The Passive Paradox & What's Next

Should asset prices be primarily driven by wage and productivity growth, with price discovery being a key factor in driving efficiency? Or, should asset prices primarily be driven through government debt creation and accommodative monetary policy?

I see these two questions interlinked with the past two decades of Federal Reserve balance sheet expansion, the rise of passive index investing, government debt explosion, wealth inequality within society and within the companies utilizing the financial markets for growth.

The rise of passive index investing over the last several decades has reshaped the financial markets in profound ways, but it also introduces important unknowns and risks that deserve careful attention. While passive funds have delivered low-cost, diversified market exposure and helped millions of investors capture broad equity returns, it is not a guaranteed path to forever smooth gains. The dynamics underlying passive investing imply potential vulnerabilities whose trajectories are uncertain.

Looking back, the 1990s delivered strong returns with the S&P 500 averaging nearly 20% annually, fueled by a booming technology sector. However, the 2000s presented a stark contrast. The dot-com bubble burst in 2000 led to a prolonged period, more than a decade, where the market struggled to reclaim previous highs, culminating in another severe recession in 2008. Passive investors in retirement at the time might not have ever regained their value within their lifetimes. It wasn’t until after the Federal Reserve unleashed quantitative easing (QE), injecting unprecedented liquidity and maintaining an ample reserves regime, that the S&P 500 again began hitting sustained new highs.

In this low interest rate and high liquidity environment, passive index investing grew dramatically. Vanguard, under Jack Bogle’s vision, championed broad market exposure at low cost, attracting vast inflows. The growth of passive funds now means they represent over half of U.S. mutual fund and ETF assets. These flows disproportionately favor mega-cap companies such as Apple, Microsoft, and Amazon, leading to a concentration unseen in prior decades.

Yet here lies a key paradox: passive investing’s very design can amplify risks it seeks to dampen. Because index funds buy stocks based on market capitalization, they accumulate ever more shares of already disproportionately priced mega-caps, often irrespective of underlying fundamentals. This “price-insensitive” buying can detach stock prices from intrinsic value and inflate bubbles around a handful of companies. Concurrently, smaller companies with potentially strong fundamentals get less capital, weakening market breadth and diversity. Smaller companies often times use private markets and wait until their size can garner passive flows through their own gravity before going public. This unknown opportunity cost of lost innovation will never fully be known. However, we do feel its negative effects through society in the real economy.

Does the concentration of capital in mega-caps increase systemic market risk? If these few companies stumble, the ripple effects across indexes and passive vehicles could be severe, exacerbated by the sheer size of their weightings.

Will the market’s diminished price discovery and elevated correlations, partly driven by passive investing, make equity markets more prone to shocks or sudden corrections?

Can passive flows continue growing indefinitely, or will diminishing opportunities in mega-caps, regulatory changes, or investor fatigue trigger a reversal or disruption? The assumption that passive investing is a permanent, risk-free default may underestimate market complexity.

This inherent uncertainty underscores the importance of active management. Skilled managers can identify mispricings, manage risk, and adjust exposure dynamically. This has the opportunity to hedge against scenarios where passive investing’s structural vulnerabilities are exposed. In the past, many active funds have outperformed during market corrections or volatile periods when passive index strategies offer no defense against falling prices. They also help maintain capital allocation to smaller companies and undervalued sectors, supporting market functioning and broader economic growth.

Not all investors are the same. Investors nearing retirement with a defined accumulated ‘nest-egg’ or seeking stable income should not rely solely on passive funds indexed to mega-cap heavy benchmarks due to the volatility risk and concentration. These investors can benefit from approaches blending passive exposure with active strategies focused on risk reduction and income stability.

Passive index investing has undoubtedly changed the investment landscape by lowering fees, simplifying market access, and driving historic returns that coincided with unprecedented monetary expansion through the central bank and government debt. However, its rise brings structural risks and unanswered questions about sustainability and systemic impact. It is neither a guaranteed smooth ride nor a permanent solution for all investors. The future likely demands a balanced approach where passive and active strategies coexist. Each one addressing different needs and mitigating the unknown risks inherent in today’s financial markets.

A good Active Manager will allow the investor/owner of the fund to be Passive. Investors should utilize risk-adjusted returns, such as the Sortino Ratio or Sharpe Ratio. This gives investors a way to sort through the multitude of funds available. A Sortino Ratio that is consistently higher than the overall indexes with a similar absolute return is a good measurement of success for an Active Manager looking to mitigate the risks of the Passive Paradox.