ben ji, if you read the paper, they discuss that overvaluation would be predicted to dissipate due to arbitraging investors. they speculate that it has not happened (not happened enough to remove the effect) because the arbitraging investors are not attracted to the opportunity due to the long and unpredictable time frame over which the overvaluation might reverse.
presumably, if passive funds continue to increase to the degree you mention (50% of total invested funds), the arbitrage would become proportionally more attractive and would begin to attract more investors, acting to reverse any overvaluation.
the market should correct itself. afaik, no index funds attempt to hedge anything to correct any possible effect themselves. but they could, if investors became interested in that - and willing to pay a little for it. you could perhaps consider fundamental weighting an attempt to reduce similar effects.
