Passive investing and Big Tech: an ill-fated match

Tracker funds are choking out active managers, leading to hyped valuations for a dangerously small number of equities

Key points Summary Q&A

• Seven AI leaders – Alphabet, Amazon, Apple, Broadcom, Meta, Microsoft and Nvidia – now make up 28% of the S&P 500. In 2000, the biggest seven names made up just under 19% of the index.
• This concentration is thought to be partially caused by passive funds, which now hold $19 trillion of assets versus $16 trillion in active funds.
• Academics have found that index funds have made US markets about 11% less elastic.
• The concentration of sector-specific names in the index, plus inelasticity caused by passive investing, could squeeze markets in the event of a repricing of AI-related assets.

These summaries are generated by an LLM, but edited by humans.

Is the AI boom about to go bust? ‘Big Short’ contrarian Michael Burry earlier this month described the AI as a “bubble” that was “too big to save”. In other words, a loud bang is inevitable.

Respondents to Risk.net’s poll on the Top 10 investment risks for 2026 are twitchy, too. They ranked AI as their number one fear, citing concerns over heavy capex spend, tech obsolescence and runaway resource consumption.

It’s easy to see why investors would be apprehensive. The market dominance of such a small number of sector-specific companies today far exceeds the levels even of the dotcom boom.

And one view is that the rise of the passive investment industry has inflated tech valuations for a narrowing segment of major indexes in a way that contributes to the growing risk.

Parallels between today’s frothy market and the collapse of March 2000 are inevitable. Then, the seven biggest names in the S&P 500 accounted for just under 19% of the index. Today, the seven AI champions – Alphabet, Amazon, Apple, Broadcom, Meta, Microsoft and Nvidia – make up 28%. These are the giant sequoias shading out the rest of the forest.

Today’s index heavyweights are also more concentrated in one single sector. In 2000, the S&P 500’s biggest 20 names featured five tech companies. That number is now 10.

The concentration in Big Tech leaves the index more susceptible to a sector-specific market event: say, a DeepSeek 2.0 or an invasion of Taiwan.

 

At the same time, investor habits have changed. Passive funds that track an index are hoovering up a growing share of investors’ dollars. Last October, passive assets held in exchange-traded and mutual funds stood at $19 trillion, with active funds at $16 trillion, according to data provider Morningstar. At the turn of the century, passive’s piece of the pie was barely 15%.

Terry Smith, of investment firm Fundsmith, reckons the growing amount of equities swallowed up by index funds has created “dangerous distortions”. Index funds aim to mimic a benchmark. The underpinning logic – which has proven strong until now – is that replicating the index is a more solid predictor of returns than giving your cash to stock-picking experts that charge hefty fees.

But passive investing is blind. Tracker funds follow simple rules; they aren’t designed to assess the value of stock in the way a human does. Normally, if the price of an asset rises but its fundamental value is unchanged, the price will soon revert to the mean. This idea underpins many of the classical assumptions about financial markets. Passive investing upends these assumptions.

As Michael Green, a portfolio manager and chief strategist at Simplify Asset Management and an arch-sceptic of passive investing, said in a recent CNN interview: “When you switch to passive investing, you’re adding more money to things that go up. You kill the mean reversion that is central to all the models that we have around how markets are supposed to function.”

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Risk.net’s top 10 investment risks for 2026 

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Under normal market conditions, a wave of active investors would sweep into the markets to arbitrage away the distortions in value that passive investing has created. But these active investors are shrinking in number and heft. Now, rises in equity prices are more inclined to balloon in a way that previously wouldn’t, or couldn’t, have happened.

Academics have been able to put a number on this effect. A landmark paper by Valentin Haddad in 2021 looks at the elasticity of stock markets – in other words, how responsive buyers and sellers are to price changes. The paper concluded that the rise in passive investing over the past 20 years has made US stock markets 11% less responsive. Put simply, buyers keep buying even when the price keeps going up.

Of course, inelasticity also affects the way prices might decline. It’s true that the design of passive funds means they aren’t necessarily forced to sell holdings in a downturn. As a stock loses value, its weighting in the index also declines – which is mirrored in the mutual fund or ETF. During normal ups and downs, the fund can sit tight.

What could trigger forced selling, though, would be mass investor redemptions. An AI crash, spilling over into wider markets, would leave investors scrambling for the exit, potentially driving a downward spiral.

As for whether AI stocks are overvalued, the lights are flashing orange, if not red. The average price/earnings ratio for the S&P 500 is now almost as stretched as it was before the dotcom crash. The cyclically adjusted 10-year P/E ratio is at 45, compared with 53 in March 2000, according to data provider Finaeon.

The Nasdaq Composite rose sixfold in the five years leading up to the dotcom crash. The rise in some AI stocks has eclipsed this. AI software firm Palantir’s stock has risen by a factor of six in the past five years. Semiconductor firm Broadcom’s stock is up eight times over the same period. And Nvidia tops them all: up by a factor of 13.

As the saying goes, the bigger they are, the harder they fall.

Editing by Rob Mannix