Equities

The impact of passive flows and the role of active management

June 20, 2025 - 9 min read

Juan Sebastian Caicedo CFA
Quantitative Equity Portfolio Manager
Ostrum AM

Highlights

Impact of passive management
Passive management, which now accounts for more than half of assets under management, fundamentally changes the structure of financial markets, increasing systemic risk due to the lack of arbitrage.
The paradox of passive investing
While rational and cost effective for individual investors, the widespread adoption of passive management weakens the overall system, amplifying the inelasticity of markets.
The role of investors in the conversation
In a context of extreme risk concentration, where the marginal investor delegates his or her view to that of others, the importance of active investor engagement becomes crucial.
Active diversification opportunities
An active approach to diversification, putting risk at the center of the allocation, can be decisive for navigating an environment where the dominance of passive flows can lead to prolonged rotations.

Nearly fifty years ago John ‘Jack’ Bogle, founder of the Vanguard Group, transformed investing with the launch of the first index funds in 1975. This innovation, arguably the most significant in finance in recent decades, has profoundly changed the way investors approach markets. Shortly before his death in 2019, Bogle warned of governance risks associated with an oversized market share of index funds. At the time, passive strategies accounted for 40% of assets under management. According to a recent Bank of America report, this proportion reached 54% in 2024.

Recent years have seen numerous studies, often contradicting classical theory, exploring the links between flows and asset prices. The dynamics of today's markets are now inextricably linked to a marginal flow that invests passively, agnostic to fundamentals or risk, with market capitalization as the sole reference. Understanding the structural implications of this dominance is key for every investor.

The paradox of passive investing

For investors, the shift from active to passive management is driven by various factors: relative risk aversion, lower fees, and a belief in market efficiency. Bogle's genius lay in his understanding that financial markets are a zero-sum game, where the difference between the market and active management equates to total fees. In other words, active management as a whole can only underperform. Thus, creating funds that replicate indices with increasingly reduced costs proves to be a flawless strategy. Vanguard has grown from managing $2 billion in 1975 to $10 trillion in 2024.

But markets are collective systems. When liquid, the price of a stock results from the balance between supply and demand. Indices are deemed efficient when they embody this aggregated judgement of all investors. Initially, passive investment means relying on the implicit views of other investors. The astute reader will have anticipated the question: What happens if a growing number of market participants adopt the same approach? What happens when the majority of market views mirror a consensus view, regardless of fundamentals or risk? In other words, what happens when we all become, often inadvertently, free riders?

This is the central paradox of asset management today. On one hand, the rational and individual decision to expose oneself passively and at low cost to the market. On the other hand, a global system weakened by the lack of arbitrage. Many academic researchers and investors have been studying the impact of flows on market structure for some years. Economists Xavier Gabaix and Ralph Koijen, affiliated with Harvard and Chicago universities respectively, published their 2021 Inelastic Market Hypothesis¹, already considered one of the most disruptive works in financial economics. Their conclusion? Today, one dollar invested raises market valuation fivefold. In other words, even as prices rise, aggregate demand does not necessarily weaken. More recent studies go even further: contrary to what one would assume, these impacts increase with the size of the stocks in an index. Concretely, the bigger a company, the less active management is capable of rebalancing the price distortion that results from the dominant passive flow². The valuation distortions observed over several years are a direct consequence. (Fig.1).

The upward correlation trend between size and valuation

Sources: Ostrum AM, FactSet, Bloomberg, MSCI
Figure 1 - By ranking European and US stocks according to their valuations and size, a rising trend of correlations between the two rankings is observed, particularly in the United States. The link between a company's high price and its market capitalization is increasingly evident

We must take a moment to appreciate the magnitude, and also the irony, of these results. We are worlds apart from the Efficient Markets Hypothesis, which posits that market prices reflect all the information available, and according to which the impact of flows can only be marginal. This hypothesis underlies Bogle's genius and the very utility of passive investing.

Suddenly, all questions about the atypical recent behavior of equity markets converge: concentration, weak arbitrage forces, the impact of share buybacks, large-cap domination, overvaluation. In a world in which active management weakens, where passive management relies entirely on imposed capitalization weights, demand elasticity relative to price dissolves as well. The marginal buyer continues to purchase at any price. The lack of relative risk taking by the majority of investors leads to an increase in systemic risk (Fig.2).

"MAG 7" : Fundamental growth only partially accounts for the achieved levels of concentration

Sources: Ostrum AM, FactSet, MSCI
Figure 2 - The weight of the top seven capitalizations in the US accounted for about a third of the major indices at the end of 2024, the largest concentration since at least 1900, according to a recent Bridgewater report. Crucially, while the share of sales and profits of these seven largest tech companies has doubled in the in the last decade, their total contribution to the risk of the MSCI USA index has been multiplied by 7. Today, they represent almost half of the total risk.

A few weeks before the tariff escalation, I was listening to an interview with Howard Marks, co-founder of Oaktree Capital Management. Marks, unanimously recognized in the United States as one of the greatest investors of the past forty years, shared his thoughts with two journalists. Although his reputation is primarily based on credit and distressed asset markets, he attempted to compare the current environment to major exuberance phases he experienced, such as the early 70s, late 90s, and 2006-2007. To the classic question "Are we in the midst of a new bubble?", Marks replied that quantifiable indicators were largely present, though he was more nuanced about psychological and cultural markers.

Despite this impression of uncertainty, Marks wished to highlight two immutable principles that he believes are essential to an investor. First, the importance of analyzing the present. Due to our inability to predict the future, Marks argued that our best weapon as investors is the continual assessment we must make of the current state.

Second, he emphasized our role as investors. This question, rarely central to the debate, is nevertheless crucial in the modern market ecosystem. Marks paraphrased Buffett: ‘The role of an investor is to remain cautious when others are not.’ Essentially, he stressed the need to reposition active management back at the heart of our profession.

This perspective is the greatest contrast that can be given to the increasingly notable distortions within markets today. The choice to construct one's allocation largely passively overlooks this central role each investor must bear and contributes to reinforcing an increasingly fragile balance. Beyond delegating one's view to that of consensus, the nature of global indices today makes passive allocation a bet on continued risk concentration beyond already record levels.

The importance of risk-based choices

If I were to emphasize one message, it would be: diversification deserves active consideration. It is unwise to anticipate the peak in market concentration, but a slowdown in passive allocations³ or a relaxation of index constraints by major investors could lead to abrupt and prolonged rotations, impacting the vast majority of investors. As in any collective system, balance depends on individual choices.

The question that arises is not that of a binary active/passive arbitrage, but that of the importance for each investor to assert their own views to ensure global resilience. In this regard, we have been highlighting for just over a year that the opportunities in the current environment are no longer directional but relative⁴. We stress that despite high absolute valuations, several relative valuations between different equity market segments are historically attractive.

We have always favored a risk-based approach to markets. It is an approach that allows us to be more reactive and circumvent most biases inherent in estimating future performance. We are convinced that this approach is all the more relevant today in a context where the dominance of passive flows results in dislocations that urgently need to be identified.

Valuation spread based on stock volatility remains at rarely seen levels

Sources: Ostrum AM, FactSet, MSCI. April 2025
Figure 3 - Valuation spreads between more speculative and less volatile ones reached historical records in 2024. Despite the sharp rotations observed since the start of the year, low volatility stocks continue to offer significant diversification and relative risk/return potential.

By the end of April, for a year now, all of our strategies aimed at minimizing equity market volatility have outperformed their indices. This outperformance has intensified this year with uncertainty rising sharply, outflows from the United States and tariff chaos. As always during periods of stress, the adjustment dynamics initially fit the response to the new economic context. But the scale of this response is also a function of investors' initial positioning. Understanding this positioning and the impacts of the flows that preceded it is a key factor today (the present observation Marks spoke of).

Despite the recent modest correction, we notably observe that valuation gaps favoring more speculative segments remain at record levels (Fig.3), and several less risky and more decoupled sectors collectively show historically low relative levels. In this sense, the return of volatility must be integrated into a context of normalizing excesses built over recent years, and the continuation of this normalization should serve as a basis for continued outperformance.

I cannot recall where I first heard this expression, but I can't find a better way to conclude: ‘Risk does not disappear; it transforms.’ The rise of passive investing is indisputable, and the economic arguments underpinning it cannot be contested. However, an investor must not confuse the logic behind choosing to invest passively with a risk free or impact free alternative. On the contrary, given its size today and its construction anchored on company capitalization and past momentum, the implicit cost of passive growth today is multifaceted, disrupting market balance and elasticity far beyond what its name might suggest. Through this note, I wished to highlight this contrast, which in my view deserves ongoing discussion: how to balance the economic benefits of passivity with the responsibility of individual action? This reality invites us to reconsider the importance of active management and the continuous analysis of diversification and risk.

¹Gabaix, Xavier and Koijen, Ralph S. J., In Search of the Origins of Financial Fluctuations: The Inelastic Markets Hypothesis, http://dx.doi.org/10.2139/ssrn.3686935

² See for example Haddad, Valentin and Huebner, Paul and Loualiche, Erik, How Competitive is the Stock Market? Theory, Evidence from Portfolios, and Implications for the Rise of Passive Investing, http://dx.doi.org/10.2139/ssrn.3821263

³ With US pension funds and scheduled allocations accounting for a significant proportion of passive flows, changes in regulation or the shrinking labour force associated with an ageing population may be a catalyst.

⁴https://www.ostrum.com/fr/news-insights/insights/diversification-langle-mort-des-marches-actions

This material has been provided for information purposes only to investment service providers or other Professional Clients, Qualified or Institutional Investors and, when required by local regulation, only at their written request. This material must not be used with Retail Investors.

In the E.U.: Provided by Natixis Investment Managers International or one of its BRANCH offices listed below. Natixis Investment Managers International is a portfolio management company authorized by the Autorité des Marchés Financiers (French Financial Markets Authority - AMF) under no. GP 90-009, and a simplified joint-stock company (société par actions simplifiée - SAS) registered in the Paris Trade and Companies Register under no. 329 450 738, Registered office: 43 avenue Pierre Mendès France, 75013 Paris. Germany: Natixis Investment Managers International, Zweigniederlassung Deutschland (Registration number: HRB 129507). Registered office: Senckenberganlage 21, 60325 Frankfurt am Main. Italy: Natixis Investment Managers International Succursale Italiana (Registration number: MI-2637562). Registered office: Via Adalberto Catena, 4, 20121 Milan, Italy. Netherlands: Natixis Investment Managers International, Dutch BRANCH (Registration number: 000050438298), Registered office: Stadsplateau 7, 3521AZ Utrecht, the Netherlands. Spain: Natixis Investment Managers International S.A., Sucursal en España (Registration number: NIF W0232616C), Registered office: Serrano n°90, 6th Floor, 28006 Madrid, Spain. Luxembourg: Natixis Investment Managers International, Luxembourg BRANCH (Registration number: B283713), Registered office: 2, rue Jean Monnet, L-2180 Luxembourg, Grand Duchy of Luxembourg. Belgium: Natixis Investment Managers International, Belgian BRANCH (Registration number: 1006.931.462), Gare Maritime, Rue Picard 7, Bte 100, 1000 Bruxelles, Belgium.

In Switzerland: Provided for information purposes only by Natixis Investment Managers, Switzerland Sàrl (Registration number: CHE-114.271.882), Rue du Vieux Collège 10, 1204 Geneva, Switzerland or its representative office in Zurich, Schweizergasse 6, 8001 Zürich.

In the British Isles: Provided by Natixis Investment Managers UK Limited which is authorised and regulated by the UK Financial Conduct Authority (FCA firm reference no. 190258) - registered office: Natixis Investment Managers UK Limited, Level 4, Cannon Bridge House, 25 Dowgate Hill, London, EC4R 2YA. When permitted, the distribution of this material is intended to be made to persons as described as follows: in the United Kingdom: this material is intended to be communicated to and/or directed at investment professionals and professional investors only; in Ireland: this material is intended to be communicated to and/or directed at professional investors only; in Guernsey: this material is intended to be communicated to and/or directed at only financial services providers which hold a license from the Guernsey Financial Services Commission; in Jersey: this material is intended to be communicated to and/or directed at professional investors only; in the Isle of Man: this material is intended to be communicated to and/or directed at only financial services providers which hold a license from the Isle of Man Financial Services Authority or insurers authorised under section 8 of the Insurance Act 2008.

In the DIFC: Provided in and from the DIFC financial district by Natixis Investment Managers Middle East (DIFC BRANCH) which is regulated by the DFSA. Related financial products or services are only available to persons who have sufficient financial experience and understanding to participate in financial markets within the DIFC, and qualify as Professional Clients or Market Counterparties as defined by the DFSA. No other Person should act upon this material. Registered office: Unit L10-02, Level 10 ,ICD Brookfield Place, DIFC, PO Box 506752, Dubai, United Arab Emirates

In Japan: Provided by Natixis Investment Managers Japan Co., Ltd. Registration No.: Director-General of the Kanto Local Financial Bureau (kinsho) No.425. Content of Business: The Company conducts investment management business, investment advisory and agency business and Type II Financial Instruments Business as a Financial Instruments Business Operator.

In Taiwan: Provided by Natixis Investment Managers Securities Investment Consulting (Taipei) Co., Ltd., a Securities Investment Consulting Enterprise regulated by the Financial Supervisory Commission of the R.O.C. Registered address: 34F., No. 68, Sec. 5, Zhongxiao East Road, Xinyi Dist., Taipei City 11065, Taiwan (R.O.C.), license number 2020 FSC SICE No. 025, Tel. +886 2 8789 2788.

In Singapore: Provided by Natixis Investment Managers Singapore Limited (NIM Singapore) having office at 5 Shenton Way, #22-05/06, UIC Building, Singapore 068808 (Company Registration No. 199801044D) to distributors and qualified investors for information purpose only. NIM Singapore is regulated by the Monetary Authority of Singapore under a Capital Markets Services Licence to conduct fund management activities and is an exempt financial adviser. Mirova Division (Business Name Registration No.: 53431077W) and Ostrum Division (Business Name Registration No.: 53463468X) are part of NIM Singapore and are not separate legal entities. This advertisement or publication has not been reviewed by the Monetary Authority of Singapore.

In Hong Kong: Provided by Natixis Investment Managers Hong Kong Limited to professional investors for information purpose only.

In Australia: Provided by Natixis Investment Managers Australia Pty Limited (ABN 60 088 786 289) (AFSL No. 246830) and is intended for the general information of financial advisers and wholesale clients only.

In New Zealand: This document is intended for the general information of New Zealand wholesale investors only and does not constitute financial advice. This is not a regulated offer for the purposes of the Financial Markets Conduct Act 2013 (FMCA) and is only available to New Zealand investors who have certified that they meet the requirements in the FMCA for wholesale investors. Natixis Investment Managers Australia Pty Limited is not a registered financial service provider in New Zealand.

In Korea: Provided by Natixis Investment Managers Korea Limited (Registered with Financial Services Commission for General Private Collective Investment Business) to distributors and qualified investors for information purpose only.

In Colombia: Provided by Natixis Investment Managers International Oficina de Representación (Colombia) to professional clients for informational purposes only as permitted under Decree 2555 of 2010. Any products, services or investments referred to herein are rendered exclusively outside of Colombia. This material does not constitute a public offering in Colombia and is addressed to less than 100 specifically identified investors.

In Latin America: Provided by Natixis Investment Managers International.

In Chile: Esta oferta privada se inicia el día de la fecha de la presente comunicación. La presente oferta se acoge a la Norma de Carácter General N° 336 de la Superintendencia de Valores y Seguros de Chile. La presente oferta versa sobre valores no inscritos en el Registro de Valores o en el Registro de Valores Extranjeros que lleva la Superintendencia de Valores y Seguros, por lo que los valores sobre los cuales ésta versa, no están sujetos a su fiscalización. Que por tratarse de valores no inscritos, no existe la obligación por parte del emisor de entregar en Chile información pública respecto de estos valores. Estos valores no podrán ser objeto de oferta pública mientras no sean inscritos en el Registro de Valores correspondiente.

In Mexico: Provided by Natixis IM Mexico, S. de R.L. de C.V., which is not a regulated financial entity, securities intermediary, or an investment manager in terms of the Mexican Securities Market Law (Ley del Mercado de Valores) and is not registered with the Comisión Nacional Bancaria y de Valores (CNBV) or any other Mexican authority. Any products, services or investments referred to herein that require authorization or license are rendered exclusively outside of Mexico. While shares of certain ETFs may be listed in the Sistema Internacional de Cotizaciones (SIC), such listing does not represent a public offering of securities in Mexico, and therefore the accuracy of this information has not been confirmed by the CNBV. Natixis Investment Managers is an entity organized under the laws of France and is not authorized by or registered with the CNBV or any other Mexican authority. Any reference contained herein to “Investment Managers” is made to Natixis Investment Managers and/or any of its investment management subsidiaries, which are also not authorized by or registered with the CNBV or any other Mexican authority.

In Uruguay: Provided by Natixis Investment Managers Uruguay S.A. Office: San Lucar 1491, Montevideo, Uruguay, CP 11500. The sale or offer of any units of a fund qualifies as a private placement pursuant to section 2 of Uruguayan law 18,627.

In Brazil: Provided to a specific identified investment professional for information purposes only by Natixis Investment Managers International. This communication cannot be distributed other than to the identified addressee. Further, this communication should not be construed as a public offer of any securities or any related financial instruments. Natixis Investment Managers International is a portfolio management company authorized by the Autorité des Marchés Financiers (French Financial Markets Authority - AMF) under no. GP 90-009, and a simplified joint-stock company (société par actions simplifiée - SAS) registered in the Paris Trade and Companies Register under no. 329 450 738. Registered office: 43 avenue Pierre Mendès France, 75013 Paris.

The above referenced entities are business development units of Natixis Investment Managers, the holding company of a diverse line-up of specialised investment management and distribution entities worldwide. The investment management subsidiaries of Natixis Investment Managers conduct any regulated activities only in and from the jurisdictions in which they are licensed or authorized. Their services and the products they manage are not available to all investors in all jurisdictions.

Although Natixis Investment Managers believes the information provided in this material to be reliable, including that from third party sources, it does not guarantee the accuracy, adequacy, or completeness of such information.

The provision of this material and/or reference to specific securities, sectors, or markets within this material does not constitute investment advice, or a recommendation or an offer to buy or to sell any security, or an offer of any regulated financial activity. Investors should consider the investment objectives, risks and expenses of any investment carefully before investing. The analyses, opinions, and certain of the investment themes and processes referenced herein represent the views of the individual(s) as of the date indicated. These, as well as the portfolio holdings and characteristics shown, are subject to change and cannot be construed as having any contractual value. There can be no assurance that developments will transpire as may be forecasted in this material. The analyses and opinions expressed by external third parties are independent and does not necessarily reflect those of Natixis Investment Managers. Any past performance information presented is not indicative of future performance.

This material may not be distributed, published, or reproduced, in whole or in part.

All amounts shown are expressed in USD unless otherwise indicated.

DR-71750