The Passive Boom and Why It Could Be the Next Big Risk

Investing passively in equities today is the riskiest it has ever been. 

Indeed, it is a paradox that passives become riskier the more successful they are, because they concentrate flow into the biggest weights, increasing concentration and driving up valuation. To the extent that valuation is self-correcting (mean reverting), and that the history of concentrated markets becoming less concentrated is any guide, today’s highly priced and extremely concentrated market is a risky one.

Let’s take each in turn.

Market Concentration

One major consequence is the unprecedented levels of market concentration; today the top seven stocks in the S&P 500 make up ~33% of the index. This stems from the mechanics of passive investing. Larger companies receive more capital, not necessarily because of stronger fundamentals, but simply due to their size. Over time, this can create a momentum driven cycle, which can disconnect prices from company performance. The danger arises if the dominant stocks falter, whether due to underlying earnings concerns, market shifts or a broader economic slowdown. The latter point is important; job security and strong wages support greater retail participation and boost pension contributions, which in turn fuel passive flows. A slowing employment market could thus have outsized ripple effects.

Should this concentration begin to unwind, which history suggests is mean reverting, it could mark a turning point. Historically, periods of lower market concentration have coincided with stronger relative performance from active managers. This makes intuitive sense as active managers often hold less of the most heavily weighted stocks, allowing them to benefit when market leadership broadens or rotates.

What’s more, the dominant rise of the technology sector means that passive investors can be increasingly exposed to one part of the market. For example, Information Technology makes up ~27% of the MSCI ACWI index. While capital may be spread across many companies, true diversification is lacking when risk remains heavily tied to a single sector. If key technology companies begin to face earnings headwinds, the consequences could be significant, particularly amid growing concerns about a potential bubble in AI-related stocks.

IT weight in MSCI AC world index

Source: Morningstar, Bloomberg.

A truly active, even concentrated portfolio, can be well positioned in this environment. “Concentrated” might sound surprising, but academic research shows that risk reduction can actually be achieved with a relatively small number of holdings. The chart below shows that beyond ~30 stocks, adding more offers little further risk reduction. A well-constructed, relatively concentrated portfolio can still achieve effective diversification and strong risk-adjusted outcomes.

Source: W1M, Foundations of Finance Eugene Fama 1976.

Meanwhile, passive investing picks up market exposure in a price and value agnostic way. Whilst it does spread your capital across more companies, it doesn’t necessarily spread your risk in the way you might expect. You can still be heavily exposed to a singular sector or thematic.

Valuation Risk

Beyond market concentration, another key reason supporting active investing today is the heightened valuations seen at an index level. The ability to selectively avoid parts of the market becomes increasingly important.

The chart below, plotting the Shiller CAPE P/E Ratio against the subsequent 10 year annualised returns of the S&P 500 since 1950 shows a clear pattern. Low starting valuations have often led to strong, even double-digit returns, whilst higher valuations have typically resulted in low or even negative returns. Today, we sit at the high end of historical valuation ranges, suggesting that future returns may fall well below the ~10% long-term average.

The data is a crucial reminder that the price you pay today shapes the returns you get tomorrow. This dynamic poses a challenge for passive strategies as they tend to allocate more capital to names that are already expensive and heavily concentrated. Active managers do not have to own anything they feel is inappropriately priced.

US Shiller CAPE and subsequent 10 year S&P returns | 1950 to September 2015

Source: W1M, Morningstar. As at 30.09.2025.

In summary, active investors have flexibility. They can mitigate concentration and valuation risks by moving away from the index and by focusing on areas of the market that are often undervalued or overlooked, an edge that could prove especially important in the decade ahead.

Multi-Asset at W1M

At W1M, we invest actively, giving us increased flexibility to manage exposures. By investing directly, we know exactly what we own, enabling us to make informed, high conviction decisions. Our Multi-Asset portfolios are diversified across equities, bonds, alternatives, and also use hedging strategies. Within the equity allocation, the Multi-Asset Funds hold 40 direct names, diversified across industries and regions. We are underweight the IT sector.

As seen below, this approach has enabled us to deliver superior risk-adjusted returns versus passive. Please get in touch for further detail on our strategies.

Active vs Passive: Waverton Multi-Asset funds & MPS vs. vanguard LifeStrategy; 5 years

Source: W1M, Morningstar. Data to 30.06.25. ​

Returns are calculated on a NAV to NAV basis, net of fees and assumes income is reinvested.

Risk warning: Past performance is no guarantee of future results and the value and income from such investments and their strategies may fall as well as rise. You may not get back your initial investment. Capital security is not guaranteed. Different asset allocation strategies will lead to varying investment performances.