Flying on Autopilot: Index Funds Aren’t as Passive or Diversified as You Think

The Diversification Test: One Theme Rules the Index

Let’s start with diversification. The top ten companies alone account for over 41% of the S&P 500.[1] Count everything tied to AI, the data centers, the semiconductors, and the power to run them, and roughly half the S&P 500 is exposed to a single theme. The Nasdaq 100 is even more lopsided.

Concentration risk is not just in American index funds. In emerging markets, the widely followed MSCI Emerging Markets Index holds nearly 30% of its weight in just three stocks: TSMC, Samsung, and SK Hynix. All three are geared to AI. We wrote about rising concentration risk in index funds in 2024, and it has only intensified since.

Most major index funds today are not a little bit of everything. They are a concentrated bet on one theme: AI. But concentration is the easy critique. The more interesting problem is the word passive itself.

How the Index Machine Works: Size Decides Where Your Money Goes

Index funds are called passive because they do not have a fund manager picking stocks. The story goes that a passive fund doesn’t make investment decisions, it just owns the market. However, that’s not the case. The investment decision hasn’t disappeared completely, rather it has been written into a rule. Most index funds simply own stocks in proportion to their size. The larger the company, the more of your money goes to it. Send $100 into an S&P 500 index fund and roughly $8 goes to the single largest stock, Nvidia, while the smallest 100 companies split about $2 among them.[2]

The rule never asks whether the largest stocks are expensive. It never asks whether the smallest ones are cheap. Size is the only input, and size is simply yesterday’s price performance, compounded. So, every dollar that flows into an index fund gets allocated based on past returns. That’s not a passive strategy. It’s momentum, a point the British investor Terry Smith has been hammering in his recent annual letters. Calling an index fund passive is like saying the autopilot isn’t flying the plane. The plane is being flown. Just by a fixed set of rules.

Flows Move Prices

You might think: So what if more money flows into the largest stocks? Money flowing in doesn’t move prices. But, research suggests otherwise. A 2021 study published through the National Bureau of Economic Research, “The Inelastic Markets Hypothesis,” estimated that a dollar flowing into the stock market pushes the market’s value up by roughly five dollars.

Put the two pieces together and you have a loop. Index money flows mostly to the biggest stocks. Those flows push their prices higher. Higher prices make those stocks a bigger share of the index, so the next dollar sends even more their way. The big get bigger. A disciplined and prudent investor trims a position that has grown to dominate the portfolio. The index doesn’t. It lets the winner grow without limit.

Momentum Cuts Both Ways

Momentum works beautifully as a virtuous, compounding circle on the way up, which is exactly why you should think about the way down.

If, at some point, money starts leaving index funds, the machine runs backwards. The virtuous circle becomes a vicious circle. The index fund must sell, and most of what it sells is the biggest stocks. That selling pushes prices down, which pushes more investors out. The same loop that lifted the market on the way up now drags it down. We have seen concentrated markets unwind before: the Nifty Fifty in the 1970s, Japan in 1989, and the tech bubble in 2000. In each case, the leading stocks that “couldn’t lose” eventually collapsed and many took a decade or more to recover. Nortel Networks on its own made up 35% of the TSX Composite in 2000. Not many years later, it was bankrupt. What is different this time is that the largest owner of the stock market is a mechanism with no opinion, no memory, and no brake. Of course, the first word of this paragraph should not be “if”, it should be “when”. It may not happen for months or years, but the reversal is certain to happen eventually.

Our Philosophy: Know What You Own

None of this is to say that index funds are bad. They are cheap, tax-efficient, and can be sensible for many investors. The point is to know what you own. Today, owning the index means owning a concentrated bet on a handful of stocks, sized by a rule that buys more of those same stocks and never asks what anything is worth. That’s fine, until it isn’t.

At Nexus, every position we own is there because we analyzed what the business is worth and concluded that the market price was reasonable. And we will sell it when that stops being true. We don’t just think about the upside, we think about the downside too.