How Passive Investing Is Changing the Way Markets Work

---

Passive investing was once a tiny corner of the US equity market. Around 1994, passive share was below 1%. Today, depending on how it is measured, estimates sit around 50% to 60%. That shift is changing how markets behave.

The issue is not that passive investing is “bad.” Passive has clear advantages. It is cheap, transparent, and easily accessible for most investors. The problem is: what happens when passive stops being a participant in the market and starts becoming the market itself?

Markets need a mechanism that pulls prices back toward some notion of fundamental value. That mechanism is not automatic and depends on active investors looking at prices, comparing them to fundamentals, and deciding whether to buy or sell. As the active share of markets shrinks, that pull may weaken.

Why Markets Still Need Active Managers

Active managers don’t always price things correctly. Individually, they are usually wrong. But in aggregate, they are the part of the market asking whether a stock is cheap, expensive, over-owned, under-owned, or disconnected from reality. Their buying and selling helps create the market’s self-correcting mechanism and pulls prices toward some notion of fair value.

Passive investors do not perform that role. A passive fund buys according to index weights. It does not ask whether a company’s valuation makes sense or whether the market is becoming too concentrated. If money flows in, it buys. If money flows out, it sells.

That works when passive investing is one part of a larger market. But as passive grows, the burden of price discovery falls on fewer active investors. If that active base becomes too small, the market’s ability to correct itself becomes weaker.

How Passive Investing Can Amplify Volatility

A recent paper on passive investing argues that the consequences of rising passive share are not linear. The risk is not that markets become slightly less efficient with each additional dollar flowing into index funds. The risk is that, beyond a certain point, the stabilizing force in the market becomes too weak to contain volatility.

In the model, once passive share reaches around 65%, index volatility may begin rising sharply under certain assumptions. Around 90%, volatility can grow at a cubic rate, meaning very quickly. At still higher levels, the model contains the theoretical possibility that a major index could fall to zero before rebounding.

That last point is not a forecast. It is a technical result of the model, not a prediction that the market is going to zero. In the real world, circuit breakers, central bank action, government intervention, and other safeguards would almost certainly prevent that outcome.

The more important point is that instability does not require a wave of selling. Most passive-investing risks are framed around mass redemptions or forced liquidations. This paper makes a more subtle argument: even without net outflows, a market can become fragile once enough active capital has disappeared and the link between prices and fundamental value has weakened.

The Mega-Cap Feedback Loop

Passive flows do not spread evenly across the market. In a cap-weighted index, the largest companies receive the largest dollar allocations. The bigger they become, the more passive money they attract.

That creates a powerful feedback loop. The largest stocks get more flows, those flows can push prices higher, and higher prices make those companies even larger parts of the index. So they get larger, faster than fundamentals alone would justify.

Many of these companies are genuinely strong. But some of what looks like pure business strength may also be the market structure feeding itself. This kind of loop can work for a long time, right up until the capital behind it starts to reverse.

The $500 Trillion Asset Bubble

At a certain size, markets stop being just a reflection of the economy. They become one of the forces driving it. Asset prices today influence borrowing, spending, and policy itself. Global long assets are roughly $500 trillion. Public equities alone are about $150 trillion. If markets rise or fall sharply, they create or destroy tens of trillions of dollars in collateral.

This has fundamentally changed the relationship between markets and policymakers. The Fed and Treasury may not control a system this large, but they cannot ignore it either. When asset prices fall too far, the damage will not stay inside investor portfolios but also spill into the economy and the political system.

That is why every major disruption now seems to invite some form of support or intervention. The market has become too important to the economy to be treated as a separate scoreboard.

The New Rules for Investing in a Passive-Dominated Market

None of this means investors should abandon passive investing or long assets altogether. If passive flows continue to support the largest parts of the market, that engine will keep working and the upward momentum may last longer than fundamentals alone would suggest.

But investors should be careful about relying on long-only exposure as their only answer. In a market where passive flows and concentration play a bigger role, breaks can happen quickly. When the selloff comes, it may be too late to rebalance out of trouble.

That means thinking beyond a simple long-only portfolio. Upside convexity can help investors participate if the market keeps rising without simply chasing the most crowded names. Downside hedges matter because the unwind, when it comes, may be sharp. Inflation-sensitive assets, trend-following strategies, and selective short exposure may also play a larger role if the old 60/40 framework is less reliable in a world of higher rates and higher inflation.

---

DISCLAIMER: This article is based on a conversation from Top Traders Unplugged and reflects themes, ideas, and perspectives discussed during the episode. The views expressed are those of the guest and participants in the conversation and should not be interpreted as investment advice or as the official views of Top Traders Unplugged.

To receive future episodes, research, and weekly insights from the world of investing, macro, and trend following, sign up for our newsletter or subscribe on your preferred podcast platform.