Passive investing has become one of the most influential trends in modern financial markets. Over the past several years, investors have increasingly moved away from actively selecting individual stocks and toward index funds. These investment products allow investors to own a broad collection of companies while paying lower fees compared with many actively managed funds.

Although passive investing has many advantages, critics argue that its rapid expansion has created new risks for financial markets. One of the strongest arguments against passive investing is that it can contribute to overpriced stocks by creating constant demand for shares without considering whether those companies are fairly valued

1.Passive Funds Buy Stocks Without Evaluating Their True Value

One of the main arguments that passive investing causes overpriced stocks is that passive funds do not analyse individual companies before purchasing shares.

Active investors decide whether a stock is undervalued, fairly priced, or overpriced.

Passive investors, however, follow a different approach. Their goal is not to identify the best companies but to replicate the performance of a market index. If a company is included in an index, passive funds must own shares of that company regardless of whether its valuation is reasonable.

This creates a situation where a company’s stock price may continue rising because of automatic investment flows rather than because its financial performance is improving.

For example, if a company’s stock price rises significantly, it becomes a larger part of a market index. Passive funds tracking that index must then increase their holdings of that company. This additional demand can push the stock price even higher, creating a cycle that may lead to overvaluation. A classic example of this was the rise in 2025 of bank shares, especially CBA.

2.Market-Capitalization Weighting Creates a “Buy High” Effect

Most major indexes are based on market capitalisation, meaning companies with larger stock market values receive greater representation in the index.

This structure creates a potential problem because passive funds automatically allocate more money toward companies that have already increased in value.

The process works as follows:

A company’s stock price rises, increasing its market capitalization. Because the company is now larger, it represents a greater percentage of the index. Passive funds then purchase more shares because they must match the index allocation.

Critics argue that this creates a “buy high” mechanism. Instead of buying companies because they appear undervalued, passive funds buy more of the companies that have already become expensive.

This is the opposite of traditional value investing, where investors search for companies whose prices are below their estimated worth.

Over time, this automatic buying pressure may allow highly valued companies to become even more expensive, increasing the risk that their stock prices move beyond their fundamental value.

3.Passive Investing Can Create a Self-Reinforcing Price Cycle

Another argument is that passive investing creates a feedback loop that pushes stock prices higher.

The cycle begins when a group of companies performs well. As their stock prices rise, they attract attention from investors and become larger parts of major indexes.

Because passive funds track these indexes, they automatically increase their holdings of these successful companies. The additional buying pressure supports further price increases.

As prices rise, investors may interpret the performance as evidence that these companies are strong investments. This encourages more money to enter passive funds, creating even more demand.

Critics argue that this process can cause stock prices to rise faster than company earnings, resulting in inflated valuations.

 4.Reduced Price Discovery Can Allow Overpriced Stocks to Continue Rising

Financial markets depend on price discovery, which is the process through which investors determine the fair value of assets.

Active investors play an important role in price discovery by researching companies and making investment decisions based on information. When they believe a stock is overpriced, they may sell or avoid buying it. This helps prevent excessive price increases.

However, critics argue that the growth of passive investing reduces the number of investors actively evaluating individual companies.

If more investors simply buy indexes without considering valuations, fewer market participants may challenge unrealistic stock prices.

This could allow overpriced stocks to remain expensive for longer periods because there are fewer investors willing to question whether their valuations are justified.

In this view, passive investing may weaken one of the market’s natural correction mechanisms.

 5.Passive Investing Can Increase Concentration in Large Companies

Another argument is that passive investing encourages market concentration.

Although index funds often hold hundreds of stocks, a large portion of their value may come from a small number of extremely large companies.

When these companies perform well, their market capitalization increases, causing them to become even larger components of major indexes. Passive funds then allocate more capital toward these companies.

This creates a situation where a small group of companies can have a major influence on overall market performance.

Critics argue that concentration can lead to overpriced stocks because these companies receive continuous investment simply because of their size.

If investor expectations become unrealistic, these companies may trade at valuations that are difficult to justify based on their actual earnings.

6.Passive Investing Encourages Herd Behaviour Among Investors

Market bubbles often develop because investors follow trends rather than independently evaluating investments.

Passive investing may contribute to herd behaviour because many investors purchase the same indexes and gain exposure to the same group of companies.

When certain stocks perform well, investors may assume that those companies will continue succeeding. More money flows into passive funds, which then purchase additional shares of those companies.

This can create excessive optimism.

Investors may focus on past returns instead of asking whether current stock prices are reasonable. As confidence increases, stock prices may rise beyond levels supported by realistic expectations.

 7.Passive Funds Provide Less Selling Pressure Against Overvalued Stocks

Active investors often help correct overvalued stocks by selling when prices become unrealistic.

For example, if a company’s stock price rises far above what its earnings justify, active investors may decide that the stock is too expensive and reduce their holdings.

Passive funds generally do not make these decisions. They continue holding stocks as long as those companies remain part of the index.

This means expensive companies may continue receiving investment even when some investors believe their valuations are excessive.

The lack of valuation-based selling may allow overpriced stocks to remain inflated for longer periods.

8.Passive Investing May Increase Market Risk During Corrections

Critics also argue that passive investing could make market declines more severe.

During a strong market, passive funds create consistent demand because investors continue contributing money.

However, during a market downturn, investors may panic and sell their index funds. Because many passive funds own similar companies, widespread selling could create significant downward pressure.

If many investors attempt to exit at the same time, stock prices may fall rapidly.

This creates concern that passive investing could increase market instability by encouraging investors to move together rather than make independent decisions.

Lauren Hua is a private client adviser at Fairmont Equities.

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