Passive investment funds track market indices rather than trying to pick winning stocks. They have grown enormously: as much as 60% of net assets overseen by American equity funds are in such passive vehicles, according to the Investment Company Institute.
The revolution was motivated by a once-heretical, now commonplace observation: most active managers fail to beat their benchmark index, while passive alternatives hug theirs closely and charge rock-bottom fees. Trillions of dollars have poured from actively managed funds into trackers, and the flow shows no sign of stopping.
In 2024, according to Vanguard, 64% of Americans' pension contributions went into "target-date" funds. These split their portfolios between stocks and bonds in proportions determined by the dates when savers hope to retire rather than by market prices. Their steady inflows buy shares regardless of what investors think about firms' future profits.
Passive funds' detractors make a valid complaint: markets' social function is to direct capital to where it will be used most effectively, and passive funds make no attempt to do this. Their indiscriminate buying could pull share prices out of whack with underlying earnings.
Xavier Gabaix of Harvard University and Ralph Koijen of the University of Chicago set out the "inelastic-markets hypothesis" in a much-discussed working paper. It contradicts the textbook argument that money flowing into stocks should barely raise prices. Analysing "idiosyncratic" flows into stocks between 1993 and 2019, they find that an investor who buys $1-worth of stocks using fresh cash pushes up aggregate market value by $3-8.
Market inelasticity has structural roots. Hedge funds hold less than 5% of the value of stocks and face strict risk limits; they must exit positions when clients withdraw money. Funds that maintain fixed allocations—exactly the type into which many people now funnel their savings—can push up prices because the number of shares in existence does not change even as demand for them rises. Flows between investor groups are low in practice, so the only way to put cash to work is to buy fewer shares at a higher price.
If Gabaix and Koijen are right, each dollar of the steady flow into target-date and index funds drives up stockmarket value by several more, regardless of what investors think about firms' future profits—raising the question of whether passive investment is inflating a bubble.
By 2025 around $36trn of capital sat in passive funds, automatically tracking decisions by MSCI, FTSE Russell, S&P Global and others. This has spawned a hedge-fund strategy of trying to surf ahead of the wave of rebalancing trades. The average stock added to the S&P 500 in the 1990s beat the index by 7.4 percentage points between announcement and inclusion; since 2010 the bump has fallen below one point (Greenwood and Sammon, Harvard Business School). When Robinhood joined the S&P 500 in September its share price jumped 16%. Norway's $2.3trn sovereign-wealth fund made $4bn in 2025 through index-rebalancing arbitrage. Even nominally passive S&P 500 funds had allocations diverging from the index by between 1.7% and 7.5% of their assets in Q4 2022.
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