By
Borsgade
In his 2024 shareholder letter, Terry Smith argues that passive funds function as momentum strategies, creating a self-reinforcing cycle that inflates large-cap stock valuations.
As of late 2023, passive investments through index funds have surpassed active funds in Assets Under Management (AUM), now accounting for over 50%, compared to just 10% during the Dotcom boom. While labeled “passive,” index funds rely on market-cap weighting, which disproportionately favors large companies with strong past performance.
Terry argues that this dynamic drives a feedback loop, further boosting large-cap stocks. However, an economic downturn—particularly in areas like tech spending or AI—could disrupt this cycle. If major companies underperform, index funds may face greater losses than active managers. Still, pinpointing the timing or trigger for such a shift remains uncertain.
The vast majority of index funds are market capitalisation weighted, like the indices on which they are based. The size of holdings in companies in the index fund is based upon their market value compared with the market value of the index.
So when there are inflows to index funds, the largest portion goes to the largest companies, and vice versa when there are outflows. The result is that as money flows out of active funds and into index funds, as it has been doing, it drives the performance of the largest companies, which are companies whose shares have already performed well, which is how they came to be the largest companies by market value.
This is a self-reinforcing feedback loop which will operate until it doesn’t.
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