Every week, countless workers automatically invest part of their paycheque into the stock market.
Few analyse financial statements, forecast future cash flows or ask whether a company is actually worth its current share price.
Instead, much of that money simply flows into index funds, which automatically buy stocks based on their size rather than their valuation.
For decades, this has been one of investing’s greatest success stories. Passive funds have consistently outperformed most actively managed funds after fees while offering investors low costs, acessibility and broad diversification.
But their success has raised an increasingly uncomfortable question.
If more and more investors simply buy the market, who is left to determine what companies are actually worth?
It’s a debate that has divided investors for years.
Some, including hedge fund manager David Einhorn, argue that the rapid rise of passive investing is fundamentally changing how markets function. Others dismiss those concerns, arguing that active managers are simply looking for someone else to blame for years of underperformance.
New academic research suggests the truth may lie somewhere in between.
The Market Needs Someone To Set The Price
Every trade in the stock market has two participants: a buyer and a seller.
But not every investor decides what a company is worth.
That role belongs to a process known as price discovery.
Traditionally, active fund managers, hedge funds and analysts spend large amounts of time analysing businesses. They build financial models, interview management teams, assess competitive advantages and estimate what a company should be worth. If they believe a stock is undervalued, they buy it. If they believe it is overvalued, they sell.
Collectively, those decisions help determine market prices.
Passive investors operate very differently, very passively.
Rather than deciding whether Nvidia, Apple or Microsoft are expensive, index funds simply buy companies according to their weight in an index. If a company’s market value rises, it becomes a larger part of the index and passive funds automatically buy more of it as money flows in.
That approach has delivered excellent returns for investors over the past two decades.
But it also raises an important question.
If a growing share of the market is buying stocks without making valuation decisions, who is doing the work of determining what those companies are actually worth?
The Passive Investing Paradox
For years, critics of passive investments have argued that the growing popularity of index funds is changing how markets behave.
One of the most vocal has been hedge fund manager David Einhorn, who has described modern markets as “fundamentally broken.” His argument is straightforward: as more money flows automatically into index funds, stocks are increasingly being bought because they are large and they are there, not because investors have concluded they are good value.
Supporters of passive investing have largely dismissed that criticism.
After all, index funds have consistently outperformed most active managers after fees, while active investors have repeatedly failed to generate meaningful alpha.
New research, however, suggests there may be another reason why active management has become so difficult.
In an award-winning paper, University of California researcher Hannah Unterberg found that the rise of passive investing may itself be making life harder for active fund managers.
Her argument isn’t that markets are broken.
Instead, she shows how money flowing from active funds into passive funds creates a subtle but persistent headwind for stock pickers.
When investors withdraw money from an active fund, managers are often forced to sell the stocks they have selected. At the same time, much of that money flows into index funds, which automatically purchase stocks according to their weight in the benchmark.
The result is an asymmetry.
The companies favoured by active managers experience selling pressure, while the largest index constituents receive additional buying pressure, not because new information has emerged, but because money has simply changed vehicles.
Are Markets Really Broken?
The rise of passive investing doesn’t mean markets have stopped functioning.
Active investors still determine prices, analyse businesses and exploit mispricings. In fact, some economists argue that if passive investing continues to grow, opportunities for skilled active managers may actually increase as fewer investors compete to identify them.
What the latest research does suggest, however, is that the playing field may have changed.
Active managers are no longer competing solely against one another. They are increasingly competing against a steady stream of capital flowing automatically into index funds, regardless of valuation.
That presents an interesting paradox.
Passive investing has been one of the greatest innovations in modern finance, helping millions of investors build wealth at a lower cost than traditional active management.
But its success ultimately depends on there still being enough active investors willing to do the work of pricing companies in the first place.
The question is no longer whether passive investing works, clearly it does.
The question is whether markets can continue to function the same way if almost everyone eventually decides to become passive.