The relentless growth of passive investing, particularly through Exchange Traded Funds (ETFs), is creating systemic risks within financial markets, according to Michael Green, chief investment strategist at Simplify Asset Management. Green argues that the structure of passive investment vehicles is distorting valuations, favoring large, volatile stocks and creating a disconnect between market performance and underlying economic fundamentals.
Speaking to BNN Bloomberg, Green explained that the proportional allocation within index funds – “Everything in the index is in proportion to its market capitalization” – inherently amplifies the impact of large companies. This means that inflows into ETFs don’t distribute capital based on company performance, but rather reinforce existing market weightings. “That ends up pushing the securities that are the largest and most volatile components of the index up disproportionately,” he said. “That, in turn, means the next dollar in which comes the very next day, or, in the case of ETFs, sometimes the next minute, will actually push them even further in that same direction.”
The core issue, as Green outlines, is that this constant influx of capital into ETFs is driving company valuations beyond what their financial performance would justify. Instead of prices being determined by traditional metrics like earnings or revenue growth, they are increasingly dictated by the sheer volume of money flowing *into* the funds that hold those stocks. This creates a feedback loop where rising prices attract more investment, further inflating valuations, regardless of underlying business realities.
This isn’t simply a matter of inflated stock prices; Green contends that it fundamentally alters the relationship between stocks and their economic drivers. Passive investments, by their nature, bundle securities together, increasing the correlation between individual stocks and the broader index. This reduces the ability of individual company performance to influence its stock price, as it becomes more closely tied to the overall market trend. The result is a market where price discovery is impaired, and capital allocation becomes less efficient.
While investors have benefited from the lower fees associated with passive investment strategies, Green points out a critical limitation: liquidity. “Liquidity does not scale with market capitalization and so bias has been created in the market as we have grown passive.” Larger companies, already benefiting from their size and market presence, are further advantaged by the increased capital flows directed towards them through passive vehicles. This creates an uneven playing field and potentially disadvantages smaller, growing companies that may offer more compelling long-term investment opportunities.
The consequences of this trend extend beyond individual investors. Green warns of a “remarkable disconnect between the economic underpinnings and the actual performance of the securities” which creates a systemic risk that is difficult to mitigate through traditional diversification or hedging strategies. This systemic risk stems from the concentrated nature of the market, particularly within the “Magnificent Seven” – a group of large technology companies that have driven a significant portion of recent market gains, as reported by Pensions & Investments. The concentration of market value in a handful of companies exacerbates the vulnerabilities created by passive investing.
The implications for future market returns are also concerning. Green’s research suggests that passive investing and the resulting correlated stock behavior will ultimately lead to lower returns. “Unfortunately, we have very clear evidence that this is actually what is happening in markets,” he stated. This is particularly relevant given the increasing reliance on passive investment vehicles for long-term savings, including government-sponsored retirement programs focused on large-cap stocks. This reliance, Green argues, could have broader “social ills” as it distorts market signals and potentially undermines long-term economic growth.
The concerns raised by Green are not new. , ETF.com reported on similar warnings from Green, highlighting the vulnerability of stock markets to crashes as passive investing concentrates capital in less liquid equities. The issue is gaining traction as the scale of passive investing continues to grow, prompting a re-evaluation of its long-term impact on market stability and efficiency. The question now is whether regulators and investors will address these concerns before the systemic risks materialize into a more significant market correction.
The shift towards passive investing has undoubtedly democratized access to financial markets and lowered investment costs. However, as Green’s analysis demonstrates, this progress comes with potential drawbacks that require careful consideration. The increasing concentration of capital in a few large stocks, the distortion of price discovery, and the potential for lower future returns all point to a need for a more nuanced understanding of the risks associated with the continued growth of passive investment strategies.
