if "actively managed" money didn't put in sell orders). The index could rename itself the S&P 1.

The Inefficient Market Theory

OK, but since both prisoner's dilemmas and self-fulfilling prophesies can make an investor money before they implode like a supernova, can the index investor stay in a little longer?

It's probably a little early for the S&P 500 bubble to burst, but the inefficiencies of having that much capital invested that way are starting to rear their heads. And as a result, all investors may be worse off, because a world with less-efficiently priced securities is a little more dangerous.

You would think that as technology generated all this new information about investing in the 25 years since the EMH was first cooked up, that markets would be even more efficient today than they were then. In fact, between indexing, daytrading and investing by others who are not really analyzing stocks, the markets are probably less efficient than they were when Malkiel's book was first released.

If you told Mr. Dow and Mr. Jones way back when that the stocks in their index would stop driving the index, and that instead the index would drive the stocks in it, they would have been more than a little surprised. The mere fact that a stock is added or dropped from a major index today can move the price as much as 10% -- with no fundamental change in news about the company. What we really have now is a budding inefficient market hypothesis -- one driven by the theory that investors' sheer faith in efficient markets drives the markets to inefficiency.

Where is this going? The thing to remember is that indices can go down in a similar fashion to how they went up, only faster. If people start pulling money from S&P 500 index funds because they start to underperform actively managed funds (and we've been seeing signs of this in the last few months), the funds will have to sell. And as they sell, those stocks at the top of the index will fall faster, meaning the funds will have to sell more of them. Maybe someone should start a fund that shorts the top 50 stocks in the S&P 500. If past performance is the only thing that makes sense about your investment, maybe it's time to re-evaluate your investment strategy.

Jonas Max Ferris is the CEO and co-founder of

Maxfunds.com, a Web site that provides analysis of mutual funds with a spotlight on new and undiscovered funds.