Author: Professor Ian Tonks, Professor of Finance, University of Bristol Business School.
Our researchers have produced a report commissioned by the UK’s financial markets regulator on the impact of passive investment strategies. The report “A Survey of the Consequences of Passive Investment Funds for Financial Markets” was produced for the Financial Conduct Authority by colleagues in our Financial Markets Research Group:
- Dr Anne-Florence Allard
- Dr Miklos Farkas
- Dr Manuela Pedio
- Dr Silvina Rubio
- Professor Ian Tonks.
A feature of asset management over the last thirty years has been the growth in passive investment strategies. A passive investment strategy – sometimes called index investing or tracker investing – involves funds being invested in a diversified portfolio of securities that simply replicates a stock market index.
According to the UK’s Investment Association, by 2024, over a third of investment funds were managed through passive strategies. The report provides a survey of the theoretical and empirical literatures on the consequences of this trend towards passive strategies.
In the report, the authors document the growth in the numbers and size of passive mutual funds compared to actively managed funds in the UK and other countries. Using data from the Investment Association’s annual surveys of investment management in the UK, Figure 1 shows the growth in assets under management (AUMs) by UK-based fund managers from 2005-2023, and the split between assets managed actively and passively. Assets under management have increased from £2.8 trillion in 2005, when around 20% of assets were managed passively, to £9 trillion in 2023, with 33% of assets managed passively.
This trend toward passive investments is a global phenomenon affecting all the major developed capital markets and across various asset categories.
What are the factors responsible for this growth?
Standard finance theory predicts that in an efficient stock market, investors can do no better than hold a well-diversified portfolio of securities. The two-fund separation paradigm recommends that an investor’s portfolio should consist of just two funds: a safe asset and the market portfolio, which could be proxied by a well-diversified passive index portfolio.
But in a less-than fully efficient stock market, there may be opportunities for active fund management to generate abnormal returns. However, the evidence on the performance of active funds is generally that active funds on average do not outperform their benchmarks.
Further, over recent years, expense ratios have fallen significantly across various fund types. FCA data reports AUM-weighted average fees for UK-domiciled passive funds have declined from 0.29% of AUM per year in 2015 to 0.15% in 2020, and fees for UK-domiciled active funds have fallen over time to 0.89% in 2020.
With passive fund fees converging towards zero, this is indicative of passive fund management being a natural monopoly with implications for the need for regulation. The three largest passive institutional investors in Europe, BlackRock, Vanguard, and Legal and General Investment Management, have combined ownership stakes of up to 10% of company equity across 37% of the constituents of the EuroStoxx 600 index. Because passive funds are larger than actively managed funds, the shift to passive strategies has increased industry concentration.
The Investment Company Factbook 2024 reports that the 5-firm concentration ratio of assets managed by US mutual fund families increased from 35% in 2005 to 56% in 2023. The trend to passive strategies is reinforced not only by the inherent cost-efficiency of passive management but also by broader industry shifts, such as the growth of robo-advisors, stricter fiduciary standards, and regulatory efforts promoting fee transparency, that collectively drive investors toward lower-cost, passive investment strategies.
The rapid growth of Exchange Traded Funds (ETFs) has further transformed the investment landscape by offering a more liquid, transparent, and cost-effective alternative to traditional mutual funds. As initially most ETFs pursued passive strategies, their growth coincided with the shift to passive fund management.
What are the effects of passive investments on stock market informational efficiency?
Mapping active funds to ”informed traders” and passive funds to ”uninformed traders” in the celebrated Grossman–Stiglitz framework reveals that an increase in the share of passive funds can lead to reduced price informativeness, particularly when higher information costs drive more investors to passive strategies.
However, the model shows that the effect on price informativeness depends on the source of variation in passive participation and remains inconclusive in establishing causality, since both passive investing and price informativeness are endogenous to market conditions. This issue is further complicated by concurrent trends such as the rise of ETFs, which allow intraday trading and may increase volatility, as well as the growth of high-frequency trading and improvements in data processing that affect how information is produced and disseminated.
There is a general consensus that stock inclusions in an index are followed by an increase in the prices of the stock being included of around 3%. This effect is attributed to the price pressure exerted by passive investors. However, there is less consensus on whether this effect is temporary or permanent. Contrasting results are probably due to the difficulties of measuring stock inclusions’ effects over long windows and to the time-varying nature of such effects. Recent work has found that the inclusion effect has decreased over time and is disappearing.
A major concern regarding passive investing is that it increases correlations among stocks, thus reducing investors’ diversification opportunities. This phenomenon has been widely documented: when a stock is included in an index, its correlation with other stocks in the index increases. This fact is attributed to ”basket trading” by passive funds that track the same index and have to trade a basket of stocks together, for example, due to rebalancing.
There are macroeconomic consequences of the growth in passive investment strategies on market concentration and financial stability. Aggregate investor flows for passive mutual funds are less sensitive to past performance than flows of active funds. Hence, passive mutuals appear to face less redemption risks than active funds following poor returns, and particularly at times of financial stress. But there is some evidence that the growth of international ETFs has increased the sensitivity of international capital flows to the global financial cycle.
In general, with respect to concerns about financial stability, while passive investing mitigates some macroeconomic risks, such as those related to liquidity transformation, it simultaneously increases others, including volatility and industry concentration.
An important question is whether passive investing impairs the allocational role played by capital markets.
There are contrasting findings with some work demonstrating that passive investment decreases the quality of firms’ investment decisions; promotes the rise of mega-firms; and distorts capital allocation by disproportionally lowering the financing costs of overvalued firms.
Other work supports a more benign view of passive funds, exploring the link between real investment and ETF ownership and finds that higher ETF ownership is associated with a greater sensitivity of real investment to financial valuation metrics.
As indexing investments is a conventional recommendation that financial advisors give to retail investors, it is important to understand whether passive strategies actually improve their welfare. Some work has investigated this issue and generally produced a positive view. The availability of cheap index investments increases the market participation of uninformed investors, who become better off.
In contrast, the welfare of investors who were already participating in the market only modestly decreases when they switch from active to passive strategies. The Report notes that pension funds allocate around 30% of their assets to passive strategies. Defined benefit pension schemes, which constitute the largest group of institutional funds, have reduced their allocation to equities over time, due to risk management reasons, but defined contribution schemes are more likely to invest in equities and more likely to invest in passive vehicles. This has led to policy concerns that pension funds are not investing sufficient funds in smaller UK companies.
The recent Mansion House Accord (May 2025), signed by the major workplace pension providers, pledges them to invest 10% of their pension portfolios (around £50 billion) in alternative assets such as infrastructure, property and private equity by 2030, and can be interpreted as a policy response against the trend to passive investments.
The role of index funds in corporate governance is nuanced and theoretically ambiguous.
Their large and long-term ownership stakes, coupled with their fiduciary duties and reputational concerns, potentially give them substantial influence over corporate policies through voting and engagement. However, index funds operate under low-fee structures that limit the resources available for governance activities, and their fund managers may have weak incentives to actively push for corporate improvements.
Additionally, conflicts of interest within fund families and the scale of index ownership raise concerns about their capacity to engage in activism effectively. As a result, whether passive ownership enhances or weakens governance remains an empirical question.
The existing evidence, often from the US, provides a complex picture. Studies show that index funds, particularly the US “Big Three”, BlackRock, Vanguard, and State Street, have relatively small stewardship teams and engage with only a minority of portfolio companies (less than 11% of companies in their portfolios per year). Their engagements tend to focus on broad governance principles rather than firm-specific issues, and their voting behaviour often favours management (10% more likely to vote with management compared to active mutual funds).
Some research suggests that index funds can drive improvements in areas like board diversity and ESG concerns, but other studies find limited effects on governance quality or firm performance. The consequences of passive investing appear to depend on which investors are displaced—replacing active funds may weaken governance, while replacing non-fund investors may improve it.
Higher passive ownership at the firm level is linked to worse M&A outcomes, lower investment, and weaker innovation, likely due to reduced monitoring intensity. For example, a 1% increase in passive ownership leads to 0.32% to 0.38% lower M&A announcement returns. However, evidence suggests that firms with greater passive ownership exhibit better financial reporting quality and increased disclosure.
“To summarise, the report assesses the likely consequences of the growth of passive investments on various aspects of financial markets. Looking to the future, the report identifies three important demographic trends:
- Continued growth of defined contribution pension schemes through Auto-enrolment.
- growth of drawdown arrangements for pensions in their decumulation phase – allowing investments to be fully invested in growth assets for a longer period.
- and investor demands for socially responsible investments.
These three trends are likely to lead to further demands for low-cost passive investment strategies.