Low costs and simplicity are the hallmarks of passive investing – and investors remain keen on them for core portfolios. We can’t fault that logic. According to Morningstar, 2025 was a record year for passive U.S. open-end and exchange-traded funds, taking in $951 billion, standing in stark contrast to the $187 billion pulled from active funds. The track record that drove those flows is real: over the past decade, passive has delivered on a foundation of consistency and index tracking performance that outpaced the majority of active peers… but not all.
Passive now commands the majority of assets under management — north of 55% of the U.S. funds market. But that dominance has quietly introduced some distortions, ones that don’t show up in expense ratios or fund fact sheets. At its core, index investing is institutionalized herd behavior: every dollar flowing into an index fund buys the same stocks, in identical proportions, alongside every other dollar tracking that benchmark. When the herd was small, that didn’t matter much. Now that the herd is the market, those distortions are harder to ignore. Here are three passive pitfalls every investor should understand, and where disciplined active management may help fill in the gaps.
Index funds lead with their low costs — sometimes as little as three basis points annually. That expense ratio is real, but it’s only a fraction of what investors actually pay.
Every major index periodically refreshes its roster — new names in, old names out, weightings shift. Funds mirroring those indices must execute the corresponding trades on a publicly-known schedule. Traders know this. They buy stocks before passive funds are forced to, then sell them back at inflated prices. The index funds are handcuffed: they must transact regardless of conditions.
Studies of S&P 500 Index changes from 1970 to 2021 found that stocks added to the Index traded at valuation premiums roughly 92% above the market, while deletions traded at 55% discounts — a systematic buy-high, sell-low dynamic baked into the structure of index investing. This isn’t just a valuation problem; it’s also a timing problem. Research by Iro Tasitsiomi found that trading costs on mandatory rebalancing days can run hundreds of basis points above what a patient, opportunistic execution would require. Morningstar’s research also confirms passive managers often trade in the final minutes of rebalance day, demanding a lot of liquidity in a handful of names over a short window.
All of this creates a hidden implementation drag that never appears in the expense ratio. And cash held in reserve for redemptions — idle capital earning far less than the market while the rest of the portfolio compounds — adds further drag that similarly never appears in any headline fee.
The active alternative: Active managers face transaction costs too, but those costs are not as predictable for traders to front-run. And unlike rote index reconstitution costs, active trading costs depend on the skill and discipline of individual managers – a variable difficult to assess in advance. However, skilled managers can adjust holdings gradually, trading when conditions are favorable rather than when deadlines force their hand. They can harvest tax losses and exit acquisition targets once the deal premium is priced in – redeploying capital somewhere with actual return potential. Index funds must hold the target (which now effectively trades like cash) for months until the deal closes, forfeiting some flexibility. The visible fee may be higher for active funds, but once implementation friction is factored in, the true cost gap narrows considerably.
MARKET CAP CONCENTRATIONS
One appeal of index investing is knowing exactly what you own. A small-cap fund owns small-cap stocks; a tech fund holds tech stocks. In practice, the reality is messier — because index construction is based almost entirely on market cap, not on company fundamentals. And the cap-weighting plays on a loop: price appreciation drives index weight, higher weight attracts more capital, more capital pushes prices higher still.
Because cap-weighted indexes allocate based on price rather than fundamentals and reconstitute only periodically, they can drift from their stated mandates between rebalancing events. Research by Dimensional Fund Advisors found that from 2009 through mid-2023, roughly 20% of the Russell 2000 Index — marketed as a small-cap index — was actually composed of the largest stocks in the broader Russell 3000. The overlap between Russell 1000 Value and Growth indices averaged around 300 companies over the same period.
The issue is front and center with the S&P 500 Index. Originally a broad cross-section of the U.S. economy, the Index now looks more like a large-cap growth fund — IT alone now accounts for roughly 32% of its weight. Meanwhile, the universe of publicly listed U.S. companies has shrunk by half since the late 1990s; yet U.S. asset inflows pour in at record levels. Vastly more capital chasing a dramatically smaller pool of companies increasingly concentrated at the top — that’s not diversification in the classic sense. That’s the herd compressing into an ever-narrower space rewarding scale and momentum, sometimes regardless of whether the underlying businesses justify either.
QUALITY QUESTIONS
So let’s talk about that. Newly public companies with limited operating histories, deeply distressed businesses approaching insolvency, and speculative small-caps with no profitability can land in an index. No analyst, no portfolio manager, and no risk framework stands between the index methodology and investor capital. The company makes the cut, so the index holds it – no questions asked.
The active alternative: Active managers can do something index funds structurally cannot: say no. They can decline to hold newly public, distressed, or speculative firms before those positions drag on returns. They can rebalance more frequently than index reconstitutions allow, rather than drift quietly toward whatever has appreciated most – offering a differentiated product when the rest of the market stumbles. We saw this in the March 2020 COVID crash, when passive funds dumped stocks en masse, amplifying volatility and leaving fundamentally sound companies temporarily mispriced. Those are actually some of the best times to be active value managers. The risk, however, is that the freedom to say “no” can become the freedom to be wrong. Active managers who avoid a rising stock or sector — even for sound fundamental reasons — can lag benchmarks for long periods.
The third pitfall isn’t about individual stocks – it’s a systemic concern, it’s about what happens to financial markets when the majority of invested capital stops asking whether any of those stocks are fairly valued.
Markets function because participants disagree. Active managers study companies, react to earnings, and reprice securities quickly when conditions change. When a stock is overvalued, they sell; when it’s cheap, they buy. Passive funds simply hold what the index holds at whatever price it trades, contributing nothing to the price discovery process while free-riding on the analysis of active investors.
The consequence: research published in 2025 found that stocks with higher passive ownership display rising betas (sensitivity to broad market movements) regardless of company-specific developments, while stocks with more active ownership retain more independent price behavior. The diversification that index investing promised — owning assets that behave differently from one another — is quietly eroding at the margin. When the herd moves, everything moves with it. What looks like a diversified portfolio on paper is increasingly looking like one big bet on market sentiment.
THE RETAIL TAKEOVER
Passive investing has absorbed institutional flows, turning single-stock trading into a retail-dominated activity. Retail’s share of daily volume sat below 10% before 2020. J.P. Morgan put it at 36% by April 2025 — an all-time high, double the share from a decade ago.
This matters because market efficiency rests on a particular assumption: prices get set by research analysts and portfolio managers doing the work — reading filings, building models, updating valuations when facts change. That’s less true today. Retail investors favor simple strategies, chase momentum, and nearly half (between the ages of 22-37) cite social media (not 10-Ks) as their primary input. The result looks less like price discovery and more like a crowded trade: retail buys what’s working, passive piles into the same mega-cap names, and the cycle reinforces itself. Expensive stocks stay expensive — not because they’ve earned it, but because the next buyer isn’t asking any questions. Active managers ask.
The active alternative: Active managers serve a function that extends well beyond their own portfolio returns. They are the market’s counterweight — willing to buy with fundamental conviction when passive flows drive indiscriminate selling, and to sell when momentum has carried prices beyond what underlying businesses support. It is ironic, really: the forces most often cited as arguments against active management — the rise of passive, the dominance of retail — are simultaneously creating the conditions in which skilled fundamental work may be especially valuable.
Passive investing offers relatively low costs and simplicity, making it a sensible core holding for many investors, especially in large-cap U.S. equities where markets are generally efficient. But its strengths can also create blind spots: concentrated flows, implementation friction, overcrowding and reduced diversification can leave investors more exposed than they realize. Even Vanguard’s own John Bogle warned of this, predicting that if index funds came to own half of all U.S. stocks, it “would not serve the national interest.”
That is where active management matters. In less-efficient areas such as small caps and international equities, skilled active managers can be more selective, manage risk more deliberately, and avoid crowded names. Passive investing is a strong foundation, but active investing can add flexibility and help fill the gaps where indexing is most vulnerable.
This blog was penned by Jason Crawshaw, EVP and Portfolio Manager, in April 2026. Mr. Crawshaw joined the firm in January 2014 as an Analyst. In 2015, he became an LLC member and was named an Assistant Portfolio Manager in 2016. He was promoted to Portfolio Manager in January 2021 and was named the firm’s Executive Vice President in late 2023. Mr. Crawshaw is a generalist and conducts fundamental analysis of potential investment opportunities. He brings 30+ years of investment industry experience to the firm.
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The S&P 500 Index is a broad-based, unmanaged measurement of changes in stock market conditions based on the average of 500 widely held common stocks. The Russell 3000 Index tracks the 3,000 largest U.S. companies (covering ~98% of the investable equity market), while the Russell 2000 Index is a subset representing the 2,000 smallest companies within that top 3000. The Russell 1000 Value Index/Russell 1000 Growth Index measures the performance of the large-cap value/growth segment (respectively) of the U.S. equity universe.
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