Passive Investing Surge: Market Risk Concentrated, Shocks Looming
Overview
Passive investing, dominated by index funds and ETFs, now holds a majority of US equity assets and is rapidly expanding in India. This shift concentrates capital into a few large-cap trades, creating a steady bid that masks underlying market fragility. While appearing orderly, this trend reduces price discovery and friction, potentially delaying necessary adjustments and increasing the risk of sudden, sharp market shocks.
Global financial markets present a paradox: increasing geopolitical, climate, and debt risks coexist with an unusual calm. A significant driver of this apparent stability is the overwhelming rise of passive investing, particularly index funds and exchange-traded funds (ETFs). In the United States, these passive vehicles now command close to 55% of all equity fund assets, a dramatic increase from a decade ago.
India is also experiencing a rapid, albeit smaller, surge in passive investing. Assets under management (AUM) in passive equity funds have surpassed ₹12.5 lakh crore, approximately $150 billion, fueled by systematic investment plans (SIPs) and institutional allocations. Monthly SIP inflows alone are now exceeding ₹20,000 crore. This constant stream of capital automatically deployed into markets, irrespective of macroeconomic conditions or valuations, creates a predictable, steady bid.
The Illusion of Stability
Passive funds do not 'panic' or 'reassess' valuations like human managers. Their mandate is to track an index. Money flows in, and it gets invested, predominantly into the largest companies that form the bulk of major indices. This mechanism bypasses traditional price discovery. A rising stock price may simply reflect strong passive inflows rather than genuine investor confidence, while a falling stock doesn't necessarily attract value buyers because index funds only adjust weights rather than actively seeking bargains.
Concentrated Risk and Delayed Feedback
This concentration of capital in a few large-cap names, especially in sectors like technology heavily represented in indices, means systemic risk is accumulating in ways that are easily overlooked. Despite elevated interest rates and geopolitical stress, market volatility has remained below long-term averages for extended periods. This has allowed large companies to raise and spend capital aggressively, particularly in areas like AI, without the usual valuation scrutiny that would naturally dampen such expansion. The financial system develops less friction, meaning problems can persist unseen for longer.
The Inevitable Adjustment
Systems with reduced friction and delayed feedback tend to carry issues for an extended period. When adjustments are finally necessitated, they rarely occur in measured steps. Instead, they often manifest suddenly and simultaneously, creating sharp, unexpected market corrections. While some argue this represents progress with 'patient capital' replacing 'panic,' the risk remains that crucial price signals are being suppressed. This could lead to significant, abrupt shifts when market forces eventually reassert themselves, making outcomes feel sudden despite the prolonged build-up of underlying pressures.
