The growth of passive investing has stimulated academic and policy interest in how it affects asset prices and the real economy.

Hao Jiang, Dimitri Vayanos, and Lu Zheng, authors of the March 2025 paper “Passive Investing and the Rise of Mega-Firms,” set out to understand how the increasing shift from active to passive investing influences asset prices, particularly the prices of the largest firms in the market. They developed a theoretical model showing how the rise of passive investing should affect prices in market equilibrium. They also tested some of the predictions of the model in the data, by analyzing the effects of capital flows into passive funds—such as index funds and exchange-traded funds—on the stock prices and volatility of large-cap companies. Their data sample took the S&P 500 and flows into index mutual funds and index ETFs tracking it. It covered the period from 1996 to 2020.

Before digging into their findings, we need to discuss two key points. First, research (see here and here) has found that active institutional investors (such as mutual funds), in aggregate, underweight large stocks. Second, the investors who then overweight these large stocks are active retail “noise traders”—investors who make decisions to buy or sell based on factors they believe to be helpful but in reality will give them no better returns than random choices. The idea of a noise trader comes from the belief that price action has “noise” that is unrelated to the signal of fundamental analysis about a security’s value.

Their key findings:

• Disproportionate Price Increases for Large Firms: Their theoretical model shows that inflows into passive funds disproportionately raise the stock prices of the largest companies in the economy (reducing their financing costs), especially those that are already overvalued by the market in the sense of experiencing high demand by noise traders.
• Wide Market Impact: These price effects are significant enough to lift the overall market, even if the inflows are simply due to investors reallocating from active to passive strategies, rather than new money entering the market.
• Increased Idiosyncratic Volatility: The authors observed that passive flows create additional idiosyncratic (firm-specific) volatility for large firms. This increased volatility discourages active institutional investors from correcting mispricing caused by passive flows, allowing price distortions to persist.
• Empirical Evidence From the S&P 500: Consistent with their theoretical model, the largest firms in the S&P 500 experienced the highest returns and the greatest increases in volatility after passive fund inflows into the index. Moreover, consistent with households investing at the beginning of each month a fraction of their monthly paychecks in passive funds through their retirement plans, the largest stocks outperform the index in the first week of each month.

The authors explain the intuition for their results through a feedback loop mechanism. They use a stylized example of a large firm that is in such high demand by noise traders that active funds short-sell it in equilibrium:

“A switch by some investors from active to passive generates additional demand for the firm because passive funds hold the firm with its weight in the market index while active funds hold it with negative weight. Active investors can accommodate the additional demand by scaling up their short position. This renders them, however, more exposed to the firm’s idiosyncratic risk, which is non-negligible because the firm is large. The firm’s stock price must then rise to induce active funds to take on the additional risk. Crucially, because the stock price rises, the stock’s idiosyncratic price movements become larger in absolute terms. This gives rise to an amplification loop: The short position of active funds becomes even riskier, causing the stock’s price to rise even further, and the stock’s idiosyncratic price movements to become even larger. The amplification loop explains why passive flows have their largest effects on large firms in high demand by noise traders.”

Their findings led the authors to conclude: “Our theory implies that passive investing reduces primarily the financing costs of the largest firms in the economy and makes the size distribution of firms more skewed.”

Key Takeaways for Investors

• Passive Flows Can Distort Prices: Investors should be aware that the mechanics of passive investing can drive up the prices of the largest index constituents, sometimes beyond what fundamentals justify.
• Volatility Risks: The increased idiosyncratic volatility in mega-cap stocks may present both risks and opportunities for investors, particularly those employing active or contrarian strategies.
• Market Concentration: The rise of mega-firms, fueled by passive flows, can lead to greater market concentration, which may have implications for portfolio diversification and systemic risk.
• Active vs. Passive Dynamics: While passive investing offers low fees and broad market exposure, its growing dominance can create feedback loops that institutional investors may exploit.

Shaping the Market

The paper highlights a crucial dynamic in today’s markets: The surge in passive investing doesn’t just mirror the market—it shapes it, often amplifying the rise of the largest firms and creating new risks and opportunities. For investors, understanding these effects is essential. While passive strategies remain a powerful tool for long-term wealth building, awareness of their broader market impact can help investors make more informed decisions about diversification and risk management.

Postscript

Jiang, Vayanos, and Zheng showed that flows to passive funds have led to a rise in the valuations of the largest stocks more than is justified by fundamentals and lowered their financing costs, raising the question: Could that lead to misallocation of capital?