The U.S. markets have long been the beating heart of global capitalism – a system built on competition, innovation, and the relentless search for value. But today, the proliferation of index-tracking funds has created a system where a company’s inclusion in a benchmark, not business performance, determines how capital is allocated. The results aren’t just academic. Among other things, fewer companies are going public as they compete with index funds for capital.
This over reliance on passive investing flattens returns and dulls the meritocracy that has long powered American markets. Winners can’t pull ahead as much as they should, and laggards stay afloat longer than they would otherwise.
This begs an important question for firms and individuals with significant holdings in index-tracking funds: in a world where everyone indexes, who is left to value companies for what they’re truly worth?
Per Morningstar, passive funds have steadily gained market share in the 21st century, finishing 2023 with more assets than their active counterparts for the first time.
The dominance of index-tracking funds isn’t a reflection of their inherent superiority – it’s the product of a market dynamic that has evolved into a self-fulfilling prophecy. Index funds allocate capital indiscriminately to every constituent of the index they track, regardless of the individual company’s performance or growth potential. Over time, the sheer scale of these passive inflows suppresses performance disparities among companies, as we can see in the rising co-movement in the S&P 500 from the late 1990s to today. This flattening effect fundamentally alters the playing field for active managers who lose the edge they need to identify and reward high-potential companies.
Investors Have Sidelined IPOs in Favor of Index Funds
One of the clearest consequences of this shift is visible in the IPO pipeline. Companies go public as an efficient means of capital formation, but with so much capital flowing into passive funds, it becomes difficult to attract investor interest outside of the major indices. This dynamic incentivizes firms to delay IPOs until they are larger and more likely to be included in those benchmarks – they only get one shot at going public, after all. As a result, the pipeline of earlier-stage, high-growth companies reaching public markets has thinned.
The decline in IPOs isn’t a passive investing story in itself. Intensifying regulatory burdens and increasingly widespread access to private markets have also played a significant role. But together, these forces undermine a market system that was designed to connect innovative businesses with the funding needed to scale and compete. Over time, capital becomes increasingly concentrated in established incumbents, reducing competitive pressure and slowing innovation. It’s a shift that cuts against the foundational strengths of U.S. capital markets: openness, dynamism, and broad-based opportunity.
With Fewer Active Managers, There Will Be More Meme Stock Manias
The dominance of passive investing has hollowed out the pool of participants engaged in price discovery. We’ve seen the consequences firsthand: “meme stocks” like GameStop experienced wild price swings, driven by speculative retail trading while index funds remained static. With fewer active investors correcting these distortions, volatility spikes of this nature will continue to increase, eroding trust in public markets.
Active management provides a critical counterbalance, injecting rationality and stability into a system increasingly shaped by momentum and speculation. As active managers exit the market, the demand and funding for fundamental research will dry up. Without the insights provided by this research, the landscape becomes even more homogenous, further eroding the vigor that has long defined our markets. The managers who remain will be even less equipped to identify and reward high-potential companies. It’s a veritable death spiral for active management.
U.S. markets remain the most robust in the world, but the attributes that made it so are being quietly eroded. That should make us all worried, both as financial services professionals and as Americans. The solution lies in reclaiming the principles that made our markets so dynamic to begin with.
Thoughtful investors must consider the long-term effects of passive capital inflows. The future of our markets and society is shaped by our investment choices now. This is a moment to act with purpose, intensity, and accountability. That means embracing the diverse benefits of active management – and ensuring that the invisible ceiling on innovation doesn’t become a permanent barrier.
David Choate is chief operating officer of CAPIS
