The rise of passive investing and exchange-traded funds (ETFs) has been one of the biggest financial trends of the past two decades – low costs, instant diversification, and strong performance in a 15-year bull market. But with passive flows dominating markets, a question worth asking is whether the very popularity of indexing has quietly created other risks.
A revolution in how the world invests
The growth of ETFs over the past two decades has been staggering. ETF assets under management grew over 30% in 2025, surpassed US$19 trillion globally by year-end. By 2029, industry forecasters expect that number to approach US$30 trillion. In the US, roughly half of all managed fund and ETF assets are now in passive vehicles, and since 2010 approximately 80% of every dollar invested in US markets has flowed through just three providers: BlackRock, Vanguard, and State Street.
The appeal of ETFs, most of which are ‘index tracking funds’ is easy to understand. Low fees, broad exposure, and market returns. Yet the sheer scale of passive flows has begun to reshape markets in ways that deserve careful attention. Index funds, by construction, buy more of whatever has already gone up. As passive flows pour into market cap weighted indices like the S&P 500, the largest stocks receive the most capital – not because they are the most attractively valued, but simply because they are the biggest.
Diversification in name only
Diversification is a critical plank in portfolio construction. It makes sense to have a portfolio that is broadly spread across different sectors and geographies; is exposed to different trends; and has a blend of cyclical and defensive businesses. This means investors aren’t overly exposed to any one company, country, or sector of the economy.
The risk is that that while indexing may promise broad diversification, it may not always deliver this to investors. The US S&P 500 Index is a case in point. The top ten stocks in the S&P 500 now account for over 40% of the entire index – double the 19% share they held in 1990. Cut another way, technology companies combined also account for over 40% of the index. Additionally, , companies viewed as impacted by AI (either ‘AI-winners’ or ‘AI-losers’), now account for close to 50% of that index by some estimates.
Herein lies the paradox. An investor who buys an S&P 500 index ETF believing they are getting broad, safe diversification across 500 companies is, in reality, placing more than a third of their portfolio into a handful of technology mega-caps. They are taking a large risk on a small cluster of highly correlated businesses.
It isn’t just the US market that has become concentrated. Broad global indices like the MSCI World Index have followed the same path. 70% of the MSCI World is invested in US-based companies, with the ‘Magnificent Seven’ stocks (Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia and Tesla) now representing over 25% of the index.
Lessons from Japan
History offers a powerful warning. At the peak of Japan’s asset bubble in 1989, Japanese equities represented close to 45% of the MSCI World. A global index investor was, without realising it, almost half-invested in an extremely overvalued share market that traded on over 60 times earnings. When the bubble burst, the Nikkei lost more than 80% of its value over the following decade, subtracting c.30% off the value of the MSCI World Index on its own. Japanese equities now represent roughly 5% of the same index, and it took 31 years for the Nikkei to reclaim its 1989 high.
The lesson: blind indexing can mean blindly inheriting extreme concentration risk.
When passive flows amplify volatility
The dominance of passive strategies also has implications for how markets behave during periods of stress. When markets sell off, index fund redemptions force mechanical, indiscriminate selling of every stock in the index – good and bad alike. This happens simultaneously across trillions of dollars of assets, amplifying downward moves in ways that pure fundamentals alone would not justify.
This effect is compounded by a range of strategies that have grown alongside the passive boom: risk-parity funds, which automatically reduce equity exposure as volatility rises; ‘trend-following’ funds, which sell into falling markets; and volatility-targeting strategies, which mechanically unwind leverage when markets become choppy. The European Central Bank documented how, during the March 2020 Covid crash, risk-parity strategies alone were required to sell assets equivalent to 225% of their portfolio capital to meet volatility targets. Academic research confirms that stocks with higher ETF ownership experience meaningfully greater volatility – a risk that most index investors do not fully appreciate and has yet to play out in a major way.
The case for looking beyond the index
None of this is to suggest that passive investing has no place in a portfolio. Rather, it is to highlight that an unexamined reliance on cap-weighted indexing, particularly at a moment of historically extreme market concentration, carries risks that are easy to overlook. When one-third of a ‘diversified’ global portfolio sits in US technology mega-caps, and some of those companies are priced for perfection, the margin for error is slim.
At Fisher Funds, our approach is to build portfolios from the bottom up, seeking out quality businesses at reasonable valuations, regardless of their index weight. That means our portfolios often look very different than the benchmark. That is a feature, not a bug. The goal is to deliver strong absolute returns over the long run – not to replicate a concentration risk that most investors would not choose if they were designing a portfolio from scratch.
Talk to us
This article is for general information purposes only and does not constitute financial advice or take into account your individual circumstances. If you’ve got questions about your investment, our friendly team are here to help. You can drop us an email, call us on 0508 347 437, or chat with us online.
