The S&P 500 and other large-cap benchmarks such as the Nasdaq-100 and Dow Jones Industrial Average have grown spectacularly over the last 20 years, as more and more market participants embrace passive investing as a safe and efficient way to build wealth. Yet beneath this surface of safety lies a growing passive investing risk, where the very act of indexing may be concentrating rather than reducing exposure. One of the main reasons for indexing is that benchmarks such as the S&P 500 are heralded as epitomes of diversification. And when one mentions diversification, that reference reaches the very foundation of modern financial theory: the Capital Asset Pricing Model (CAPM).

What CAPM Says About Risk and Return

The CAPM rests on a simple assumption — that investors require greater return for greater risk, and that all risk can be divided into systematic (market-wide) and unsystematic (unique or diversifiable) components. Systematic risk represents the risk of the entire market — volatility driven by factors such as the business cycle, interest rates, and trade policies. This type of risk is unavoidable; one cannot invest outside the market itself.

Unsystematic, or unique, risk on the other hand, is tied to specific assets and depends on internal factors of the company or investment in question. For instance, nonsystematic risk is what a medical startup faces when its only research-stage pharmaceutical product might fail, rendering its equity worthless. More common examples include changes in a company’s earnings, debt issues, or management errors.

The “Free Lunch” of Diversification

The core assumption of CAPM is that unsystematic risk can be lowered to near zero through proper diversification. This is because the risks of one company may become the opportunities of another. When multiple stocks are combined in a portfolio, their unique risks tend to offset or cancel out against each other, leaving only the non-diversifiable market risk. According to CAPM, once a portfolio holds roughly 30 or more assets, the nonsystematic risk is reduced to virtually zero.

Under this model, diversification is considered a “free lunch,” because anyone can achieve it. Moreover, with ETFs and mutual funds tracking broad indexes, diversification can, in theory, be achieved by owning just one asset. Since there is no cost to diversification, CAPM concludes that holding unique (nonsystematic) risk offers no benefit in terms of risk-return potential and is therefore irrational. Supposedly, no rational investor would bear such risk. This belief has led many to overlook the growing passive investing risk embedded within the very indexes they trust for safety.

Owning an S&P 500 or other large-index ETF such as the Nasdaq-100 should, in principle, provide more than enough protection against unique risks, making an investor’s asset allocation as safe as possible. But does it really grant that diversification? Under current conditions — given how many investors now own S&P 500, Nasdaq-100, or similar index products — that diversification benefit may be significantly reduced. Moreover, the indexes themselves may carry their own unique risks, making them, paradoxically, much less the safe and efficient investments they are assumed to be.

When Independence Disappears

Let’s explore why the enormous and growing number of people engaged in passive investing makes this asset potentially risky. To do that, we need to analyze the mechanisms through which massive indexing undermines diversification.

Diversification is the opposite of correlation. The less correlated two assets are, the greater their contribution to portfolio diversification. Two assets with perfect correlation add no diversification, while two assets with perfect inverse correlation create a perfectly diversified portfolio.

Under the dominant single-index model, each asset’s return is composed of three elements: its abnormal (or stock-specific) return, known as alpha; the excess market return, defined as the market return minus the risk-free rate multiplied by the stock’s beta; and the idiosyncratic residual, which captures unsystematic risk. This model assumes that residuals are uncorrelated across assets — meaning that, once the market factor is removed, the remaining returns are independent.

The single-index model underlies the simplicity of the CAPM: asset returns depend on a single systematic factor. And because diversification is considered “free,” as discussed earlier, nonsystematic risk is assumed to be eliminated from portfolio construction.

A Market Moving in Unison

However, what happens when the residuals in the single-index model are not independent but correlated? One of the model’s basic assumptions collapses, making unsystematic risk an unavoidable component of every portfolio. As we will see, widespread ownership of the S&P 500 and other major indexes such as the Nasdaq-100 and Dow Jones Industrial Average effectively introduces comovement and covariance among all the assets included in these benchmarks.

Empirical evidence confirms this shift. Recent research shows that average pairwise correlations among U.S. stocks more than doubled after the late 1990s — rising from around 6% in the decades before 1997 to over 13% in the following years. This structural break coincides with the widespread adoption of index-based investing, marking the beginning of a regime where stocks increasingly move together.

Average pairwise stock correlation in U.S. equity markets from 1962 to 2020. Correlations remained low for decades but rose sharply after the late 1990s alongside the expansion of index investing. Source: Fang et al. (2023), “Limits to Diversification: Passive Investing and Market Risk,” AFA working paper.

The Scale of Passive Investing

The first factor to consider in understanding correlation among index constituents is the scale of direct indexing relative to the total market. Some estimates suggest that roughly 33%–43% of market participants now own index mutual funds or ETFs. In addition, empirical studies indicate that 70%–80% of nominally active U.S. equity funds have tracking errors small enough to classify them as closet indexers—funds that mimic index holdings while appearing active. These figures reveal that the potential impact of indexing is enormous, as a large proportion of market participants are engaged in passive investment.

This trend is not theoretical. As shown below, passive investment inflows have steadily outpaced active ones over the past decade, with passive funds now representing a growing share of global equity assets.

Cumulative net flows into active and passive equity funds (2014–2024) and the growing share of passive funds in total assets under management. Source: European Central Bank (2024), Financial Stability Review, Box 11.

Massive ownership of index funds and ETFs produces several effects that cause stocks—which would otherwise experience independent residual shocks—to move more in tandem. These effects can be summarized as follows:

1. Synchronous buying and selling flows during index rebalancing or reconstitution;
2. Common ownership (“connectedness”) through shared institutional investors;
3. Reduced information incorporation and dilution of price informativeness; and
4. Structural changes, contagion, and regime shifts.

This alignment of market behavior is the very mechanism behind growing passive investing risk, where diversification no longer functions as theory predicts. Let’s explore each element in turn:

Different Causes for Correlation of Direct Indexing

1. Synchronous buying / selling flows on index rebalancing / reconstitution

Index funds must buy or sell stocks when the index membership or weights change (additions, deletions, rebalancing). These mechanical flows create coordinated demand shocks across many index stocks simultaneously.

A paradigm example is when Tesla was added to the S&P 500 in December 2020, every S&P 500 index fund had to buy Tesla stock on the same day to replicate the new index composition. That meant hundreds of billions of dollars of buy orders arriving simultaneously, pushing up Tesla’s price sharply. This coordinated demand affected many index constituents together as other stocks were sold to make room for Tesla.

2. Common ownership / “connectedness” via shared institutional investors

When two stocks share common large holders, flows of those holders can create comovement. This is a factor seen even for active holdings, when institutional investors hold large portfolios of specific stocks. When a mutual fund or ETF increases or decreases its exposure broadly, it affects all its holdings simultaneously.

This is especially important when there is trading cost amplification and common liquidity shocks. Sudden market-wide liquidity needs, margin calls, or redemption pressures, can force many index funds to rebalance or sell simultaneously. Because index funds hold many of the same assets, a liquidity shock to the index may propagate across constituent stocks similarly.

For instance, during the March 2020 COVID panic, investors pulled billions from broad ETFs like the S&P 500 SPY fund. To meet redemptions, ETF market-makers had to sell shares of all constituent companies at once, regardless of each firm’s specific outlook. Even fundamentally solid firms saw sharp declines, creating synchronized residual shocks.

This also creates bid-ask spreads widening. Suppose Apple — a heavyweight in the S&P 500 — experiences a sudden sell-off after an earnings disappointment. Market-makers and ETF arbitrage desks who provide liquidity in the SPY ETF must hedge their exposure by shorting a representative basket of S&P 500 stocks.

To manage this, they widen the bid-ask spreads not only for Apple but also for Microsoft, Amazon, and other large constituents they use as proxies in their hedges. These dealers face higher inventory risk across all correlated names. As a result, even firms with no news now trade with wider spreads and greater short-term volatility.

3. Reduced information incorporation / price informativeness dilution

In classical finance theory, idiosyncratic shocks reflect firm-specific news (e.g. earnings surprises, product announcements, leadership changes) which get processed by active traders and reflected in prices. But as passive ownership increases, there are fewer marginal active investors to trade on firm-specific signals (liquidity for those signals dries up). So, firm-specific information is less fully incorporated immediately.

In the 1990s, before ETFs dominated, analysts’ recommendations produced large cross-sectional dispersion. Today, with ~40 % of equity assets passively held, new firm-specific information often moves entire sectors, not just individual stocks. Company-specific variance shrinks while shared “noise” variance rises.

4. Structural changes, contagion, regime shifts

In stress or crisis periods, residual correlations (i.e. cross-stock comovements) tend to increase (“correlation breakdowns” or contagion effects). What once were independent shocks become correlated under stress. Passive ownership amplifies this: when many participants behave similarly in stress (sell-offs), residual shocks get pulled into the common tail.

A historic example occurred in 2008. During the Lehman collapse, stocks with high ETF ownership fell more sharply and simultaneously than less-indexed stocks. Liquidity stress in ETFs transmitted across all components.

The future of indexing

The impact of indexing is momentous in changing correlations between independent stocks. And when the correlation between the residual nonsystemic risk of different stocks rises, the entire CAPM theory falls apart. Quantitative studies by the European Central Bank (2024) find that a one-percentage-point rise in passive ownership increases stock return correlation by roughly 0.005. This may appear small, but compounded across the market, it represents a powerful force driving homogenization among equities and eroding diversification benefits.

Estimated relationship between passive ownership and stock return co-movement: a one-percentage-point increase in passive share raises correlation by about 0.005. Source: European Central Bank (2024), Financial Stability Review, Box 11.

Diversification is no longer possible by holding the 500 stocks of the S&P 500. Unsystematic risk cannot be eliminated or reduced significantly, and the idea of diversification as a “free lunch” disappears.

Looking ahead, the outlook for S&P 500 mutual funds, ETFs, and other large indexes becomes even more complex. As more investors move into passive strategies, the marginal benefit of diversification declines—the “idiosyncratic risk reservoir” shrinks. As residual correlations increase, index tracking becomes self-reinforcing. Investors perceive less differentiation, favor index funds even more, and thereby deepen the underlying commonality. The market drifts toward homogenization—stocks move increasingly in unison, dispersion narrows, and active management becomes ever more difficult.

This dynamic already affects individual stocks in varying degrees because not all companies are equally indexed. Those with higher passive ownership experience greater induced comovement, concentrating systematic exposure in those names. Among them, stocks with smaller float or lower market capitalization are particularly vulnerable to residual shock spillovers. The reason is that passive flows have a stronger price impact. These developments reflect an expanding passive investing risk across all major benchmarks.

All eggs in one basket.

The change in paradigm means that passive investors in index funds and ETFs now operate, at least partially, outside the framework of CAPM theory. Variance decomposition is no longer clean. This is because residual variance does not fully diversify away in large portfolios because residuals are partly shared. This correlation among assets within the same portfolio gives large indexes their own nonsystematic risk. Instead of serving purely as proxies for the entire market — and thus being inherently diversified — they become assets with unique risk, like any other, that must be held alongside other assets to neutralize that risk.

In summary, passive investing now carries a risk akin to putting all your eggs in one basket — or holding a single asset with its own nonsystematic risk. While correlations among the S&P 500, Nasdaq-100, and other large-index constituents are not perfect, they are meaningful. Anyway, they appear strong enough to challenge the notion that ownership of these large indexes represents true — let alone perfect — diversification.

True diversification isn’t achieved by following the crowd. Tiempo Capital’s investment management team helps investors move beyond passive benchmarks through disciplined, tax efficient investing strategies built for long-term resilience. Learn more about our Investment Management Services to explore a more intelligent approach to portfolio construction. Contact us today to schedule a private consultation.

This material is for informational purposes only and does not constitute financial, legal, tax, or investment advice. All opinions, analyses, or strategies discussed are general in nature and may not be appropriate for all individuals or situations. Readers are encouraged to consult their own advisors regarding their specific circumstances. Investments involve risk, including the potential loss of principal, and past performance is not indicative of future results.

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Sources

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Höfler, Philipp, Christian Schlag and Maik Schmeling (May 15, 2024). “Passive Investing and Market Quality”. Taken from: https://www.paris-december.eu/sites/default/files/papers/2024/5373_schlag_2024_complete.pdf?utm_source=chatgpt.com paris-december.eu.

Antón, Miguel and Christopher Polk (June 2014), “Connected Stocks”, taken from: https://personal.lse.ac.uk/polk/research/ConnectedStocks.pdf?utm_source=chatgpt.com personal.lse.ac.uk.

Chinco, Alex and Marco Sammon (May 19, 2023). “The Passive‑Ownership Share Is Double What You Think It Is”. Taken from: https://www.hbs.edu/ris/Publication%20Files/double-what-you-think-it-is%20may%2023_3c1ae213-5aec-407d-b656-13e3822f0b8b.pdf?utm_source=chatgpt.com hbs.edu.

Fang, Lily, Hao Jiang, Zheng Sun, Ximing Yin and Lu Zheng (March 12, 2023). “Limits to Diversification: Passive Investing and Market Risk”. Taken from: https://afajof.org/management/viewp.php?n=12656#:~:text= afajof.org.

European Central Bank (November 2024). “Passive Investing and its Impact on Return Co-Movement, Market Concentration and Liquidity in Euro Area Equity Markets.” Financial Stability Review, Box 11. Taken from: https://www.ecb.europa.eu/press/financial-stability-publications/fsr/focus/2024/html/ecb.fsrbox202411_03~87408e7fb3.en.html