• Passive investing has been the dominant strategy for years as active funds lagged.
• However, there’s a major risk building as everyone plows money into index funds.
• Here’s why market observers see a bubble forming — and what could finally pop it.

For years, investors who’ve done the least have performed the best.

Despite their best efforts, fund managers broadly have consistently trailed the market. Only 30% of actively managed global funds beat their indexes in 2024, according to Bank of America.

US-based managers weren’t much better. BofA found that 36% of active large-cap mutual funds in the US exceeded their benchmarks last year, in line with the long-term average of 37%. The last time a majority of large-cap funds outperformed was in 2007, right before the financial crisis.

Ironically, those figures seem to suggest that effort is negatively correlated with portfolio returns. To add insult to injury, active managers also often charge lofty fees. Meanwhile, the S&P 500 has risen at least 9.5% in all 12 of its up years since 2007, and is on pace to again this year.

Investors have responded accordingly. Passive investing has taken off, as low-cost index funds have steadily taken market share and are now more prevalent than their active counterparts. BofA found there’s a staggering $22.5 trillion in assets across passive ETFs and mutual funds.

“Passive indices have been gaining market share versus active managers for decades, at this point,” Jeff Schulze, ClearBridge Investments’ head of economic and market strategy, said in an interview. “Higher fees, a lot of times, have not justified outperformance for active managers.”

Passive investing is one big paradox

But there’s a problem: when everyone pours money into index funds tracking the same stocks, valuations for those companies become inflated — thereby reducing expected future returns.

Put another way, passive investing is usually the best strategy, unless everyone in markets is following it at once. And that’s exactly what several market veterans say is happening.

“We are in a passive bubble right now,” John Creekmur, the investment chief at the eponymous Creekmur Wealth Advisors in Illinois, said in a recent interview.

Passive index funds have become a “self-fulfilling prophecy,” Creekmur said. US workers are saving for retirement at record rates, investment giant Vanguard said last year, and they’re often choosing from a handful of target-dated funds that include those that track indexes like the S&P 500.

The passive boom means that trillions of dollars are flowing into a few hundred stocks. By extension, the S&P 500’s valuation has surged to a lofty 22.5x earnings, which Creekmur thinks is red-flag territory. And the Shiller price-to-earnings (P/E) ratio, a widely followed metric that tracks inflation-adjusted S&P 500 profits over 10-year spans, is right at its second-highest level ever.

This dynamic has given a disproportionately big boost to the mega-cap growth firms that have long led the market. These Magnificent Seven stocks, as they’re often called, have become richly valued as they’ve ballooned to a strikingly large one-third share of the S&P 500. On a related note, BofA noted the technology, communication services, and consumer discretionary sectors make up over half of the index, which is an unprecedented rate for the market’s hottest stocks, dating back at least 60 years.

Arguably the main reason active funds haven’t kept up with their passive peers, at least in recent years, is that they have had far less exposure to these mega-cap growth leaders.

However, most market observers agree that such narrow leadership isn’t sustainable long term.

“History suggests that a reversion to the mean will eventually occur, with the average stock outperforming in the coming years,” Schulze said. “So we think that this is a very ripe environment for active managers to be able to claw back some of that relative performance.”

Why the shift away from indexes may take time — and what will spark it

Although US stock valuations are elevated, that has been the case for years. There’s always a risk that these warnings about passive investing going too far could be another false alarm.

“I don’t think passive investing is in a bubble,” Christian Chan, the chief investment officer at AssetMark, told Business Insider via email. “Investors are getting more discerning about what they are willing to pay for, and I believe they are still willing to pay for services/products that offer value.”

Besides, active and passive strategies don’t have to be mutually exclusive, as Chan noted. By necessity, one approach will outperform the other at a given time, though investors can build balanced portfolios using both index funds and mutual funds, even though the latter has lagged.

“I do think we’re at a critical crossroads where, yes, passive indices will give you lower fees, but I think that active managers have a very strong opportunity to provide alpha or outperformance versus the index,” Schulze said.

Naturally, portfolio manager Brian Recht concurs with that assessment — and is about to put his convictions to the test. In early February, Recht and colleague Nick Schommer launched the Janus Henderson Transformational Growth ETF (JXX), which aims to invest in 20 to 30 stocks with clear competitive edges and potential to be the next Magnificent-Seven style behemoths.

The thesis Recht is testing may not pay off unless earnings growth broadens from mega caps to smaller growth stocks and the rest of the market. Many on Wall Street have expected that gap to narrow for years, and if they’re right in 2025, fund managers like Recht will be well-positioned.

“We’re seeing record levels of concentration in many indexes,” Recht said in a recent interview. “So if we were to see the largest weights in the index underperform — and active management tends to be underweight those names — it would be an aggregate tailwind.”

There are several ways the purported mega-cap bubble could pop, Schulze said, including an unwinding of the AI-driven rally. Chinese AI startup DeepSeek‘s shockingly capable chatbot called into question whether tech giants will keep plowing money into pricey AI chips. It looks like they will, though those bets will backfire. Tariffs could be another headache, as Schulze said mega caps are especially at risk since they generate more than half of their money overseas.

As much as investors want to buy low and sell high, many just follow the crowd or go off their emotions or gut instinct. That may mean they’ll stick with passive, mega cap-heavy strategies until they start to underperform — at which point, everyone in markets should look out below.

“Typically, there’s an event that triggers,” Creekmur said. “Once the trigger happens, there’s the initial little bit of shock. It’s like, ‘Oh, my goodness.’ And then after that happens, you start to see more people selling out. Then it gets to the point where we do have a domino effect starting to go.”