When Diversification Results in Concentration: The Fake Sense of Security from Passive ETFs

What is a Passive ETF and Why is it Favoured by Us

A passive ETF is defined as an investment fund that tracks a market index. The aim of a passive ETF is to trace the market’s return, for example the VUSA is aimed to trace the US S&P 500 index or the LYP6 that tracks the STOXX Europe 600. These funds match index performance because they automatically invest capital into all constituent stocks.

There are clear reasons why passive ETFs are often favoured by retail investors. Firstly, passive ETFs are supposed to provide market returns, making them one of the easiest ways for normal people to enjoy the benefits of the long-term market gain with little to no financial knowledge. Secondly, as passive ETFs all follow strict rules on how specific assets are allocated, this massively lowers the cost for research, management and high-frequency transactions. This has resulted in passive ETFs like VUSA becoming one of the lowest-cost mutual funds. Lastly, and perhaps one of the biggest drivers for why ETFs are so popular is the ability to easily achieve diversification. By buying the VUSA the investor has invested in 500 of the largest companies in the US stock market. Theoretically, this should easily lower the unsystematic risk of the overall investment, achieving what is commonly considered as “not putting all eggs into a single market”.

Due to the benefit that passive ETF have, millions of international investors put their savings through their 401K or ISA into those funds. These have not only supported the rise of major indices in recent decades, but have also made passive ETFs one of the fastest growing investment vehicles. The AUM of all ETFs has increased from 70 billion USD in 2000 to almost 24 trillion USD in 2026, around 312-fold¹.

The brutal truth of how we turn “diversification” into concentration.

The current reality about the passive ETF

As the size of the ETF market is continuously growing larger, it also means that more and more stocks are bought by passive asset management firms. For example, in the US three of the biggest passive asset management firms (BlackRock, Vanguard, State Street) now own around 23% of the physical shares of the S&P 500². Furthermore, these companies are often the stakeholders that own the most voting rights in these companies at around 25% to 27% in most S&P 500 companies.

From the perspective of an individual investor, the effect of those giant funds may feel invisible, but the market is already experiencing many of their negative effects. If the trend continues, 35% to 40% of the voting rights will be in the hands of those “big three” firms in the coming decades, and by then investors will experience the negative effects that it brings².

The Loss of Price Discovery

An efficient trading market is supposed to allow price to transmit market preferences and the commercial value of a company, as quickly and as accurately as possible. However when capital from passive ETFs only choose the company with the highest market cap, it often ignores other key metrics like ROE, or P/E. As 23% of the stock is owned by passive ETFs, it can almost be argued that 23% of the capital of the company isn’t based on what the company is but purely on its market valuation³. Beyond the loss of efficient price formation, this forces companies to be even more short-sighted and ignores things like long-term strategy and ethics, just to push up the price valuations.

The Passive Feedback Loop

In addition, it is also important to note that most of the passive ETFs are Cap-weighted ETFs, this means that when 500 dollars is invested into the VUSA, it doesn’t mean all 500 stocks in the S&P 500 are being invested with 1 dollar. This is because more money will be invested into the company with higher market cap and less for the others.

The consequences of the Cap-weighted ETF is significant as this creates a snowball effect for those top companies in the index. With more money flowing into these top companies, this would only make the market cap of those companies even larger. This passive loop would only continue mathematically if the supply of money doesn't stop. More and more of that money will be concentrated in the S&P 10 rather than the S&P 490.

Potential Liquidity Cascades

It is crucial to understand that the passive feedback loop operates in both directions. While it artificially inflates mega-cap valuation during a bull market, it also creates structural fragility during an economic panic. When retail and institutional investors simultaneously sell their ETF shares during a market shock, the passive fund is forced to liquidate the underlying constituents’ stocks.

As those shares are strictly relative to their market capitalisation, a massive sell-off would violently drag down the top S&P 10 companies. More alarmingly, this process would also remove liquidity from the remaining 490 companies - regardless of the state of the company. The mechanism of selling stocks would transform a single company specific volatility event into a systemic liquidity cascade, where all companies in an index are punished together just because they are in the same index. This is especially true for the less liquid mid-cap stocks in the index as the cascades would affect them more than the mega-caps due to the difference in liquidity.

What the data is telling us

The consequence of money only flowing into the top companies with little evaluation has been known for years, yet the data shows that the issue has never been this pronounced. In 2026 38.5% of money was concentrated in only 10 out of 500 firms, this is significantly higher than in previous years. Furthermore, it is even more concerning when these numbers are currently higher than the number at the 1973 Nifty Fifty Peak (around 33.2%) and the 2000 financial crisis (around 26.6%). Whilst passive ETFs aren’t the only factor that causes this, the overoptimism of AI is also contributing to this higher ratio, but it does bring the concern of what will happen if those leading stocks crash.

This phenomenon is not limited to the US market; similarly in Europe, the 11 mega-caps commonly known as “GRANOLAS” now account for around 25% of the Europe 600⁴. Although this is still considerably more diverse than the USA, as the mega-caps are spread across different industries and countries, similar effects of the rise of passive ETFs are seen.

Additionally, it is also concerning when we study the correlation between the stock and the index. When the correlation is high (approaching 1), it usually implies that there is a widespread market panic, much like during the financial crisis, that causes a macro sell-off. However, when the correlation is low it indicates a market divergence where a tiny group of stocks drives index returns and the others move independently and mainly stagnate. Currently in 2026 the leading tech companies like Nvidia and Apple are contributing to it, this, combined with the enormous investment from passive ETFs, means that personal investors in passive ETFs are actually heavily invested in tech.

How Are We Affected and What Can We Do About It

To fully understand how this passive ETF mania will affect more than just the market structure, but also personal retail investors, we have to understand the purpose of diversification. Diversification is more than just selecting more than one stock, it is with the aim of lowering risk to only the systemic risk of the economy. As the passive ETF becomes the default savings vehicle and 10 companies account for 40% of the index, the original goal of true diversification has been entirely lost. We can no longer insulate ourselves from the danger of a single company failing. In fact, now a single iPhone failure from Apple or a not-so-good AI model from Alphabet or an earnings miss from Microsoft is affecting the 'diversified' retirement portfolios of millions.

There are many actions that we can take to counteract this risk if we don’t favour it. The most obvious approach could be just including more stocks in the portfolio. This could easily be achieved by holding ETFs that cover different geographical areas, or buying an ETF with international coverage like the VWRP. However this doesn't solve the problem of mega-cap dominating the index and simply dilutes it slightly across geography.

In today’s world, Equal-Weight ETFs like the RSP have also become more relevant and popular as they allow money to be distributed across the 500 stocks equally. Furthermore, the demand for other metrics-based passive ETFs rises; for example the COWZ has become more and more favoured as it focuses on the stocks with the highest free cash flow yield rather than market cap. Another metric based ETF can be “Smart Beta”/ factor ETFs, where the inclusion of wider metric-based passive ETFs could ensure that a person’s portfolio is not only fully diversified but also distributed across geographical areas and not limited to a rising sector.

Is it Worth the Risk? Greater Returns Come with Greater Concentration

Ultimately, the additional risk brought by cap-weighted ETFs did deliver strong returns over the years. The compound annual growth rate (CAGR) between 2006 and 2025 has been around 11%, so the most important thing for investors is to understand that the strong returns on their investment come with the additional risk they have taken on.

Once investors understand that a standard cap-weighted portfolio is no longer as diversified as it appears, they must re-evaluate their holdings against their personal risk tolerance and investment goals. The key is no longer just holding the market, but understanding exactly what part and how much of the market that we are truly holding.