The Passive Investing Problem Nobody Talks About

The Triumph of Passive

The argument for passive investing is one of the most well-evidenced in all of finance. Over any 15-year period, the vast majority of active fund managers underperform their benchmark index after fees. The SPIVA scorecards — published twice a year by S&P Dow Jones — consistently show that 85-90% of active large-cap funds trail the S&P 500 over a decade.

The logic is straightforward: markets are efficient enough that most professionals can't consistently beat them, and the fees they charge for trying guarantee that the average active investor ends up worse off than someone who simply bought the index.

This isn't a fringe view. It's supported by decades of data and endorsed by investors from Warren Buffett to Nobel laureates. Jack Bogle founded Vanguard on this principle in 1976, and the world has been catching up ever since.

By the end of 2025, passive funds held more than half of all US equity fund assets. In the UK, flows into passive funds have outpaced active for over a decade. The debate, for most retail investors, is over.

But winning the debate doesn't mean there are no consequences.

What Happens When Everyone Indexes

An index fund doesn't analyse companies. It doesn't read earnings reports, assess management quality, or make judgements about whether a stock is overvalued. It simply buys every company in the index, weighted by market capitalisation.

This is the feature, not a bug — it's what makes passive investing cheap and effective. But it relies on an assumption that's easy to overlook: that someone else is doing the work of setting prices.

Active managers are the ones who decide that Company A is overvalued at £50 and Company B is undervalued at £12. Their buying and selling is what moves prices toward something resembling fair value. This process — price discovery — is what makes markets function as an allocator of capital.

As passive's share of the market grows, fewer participants are engaged in price discovery. The prices that index funds accept as given are being set by a shrinking pool of active traders.

The Concentration Problem

Market-cap weighting means index funds buy more of whatever is already large. The bigger a company gets, the more of it every index fund must hold. This creates a feedback loop: money flows into the index, the index buys more of the largest stocks, those stocks get larger, and the index buys even more of them.

The result is visible in today's markets. As of early 2026, the ten largest companies in the S&P 500 account for over 35% of the index. The so-called "Magnificent Seven" technology stocks alone represent a concentration that hasn't been seen since the dot-com era.

A UK investor in a global tracker fund might think they're diversified across thousands of companies in dozens of countries. In practice, they have a third of their money in a handful of American tech firms. That's not necessarily wrong — but it's not the diversification most people think they're buying.

Correlated Flows, Correlated Crashes

When active managers sell, they sell specific companies for specific reasons. When passive investors sell, they sell everything — because that's what an index fund does. Redemptions from an index fund trigger proportional selling across every holding.

This means that in a downturn, passive outflows hit all stocks simultaneously, regardless of their individual fundamentals. A perfectly healthy company with growing earnings gets sold alongside a struggling one, simply because they're both in the index.

Research from the Bank for International Settlements and others has documented increasing correlation among stocks within major indices — meaning individual shares increasingly move together rather than on their own merits. Some of this is attributable to passive flows creating synchronised buying and selling pressure.

In calm markets, this barely matters. In a crisis, it could amplify the speed and depth of a sell-off. If half the market is passively held and a shock triggers widespread redemptions, the active managers who remain may not have enough capital to absorb the selling and stabilise prices.

The Capital Allocation Question

Stock markets exist, in theory, to allocate capital to productive enterprises. A company with a good idea issues shares, investors buy them because they believe in the business, and the capital flows to where it can create value.

Passive investing disrupts this mechanism. An index fund doesn't direct capital toward good businesses — it directs capital toward large businesses. A company that grows its market cap through share buybacks, financial engineering, or momentum receives the same automatic inflows as one that grows through genuine innovation.

Meanwhile, smaller companies that might represent better value or higher growth potential receive proportionally less capital, because they're a smaller weight in the index — or excluded from it entirely.

This isn't a theoretical concern. There's growing evidence that the IPO market has shrunk significantly over the past two decades, partly because public markets increasingly reward size over substance. Fewer companies are choosing to go public, and those that do face a market that may not price them efficiently because the marginal buyer is an index fund that doesn't care what they do.

The Governance Gap

When an index fund owns shares in a company, it has voting rights — but no particular reason to exercise them thoughtfully. An active manager who has researched a company extensively might vote against a bad acquisition or challenge excessive executive pay. An index fund owns thousands of companies and can't conduct deep analysis on each one.

The big index providers — BlackRock, Vanguard, State Street — collectively hold enormous stakes in virtually every public company. They've built stewardship teams to handle proxy voting and engagement, but the scale is unprecedented. Three firms effectively have significant voting power over most of the world's largest companies.

Whether this concentration of passive ownership leads to better or worse corporate governance is still debated. But it's a structural shift that has no historical precedent, and its long-term effects on how companies are run remain genuinely unknown.

Merryn Somerset Webb makes this case forcefully in Share Power. Her argument is that share ownership comes with responsibilities — voting rights, engagement, accountability — and that the rise of passive investing has severed the link between owning a company and caring about how it's run. When millions of investors hold shares through index funds, nobody is really holding management to account. The power that comes with ownership is being quietly surrendered to a handful of asset managers who may not use it in investors' interests.

Andrew Craig has explored similar territory in his analysis of active versus passive investing. His argument isn't that active funds are universally better — most aren't — but that the blanket "just buy an index fund" advice ignores real structural problems. When passive becomes the default and active managers are squeezed out, markets lose the participants whose job it is to identify mispriced companies and allocate capital efficiently. The more dominant passive becomes, the more opportunity there may eventually be for genuine active management to add value — but only if anyone is still doing it.

Does Any of This Matter to You?

If you're a UK investor saving into a pension or ISA using low-cost tracker funds, this might all sound abstract. And in practical terms, for most people, passive investing remains the right approach. The evidence against active management is overwhelming, and the fee savings are real and compound over decades.

But it's worth understanding what you're participating in. You're not buying a diversified basket of the economy — you're buying a market-cap-weighted slice of whatever happens to be large right now. Your returns are tied not just to the performance of those companies, but to the continued flow of money into the same strategy.

The risks of passive dominance are systemic, not individual. They won't show up in a comparison of fund performance tables. They'll show up — if they show up — as increased market fragility, reduced price efficiency, and a public market that's less effective at funding the businesses that drive economic growth.

None of this means you should switch to active funds — the data still doesn't support that for most investors. But it does mean the question "active or passive?" is more nuanced than the standard advice suggests. The right answer for an individual investor isn't necessarily the right answer for the market as a whole.

What You Can Do

• Understand your concentration. Check how much of your portfolio is in the top 10 holdings. If it's above 30%, you're less diversified than you think.
• Consider equal-weight or multi-factor funds as a complement to market-cap-weighted trackers, to reduce concentration risk.
• Don't assume passive is zero-risk. It's low-cost and evidence-based, but it's not a free lunch. The risks are different from active management, not absent.
• Model it. If you want to see how concentration risk or a market correction in large-cap tech would affect your retirement plan, you can build a free scenario and stress-test it.

Further Reading

• Sushko, V. & Turner, G. (2018). "The implications of passive investing for securities markets." BIS Quarterly Review, March 2018.
• Bogle, J. (2018). "The Index Fund, the 'Know-Nothing' Investor, and the Rise of Passive Investing." Remarks at the Bogle Financial Markets Research Center.
• Garleanu, N. & Pedersen, L. (2022). "Active and Passive Investing: Understanding Samuelson's Dictum." Review of Asset Pricing Studies, 12(2), 389–446.
• Somerset Webb, M. (2022). Share Power: How Ordinary People Can Change the Way That Capitalism Works. Short Books.
• Craig, A. "Active vs Passive Investing." Plain English Finance (YouTube).
• SPIVA U.S. Scorecard, Year-End 2025. S&P Dow Jones Indices.