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Founded in 1975 by John Bogle, The Vanguard Group pioneered passive investing, an innovative way to reduce the cost of the investment process and simplify it for everyday Americans. Since then, passive investing, led by index funds and exchange-traded funds, has exploded. According to Statista, passively managed index funds accounted for 19% of the total assets investment companies managed in the United States in 2010. As of 2023, that number had skyrocketed to 48%.

But even Bogle began to wonder about the unintended consequences of too much passive investing. Shortly before he passed away in 2019, he predicted it wouldn’t be long until index funds would own half of all U.S. stock, which he didn’t consider a good thing: “I do not believe that such concentration would serve the national interest.”

‘Passive Investing and the Rise of Mega-Firms’

What happens, then, if passive investing becomes too successful for its own good? This is the question Lu Zheng, professor of finance at UCI’s Paul Merage School of Business, and her co-researchers, Hao Jiang of Michigan State University and Dimitri Vayanos of the London School of Economics, set out to answer in their award-winning paper: “Passive Investing and the Rise of Mega-Firms.”

“When I started my doctoral research years ago, the mutual fund sector was just starting to flourish,” Zheng says. “Empirical evidence shows that, on average, index funds performed better than actively managed funds after fees. But now that we’ve seen dramatic growth in passive investing, people are starting to wonder about its long-term market impact.”

Based on her research, one of the primary effects of passive investing is the largest firms in the S&P 500 experience the highest returns and increases in volatility following flows into that index. In this way, passive investing biases the stock market toward overvaluation.

“Basically, what we see happening is large firms keep getting bigger, and their stock prices keep going higher,” Zheng says. “One day there might be a reversal of this trend, but for now, our study shows a rise of mega-firms in large concentrations.”

Increased Flow into Passive Funds Results in Overvaluation

The reason for this has much to do with the strategies behind passive investing. A passive investing strategy usually tracks a value-weighted index, which involves putting more money into large cap stocks. As a result, the economy’s largest firms receive more flow, thereby increasing in price. If a large firm was overvalued, the flow from passive funds would exacerbate overvaluation.The now overpriced stocks are riskier for active investors who would otherwise offset the flow’s effect on price.

In other words, these flows into passive funds disproportionately increase the stock prices of the market’s largest firms, and especially those large firms that the market overvalues. The effect on a grand scale is a rise in the aggregate market, which happens even when a flow is entirely the result of investors switching from active to passive strategies.

The Loop of Rising Prices

This finding was somewhat surprising to Zheng and her co-researchers. They anticipated new money flowing into the mega-firms would lead to overvaluation, but they did not anticipate switching also causes overvaluation.

“The reason for this has to do with proportions,” says Zheng. “As people switch to passive investing, there are fewer active investors in play. The additional demand for the mega-firm’s stock then leaves these few active players more exposed to risk, so the stock price must rise to convince them to accept that risk. We end up with a loop of rising prices.”

Data Corroborates Researchers’ Mathematical Model: Capturing the ‘What’ and ‘Why’

Part of what makes this research valuable enough to win awards is its combination of theory and empirical evidence. Using a mathematical model, the team was able to manipulate different variables. This allowed them to see cause and effect more clearly.

“In the real world, it’s hard to disentangle all the effects of passive investing, but the modeling we did here gave us good calibration,” Zheng says. “It helped us see each individual element more clearly. Then, when the empirical data corroborated the model’s results, we saw that as confirmation.”

Without this extensive modeling, the complexity of the empirical data would limit the research. It wouldn’t be possible to unpack the theoretical motivation—the “why ”—behind the market phenomenon in question. Being able to capture the “what” and the “why” is what Zheng believes is the most valuable contribution of this research.

“We’ve documented some of the consequences of indexing that have yet to be documented up to this point,” says Zheng. “This information is important for market participants and regulators to know. To make informed choices, they need to understand how the market adjusts itself and where it could head from here.”

The Next Questions: Exploring How Passive Investing Affects Diversification

How big can indexing get? And what are other unintended consequences of it? These are the questions Zheng wants to answer next. In fact, she and Jiang have recently collaborated with another group of co-researchers to explore how passive investing affects diversification. According to their study, the rise of indexing corresponds with an increase in market-level volatility, which limits the power of diversification and the advantages of passive investing itself.

“Diversification has been a strategy investors use to diversify away firm-specific risk and reduce portfolio risk, but index funds tend to buy and sell together, which increases the co-movement among stocks,” Zheng says. “The more stocks co-move, the less benefit we get from diversification, so indexing can lead to more co-movement—and thus increased market risk.”

What Are Other Consequences of Passive Investing?

From here, Zheng wishes to investigate other consequences of passive investing, particularly within the realm of mutual funds. She also wants to look into how passive investing affects the information efficiency of the market during crises—that is, how the market absorbs shocking news when its investments are mostly passive.

“For example, when Tesla entered the S&P 500, it was a significant event, but people knew about it beforehand.,” Zheng says. “Index funds had to buy Tesla, and the market participants were aware of this- some would front-run and drive up the price.The question is how index funds can time their purchases to serve the best interests of their investors while minimizing the impact of these inflated prices, despite their lack of discretion in trading strategies.”

Lu Zheng is a professor of finance at UCI’s Paul Merage School of Business. She obtained her Ph.D. in finance from Yale University and received her bachelor’s degree from Agnes Scott College. Prior to joining UC Irvine, she served on the faculty of the University of Michigan. Dr. Zheng’s research covers many aspects of investments, including mutual funds, hedge funds, equity markets, investor behavior and expectations, and institutional trading.