Beyond ETFs: What Passive Investing Really Changes in Financial Markets
Beyond ETFs: what passive investing really changes in financial markets
Passive investing, which now captures more than half of equity investment flows in the United States, does not merely replicate indices: it alters price formation, amplifies concentration, and distorts correlations — with structural consequences that the product’s apparent simplicity does not reveal.
When an investor buys an ETF, they are making a gesture that feels simple. The mechanics it triggers behind the scenes are increasingly complex — and potentially systemic in ways that are still poorly measured.
The ETF is probably the most democratizing financial innovation of the last thirty years. It has made diversified investing accessible, transparent, and inexpensive. An individual can, with one click, buy a basket of 1,500 global stocks for just a few basis points in fees. That simplicity is a genuine improvement. But it masks a profound transformation in markets unfolding beneath the surface.
When 50% of equity investment flows go through products that mechanically buy the same securities, in the same proportions, with no fundamental analysis whatsoever, something changes in the way prices are formed. This is not a theoretical hypothesis: it is measurable in the data on index concentration, stock correlations, and stress liquidity. Understanding the passive revolution and index investing means understanding a structural shift whose effects are still unfolding.
How an ETF works: the creation-redemption mechanism
An ETF is not a traditional fund listed on an exchange. Its functioning relies on a specific mechanism — creation and redemption of shares — involving a key actor: the authorized participant (AP).
When demand for an ETF increases, the AP buys the underlying stocks in the market, delivers them to the ETF manager, and receives new ETF shares in return. When an investor sells ETF shares in size, the mechanism reverses: the AP redeems the shares, exchanges them for the underlying stocks, and sells those stocks in the market. This arbitrage process keeps the ETF price aligned with the value of its underlying assets.
Under normal conditions, this mechanism works smoothly. The price formation and liquidity process in ETFs is efficient as long as the underlying securities are themselves liquid and APs have an economic incentive to keep arbitraging. But neither condition is always met — and that is where the risks lie.
An ETF is never more liquid than its underlying assets. An ETF tracking high-yield bonds may trade on the exchange within seconds, but the bonds it holds may take days to sell in the over-the-counter market. In times of stress, APs reduce their arbitrage activity, the ETF price disconnects from its net asset value, and meaningful premiums or discounts appear. This phenomenon, observed in March 2020, challenges the idea that ETF liquidity is inherent to the product.
What passive investing changes in price formation
When an active manager buys a stock, it is because they believe that stock is undervalued. Their purchase is an informational signal: it embeds an analysis of fundamentals into the price. When an index ETF buys a stock, it does so because the stock is in the index, period. Its purchase contains no information about the quality of the company, the strength of its earnings, or the relevance of its valuation.
In theory, this is not a problem as long as active managers remain numerous enough to ensure “price discovery” — the process by which prices reflect fundamental information. In practice, the share of active management in total flows is shrinking year after year. According to Morningstar data, passive funds now hold more assets than active funds in the United States. And flows continue to move massively into passive products.
The consequences of this trend for market microstructure are documented but not yet fully understood. Among the effects identified in academic research: higher correlations among stocks within the same index (because passive flows buy and sell all the names together), reduced informational efficiency in individual stock prices (because a stock’s price is increasingly determined by ETF flows rather than company analysis), and amplified market moves when large flows go in one direction or the other.
Index concentration: a mechanical risk
Passive investing has a structural side effect: it amplifies the concentration of capitalization-weighted indices.
The mechanism is self-reinforcing. A company whose stock rises sees its weight in the index increase. ETFs that track that index must buy more of that company’s shares to maintain the weight — which pushes the price up further, which increases the weight again, and so on. This is a virtuous circle for large-cap stocks, but a vicious one for diversification: the ten largest companies in the S&P 500 now account for more than 35% of the index — an unprecedented level of concentration.
For an investor who thinks they own a “diversified” portfolio through an S&P 500 ETF, this concentration means performance depends disproportionately on a handful of names. The analysis of valuations and profit dynamics in these mega-caps shows that their valuation multiples are significantly above the index average — making them mechanically more vulnerable to an earnings disappointment or a shift in the rate regime.
The correlation dynamics within markets confirm this shift. In a regime dominated by passive flows, intra-index correlations rise during directional phases (broad market rallies or selloffs) and collapse sharply during sector rotations — when the market moves from a “everything rises together” regime to a selection regime.
Stress liquidity risk: when everyone sells the same product
The most discussed — and perhaps the most underestimated — risk linked to passive investing concerns stress episodes. If a shock triggers massive ETF selling, the creation-redemption mechanism works in reverse: APs must sell the underlying stocks in the market. If millions of investors sell the same S&P 500 ETF at the same time, APs must sell the same 500 stocks at the same time — in a market where everyone is selling.
The liquidity of ETFs during market drawdowns has been the subject of growing literature since the episodes of March 2020 and autumn 2022. The empirical conclusion is that liquidity deteriorates nonlinearly: it works well until the moment it does not, and the tipping point is hard to predict.
The illusion of ETF liquidity continuity relative to the underlying market is especially pronounced in less liquid segments: corporate bonds, emerging markets, listed real estate. In these segments, the ETF’s daily trading volume can far exceed that of its underlying assets — a structurally unstable situation when selling pressure intensifies.
The weakening of ETF liquidity in high-rate regimes adds another layer. When rates are high, the carrying cost of market-making positions rises. APs have less economic incentive to maintain tight quotes. The result is a structural deterioration in liquidity quality — invisible in trading volumes but measurable in spreads and order-book depth — that makes the system more fragile in the event of a shock.
Thematic ETFs and AI: the latest layer of risk
Thematic ETFs — especially those focused on artificial intelligence — are the newest and most concentrated extension of passive investing. An AI thematic ETF may hold 30 to 50 securities, with 5 to 10 accounting for more than 60% of the weight. Diversification is minimal. Sector exposure is maximal. And the link to a narrative (“AI is going to transform the world”) creates a self-referential flow risk: investors buy the ETF because the theme is rising, the theme rises because ETF flows push prices higher, and the loop feeds itself — until it reverses.
The analysis of sector and thematic dynamics shows that this type of thematic concentration has historically produced episodes of spectacular outperformance followed by equally sharp corrections. ETFs focused on renewable energy, blockchain, or cannabis followed that pattern. AI may not escape it — not because the technology is not real, but because passive-flow mechanisms amplify the disconnect between prices and fundamentals.
What to take away for portfolio construction
ETFs remain a remarkable tool because of their transparency, low cost, and accessibility. Nothing in this analysis suggests they should be abandoned. But treating them as “simple” products whose internal mechanics can be ignored means underestimating the structural risks they carry.
The questions raised by this analysis are concrete for portfolio risk management. What is the true concentration level of my portfolio if I hold an S&P 500 ETF? What is the real liquidity of my ETFs in a stress event? Does my allocation reflect my convictions, or merely the current market capitalization of companies — which itself mechanically embeds passive flows?
For readers beginning with ETFs, these considerations do not undermine the product’s usefulness. They invite a fuller understanding — of its strengths and its limits. The ETF is a vehicle, not a destination. And like any vehicle, it is most useful when you know its characteristics, including the ones that do not appear in the brochure.
Mis à jour : 30 March 2026
This article provides economic and financial analysis for informational purposes only. It does not constitute investment advice or a personalized recommendation. Any investment decision remains the sole responsibility of the reader.
