The Hidden Risks of Passive Investing

Passive investing is no longer just a strategy - it’s quietly reshaping markets, inflating valuations, and creating systemic risks that most investors don’t see coming.

“Because something is happening here / But you don’t know what it is / Do you, Mister Jones?”Bob Dylan

The Rise of Passive Investing

Few trends have reshaped modern finance as profoundly as the rise of passive investing. With its promises of low cost, diversification, and reliable long-term returns, it has become the default strategy for millions of retail and institutional investors. Over the past decade, index funds and ETFs have attracted relentless inflows, while active managers have faced steady redemptions.

Today, passive vehicles are estimated to represent roughly half of global equity market capitalization — and that figure continues to climb. The true share is likely higher when accounting for “closet indexers” among institutional managers.

These flows are not primarily the result of deliberate investment choices but of a complex web of policy incentives, regulatory frameworks, and automated default settings that most investors - retail or professional - barely notice.

 
Fig. 1: Percentage of assets under management in U.S. equity funds
Source: Research Affiliates, Morningstar

The Fallacy of Composition

Passive investing offers undeniable benefits. It democratizes access to financial markets, allowing ordinary investors to own diversified portfolios at minimal cost. Yet its rapid growth illustrates a classic economic paradox: the fallacy of composition - the mistaken belief that what is rational for an individual is necessarily good for the system as a whole. For a single investor, buying an index fund makes sense. But when the majority do so, the mechanism that keeps markets efficient - active price discovery - begins to erode. If one person stands at a concert, they see better. If everyone stands, no one’s view improves. Likewise, when everyone invests passively, the collective result may be diminished efficiency and distorted prices.

While passive strategies are efficient at the individual level, their collective dominance introduces profound, often hidden risks that threaten the very foundations of modern markets.

“If everybody indexed, the only word you could use is chaos, catastrophe… The markets would fail.”  John Bogle, founder of Vanguard (2017)

The Assumptions Behind Passive Investing

At its core, passive investing rests on two central beliefs:

• Market efficiency
  Prices reflect all available information, making it futile to try to outperform the market.
• Market neutrality
  Passive investing does not materially affect prices.

Both assumptions are flawed.

The Efficient Markets Assumption

Passive investing treats prices as sacrosanct - as if they always represent a company’s true value. This assumption is challengeable at the best of times. But it certainly only holds when markets are dominated by active participants who analyze companies, challenge valuations, and correct mispricings. When active participation declines, markets lose this self-correcting function and become less efficient.

“Passive” Is Not Passive

Passive strategies are often portrayed as static, but in reality, they involve constant buying and selling driven by investor inflows, redemptions, index inclusions and deletions, and periodic rebalancing. These mechanical trades can move prices substantially. Passive investing is not “hands-off” - it is algorithmic, reflexive, and pro-cyclical.

The Myth of Market Neutrality

Passive managers like to claim their funds merely “mirror the market.” In truth, they shape it. When billions of dollars flow into or out of index funds, they move entire baskets of stocks simultaneously, amplifying market swings and contributing to synchronized price movements.

The Risks of Passive Investing

These flaws mattered little when passive funds were a small share of the market. Now that they dominate, their structural weaknesses expose investors - and the system - to a range of risks.

1. Erosion of Price Discovery

Active investors perform a crucial public service: they analyze businesses, evaluate fundamentals, and help set fair prices. Passive investors, by contrast, simply accept prevailing market prices. When passive flows account for most of the buying and selling, fewer participants remain to determine what a company is truly worth. The market’s ability to value firms on their merits weakens, leading to more violent corrections when active bids briefly overpower passive flows.

2. Rising Valuations and Feedback Loops

Market-capitalization¹ weighting ensures that passive funds allocate more capital to companies whose share prices have already risen - irrespective of their fundamentals. This momentum effect perpetuates overvaluation, as capital continually chases size and price². In a world where over 100% of marginal flows are passive, traditional market mechanisms that once corrected excesses lose traction. This undermines the natural reversion to the mean that usually occurs when valuations become stretched. Rising prices attract more inflows, which drive prices higher still - a self-reinforcing feedback loop that inflates bubbles and deepens crashes once they burst.

Fig. 2: An ever-more expensive market : Price/Sales ratio of the S&P 500
Source: Bloomberg

3. Increased Correlation

As passive investing expands, so does the correlation among stocks. Index-tracking funds invest in the same large-cap names regardless of the companies' individual characteristics and performance, causing prices across sectors to move in lockstep. This erodes diversification - the very benefit many investors seek.

4. Market Concentration

Major indices are often heavily skewed toward a handful of mega-cap stocks. As passive funds replicate these indices, they funnel disproportionate capital into the same few companies. What appears to be diversification is often concentrated exposure to the same dominant firms. The performance of entire markets can hinge on a few names - a fragile structure disguised as stability.

5. The Illusion of Liquidity

The apparent liquidity of passive vehicles can be deceptive. Inflows lift prices across the board, but when sentiment turns and outflows begin, liquidity can evaporate. Many large stocks are far less liquid than their market capitalization suggests, since a significant share of their float sits locked inside passive vehicles. In times of stress, selling by index funds can overwhelm buyers, triggering sharp price declines.

6. Synthetic Demand and Derivative Exposure

Passive demand often exceeds the supply of available shares. To maintain exposure, funds may rely on derivatives such as futures rather than purchasing the underlying stocks. Multiple investors may, in effect, claim ownership of the same underlying exposure. This synthetic structure introduces leverage and creates a dangerous illusion of liquidity.

7. Systemic Risk

The combination of high correlation, synthetic exposure, and liquidity mirages heightens systemic vulnerability. Passive products promise daily liquidity to investors, but their underlying assets may become illiquid in practice. When redemptions occur, forced selling cascades across funds holding the same securities, magnifying volatility. In essence, passive investing has turned vast segments of the market into a single, synchronized trade.

8. Narrative Distortion

As price discovery erodes, markets increasingly create the fundamentals rather than reflect them. Rising share prices generate optimistic narratives that then justify further price increases - a circular logic that detaches valuations from reality.

Recent examples abound in the technology sector. Nvidia’s investment in OpenAI, and OpenAI’s subsequent promise to purchase Nvidia chips, or OpenAI's commitment to buy AMD chips and in return getting warrants in AMD have all driven soaring stock prices, each movement reinforcing the illusion of fundamental strength. In many cases, commercial reality lags far behind market enthusiasm.

“We are moving PalantirTech to the Nasdaq because it will force billions in ETF buying.” Alex Moore, Palantir board member (2024)

Few companies have benefited from index dynamics as effectively as Palantir Technologies. By ensuring inclusion in major indices, Palantir has attracted vast passive inflows and now trades at more than 100 times sales - despite having increased its share count fivefold in six years. Traditionally, such dilution would alarm active investors as it signals weak capital discipline and dilutes existing shareholders. Yet in a world dominated by passive flows, issuing more shares can increase a company’s market capitalization and index weight, thus attracting more capital - an inversion of fundamental logic.

Fig. 3: Palantir Technologies’ stock price
Source : Bloomberg

9. Market Signals and Policy

Policymakers often look to the stock market for economic signals, assuming that the health of the market reflects the health of the broader economy. But when markets are driven largely by passive flows rather than fundamentals, those signals become unreliable. Policymakers may draw misleading conclusions about the state of the economy from what are, in effect, mechanical portfolio reallocations.

10. Governance Risks

A small number of asset managers - notably BlackRock, Vanguard, and State Street - now control the majority of global passive assets. Through their proxy voting power, they influence corporate governance, executive pay, environmental policies, and strategic decisions across the economy. Yet their ability to monitor individual firms is limited by the sheer scale of their holdings. The result is concentrated power with diluted accountability - and governance decisions that may prioritize short-term returns over long-term value creation.

Economic and Social Implications

Beyond financial stability, the dominance of passive investing carries wider economic consequences.

Regulation and the growth of passive investing

The rise of passive investing has been propelled by policy design as much as by market preference. Tax-advantaged retirement schemes, such as U.S. 401(k)s, encouraged investors to favor low-cost, diversified vehicles. Regulations like the Employee Retirement Income Security Act institutionalized passive funds in pension portfolios, embedding them as default options for long-term savers.
Today, BlackRock, Vanguard, and State Street together control over 70% of the global passive market and spend more on lobbying than the rest of the financial industry combined. Their influence on policy is formidable. Given their size and political clout, meaningful regulatory intervention appears improbable. Policymakers, reluctant to disturb what seems a stable system for retirement saving, are likely to act only after a crisis. History so often shows that regulatory bodies typically respond to crises, rather than anticipating them.

What Could Trigger a Reversal?

Until now, index funds have known only inflows. Passive investing has never been tested through a sustained period of large outflows. The risks will remain hidden until that day arrives. Potential catalysts include:

• Deteriorating market efficiency
  Persistent mispricing could push investors back toward active management.
• Rising volatility
  Concentrated passive exposure to a few sectors may amplify downturns, prompting investors to seek more selective strategies.
• Regulatory changes
  Currently unlikely, but mounting concentration may eventually force policymakers’ hands. Alternatively, lobbying from private equity and venture firms to capture part of the 401(k) market might lead to outflows from equity ETFs.
• Demographic shifts
  The greatest structural risk. As baby boomers retire and begin withdrawing from their 401(k)s and IRAs, decades of net inflows could quietly reverse into net outflows. Passive funds, forced to sell to meet withdrawals, could exert sustained downward pressure on markets. With younger generations constrained by debt and living costs, the inflow of replacement capital may fall short.
• Loss of confidence in a market
  Markets like the U.S., where foreign ownership is high, might experience a loss of confidence, leading foreign investors to sell.

Such an environment would transform passive investing from a buy-and-hold machine into a sell-and-spend mechanism - with destabilizing consequences.

The rise of the Index from Passive Benchmark to Active Market Force

Benchmarks were once neutral measures of performance, a simple way to track how markets were doing. Today they drive performance. The rise of passive investing has turned indices like the S&P 500 or MSCI World from mere yardsticks into powerful allocators of capital. The companies that design and maintain these indices now wield enormous influence over corporate behavior and the direction of global savings. The benchmark itself has become one of the market’s most active participants. This transformation increasingly blurs the line between passive and active investing.

In Defense of Active Management

For active managers, the index was once a benchmark - a standard against which to measure performance. Now it is both measure and master. If the sole objective of active managers is to beat the index, many investors understandably ask: why not simply own the index?

The answer lies in the broader role of active management. Active investors bring judgment, flexibility, and discipline - qualities that algorithms and rule-based strategies lack. They help maintain market efficiency by analyzing fundamentals, challenging narratives, and allocating capital to its most productive uses. Active management is not just a quest for outperformance; it is a public good that keeps markets rational.

In a passive-dominated world, the task of active managers has become harder. Momentum-driven markets punish mean-reversion strategies and reward trend-following behavior. To outperform in this kind of market, active managers can no longer select investments purely on the basis of fundamentals. They might even have to do the opposite by investing in companies they consider to be overvalued. By so doing, their degree of confidence in the companies that they are holding will decline however, they will be less willing to hold on to certain stocks during difficult times, and their performance may even get worse. As passive flows swell, price distortions intensify, active performance deteriorates, and more capital shifts passively - a feedback loop that feeds on itself.

As Michael Green of Simplify Asset Management aptly put it: “We have created an active-manager killing machine.”

Yet without active management, markets lose their informational integrity. Prices cease to convey meaning, and capital ceases to be allocated efficiently. Active investors are the oxygen of financial markets - invisible but indispensable.

¹ The market capitalization of a company is its stock price times the number of shares outstanding

² This does not mean that every company held by passive funds will be overvalued, only that from a statistical perspective, an overvalued company is going to be overweight

Legal Notice

This document is issued by BLI - Banque de Luxembourg Investments (“BLI”), with the greatest of care and to the best of its knowledge and belief. The views and opinions published in this publication are those of the authors and shall not be binding on BLI. Financial and economic information published in this publication are communicated for information purposes only based on information known on the date of publication. Such information does not constitute investment advice or encouragement to invest, nor shall it be interpreted as legal or tax advice. Any information should be used with the greatest caution. BLI does not give any guarantee as to the accuracy, reliability, recency or completeness of this information. BLI’s liability cannot be invoked as a result of this information or as a result of decisions that a person, whether or not a client of BLI, may take based thereon; such persons retain control over their own decisions. Interested persons must ensure that they understand the risks involved in their investment decisions and should refrain from investing until they have carefully considered, in conjunction with their own professional advisors, the appropriateness of their investments to their specific financial situation, in particular with regard to legal, tax and accounting aspects. It is reiterated that the past performance of a financial instrument is no guarantee of future returns.

Guy Wagner, Chief Investment Officer

Originally from a family of entrepreneurs in Luxembourg and with a degree in Economics from the Université Libre of Brussels, Guy joined Banque de Luxembourg in 1986, where he was successively responsible for the Financial Analysis and Asset Management departments, then became Managing Director of BLI - Banque de Luxembourg Investments, an asset management company newly created in 2005.

From July 2022 on, he devotes himself exclusively to his role as Chief Investment Officer, to the management of the portfolios and to the management of the team in charge management of the various funds.

Follow me on LinkedIn