"Passive investors think they are diversified. That's doubtful. More importantly, it will not matter in another big decline."
This is nothing new. That has always been the case. Diversification within the stock asset class has never protected anybody when a big decline comes. During bear markets nearly everything goes down.
I don't see the big deal about there being 3.7 million indices. For one, last I read there were around 5000 ETFs globally, so it isn't as if each index is represented by an ETF trading against it. Two, the bulk of the money is almost certainly in a small subset of the 5000 ETFs that trade, so that there are another 3.7 million more indices doesn't mean much. Finally, those indices aren't any different than having 3.7 million ways of structuring a portfolio.
We'll eventually have a panic and ETFs will be blamed for it to deflect attention from the real source of the problems, but given that the APs (Authorized Participants) that arbitrage these ETFs against their indices or make markets in them tend to sit on their hands and do nothing during panics they will not be the source of the panic, nor will they be adding to it. Pricing is done by active participants, not the ETFs. The ETF problem will be one of liquidity for the shareholders. With the APs not doing anything during a panic it will not be possible to get a bid representing anything close to the intrinsic value (NAV) of the ETF if one wants to sell.