Is Passive Investing Creating A Bubble?

As index funds attract trillions, several outlets have voiced concern that a passive investing bubble could be forming.

getty

Is one of the most popular investing strategies quietly distorting the stock market? As index funds attract trillions, several outlets—including Barron’s and Harper’s Magazine—have voiced concern that a passive investing bubble could be forming.

The core argument is that too much money is chasing too few stocks. Passive investing—through index mutual funds and exchange-traded funds (ETFs)—has become so dominant that it funnels an enormous volume of investor capital into a shrinking pool of mega-cap names such as Apple, Microsoft, Nvidia, Amazon, and Meta, for example, which often sit at the top of major index fund holdings.

Because these funds are market-cap weighted, larger stocks attract proportionally more capital. That can create a feedback loop, where rising stock prices trigger more buying, which in turn pushes prices higher.

Critics, such as Michael Green of Simplify Asset Management, warn that this dynamic may warp prices and inflate a bubble that could burst if flows reverse. They also worry that because index funds are essentially buy-and-hold vehicles, they don’t actively contribute to price discovery—the process that determines what a stock is truly worth based on supply and demand.

Yet others push back. Steve Johnson at Financial Times, for instance, notes new research suggesting the “…surge in passive money has made equity markets more efficient, contradicting some previous research that has found the opposite.”

How Big Is Passive Investing Today?

Zooming out provides more perspective. According to Boston Consulting Group, global assets under management (AUM) hit $128 trillion by the end of 2024. Passive strategies grew to 20% of total global AUM by the end of 2024.

There’s no doubt these figures are substantial, but they are far from overwhelming. While recent estimates indicate that systematic and passive strategies combined make up more than 60% of daily U.S. equity trading volume, pure passive index-tracking flows appear to represent a much smaller portion.

In Q1 2023, ETFs—including both passive and active funds—comprised 32% of U.S. equity trading volume, according to the ICI 2024 Fact Book (p. 61). Even at the end of 2023, passive index-tracking mutual funds and ETFs accounted for just 18% of total U.S. stock market ownership—a figure that may rise to 30–35% when including other passive strategies—keeping in mind that while ownership data helps gauge influence, it doesn’t directly reflect how often positions are traded.

This highlights a key point: truly passive flows are only a subset of ETF activity and likely make up a modest portion of total market turnover.

Is The Bubble Argument Overstated?

Passive investing began gaining traction in 1976, when Vanguard founder Jack Bogle launched the first retail index mutual fund. Since then, index-based strategies have become a cornerstone of modern portfolio construction. By offering typically lower costs, broad market exposure, and built-in diversification, passive investing has attracted significant inflows from investors seeking long-term, market-matching performance.

And despite concerns to the contrary, price discovery still occurs. Even when passive holds a sizable chunk of assets, active traders can still dictate equity and bond values. Hedge funds, portfolio managers, and individual investors continue to trade billions of dollars daily based on earnings reports, valuations, and other market signals. This activity helps play a critical role in maintaining market efficiency.

Morningstar’s March 2024 U.S. Active/Passive Barometer analyzed over 9,000 unique U.S. funds representing $23 trillion in assets—about 68% of the U.S. fund market. Yes, passive funds have attracted more inflows for nine straight years, but active funds still account for more than half of total U.S. assets. So, while passive investing is significant—and growing—it doesn’t appear to be the all-consuming force some critics make it out to be.

Regardless of the rise in passive allocation, active investing is anticipated to continue playing a vital role for many reasons. Individuals pursue hands-on strategies in an attempt to beat the market, to invest in their values, to take activist positions, or even because they think they can outsmart their peers. In short, investors generally do continue to care about their money, suggesting active management is likely to remain relevant.

A Surprise Advantage For Active Funds

The real surprise? Active managers outperformed passive funds far more often than headlines might suggest. Referring back to Morningstar’s March 2024 Active/Passive Barometer:

• Across all U.S. fund categories, 42% of active funds beat their passive peers in 2024.
• In categories such as real estate (66%) and intermediate core bonds (79%), active strategies dramatically outperformed.
• Over a 10-year span, real estate (47%) and high-yield bonds (48%) showed long-term success for active managers.

As long as active funds are beating their benchmarks, market dynamics reasonably imply continued participation from investors, portfolio managers, and institutions actively trading, researching, and trying to outperform.

For those concerned that algorithmic or computer-driven trading may fuel a passive bubble, it’s worth noting that these technologies have been embedded in market operations for decades. Rather than introducing a new risk, they’ve long been a foundational part of how modern markets function.

Bottom Line: Stay Grounded

While vigilance is warranted, the evidence suggests that market concentration risks are manageable. Passive investing does come with its own set of risks, as does any strategy. But data and market history indicate abundant competition from active investors, which doesn’t support the idea that current trends are inflating a bubble. There is clearly still sustained interest in active investing, which suggests a low probability of the market losing its ability to function properly.

The fact that 42% of active funds beat their passive peers in all categories in 2024, and even more so in real estate and bonds, underscores how active management remains a key force in price discovery, even as passive strategies grow. Investors are expected to continue utilizing passive strategies as one piece of a thoughtfully constructed portfolio that often includes active avenues as well. Passive investing isn’t perfect, but the data fail to support the argument that it poses an imminent systemic risk.

By focusing on controllable factors such as diversification and costs, investors may better position themselves to grow wealth steadily over time as part of a disciplined, long-term retirement strategy.

This information is provided to you as a resource for informational purposes only and is not to be viewed as investment advice or recommendations. Investing involves risk, including the possible loss of principal. There is no guarantee offered that investment return, yield, or performance will be achieved. The mention of any company is provided to you for informational purposes and as an example only and is not to be considered investment advice or recommendation or an endorsement of any company. The reader should not assume that an investment in the securities identified was or will be profitable. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. For stocks paying dividends, dividends are not guaranteed, and can increase, decrease, or be eliminated without notice. Fixed-income securities involve interest rate, credit, inflation, and reinvestment risks, and possible loss of principal. As interest rates rise, the value of fixed-income securities falls. Past performance is not indicative of future results when considering any investment vehicle. This information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. There are many aspects and criteria that must be examined and considered before investing. Investment decisions should not be made solely based on information contained in this article. This information is not intended to, and should not, form a primary basis for any investment decision that you may make. Always consult your own legal, tax, or investment advisor before making any investment/tax/estate/financial planning considerations or decisions. The information is strictly an opinion, and it is not known whether the strategies will be successful. The views and opinions expressed are for educational purposes only as of the date of production/writing and may change without notice at any time based on numerous factors, such as market or other conditions.