Passive investing can worsen market inefficiency Copy

As noted before, passive funds have a low share of market trading so it unlikely that they support asset mispricing and a reduction in market efficiency. On the other hand, as sectors of the market or specific shares in those sectors grow, passive funds will track these changes and grow their exposure.  For example, if share A was 10% of the market cap before, but its value has increased relative to the market and it is now 15%, of the market, the index fund tracks the same increase.  On average, a share with an increasing price will tend to have a lower expected return because its market value is either closer to the higher price or indeed may even have been overtaken by the price increase.

While the passive fund will have enjoyed the increase in yield (it still holds the same number of shares, just the value has increased) it is now holding a share which is a larger part of the index, and which has a lower growth potential as measured by an active manager following a value investing style.  This can be said to be a fair criticism of passive investing and there are good examples where sectors of the market have increased aggressively, for example the tech bubble in 1999, to be followed by a crash.  At the same time extreme outcomes like this are rare and it also does not follow that active asset managers are immune from having to deal with these high growth / high valuation shares.  Look today at the present difficulties asset managers are having dealing with a high valuation stock like Tesla.