Index funds and ETFs have been the preferred choice for decades because they offer the safest and most cost-effective way to build wealth. Warren Buffett has repeatedly endorsed low-cost index funds as the optimal investment choice for investors who want to build wealth over time. The rapid expansion of passive funds has raised worries among financial professionals during the last few years. The growing amount of passive money entering the market causes valuation distortions which decreases market efficiency while producing risks that most investors remain unaware of.
The article examines passive investing’s concealed problems by analyzing verified data and expert alerts while providing investors with protection strategies against systemic risks.
The Rise of Passive Investing
Morningstar reports passive funds surpassed actively managed funds in U.S. equity fund assets for the first time during 2023 when passive funds reached more than 54% of total assets. The combined market power of Vanguard BlackRock and State Street exceeds $20 trillion which enables these companies to control major ownership positions in most large-cap U.S. companies. (Source)
Index funds have become the automatic selection for both retail and institutional investors because of their low-cost structure. The S&P 500 index fund draws billions of dollars in net investments annually without being influenced by market performance. When passive strategies receive excessive capital investment what consequences occur?
The Hidden Dangers of Passive Capital
1. Distorted Stock Valuations
Index funds acquire stocks at market weights that match the index composition without considering actual company fundamentals. The S&P 500 receives the most investment inflows which results in Apple, Microsoft and Amazon receiving the largest capital inflows because they have the largest market capitalization. The process creates a continuous loop of events:
- The rising stock prices occur because of increased investment inflows.
- The index weights increase when stock prices rise.
- The passive buying activity intensifies because of this development.
The 2022 Bernstein Research report indicated that the top 10 companies in the S&P 500 now represent more than 30% of the index’s total market capitalization which matches the dot-com bubble’s concentration levels.(Source)
2. The Illusion of Diversification
Investors believe that purchasing an S&P 500 index fund provides them with extensive diversification. The actual performance of the index depends heavily on a small number of large-cap technology stocks.
- The “Magnificent 7” consisting of Apple, Microsoft, Nvidia, Google, Meta, Amazon and Tesla generated more than 80% of the S&P 500’s total gains throughout 2023.
- The performance of these seven companies determines the overall performance of the index which makes investors more exposed to risk than they realize.
3. Reduced Market Efficiency
Active investors used to drive price discovery through their analysis of company earnings and their predictions about future performance which led them to buy or sell stocks based on fundamental values. The passive funds operate without active price-checking because they purchase stocks without considering their value.
Michael Burry who predicted the 2008 housing crisis has repeatedly stated that passive investing resembles the subprime mortgage bubble because price discovery no longer functions.
4. Systemic Risks During Market Crashes
The decline of markets becomes faster when passive funds are involved. Index funds and ETFs function through programmed buying and selling mechanisms. The panic withdrawal of investors from ETFs forces fund managers to sell all stocks equally which includes high-quality stocks and thus intensifies market crashes.
ETFs experienced their largest outflows during the March 2020 COVID-19 crash which intensified market volatility. The Federal Reserve determined that ETF redemptions caused 20% of the first wave of market selling pressure.
Are We Creating a Passive Bubble?
The experts believe passive investing has reached a point where it cannot be allowed to fail. The increasing capital flow into indexes creates a growing difference between stock prices and actual company fundamentals. The current market situation mirrors the dot-com bubble from the late 1990s because investors purchased stocks because they saw others making the same investment choice.
Bank of America research shows that the S&P 500 gains in 2023 were primarily driven by 15 specific stocks. The massive passive inflows became a major factor because trillions of dollars automatically invested in these companies without considering their earnings quality.
Real-Life Example: When Passive Funds Backfire
ARKK received strong promotion as a passive-style fund with high growth potential during 2021. The fund experienced a 150% increase during the 2020 tech market boom. The tech stock collapse in 2022 resulted in ARKK losing more than 60% of its total value. Investors who viewed it as a risk-free index fund experienced a trap because passive funds maintain their target holdings without adjusting for risk exposure.
How to Invest Wisely in a Passive-Dominated Market
1. Combine Passive and Active Approaches
While index funds are efficient for long-term wealth building, relying solely on them can expose you to bubble risks. Adding active ETFs, dividend stocks, or value funds can improve risk-adjusted returns.
2. Focus on Equal-Weight Index Funds
Instead of a market-cap-weighted S&P 500, consider equal-weight ETFs (e.g., RSP) that give each company the same weight. This avoids over-concentration in mega-cap stocks.
3. Maintain a Crisis Hedge
Allocate 10–20% of your portfolio to bonds, gold, or cash reserves to protect against sudden market downturns.
4. Monitor Market Concentration Metrics
The Herfindahl-Hirschman Index (HHI), often used in economics to measure concentration, can also highlight when stock indices become overly dominated by a few players.
5. Avoid Chasing Recent Performance
Dollar-cost averaging (DCA) into passive funds works best when you ignore market hype. Buying after large rallies often leads to disappointment.
FAQ
1. Are index funds still safe for long-term investors?
Yes, but over-reliance on passive funds without diversification can be risky, especially if market concentration worsens.
2. Is this a bubble like 2008?
Not exactly, but passive inflows could magnify the next market crash because there’s less active price correction happening.
3. Should I stop investing in index funds?
No, but consider blending them with international funds, bonds, and alternative investments.
4. Are ETFs riskier than mutual funds?
ETFs can trigger faster sell-offs because of intraday trading, but they’re not inherently riskier if used correctly.
5. How much of my portfolio should be passive?
For most retail investors, 60–70% passive allocation is fine, but 20–30% should be diversified into non-indexed assets.
Index funds themselves are not the problem but the excessive power they now possess in global markets. The passive flow of money into the market causes fundamentals to become less important than automated buying and selling which increases systemic risks.
A smart investor should not blindly follow the crowd. A smart investor should combine passive strategies with active oversight and hedging tools and periodic portfolio rebalancing. The objective is to use index funds effectively without succumbing to the excessive reliance on passive money investments.
Read our article: Why Most Index Fund Investors Are Losing Money — And How to Fix It
