The dominance of a handful of tech stocks in the equity market is likely linked to investors’ massive appetite for cheap index funds, which in turn could be a hidden risk for Wall Street, according to Bank of America. Jared Woodard, investment and ETF strategist at Bank of America, said in a note to clients that passive funds now have 54% of market share and appear to be one reason that just five stocks account for more than 25% of the S & P 500. Passive funds like the SPDR S & P 500 Trust (SPY) and Vanguard S & P 500 ETF (VOO) are consistently among the most popular by inflows on most months, meaning that investors are putting more and more money into those biggest stocks. “Because passive investing is less sensitive to valuation and other fundamentals, some market participants worry that passive funds make markets less efficient. And since most passive funds are weighted by market-capitalization, passive flows can exacerbate market concentration, thereby reducing diversification,” Woodard wrote. VOO ALL mountain Passive funds, like Vanguard’s VOO, have attracted massive inflows of investor cash over the years. Investors have shifted toward passive investing in recent decades in part because those vehicles typically have lower management fees than their active counterparts. Most traditional active stock pickers also tend to underperform the S & P 500 in any given year, and the performance numbers look even worse over longer periods. But there is a chance that 54% market share stat is more than just a trivia tidbit. Woodard wrote that passive investing has reached a “critical mass” and could cause issues for the stock market, especially during downturns. “Systemic concentration raises the stakes: passive disregard for valuations & fundamentals means big upside from innovations … but big risk in a bust cycle,” Woodard said. To be sure, Bank of America is not the first to warn of the risk of the rise in passive investing. Concerns had been raised long before recent sharp downturns, like the 2020 Covid sell-off, that did not appear to result in long-term structural damage to markets. And periods of high concentration in the markets don’t require passive investing, either. The so-called Nifty 50, which is often cited as a historical precedent to the current environment, peaked before the founding of Vanguard, a pioneering firm in passive investing.
