The Perils of Passive Investing
No Such Thing as a Free Lunch
There is a certain elegance to the passive investing thesis. Buy a broad market index, hold it indefinitely, ignore the noise, and let compounding do its work. It is simple, cheap, and backed by decades of data. For most people, particularly those without the time, temperament, and dedication to actively manage their portfolios properly, it is the default approach. But the label ‘passive investing’, particularly the ‘passive’ part, can breed a dangerous complacency about what you are actually doing when you allocate capital to an index fund and look away.
What Is Passive Investing?
Passive investing is an investment strategy that seeks to replicate the returns of a market index rather than outperform it. In practice, this typically means buying a fund, such as an exchange-traded fund or mutual fund, that holds the same securities, in the same proportions, as a given benchmark. The S&P 500, the MSCI World, and the FTSE 100 are among the most commonly tracked indices. The investor does not select individual securities, does not generally attempt to time the market, and does not rely on a fund manager’s judgement about which stocks are undervalued or overvalued. Instead, they accept the market’s collective verdict on price and simply own a slice of the whole.
The strategy is often contrasted with active investing, where a manager or individual investor makes deliberate bets, overweighting certain sectors, avoiding others, moving in and out of positions, in an effort to generate returns above the benchmark or within the confines of other investment mandate goals. Passive investing’s central claim is that, after fees and over time, most people are better off not trying active investment.
It is a claim the market has increasingly accepted. The growth of passive investing over the past three decades has been one of the most significant structural shifts in financial markets. In August 1996, twenty years after the launch of the first publicly available index fund, passive strategies represented just 6% of US-domiciled equity mutual fund and ETF assets. By 2010, that figure had risen to 19%. By the end of 2025, the shift had become overwhelming: according to the Investment Company Institute, US indexed mutual funds and ETFs held $19.26 trillion in assets, comfortably surpassing the $17.40 trillion held in actively managed funds. Globally, ETF assets alone reached a record $19.85 trillion by the end of 2025, having grown nearly 34% in a single year. Net inflows into global ETFs hit $2.37 trillion in 2025, shattering the previous record. In the US, the Vanguard S&P 500 ETF overtook the SPDR S&P 500 ETF Trust to become the world’s largest ETF, pulling in $137.7 billion in a single year, which was the largest annual inflow ever recorded for a single fund. The five-firm concentration ratio among US mutual fund families has risen from 35% in 2005 to 56% in 2023, driven in large part by the dominance of passive giants BlackRock, Vanguard, and State Street, who between them control roughly 60% of global ETF assets.
The Bogleheads (disciples of Vanguard founder Jack Bogle) have built an intellectual framework around passive investing. The core tenets are well established. Most managers underperform their benchmarks over meaningful time horizons, and the few who do outperform rarely do so consistently. The data here is damning: according to the S&P Indices Versus Active (SPIVA) Scorecard, 65% of actively managed large-cap US mutual and ETF equity funds underperformed the S&P 500 in 2024, broadly in line with the 64% average annual underperformance rate recorded since 2001. Extend the horizon and the picture worsens dramatically as over fifteen years, more than 90% of US large-cap active equity funds lag their benchmark, and over twenty years, no equity category saw majority active outperformance. The persistence data is equally bleak: among funds that ranked in the top quartile as of December 2020, not a single one remained there over the following four years. Costs compound just as returns do, and the fee differential between an index fund charging under 0.10% and an actively managed fund charging 0.5-1.00% is a near-certain drag on long-term performance. If professional fund managers struggle to beat the market and if you assume markets are broadly efficient enough that the average investor cannot reliably exploit mispricings, then any active investment management will erode returns far more than any benefits from stock selection could produce. It should be noted that this data excludes hedge funds whose industry returns are harder to judge as they have different fee structures, more privacy and a lack of industry standard data, and furthermore they often have different mandates and purposes than maximising pure returns.
The historical performance record reinforces this view. The S&P 500 has delivered an annualised total return of approximately 12% over the past fifty years with dividends reinvested, or roughly 8% after adjusting for inflation. To put that in concrete terms, one thousand dollars invested at the beginning of 1975 would have grown to approximately $290,000 by the end of 2025 if allowed to compound the whole way at 12%. Roughly two in every three calendar years have produced positive returns, with the most common annual return falling between 10% and 20%. The investor who bought before the Global Financial Crisis and simply held on was made whole within a few years and went on to enjoy one of the longest bull markets in history. Over the past decade alone, the S&P 500 has delivered an annualised return of nearly 14%, more than tripling an initial investment. Volatility, the Bogleheads argue, is the price of these superior long-term returns. Stay the course, stay diversified, keep costs low, and time will do the heavy lifting. This view has arguably the single most important financial insight available to the average person. But it is incomplete.
Inaction Is Action
Inaction is itself a form of action. The decision not to decide is still a decision. This applies directly to passive investing, because the word “passive” is doing an enormous amount of misleading.
When you buy an index fund, you are making a series of active choices. You are choosing to allocate capital to equities rather than bonds, property, cash, or any other asset class. You are choosing a specific index, most commonly the S&P 500, and in doing so, you are choosing a particular weighting methodology, geographic exposure, and sector composition. You are choosing, consciously or unconsciously, to buy at today’s valuation, whatever that valuation happens to be. You are choosing to rebalance on the index provider’s schedule rather than your own. And you are choosing to hold through drawdowns of thirty, forty, even fifty per cent, which is itself one of the most psychologically demanding active decisions an investor can make.
None of this is passive in any meaningful sense. It is a specific, opinionated capital allocation strategy dressed to be passive. The investor who dollar-cost-averages into a market-cap-weighted US equity index is not avoiding decisions. They are making a concentrated bet that the largest American companies, purchased at whatever multiple the market assigns, will continue to compound wealth at rates that justify the price paid. That bet has been a good one historically, however, it is not a neutral one.
There is a deeper irony here that is rarely discussed. The indices themselves are not passive constructs. The S&P 500 is not simply the five hundred largest American companies by market capitalisation. It is a curated list, managed by a committee at S&P Dow Jones Indices that exercises judgement about which companies to include and exclude based on criteria like profitability, liquidity, and sector representation. When Tesla was added to the index in December 2020, every passive fund tracking the S&P 500 was forced to buy the stock at whatever price it happened to be trading which, at the time, was a valuation that priced in extraordinary future growth. The “passive” investor had no say in this. They were, in effect, delegating active decisions to an index committee and calling the result passive.
This is where the comfortable narrative of passive investing begins to show some distress. The passive investing movement has been so successful, both intellectually and in terms of asset flows, that its risks have become systematically underappreciated. And risks that are not acknowledged are, by their nature, more dangerous than those that are.
The most fundamental issue is valuation indifference. An index fund buys a prescribed basket of securities at whatever price the market offers. It does not ask whether those prices are reasonable. It does not distinguish between a market trading at twelve times earnings and one trading at thirty times earnings. It simply allocates. This is the precise mechanism that makes indexing efficient and low-cost, but it is also the mechanism that exposes the passive investor to whatever excesses the market has embedded in current prices. If sentiment drives valuations to unsustainable levels, the passive investor is a full participant in driving that mispricing and a full participant in the correction that follows.
There is also a structural paradox at the heart of the passive thesis that economists Sanford Grossman and Joseph Stiglitz identified decades ago. Passive investing is a free-rider strategy. It works precisely because active investors are doing the costly, difficult work of analysing companies, discovering information, and setting prices. If everyone indexed, there would be no one left to perform this function, and prices would cease to reflect fundamental value. The more capital that flows into passive vehicles, the fewer participants are engaged in price discovery, and the less efficient the market becomes. We are not at that breaking point yet, but the direction is clear with passive funds now accounting for nearly 60% of US equity fund assets, up from just 6% three decades ago. Even Jack Bogle, the father of indexing, expressed concern before his death in 2019 that it would not be long before index funds owned half of all US stock, a level of concentration he did not consider healthy for markets. The implications for price discovery, market structure, and the very efficiency that passive investing depends upon are not fully understood.
This connects to a related concern about reflexivity. In a market-cap-weighted index, the largest companies receive the largest allocation. As passive inflows grow, more capital is mechanically directed towards the stocks that are already the most expensive. Success brings size, size begets passive inflows, and passive inflows causes further price appreciation which becomes a positive feedback loop that can amplify momentum and stretch valuations beyond what fundamentals alone would justify. The extraordinary concentration of today’s major indices, where a handful of technology mega-caps account for a disproportionate share of total index weight, is at least partly a consequence of this dynamic.
There is a reason hedge funds still have clients. It is not because their investors are unsophisticated or unaware of the data on active management as the SPIVA numbers are public and unambiguous, and nearly 64% of domestic stock funds were shuttered or merged over the past twenty years. It is because some allocators recognise that buying assets without reference to their intrinsic value carries its own set of risks, and that in certain environments like prolonged overvaluation, structural changes, and concentrated indices, those risks can materialise in ways that a backward-looking analysis of index returns does not capture. The Japanese investor who bought the Nikkei in 1989 waited over three decades to recover their nominal investment. The past performance of one index in one country over one period is not a universal guarantee.
This leads to the most important caveat of all: past performance is not a reliable indicator of future results. This disclaimer appears on every fund factsheet for a reason. The extraordinary returns generated by US equities over the past four decades were driven by a specific set of conditions. Falling interest rates, globalisation, technological revolution, expanding multiples, that may or may not persist. The passive investor is implicitly betting that they will. That may prove correct, but it is a bet, not a certainty, and treating it as the latter is a form of naive risk consideration.
There Are No Free Lunches
The appeal of passive investing lies partly in the suggestion that it has somehow solved the fundamental problem of investing: that generating returns requires hard work and accepting risk. The narrative, taken to its logical extreme, implies that you can simply buy the market, forget about it, and wake up wealthy. But there are no free lunches in finance. If passive investing appears to offer one, it is because the risks are not immediately visible due to an extended period of economic and market prosperity. Concentration risk in a handful of mega-cap names, valuation risk in a market that has been priced highly, and risk in an era of structural change do not disappear just because you are ‘passive’ investing. Now you may be more protected as companies rise or fall, you will automatically rotate into the new large players, but you still have risk here as you are reliant on the overall pie still growing.
None of this means indexing is a bad strategy. In practice, most people will do perfectly well with a diversified, low-cost index portfolio held over a long time horizon. The data supports this, and the behavioural benefits of a strategy that minimises the temptation to tinker are real and substantial. But “you will probably be fine” is a different statement from “there is no risk,” and conflating the two is where the passive investing thesis crosses from sound advice into something closer to ideology.
The most useful framing, then, is not the binary of active versus passive, but a distinction between activity and analysis. You can be passive in your activity: trading infrequently, holding for the long term, avoiding the temptation to time markets, while remaining deeply active in your thinking. You can hold an index fund and still understand what you own, why you own it, what assumptions are embedded in current prices, and under what conditions those assumptions might fail. The investor who holds through a downturn because they have thought carefully about valuations, earnings trajectories, and historical drawdown recoveries is in a fundamentally different position from the investor who holds through a downturn because someone told them to never sell. Both may achieve the same outcome. But the first has a framework for understanding when the strategy might not work, and the second is relying on blind faith. Passive investing is, for most people, a prudent option to the question of what to do with their money. But it should not be the end of thinking about investing. It should be the beginning. The decision to index is a decision, and like all decisions, it deserves ongoing scrutiny, honest risk assessment, and intellectual engagement. You can choose not to act. You should never choose not to think.
*Disclaimer: This information is for general informational purposes only and does not constitute financial, investment, or professional advice. The author may hold positions in the assets or companies discussed.
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