Ned Johnson had it right way back when. Why would anybody want average returns when they could pay him big money for below-average returns and the occasional black-monday disaster?
Seriously, index fund investing assumes an optimistic outlook. It assumes the managers of companies will do an OK job in the long term and the companies will grow. Index funds allow investors to participate in that growth without having a big chunk of it going into Mr. Johnson's pocket. A low fee burden turns OK company performance into acceptable retirement savings growth.
It's not a zero sum game. It's a slightly-positive-sum game. That means a lot of people can play and slightly win.
As for pricing the equities, the fundamental qualities of the businesses behind them are, even in the stock market casino of the 21st century, still important. Warren Buffet understands fundamentals. There's no reason a market dominated by index funds must ignore them.
There are two other aspects of successful index investing.
1. Diversification. Don't put all your money in one index. What if you have all your money in the NASDAQ index when the cultural narrowmindedness of Silicon Valley (the rule of young white brogrammers) catches up with them?
2. Disciplined rebalancing. Set a goal for diversification percentages: 60% growth equities, 20% growth-and-income, 10% nonUSA, 10% bonds for example. When your investment values move away from those percentages, sell the excess in one category and reinvest it in the other categories. This amounts to buy-low sell-high. It will serve as a ratchet to capture the upside and limit the downside.
Panic buying and selling is for the other guy. I'm grateful to that other guy; he's helped me set up a nice 401k balance.