Passive investing dominates the modern portfolio. With over $13 trillion now locked into index funds and ETFs, most investors have embraced the promise of low fees, broad diversification, and “owning the market.” Giants like Vanguard and BlackRock now move markets, not through insight, but through automated flows.

And that’s exactly the problem.

Underneath the surface, a structural flaw is growing. Passive investing works until everyone tries to exit at once. The indiscriminate buying that lifted the market quickly turns into indiscriminate selling when volatility returns. We saw it in the 2018 ETF tech flash crash and again in March 2020—liquidity vanished, and the illusion of safety with it.

Markets don’t crash because prices fall; they crash because there’s no one left to buy.

The Rise Of Passive Investing+

Passive investing began as a radical idea in the 1970s. Vanguard founder John Bogle launched the first index fund with a blunt premise: most investors can't consistently outperform the market, so they should simply own it. Decades of academic research and dismal active performance proved him right. But it was the ETF boom of the 2000s and 2010s that turned indexing from philosophy into force. What was once a niche concept is now the default. Passive funds account for over 50% of U.S. equity assets, and in some segments, it's closer to 70%. Trillions have flowed from active managers into low-cost, rules-based vehicles that reward size, not substance. The appeal is obvious: lower fees, easy access, and the comfort of “set it and forget it.” But when everyone owns “the market,” price signals fade, and structural fragility grows.

The Illusion Of Liquidity

One of the great myths of ETFs is frictionless liquidity. But the liquidity of an ETF is only as good as the liquidity of the securities it holds. When times are calm, the wrapper looks smooth. But when stress hits, that liquidity evaporates—fast. We’ve seen it before. During flash crashes and sharp corrections, ETF prices decouple from the net asset value of their holdings. In small-cap ETFs, it’s even worse—funds appear liquid, but the underlying stocks barely trade. When panic sets in, market makers step away, and pricing becomes chaotic. Even BlackRock and Vanguard acknowledge this mismatch. Their own research points to hidden risks in fixed-income ETFs and niche equity sectors. In a downturn, ETFs can become forced sellers, not shock absorbers. In short, ETFs aren’t liquidity providers. Under unfavorable conditions, liquidity traps can occur.

Price Discovery Is Broken

Healthy markets rely on price discovery—buyers and sellers using information and analysis to set fair prices. Passive investing breaks that link. It allocates capital blindly, based on market cap, not merit. When stocks rise, index funds buy more of them. What happens if a stock fails to meet expectations? They are, regardless of value. This creates momentum loops and widens the gap between price and fundamentals. Consider Tesla’s 2020 S&P 500 inclusion. Its price surged not because of earnings or innovation, but because passive funds were forced to buy. In thinly traded sectors, small ETF flows can distort prices dramatically. Meanwhile, active managers, the ones who used to provide checks and balances, have been sidelined. Their influence on pricing has collapsed. The result? The outcome is a market that functions more like a mirror than a weighing machine. Reflexive, fragile, and increasingly disconnected from reality.

The Structural Risk No One’s Watching

The more money that flows into passive funds, the more homogeneous portfolios become. Investors own the same stocks, in the same weight, through the same vehicles. That’s fine—until it’s not. When flows are positive, prices rise. But if sentiment turns—driven by inflation, geopolitical risk, or rate shocks—there’s no one on the other side. The marginal buyer disappears. And with active managers crowded out, there's no stabilizing force left. It’s like a theater with one exit. The journey in is comfortable, but the journey out can be catastrophic. Passive investing has delivered for years. But if the market turns, the very structure that made it efficient could make it unravel.

What Investors Can Do

This isn’t a rejection of passive investing. It’s a reality check. Blind indexing works in stable markets, but it creates blind spots in unstable ones. Now’s the time to diversify not just what you own but how you own it. Shift some exposure to equal-weighted, factor-based, or actively managed ETFs. Consider managers who specialize in special situations, spinoffs, or distressed assets—areas that thrive in dislocations, not despite them. Stress-test your liquidity. Do you really know how your portfolio would behave if the flows reversed tomorrow? If not, it's time to find out. Occasionally, the greatest risk in your portfolio doesn't stem from your possessions. It’s how the market owns it for you.

Conclusion

Passive investing has earned its place—but its dominance has reshaped the market’s plumbing. We’ve entered a new era where structure matters as much as selection.

When the next wave of volatility hits, many portfolios may look fine until they aren’t. These portfolios rely on momentum rather than conviction. The investments are held in vehicles that assume liquidity when it's least available. Now is the time to examine the foundation, not when the cracks start to show.

The market may be efficient. But your portfolio needs to be resilient.