New Post

Passive Investing and Market Efficiency: A Deeper Look

Welcome back, readers. Over the last few weeks, we’ve been exploring the dynamics of passive investing alongside the concerning valuations of major U.S. stocks like Apple. If you’ve been following along, you’ll recall our discussion of how passive strategies have proliferated, gaining significant control over market flows. But this week, we’re taking it a step further, guided by insights from academic heavyweights Ralph Koijen (University of Chicago) and Xavier Gabaix (Harvard). Their research has unveiled findings that challenge one of the bedrock principles underpinning passive investing.

The Rise of Passive Strategies

Passive investing, which entails buying broad-market indices like the S&P 500, has grown from representing a mere 1-2% of the market in the 1990s to dominating nearly 45-50% today. This phenomenon, at its inception, was rooted in the Efficient Market Hypothesis (EMH)—the idea that market prices are accurate because diligent active managers are continually pricing them.

The logic was straightforward: instead of paying fees between 1-2% to hire active managers, investors could simply buy the entire market index at a much lower cost and still achieve returns comparable to active funds. The EMH theory also assumed that passive investing—characterized by its "buy-and-hold" nature—exerted no significant influence on stock prices since individual trades occurred within the realm of heavily liquid, large-cap stocks.

But what happens when passive investing goes from being a mere strategy to a dominant force within market flows? New research is providing an unsettling answer.

A Market Distortion?

Koijen and Gabaix’s research reveals that passive flows—far from having no impact—might significantly distort market valuations. The study found that for every $1 invested in passive funds, there could be as much as $5 in market capitalization added to the stocks within that index.

And here’s where the numbers become eye-opening. Mike Green of Simplify Asset Management extended their research, presenting the possibility that passive inflows could inflate market valuations even further. According to his findings, every $1 passively invested might push market cap up by $17.

To better understand, think of a small, illiquid stock—say, a niche company with a market value of $10 million. A single aggressive buy order can temporarily skyrocket its valuation simply because the stock lacks continuous liquidity. Similarly, but on a much larger scale, passive inflows appear to inflate large-cap indices like the S&P 500, fundamentally due to the automatic purchase of stocks within these funds.

What makes this more alarming is that unlike active managers—who make decisions based on valuations, fundamentals, or economic conditions—passive funds simply allocate based on index weighting. For instance, a passive investment in an S&P 500 fund allocates nearly 7% into Apple regardless of whether it’s undervalued, fairly valued, or overvalued.

The Long-Term Implications

The 2006 Pension Protection Act (PPA) unintentionally accelerated passive investing's grip on markets. By making 401(k) participation automatic and designating passive index funds (initially 50% stocks, later transitioning to even higher equity allocations via target-date funds) as the qualified default investment alternative (QDIA), regulations funneled a steady and growing stream of automatic contributions into passive strategies.

Now imagine the impact:

• A young professional earning $50,000 contributes 10% annually to their 401(k), with 90% of that contribution channeled into stocks.

• If 7% of those contributions find their way into Apple shares through an S&P 500 index, even modest amounts of passive investments become significant accumulators of market cap inflation.

• Using Mike Green’s higher-range estimate, every $630 invested in Apple could add $10,000 in market cap—not based on fundamentals, but simply due to the mechanics of passive flows.

While this may sound like a victimless phenomenon—the market goes up, everyone is happy—it introduces an unsettling possibility. If passive inflows can inflate valuations disproportionately on the way up, then net outflows could accelerate declines even faster.

Revisiting the Efficient Market Hypothesis

Koijen and Gabaix’s findings throw a wrench into the underlying assumptions of EMH. The idea that passive strategies are harmless in terms of market impact now faces opposition from mounting evidence. Could the core premise that "small transactions have no substantial influence" break down when passive strategies dominate 50% of the market?

Additionally, Mike Green’s observations raise further concerns about active managers "closet indexing" to mirror index weightings and about concentration risks arising from oversized positions in mega-cap stocks like Apple and Microsoft. Though their weightings reflect market value, this circularity creates a feedback loop—a system built on momentum rather than fundamentals.

What This Means for Investors

For now, these insights should serve as a cautionary note about the potential pitfalls lurking beneath the surface of seemingly unstoppable market gains. The central question becomes increasingly pertinent: what happens when passive inflows reverse? While we hope this scenario doesn't materialize, a shift to net outflows might create a feedback loop just as severe—if not more so—as the inflows that drove markets to their current levels.

Next week, we’ll be tackling what could push passive investing flows into reverse and what investors should be watching for as indicators of impending change. Spoiler alert—there are many potential triggers, from demographic trends to policy shifts.

Until then, keep brewing over these insights.

Stay Educated, Stay Prepared

Thank you for reading the Brian Apple Retirement Newsletter. If you find our analysis thought-provoking, be sure to forward this edition to a friend who shares your curiosity about the markets.

We’ll see you again next week—same time, same place, deeper insights.