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Study supports what many suspected about passive investing

The growth of passive investing has stimulated academic and policy interest in how it affects asset prices and the real economy.

Hao Jiang, Dimitri Vayanos, and Lu Zheng, authors of the March 2025 paper “Passive Investing and the Rise of Mega-Firms,” set out to understand how the increasing shift from active to passive investing influences asset prices, particularly the prices of the largest firms in the market.

They developed a theoretical model showing how the rise of passive investing should affect prices in market equilibrium. They also tested some of the predictions of the model in the data, by analyzing the effects of capital flows into passive funds—such as index funds and exchange-traded funds—on the stock prices and volatility of large-cap companies. Their data sample took the S&P 500 and flows into index mutual funds and index ETFs tracking it. It covered the period from 1996 to 2020.

Before digging into their findings, we need to discuss two key points. First, research (see here and here) has found that active institutional investors (such as mutual funds), in aggregate, underweight large stocks. Second, the investors who then overweight these large stocks are active retail “noise traders”—investors who make decisions to buy or sell based on factors they believe to be helpful but in reality will give them no better returns than random choices. The idea of a noise trader comes from the belief that price action has “noise” that is unrelated to the signal of fundamental analysis about a security’s value.

Their key findings:

  • Disproportionate Price Increases for Large Firms: Their theoretical model shows that inflows into passive funds disproportionately raise the stock prices of the largest companies in the economy (reducing their financing costs), especially those that are already overvalued by the market in the sense of experiencing high demand by noise traders.
  • Wide Market Impact: These price effects are significant enough to lift the overall market, even if the inflows are simply due to investors reallocating from active to passive strategies, rather than new money entering the market.
  • Increased Idiosyncratic Volatility: The authors observed that passive flows create additional idiosyncratic (firm-specific) volatility for large firms. This increased volatility discourages active institutional investors from correcting mispricing caused by passive flows, allowing price distortions to persist.
  • Empirical Evidence From the S&P 500: Consistent with their theoretical model, the largest firms in the S&P 500 experienced the highest returns and the greatest increases in volatility after passive fund inflows into the index. Moreover, consistent with households investing at the beginning of each month a fraction of their monthly paychecks in passive funds through their retirement plans, the largest stocks outperform the index in the first week of each month.

The authors explain the intuition for their results through a feedback loop mechanism. They use a stylized example of a large firm that is in such high demand by noise traders that active funds short-sell it in equilibrium:

“A switch by some investors from active to passive generates additional demand for the firm because passive funds hold the firm with its weight in the market index while active funds hold it with negative weight. Active investors can accommodate the additional demand by scaling up their short position. This renders them, however, more exposed to the firm’s idiosyncratic risk, which is non-negligible because the firm is large. The firm’s stock price must then rise to induce active funds to take on the additional risk. Crucially, because the stock price rises, the stock’s idiosyncratic price movements become larger in absolute terms. This gives rise to an amplification loop: The short position of active funds becomes even riskier, causing the stock’s price to rise even further, and the stock’s idiosyncratic price movements to become even larger. The amplification loop explains why passive flows have their largest effects on large firms in high demand by noise traders.”

Their findings led the authors to conclude:

“Our theory implies that passive investing reduces primarily the financing costs of the largest firms in the economy and makes the size distribution of firms more skewed.”

Key takeaways for investors

  • Passive Flows Can Distort Prices: Investors should be aware that the mechanics of passive investing can drive up the prices of the largest index constituents, sometimes beyond what fundamentals justify.
  • Volatility Risks: The increased idiosyncratic volatility in mega-cap stocks may present both risks and opportunities for investors, particularly those employing active or contrarian strategies.
  • Market Concentration: The rise of mega-firms, fueled by passive flows, can lead to greater market concentration, which may have implications for portfolio diversification and systemic risk.
  • Active vs. Passive Dynamics: While passive investing offers low fees and broad market exposure, its growing dominance can create feedback loops that institutional investors may exploit.

Shaping the market

The paper highlights a crucial dynamic in today’s markets: The surge in passive investing doesn’t just mirror the market—it shapes it, often amplifying the rise of the largest firms and creating new risks and opportunities. For investors, understanding these effects is essential. While passive strategies remain a powerful tool for long-term wealth building, awareness of their broader market impact can help investors make more informed decisions about diversification and risk management.

Postscript

Jiang, Vayanos, and Zheng showed that flows to passive funds have led to a rise in the valuations of the largest stocks more than is justified by fundamentals and lowered their financing costs, raising the question: Could that lead to misallocation of capital?

 

Larry Swedroe is a freelance writer and author. The views expressed here are the author’s. For informational and educational purposes only and should not be construed as specific investment, accounting, legal, or tax advice. The author does not own shares in any of the securities mentioned in this article.

 

5 Comments
Steve
July 20, 2025

Won't be long before the Fed Govt will be collecting zillions in CGT revenue from CBA shareholders pass on to the next life.

Johns
July 18, 2025

Passive funds by definition are just following what others are doing completely blind.

While ever the market is dominated by active investors, the passive investors are getting a free ride because they are getting the benefit of the active investors research without paying for it

But there will become a situation where there are too many followers and too few leaders. At that point it becomes the blind leading the blind

James
July 18, 2025

The reason for the growth of passive investing is the underperformance of active investment funds verses their index in the large majority of cases (see the S&P SPIVA Report). Passive investors are simply seeking a better, less volatile return than active strategies. All investments have collateral implications, including active investments.
Does Mr Swedroe think that investors should lower their returns and increase the volatility of their portfolios for the privilege of investing in active funds and thereby paying the salaries and bonuses of underperforming active fund managers?

S2H
July 19, 2025

Larry Swedroe is Booglehead and wrote a book called the Incredible Shrinking Alpha, so he would agree with your sentiment that passive beats active as an individual investor. But that doesn't mean it isn't distorting the market and it doesn't create opportunities for sophisticated quant investors. But as an individual investor should you care? Not if you accept the principle that it is very difficult to pick an active manager who will consistently outperform an index and your goal is to maximise your return.

Steve
July 17, 2025

Still not convinced. The authors use of words like "implied" and "theory" suggest the conclusions are not as solid as first appears, it is just how they explain the observations. They acknowledge that active funds underweight the larger firms; active funds are still very large. Also how does this allow for differences between the larger firms - in Australia BHP has way underperformed CBA - passive funds don't discriminate, just apply the funds at the existing status quo. And that's if its a cap weighted fund. Other funds which are becoming more popular such as equal weight or quality focused have underweight positions in the largest stocks. I suspect CBA itself is a bit of a one-off in that many mum & dad shareholders got their shares many years ago and will "never" sell as it has been such a good investment. Not many companies have this kind of legacy which tips the demand/supply balance (less supply due to many long term holders). Ironically a good run up in share price makes selling harder as you may get a nice capital gains tax bill. Finally the run up in CBA has only really been the last few years - as you say, maybe foreign investors looking to hedge out of US investments might be the primary factor here? One other observation - it is stated that active firms are (in total) underweight the largest firms. This suggests they have therefore underperformed the index, presuming the larger firms that grow the most are the ones driving the index.

 

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