In the past few years, the financial world has witnessed an undeniable shift: the relentless rise of passive investing. As Terry Smith pointed out at the latest Fundsmith Annual Meeting, more than 50% of global assets under management now reside in so-called passive funds—index funds and ETFs. This phenomenon is not just a trend; it is a fundamental transformation of market dynamics, one that brings with it significant distortions.
Passive investing, pioneered by John Bogle, the founder of Vanguard, has revolutionized the industry. Bogle’s philosophy was rooted in providing low-cost, broad-based exposure to markets, eliminating the need for high-fee active management.
His contributions to investing were monumental, and he rightly deserves credit as a financial luminary. However, even Bogle himself acknowledged in 2017 that at some level, index investing could lead to market distortions.
He recognized that when too large a proportion of assets are held in index funds, investments occur without regard to company quality or valuation. In other words, if Tesla is in the index, investors own it—no questions asked.
This automatic allocation creates a momentum-driven market, where the largest stocks receive the most inflows simply because they are already large.
As Smith noted, “The money that goes into index funds is allocated, for most index funds, in relation to the market weighting of the shares—the value in the market—which means that the ones which are biggest get most of the inflows. And guess what that does to their share prices over time.”
The result is a self-reinforcing cycle, driving up valuations of the most heavily weighted stocks, irrespective of fundamental analysis.
What is even more alarming is the shift between active and passive investing. When investors move money from active funds—where portfolio managers make decisions based on research and conviction—to passive funds that blindly track indices, market distortions become even greater.
Smith points out, “When you take money from us, who don’t own any Nvidia, and you put it into the index where Nvidia is the largest or one of the largest stocks, guess what happens to the Nvidia share price? It goes up.”
This inflow dynamic amplifies the rise of certain stocks beyond their intrinsic value, creating an environment where fundamentals play a diminishing role.
The danger is that this cycle could lead to increased volatility and ultimately painful corrections. If valuations are being inflated not by rational investment decisions but by mechanical fund flows, what happens when those flows reverse? The market’s reliance on passive strategies has made it less discerning, rewarding size over substance.
While passive investing has provided undeniable benefits—lower costs, broader access to markets, and long-term gains—it is not without consequences.
As this trend continues, investors and regulators alike must consider whether the dominance of index investing is leading markets away from rational price discovery. The question is no longer if market distortions will occur, but how severe their impact will be when the tide inevitably turns.
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