When Passive Investing Stops Being Passive
For decades, passive investing has been sold as one of the safest and most rational ways to build wealth.
The logic is elegant.
Active managers spend enormous amounts of time and money researching companies. They interview management teams, analyse financial statements, build valuation models and decide where capital should be allocated. Their collective decisions push money towards promising businesses and away from weaker ones. Over time, stock prices and market capitalisations become a rough reflection of economic reality.
Passive investors can then simply buy the index.
Instead of trying to outperform the market, they piggyback on the work of active managers. They benefit from broad diversification and low fees.
The arrangement works because active investors do the hard work of price discovery, while passive investors free-ride on the results.
For most of the past half-century, this has been an extraordinarily successful strategy.
But there is a problem.
The free riders are becoming the majority.
The Tipping Point
According to Morningstar data, passive funds now account for 55% of US retail fund assets, up from just 34% in 2016. During that period, passive funds attracted $6.4 trillion of net inflows while active funds experienced $2.4 trillion of net outflows. The balance of power has shifted dramatically.
For the first time in modern financial history, more retail investment capital is being managed according to index rules than according to discretionary investment analysis.
This changes the dynamics of the market.
Passive investing was built on the assumption that someone else was doing the research.
But what happens when fewer people are doing the research, and more people are simply following index methodologies?
At some point, the quality of the index itself becomes more important than the distinction between active and passive.
And that is where things become interesting.
Why IPOs Were Traditionally Kept Out
Historically, major index providers understood something important about newly listed companies.
IPOs are messy.
Valuations are uncertain. Information is limited. Investor enthusiasm often runs ahead of reality. Some companies soar after listing. Others collapse once the initial excitement fades.
For that reason, many major indices historically imposed waiting periods before newly public companies could enter.
The logic was straightforward.
Allow active investors, analysts, hedge funds and institutions to determine a reasonable valuation first. Let the market digest the information. Let the excitement settle.
Only then should passive investors gain exposure.
These rules acted as a buffer between passive investors and the most speculative phase of a company’s life as a public company.
In hindsight, they were remarkably sensible safeguards.
The SpaceX Test
The recent SpaceX IPO may represent the first major challenge to those safeguards.
In an interview with the Financial Times, Senator Elizabeth Warren argued that SpaceX successfully pressured some major index providers to accelerate its inclusion into benchmark indices.
Her concern was not simply the company’s valuation.
Her concern was what happens when passive funds are required to buy.
As Warren put it, insiders would have the opportunity to sell shares into a market that includes a “captive audience” of index funds.
Whether one agrees with Warren’s politics is largely irrelevant. The structural concern deserves attention.
If a company can gain rapid inclusion into major benchmarks, hundreds of billions of dollars managed by passive funds may be forced to purchase shares regardless of valuation.
The traditional gatekeeping role performed by active investors becomes weaker.
Index methodology becomes the primary determinant of capital allocation.
This is a profound shift.
Passive investing was originally designed to follow markets.
Increasingly, markets are beginning to follow passive investing.
The New Gatekeepers
There is another dimension to this story that deserves scrutiny.
Most investors think of index providers as neutral referees.
But index providers are not charities.
They are businesses.
Their revenues come from licensing their indices to ETF providers and asset managers. The more assets tracking an index, the more valuable that index becomes.
This creates a subtle but powerful incentive.
Historically, the goal was to maintain standards.
Today, the goal is also to remain relevant.
The provider that includes the most exciting companies first attracts attention. It attracts ETF assets. It attracts licensing revenue. It avoids looking outdated.
This should sound familiar.
One of the key lessons of the 2008 financial crisis was that gatekeepers can become compromised when commercial incentives become too closely aligned with the parties seeking access.
Credit-rating agencies were supposed to provide independent assessments of risk. Yet competition for business gradually weakened standards across the industry.
The comparison is not perfect. Index providers are not rating mortgage-backed securities.
But the underlying incentive problem is remarkably similar.
The gatekeeper is no longer entirely independent from the commercial forces surrounding the asset.
And that should concern passive investors.
Elon Musk and the FOMO Problem
The pressure becomes even more intense when the company involved is controlled by Elon Musk.
For more than a decade, Musk has demonstrated an almost unique ability to attract capital. Tesla achieved extraordinary valuations long before traditional financial metrics could justify them. Investors repeatedly bet on Musk’s vision rather than current fundamentals.
Sometimes they were right.
That success creates a new problem.
Nobody wants to miss the next Tesla.
Not institutional investors.
Not retail investors.
And increasingly, not index providers.
The danger is not that SpaceX fails.
SpaceX may ultimately justify every dollar of its valuation and more.
The danger is that fear of missing out begins to influence the supposedly rules-based process governing index inclusion.
Once that happens, passive investing ceases to be quite as passive as investors believe.
The judgment has simply moved from active fund managers to index committees.
Irrational Exuberance, Institutionalised
In 1996, Alan Greenspan famously asked whether markets were suffering from “irrational exuberance.”
The phrase became synonymous with speculative bubbles — periods when investors become so captivated by a story that valuations detach from underlying fundamentals.
Historically, irrational exuberance was largely the domain of active investors. Portfolio managers, venture capitalists, speculators and retail traders chased the hottest themes of the day.
Passive investors simply observed from the sidelines.
Today’s market structure is different.
A company receives a lofty valuation. Its market capitalisation rises rapidly. It becomes a candidate for index inclusion. Passive funds are then forced buyers. That buying increases demand, reinforces the valuation and increases the company’s weight in the benchmark.
What was once merely investor enthusiasm risks becoming institutionalised enthusiasm.
The concern is not that markets occasionally become overexcited. That has always happened.
The concern is that trillions of dollars of passive capital are increasingly tied to rules that may amplify rather than dampen those periods of exuberance.
Passive investing was designed to protect investors from irrational exuberance.
The irony is that, if index providers begin chasing the next hot IPO, passive investing could become one of the mechanisms through which irrational exuberance spreads.
The AI IPO Wave
SpaceX may be only the beginning.
OpenAI, Anthropic and a growing list of AI companies are widely expected to reach public markets this year. These are precisely the kinds of businesses that generate extraordinary excitement, extraordinary valuations and extraordinary pressure not to be left behind.
The commercial incentives are obvious.
The index provider that gets the hottest companies into its benchmark fastest stands to attract media attention, ETF inflows and licensing revenue.
Investors will demand exposure.
ETF providers will demand inclusion.
Financial media will celebrate every valuation milestone.
The question is whether the safeguards that once protected passive investors survive that pressure.
Because if they do not, the passive-investing revolution may begin to look very different from the one investors originally signed up for.
The Hidden Risk Inside Your Index Fund
None of this means passive investing is broken.
Low-cost index funds remain one of the greatest financial innovations of the past half-century.
But passive investing was built upon a crucial assumption: that someone else was doing the hard work of price discovery and risk assessment.
As passive investing grows and index providers become increasingly powerful gatekeepers, that assumption deserves renewed scrutiny.
The biggest risk facing passive investors may not be the companies entering the index.
It may be the incentives of the people deciding who gets in.
For decades, investors worried about the incentives of fund managers.
In the age of passive investing, they may need to start worrying about the incentives of index providers instead.
Disclaimer
The information provided in this article is for general informational purposes only and does not constitute financial, tax, legal, investment, or other advice. While I am an authorised financial advisor, the content here is not tailored to any individual’s specific circumstances. Before making any financial decisions, you should seek professional advice suited to your unique situation. If you require guidance, please contact me directly for personalised financial advice.
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