Healthy capital markets depend on active participation from both buyers and sellers, but the continued rise of passive investing is threatening that balance, according to Dave Choate, COO of Dallas-based broker-dealer CAPIS.

“Healthy capital markets require buyers and sellers to be actively engaged in the price discovery process,” Choate told InvestmentNews. “Without this price discovery function, our capital markets quickly become unattractive to high-growth companies. Capital must be allocated by merit, not simply by index weighting.”

That concern frames a broader critique of passive investing’s growing dominance—and its implications for advisors, investors, and the future of public markets.

While institutional participants may see the structural shifts underway, Choate said retail investors are less likely to notice the erosion of price discovery in real time.

“Unfortunately, it is hard for retail investors to see the underlying impact of passive investing on price discovery,” he said. “You may simply have to accept the fact that you can’t have price discovery without someone willing to take a contrary position. If 100% of the assets are passive, every participant will tend to be on the same side and have no price-related viewpoint.”

For advisors, that dynamic has direct implications for portfolio construction.

“Financial advisors should seek out active managers that have an attractive track record of performance relative to risk,” Choate said.

A tipping point already passed

Choate argues the market may already have crossed a critical threshold where passive dominance is reshaping capital allocation.

“As evidenced by the dramatic growth of private equity over the past 20 years (3x growth since 2008), we are past the tipping point,” he said. “High-growth companies are already gravitating towards private markets where capital continues to be allocated by merit. If we remain on this path, the public markets will only be attractive to low-growth companies willing to accept capital allocation by weighting.”

That shift carries consequences for long-term investors.

“For long-term investors, the continued growth of passive investing creates risk by the flattening of returns and the weakening of our public markets,” Choate said. “If we do not take action to make our public markets more attractive to high growth companies, public market returns will be driven by index fund cash flows allocated to low-growth companies.”

Diminishing access to growth

As more high-growth firms stay private, Choate warned that retail investors could find it increasingly difficult to access meaningful growth opportunities.

“If high-growth companies choose private markets for capital needs, finding growth in the public markets will become increasingly more difficult,” he said.

At the same time, regulatory and structural factors are reinforcing passive trends.

“While well-meaning, Reg BI creates an environment whereby active management strategies have become difficult to recommend because of higher fee structures and the potential to underperform the index,” Choate said. “To avoid possible liability, advisors routinely default to index funds.”

He added that tax treatment further tilts the balance.

“For taxable accounts, passive ETFs quickly become the default,” Choate said. “The tax advantages awarded to ETFs through the use of in-kind transfers have driven the growth of these products relative to active-managed alternatives often found in traditional mutual funds.”

What advisors and investors should do

To counter these trends, Choate emphasized both advocacy and allocation changes.

“Advisors and investors need to speak with regulators and legislators about the issues impacting public markets,” he said. “Educating the policy makers is key to enacting meaningful change. Both should also seek active management strategies for their investing needs.”

He also pushed back on the idea that simply expanding retail access to private markets would solve the problem.

“No, opening up the private markets to individual investors is absolutely the wrong path,” Choate said. “These markets are often accessed at high fees (2% of AUM is not uncommon) and valuation is extremely subjective.”

Instead, he outlined a series of reforms aimed at revitalizing public markets and supporting active management.

“Federal regulations need to be reinterpreted or rewritten to provide a safe harbor for advisors to select active management strategies for their clients,” Choate said. “Listing regulations need to be softened in order to make it more attractive for smaller companies to go public.”

He also called for tax reform to level the playing field between investment vehicles.

“Level the playing field for mutual funds and ETFs by eliminating the pass-through taxation of capital gains and dividends within the fund structure,” Choate said, noting industry support for legislative solutions.

Finally, he stressed the importance of changing investor perceptions.

“Educate your clients about the virtues and importance of active investing,” Choate said. “Without it, our public markets will struggle to attract growth-oriented companies and overall returns will suffer.”