With the majority of stock investments in the United States being passively managed, as of February 2024, passive investors have benefited from lower fees and higher returns than their active peers. There is little evidence that active managers can consistently beat passive benchmarks.
However, there are signs that ever-increasing flows to passive funds may be pushing stocks of the largest companies well beyond their fundamental value, creating a risk of sudden losses to investors whose portfolio rests on the fortunes of a handful of firms.
A number of recent studies question whether a market dominated by passive investors, particularly in market capitalization-weighted indexes, may result in inflated prices for the largest companies and a long-term misallocation of capital that could threaten both economic growth and investor returns. In other words, investors may be throwing too much money at the largest firms without paying attention to whether they are able to do anything productive with the investments.
When indexes are market cap-weighted, the biggest companies will receive the majority of flows into index funds. The Magnificent 7 companies in the S&P 500 make up more than a third of the total valuation of the index. When you invest $3 in the S&P, $1 goes to buying shares of just seven stocks. The top 10 stocks make up more than 40% of the value of the S&P.
This flow of equity capital, in addition to ever-increasing valuations of the largest stocks, can also lead to increasing correlations among these large stocks whose price movement is largely based on flows rather than on future profitability.
Chris Brightman and Campbell Harvey of Research Affiliates document emerging academic research explaining how cap-weighted indexes become overvalued when passive investors dominate the market, and the risks posed when investors hold too much wealth in a small number of stocks with historically high valuations.
Passively held stocks increasingly correlate with the overall market while stocks held by active funds do not. When markets fall, then, stocks held by passive funds are more sensitive to a loss. Passively held stocks are also less sensitive to new information related to firm profitability, so prices are more a function of overall market sentiment than fundamentals. There is evidence that when the liquidity spigot that pushes stock prices of cap-weighted indexes ever higher gets turned off, stocks held by passive investors fall the most.
As more wealth is shifted into passive investments, valuations rise and household wealth increases. Because passive investments have lower fees, investors keep more of the gains. Higher net returns draw ever more capital from investors, leading to higher stock valuations and more wealth. The rise of passive investing leads to a Robinhood-like transfer of wealth from informed active traders to less-informed passive investors. That is, until the flow of wealth into passive funds slows and stock prices eventually reset to their fundamental value.
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The possibility of mechanical overvaluation of stocks is particularly important with 45.4% of household wealth in the United States being held in stocks. That’s the highest percentage in history and far above the last peak of 38.7% during the tech bubble of the late 1990s. That period was also the only other time that stock valuations as a multiple of 10-year earnings exceeded 40. Unfortunately, subsequent 10-year returns on the S&P have never been positive during months when investors bought the index with Shiller price-to-earnings ratios in the 40s.
Avoiding Cap-Weighted Risks
Investors seeking to reduce the concentration risk of cap-weighted indexes can spread their wealth across smaller companies, or firms outside the United States. A recent Morningstar report highlights the relative attractiveness of small-cap stock valuations that have increased during the recent run-up in large-cap prices as well as the low price of many international stock indexes.
According to Que Nguyen, partner and chief investment officer of equity strategies at Research Affiliates, index investors concerned about the concentration risk of the S&P 500 can add a value index.
“The indexes exclude or down-weight the Mag 7, choosing instead to focus on less expensively priced stocks,” she said.
The disadvantage of value indexes, notes Nguyen, is that they “don’t just screen for expensiveness; they also screen for lack of growth, choosing to highlight companies that haven’t grown rapidly alongside companies that are expensive. Who wants that?”
An alternative is to invest in an index that includes high-flying value stocks, but at a significantly lower allocation such as the S&P 500 equal-weighted index. With equal weighting, “the Mag 7 weight falls from 35% to about 1.5%,” she said. “This may seem like a great idea to achieve diversification, but it increases liquidity risk and consequently, volatility. Large companies tend to be more liquid, and are easier/cheaper to trade, and tend to be less volatile.”
Concentration and the Bet on AI
It is hard to separate the concentration risk of cap-weighted index investing from the astounding growth in artificial intelligence among firms in the Mag 7. The fortunes of the domestic stock market appear increasingly tied to the success of a single industry, and particularly to a small number of firms that dominate AI technology.
“As we have seen, any doubt in the AI story does lead to wobbly performance as we saw in December,” Nguyen said.
However, AI may have an equally important effect on the rest of the economy.
In 2024, Walmart announced that it had used proprietary AI software to increase the efficiency of deliveries by saving 30 million miles and 94 million pounds of carbon dioxide. Not only did its investment in AI technologies reduce the cost of transporting goods, Walmart offered the software to other retailers as a new product.
The use of AI by companies outside the Magnificent 7 to create efficiency gains is an important point that Joe Davis of Vanguard made recently. While the tech revolution of the late 1990s led to enormous investment in infrastructure that many companies still benefit from, an investment in the stock of an internet hardware giant like Cisco made at the peak of the bubble would have essentially earned nothing through the present day.
One important difference between the dot-com bubble of the late 1990s and today’s AI bubble is that many companies in the Mag 7 are making money — and many are highly profitable. Nvidia’s net income for the 12 months before Oct. 31 was $99.2 billion. In the third quarter of 2025, Mag 7 stocks grew earnings per share by 21% compared with 13% for the other 493 companies in the S&P.
Of course, another important difference between today’s market and the tech bubble is that concentration risk is significantly higher. At the peak of the tech bubble, the top 10 stocks made up just over 25% of the S&P (compared with 40% today). The risk to individual investors of a burst in the AI bubble is far greater than risk from the tech bubble.
Even if you believe that AI is going to transform the efficiency of business, holding too much wealth in seven stocks may expose investors to an unacceptable amount of firm-specific risk. For example, what will happen to the profitability of chip manufacturers like Nvidia if China invades Taiwan, where most of the products are manufactured?
Diversification has been called the only free lunch in finance, but cap-weighted indexes are becoming increasingly dependent on the fortunes of a small number of companies. Investors who want to cushion the effects of a possible correction in values of today’s highest-flying stocks may need to consider allocating wealth to sectors that have been a little more boring in recent years.
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