
Today, there’s an estimated 40% to 45% of U.S. equity assets being held in “passive” investment vehicles like index funds and exchange-traded funds (ETFs). As vast swaths of capital flows into these instruments, how does it inflate the value of the largest companies within those indexes, regardless of their individual fundamentals? And.. does this tie their results to each other in an abnormal way?
The more money that flows into these funds, the more they automatically buy shares of the largest companies, creating a feedback loop. As investors are buying the index to diversify, they automatically funnel more money into the largest players and performers with less and less relationship to fundamental factors. Index funds base allocation off of these factors only: Market Cap and Free Float Market Cap. Wouldn’t indexes then be HEAVILY overweight in these two factors? And thus the market be overvaluing these two factors?
What happens when this feedback loop creates such a large concentration of capital in such a small number of companies with their risk / reward now tied to each other? The better, or worse, any one company within the index performs, the more the price of the overall index fluctuates.
In a bubble scenario, if any one of those companies suffer a downturn the entire index will feel the effects. Just as that index feedback loop creates constant flow of capital for those top performers in a bull market, wouldn’t it also create a greater rush to ruin for said players in a sell off, even if the hiccup is from only 1 or 2 of them?
For example, Google’s antitrust lawsuit with the DOJ. By indexing all of these companies together, doesn’t Apple now assume some of Google’s risk in decline? If an index like VOO takes a hit from a halving of Google’s stock price, and investors or algorithmic investing dumps VOO to avoid the hit from GOOG, the rest of the companies will experience the sell off by cascade effect. Where in pre-index investing, GOOG’s risk would be bifurcated from the rest of the market players, now it’s heavily tied to companies that may not even have a sector or business relationship to GOOG.
As value investors, we could see detriment to any one holding that is also captured by a popular passive fund (say Vanguard Value ETF) affected by its coupling to other heavily weighted assets within the same index. Should one consider this when analyzing a held or prospective asset?

Growth of passive investing:
Move into index funds:
80s/90s slow and steady adoption
2000s rise of etf strategy
2010s explosion of passive strategies
2020s now 40-50% weighted in passive strategies
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Other factors to consider:
Rise in retail investment popularity
Around 20% of investments held in public markets are held by retail investors. This is up from 17% in 2020 and between 10-12% in the 2010s. Retail accounts are held by what would be generally considered less versed/educated investors. Highly liquid retail accounts could play a huge role in any sharp reactions to changes in market sentiment.
With the above stated popularity of "passive investing" and an uptick in retail investment accounts, we could see a perfect storm for quick downward movement across the market as a whole. No calling your broker to sell. You can do it from your phone instantly.
If more and more of investors are putting money into what they view as "passive" investments, one could draw the conclusion that they have a lesser sense of the smaller parts that make up that investment as a whole, and pay less attention to the fundamentals of those smaller parts (as stated above). With the pushing of these assets as "passive", the assumption could be made these investors expect to be able to grab returns while they are not paying much attention......... UNTIL... broader market sentiment shifts. At this moment, these large swaths go from slow moving, less active, less attentive buyers... To sellers capable of instant transaction.
Packaging of good investments with bad investments
In the case of the 2008/2009 recession, sub prime mortgages (shit investments), were packaged with higher quality mortgages, and sold as AAA rated debt investments. Due to the profitability of these ratings companies deeming them AAA, the investments were not properly assessed.
In considering the long bias involved in companies reliant on the consistent influx of capital into these passive tools to fund the further growth of their valuations (many financial institutions are held in these indexes and etfs), are we looking at a similar packaging scenario? Even if the companies that are trading at high PE ratios are valid at those valuations... unlikely compared to history... are we then being sold an overall bad package, with a skewed rating based on its upper quartile outliers? Do these "passive" investors understand the fundamentals of the rest of the S&P 500 ?
Historic Avg 10% return annually. No time reviewing the investment. Automatically rebalanced for performance...... autopilot.
Are these instruments too good to be true?
"THERE IS NO FREE LUNCH" - Charlie Munger
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