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How Passive Investing Could Threaten Market Stability

According to Bloomberg Intelligence, as of early 2024, passive investment vehicles now account for 50.2% of all US publicly traded equity fund assets—marking a major milestone in the shift away from active management. Within that, 53.8% of domestic equity assets and 41.5% of international equity assets are now passively managed (Bloomberg, 2024). Passive investing has long been praised for lowering costs and improving access. But as trillions pour into index funds, some experts warn this shift may alter how markets function—potentially distorting prices, amplifying volatility, and heightening systemic risk. This article explains how passive investing works, explores where it adds value, and breaks down the growing concern around concentration and correlation risk.
ByAlexander Harmsen
Fact checked byDiversification.com Compliance Team
How Passive Investing Could Threaten Market Stability

According to Bloomberg Intelligence, as of early 2024, passive investment vehicles now account for 50.2% of all US publicly traded equity fund assets—marking a major milestone in the shift away from active management. Within that, 53.8% of domestic equity assets and 41.5% of international equity assets are now passively managed (Bloomberg, 2024). Passive investing has long been praised for lowering costs and improving access. But as trillions pour into index funds, some experts warn this shift may alter how markets function—potentially distorting prices, amplifying volatility, and heightening systemic risk. This article explains how passive investing works, explores where it adds value, and breaks down the growing concern around concentration and correlation risk.

Key Takeaways

  • Passive strategies now control over 50% of U.S. equity assets.
  • As index funds track the same assets, price discovery may weaken and correlation may rise.
  • Large inflows or outflows can amplify market volatility—especially in times of stress.
  • Passive investing doesn’t cause systemic risk directly—but its scale may accelerate it under certain conditions.

The Rise of Passive Investing—and Why It Matters

Index funds and ETFs have fundamentally reshaped how investors allocate capital. Instead of picking individual stocks or active funds, passive strategies track predefined indexes like the S&P 500.

They offer lower fees, simplicity, and predictable exposure. But they also rewire market mechanics. As more dollars flow into funds that buy or sell entire indexes, underlying stock prices may move for reasons unrelated to company fundamentals.

According to Morningstar, passive US equity funds saw net inflows of $244 billion in 2023, while active equity funds experienced $257 billion in outflows (Morningstar, 2024).

So what happens when most of the market simply follows the index?

When Everything Moves Together: Correlation Risk

Passive investing is inherently mechanical. Funds must buy or sell securities based on index rules, not real-time news or valuation.

This can drive correlated behavior across sectors—especially in major indexes dominated by a few tech stocks.

  • When large funds rebalance or receive inflows, they often buy the same companies in the same proportion.
  • This herding can amplify price movements during bull markets.
  • During downturns, it may accelerate selloffs as funds exit broad baskets indiscriminately.

Hypothetical: Imagine a scenario where a major index experiences outflows during a market panic. Index funds may be forced to sell across the board—even healthy companies—adding to downward pressure.

The concern isn’t just volatility. It’s the potential for feedback loops: more selling triggers more redemptions, which forces more selling.

Are Prices Still Telling the Truth?

One often-overlooked consequence of passive dominance is weaker price discovery.

In theory, stock prices reflect the collective judgment of investors analyzing earnings, strategy, and risk. But when a growing share of trades are passive—driven not by analysis, but index weightings—that feedback loop can weaken.

Fewer active participants means fewer incentives to uncover mispricings. This could allow bubbles to inflate longer—or risks to go unnoticed.

So while passive investing may lower costs, it may also make prices less accurate signals of a company’s actual value.

Systemic Risk Isn’t the Same as a Crash—But It Matters

Some critics argue that passive investing could one day become a source of systemic risk. But it’s important to be precise.

Passive investing doesn’t create risk in isolation. The risk emerges from how it interacts with market structure:

  • Highly concentrated indexes can cause large capital shifts to depend on a few names.
  • ETFs that track illiquid markets may become volatile under stress.
  • Algorithmic trading tied to passive flows can reinforce price swings.

During the COVID-19 crash in March 2020, ETF trading remained robust—but some credit ETFs showed pricing gaps between the fund and the underlying bonds (Fed, 2020). This highlighted how mechanical trading strategies can introduce friction under stress.

So what? Investors assuming passive equals low-risk may underestimate the complexity beneath the surface.

Concentration and Crowded Exits: The Real Passive Risks

Critics may often cite systemic fragility as a concern—but the most tangible risk tied to passive investing emerges when too many investors rush for the exits at once. This dynamic can occur during sharp selloffs or periods of panic, when indiscriminate selling by index-linked funds accelerates market declines. Still, history shows that investors who avoid panic-selling often recover alongside the market rebound.

Another key risk is position size drift. In market-cap-weighted strategies, top-performing stocks naturally grow to dominate the portfolio—potentially creating unintended concentration. While these holdings often rise due to strong performance, over time it becomes prudent to rebalance or trim outsized positions. Doing so allows room for new allocations and helps restore diversification, rather than relying too heavily on yesterday’s winners.

So what? The risk isn’t passive investing itself—it’s the illusion of set-it-and-forget-it diversification. For investors, maintaining awareness of portfolio drift and being ready to act during moments of stress can make the difference between resilience and exposure.

Why It Matters for Portfolio Strategy

Many investors assume passive equals diversification. But if most of a portfolio is allocated to the same index that others hold, true diversification may be lower than expected. To reduce hidden concentration and correlation risk, some investors explore:

  • Diversifying across uncorrelated asset classes
  • Using factor-based or alternative index strategies
  • Monitoring portfolio overlap and exposure concentration

Passive Investing — FAQs

How can passive inflows or outflows affect short-term market moves?
Because index funds trade entire baskets, large inflows can amplify rallies, while large outflows may intensify selloffs, regardless of company-specific fundamentals.
Why might price discovery weaken as passive investing expands?
With a greater share of trades tied to index rules rather than analysis, there may be fewer incentives to identify mispricings, reducing the accuracy of prices as signals of value.
How concentrated are major equity indexes today?
Major indexes often have significant weighting in a small number of large-cap technology companies, which can create unintended concentration in portfolios tracking those benchmarks.
What did the March 2020 market stress reveal about ETFs?
While ETF trading remained active, some credit ETFs showed pricing differences relative to their underlying bonds, highlighting frictions when mechanical strategies meet less liquid markets.
How do market-cap-weighted indexes contribute to position drift?
In market-cap strategies, top-performing stocks naturally grow into larger portfolio weights, which can increase concentration risk if holdings are not periodically rebalanced.
Why does correlation risk rise in passive-heavy markets?
Since index funds buy and sell based on index composition, securities included in the same benchmarks often move together, raising cross-sector correlations and reducing diversification benefits.
Does passive investing create systemic risk on its own?
Passive investing itself does not create systemic risk, but under stress, concentrated benchmarks, illiquid ETF markets, and algorithmic trading linked to flows can amplify volatility.
How can feedback loops form during passive-driven selloffs?
Broad selling from index fund outflows can push prices lower, which may prompt additional redemptions and further selling, reinforcing downward pressure.
What is a common misconception about diversification in index funds?
Some investors assume index funds guarantee broad diversification, but heavy allocation to widely held benchmarks can lead to hidden overlap and higher portfolio correlations.
How do indexes tilt exposure toward past winners?
Market-cap weighting increases exposure to stocks that have already risen in value, which can result in concentrated positions in prior leaders rather than evenly distributed risk.