Too Many Passive Investors? There’s No Such Thing

US markets are doing much better than markets everywhere else, but no one seems to know why. Yes, there are theories: Perhaps it’s the promise of AI, although it remains to be seen how AI will play out and who will profit. Or maybe valuations are high, and the market will come down. Or … could it be that markets are doing better because no one is really thinking about them all that much?

I know I’m not — because I own passive index funds. And I am not alone. In January, the share of money in passive funds was more than 50%. In 2010, that figure was between 30% and 40%, depending on how you measure it. It could be that markets keep rising because we passive investors just keep buying stocks no matter what the information says.

There has always been a contradiction at the center of the efficient-market hypothesis: If prices reflect available information almost instantaneously, then there is no point in trying to beat the markets. This process is critical to how markets work.

Markets are supposed to allocate capital to its most productive use. If the money just goes to the biggest companies, that entrenches their market power and could undermine innovation and long-term growth. If money goes to the wrong places, stocks become overvalued and vulnerable to bubbles. And even if neither of these hypotheticals is true, some active investors complain that the rise of passive money is making it harder to incorporate important information into prices and make money.

Which leads to a second paradox: For markets to be efficient, there needs to be a critical mass of investors who don’t believe in market efficiency — or believe that they are smarter than everyone else. But how many is enough? Now that passive money is dominant, are there too few?

A recent research note from Owen Lamont, a longtime finance professor now at Acadian Capital, defends us passive investors. We are not distorting markets or making them less efficient. Like Switzerland, he argues, we’re neutral. My next 401(k) contribution may be 5% in Nvidia (its share of the S&P 500), but it is also 0.45% in McDonalds. I am not changing relative prices — and that’s what matters.