§A Thought, Not a Thesis
Let me start with a disclaimer. What follows is a personal reflection. It is not a discovery, and I am not the first to make the point. Economists, fund managers and regulators have discussed the market effects of passive investing for years. I am writing about it because one variable has changed in a way that, in my view, deserves renewed attention: the sheer size of the role index funds play today.
Never before in financial history have so many investors, most of them non-professionals, delegated their allocation decisions to a mechanical rule. That alone makes the question worth asking again.
§Valuation Is Never Purely Objective
In my earlier piece on risk perception, I argued that the way we perceive and price risk is state-dependent. It changes with the economic cycle, with our personal circumstances, and with what Keynes called animal spirits, the waves of optimism and pessimism that shape confidence. In a bull market, risk looks smaller than it is. In a recession, it looks larger.
This matters here because a price is not a measurement of value. It is the outcome of millions of subjective judgments, formed in different emotional and economic states, meeting in the same place. Keep that in mind, because the mechanism below interacts with it.
§How an Index Fund Actually Works
A cap-weighted index fund, the most common type, holds every company in an index in proportion to its market capitalization. The larger the company, the larger its weight.
When new money flows into the fund, the manager does not evaluate anything. The money is split across all constituents according to those weights. Two consequences follow:
- The inflow is price-insensitive. The fund buys regardless of whether a company is cheap, expensive or overvalued.
- The largest companies receive the largest share of each new dollar. Weight is a function of past price performance, so past winners get the most new buying.
Now close the loop:
1. Money flows into index funds. 2. Those funds buy constituents in proportion to their weights. 3. The buying supports prices, especially of the largest names. 4. Higher prices raise index levels and recent returns. 5. Strong returns attract more money into index funds. 6. Return to step 1.
Index performance drives fund flows, and fund flows influence index performance.
It is a circle. In itself, a circle is not a problem. Plenty of healthy systems contain feedback. The question is what anchors it.
§Who Moves First, and Who Follows?
The loop describes what the passive fund does, but it doesn't explain how the cycle starts. A price rises because someone wanted to buy more than someone else wanted to sell. An analyst revised earnings, a manager formed a view, a trader reacted to news. Somebody acted first, with a thesis, right or wrong.
The passive fund never plays that role. It is a follower by design. It sees that a price has moved and a weight has changed, and it allocates accordingly, without knowing who drove the move, why, or who will follow next. In effect, passive investing outsources price discovery to everyone else. Economists have a name for the tension: the Grossman–Stiglitz paradox. If nobody does the research, prices cannot be informative; if prices are informative, nobody is paid to do the research.
This is not a flaw in itself. The first mover may be right, and the price may have risen because earnings did. But a blind follower cannot tell a move backed by fundamentals from one driven by enthusiasm. And once followers are numerous, they become part of the demand that the next observer reads as a signal.
§When Does the Money Arrive?
The second circle is about timing. Inflows are not random. Fund-flow studies and behavioral finance point to the same pattern: investors tend to add money after strong performance, when news is good and confidence is high. This is where state-dependent risk perception returns. After a long rise, risk feels lower, so investing feels easier.
In other words, new money tends to arrive when others have already bought, or are buying. The well-documented "behavior gap", the difference between a fund's return and what its average investor actually earns, comes largely from this: money added late, withdrawn in declines. Index funds are not immune. It is the investor, not the product, who chooses the moment.
So two loops are stacked on each other:
- A mechanical loop: inflows → purchases by weight → higher prices.
- A psychological loop: higher prices → greater confidence → more inflows.
The first is blind to price. The second is attracted by it. Together they make the system more reflexive than its "passive" label suggests.
§The Counter-Arguments, Taken Seriously
An honest thought should face its objections. The strongest ones are these:
- The price impact of flows may be small. Daily trading volumes are enormous compared with the net flows into passive funds. Many studies find the effect to be modest, though measuring it cleanly is notoriously hard.
- Arbitrage should limit distortions. If a stock becomes overvalued purely because of flows, active investors are free to sell it or sell it short.
- Passive is still a fraction of the total. This is the argument most often heard, and the one I want to examine more closely.
§The "Only a Fraction" Fallacy
The reassurance goes like this: passive funds represent only a fraction of worldwide assets under management, so they cannot be driving the market. This framing seems to me misleading, for two reasons.
First, the share of assets is not the share of influence. Passive money is concentrated in the largest companies, and flows are consistent and one-directional for long stretches. Meanwhile, a good part of the "active" universe trades around the margins.
Second, "active" is often not very active. Much of the industry that charges active fees behaves, in practice, very close to an index. Many funds hold broadly the same positions in broadly the same weights, because deviating from the benchmark is a career risk for the manager. Underperform alone and you get fired; underperform together with everyone else and you have an excuse. The result is what is often called closet indexing: index-like portfolios sold with active commissions.
If so, the effective weight of index-influenced capital is considerably larger than the headline passive share suggests. The fraction argument may also be convenient, since it helps justify higher fees for something that resembles the benchmark more than it admits.
This is a personal impression, not a measured statistic, and I would welcome data that proves it wrong. But the direction of the effect seems clear to me.
§Two Facts to Keep in Mind
Before drawing any conclusion, I want to place two facts on the table. They pull in different directions, and both are true.
1. The past is only one path among many
It is tempting to look at decades of strong equity returns and treat them as proof that markets rise. But history gives us a single realized sequence of events. Nassim Nicholas Taleb calls this the problem of alternative histories: what happened is just one path out of many that could have happened, and it may not be the most representative one.
A trader who survives ten years of risky bets does not prove the bets were safe. Likewise, a market that has performed well does not prove it was bound to. The world could have gone very differently: another war, another policy mistake, another decade of stagnation. Japan's equity market took roughly 34 years to regain its 1989 peak, and that is a reminder that long drawdowns are not hypothetical.
So when I hear that "the market always goes up in the long run," I hear a statement based on one observed path, often one that is itself US-centric. It is not a law.
2. Profits ultimately move the stock market
Here is the counterweight, and it deserves equal respect. Over the long run, stock prices follow corporate earnings. Businesses have strong incentives to become more productive, and, particularly in the United States, they operate in a system oriented to shareholders. As long as that holds, progress tends to translate into higher profits on average, and higher profits tend to translate into positive real returns over time.
This is the engine that makes equity ownership attractive.
So there is a convergence force: earnings pull prices toward value over the long run. The question is not whether that force exists. It does. The question is what can happen along the way, and for how long.
§Where the Two Forces Meet
Put the pieces together.
The feedback loop operates on prices and flows. The convergence force operates on earnings and value. The first can run ahead of the second, and when it does, the gap between price and fundamentals widens without anyone deciding it should. State-dependent risk perception adds fuel: in good times, rising prices lower perceived risk, which invites more allocation, which pushes prices higher still.
What stops the loop? Ultimately, the micro level. Every index is an aggregation of single businesses. The loop can keep turning only as long as those businesses can justify their valuations with real cash flows. When they can, the loop is harmless and may even be benign. When they cannot, the same mechanism that amplified the rise has no special reason to be gentle on the way down, since the funds that bought regardless of price will also face outflows regardless of price.
I am not predicting that this will happen, or when. Timing is exactly what no one can know. My point is more modest: we have never had an index share this large, so history cannot fully inform us, and convergence to value is a statement about the long run, which can be long.
§What I Take From This
I do not conclude that index funds are bad. For most people, they are low-cost, diversified and practical, and they have served investors well. They have also democratized access to markets, which I consider a real good.
What I take from the thought is a habit of mind:
- Know what you own. An index is not "the market" in the abstract. It is a basket of specific companies, in specific weights, many of which have grown simply because they have grown.
- Understand that diversification across companies is not diversification across risks. If everyone follows the same rule, correlated behavior can show up when it matters most.
- Do not confuse a good past with a guarantee. The realized path is evidence, not proof.
- Keep valuation as the anchor. Understanding individual companies is the only foundation that does not depend on the loop continuing.
A market built on a single rule is robust only as long as the rule is not tested.