If those fund-holders were owning the stocks directly, instead of ETFs... Those same fund-holders would be... Selling their stocks. Causing the exact same downward price pressures.
Suppose stock X gets 1% in that basket. The issue is if stock X happens to be very illiquid, the APs selling stock X could drive down the price.
In a non ETF, managers could decide to relatively slow down the sale of X, to prevent crashing the price. However, in an index fund the mechanism dictates all stocks are sold in the same proportion.
If you are panicked, and are selling your ETF, your evil twin is panicked, and selling all their stocks.
This causes the exact same downwards pressure on the market.
I don't buy an ETF because I want someone to do financial malarkey with my money. I buy it because I want to own stocks, and I can't be assed to deal with my own brokerage account. Besides the convenience aspect, there is zero difference between the two.
They'd still follow the same herd mentality that they would, had they owned ETFs.
Moreover, if my evil twin a) owned a managed fund or b) sold in a slightly smarter way, then they would lose less on X due to liquidity.
Moreover, the hit on Xs price also has a slight hit on the ETF value. Hence there is a small positive feedback loop.
When investors sell that amount, it doesn't matter whether they hold the underlying assets directly, or via index funds or ETFs, or via actively managed funds. The market will go down. So, which part of the problem is uniquely due to index funds?
Burry hasn't made that point very clear.
There might be issues with (liquid) index funds that give exposure to inherently less liquid assets, such as bonds or real estate. There might also be issues with index funds that do not hold the assets themselves, but replicate the exposure synthetically by entering a swap with a third party, giving rise to tracking error, counterparts credit risk, etc.
However, as I said, Burry hasn't enunciated these concerns very cogently (at least in the extracts quoted by Bloomberg). This article here does nothing to address those concerns.