An Alternative Stock Market Story

April 4, 2025  | By Kevin Smith, CFA

Imagine you’re baking a cake, but instead of carefully measuring the ingredients, you you overdo it on sugar to appeal to your inner child. The cake might taste okay at first, but it’s not balanced—and eventually, it could collapse or make you sick. That’s a bit like what’s happening in the stock market with passive investing, according to researcher Mike Green. This popular way of investing is simple and affordable, but Green warns it’s piling up risks that could spoil the recipe for everyone.

What Is Passive Investing?

Passive investing is like using a pre-made cake mix. Instead of picking individual stocks—like deciding whether Coca-Cola or Netflix is a better bet—you buy a big bundle of stocks all at once. These bundles, called index funds or ETFs (exchange-traded funds), follow something like the S&P 500 index. You don’t try to figure out the perfect recipe; you just trust the mix will rise over time. It’s cheap, easy, and a lot of people use it—like folks saving in their 401(k) plans.

Too Much Sugar, Not Enough Balance

Here’s the problem Green highlights: passive investing doesn’t care about the details. When you put money into an index fund, it automatically buys shares of every company in the bundle, based on their size. The bigger the company (by market value), the more money gets poured into its stock. It’s like adding more sugar to the cake just because you already have a lot of it, not because it makes the recipe better.

This flood of money—Green calls it ‘passive flows’—has exploded. Back in 1995, passive funds were a tiny sprinkle, less than 5% of the market. Now, they’re nearly half of all the money in stocks—40% to 50%. Why? People love the low cost and the fact that these funds have beaten most active investors (the ones who tweak the recipe) over the last 20 years. But Green says this sugar rush is throwing the market out of whack.

The Big Ingredients Take Over

In a cake, sugar might overpower the flour, eggs, and butter if you add too much. In the market, big companies—like Apple, Microsoft, or Amazon—keep getting more money from passive funds just because they’re already big. Green’s research shows this creates a momentum effect: their stock prices rise, even if their businesses aren’t growing as fast. Meanwhile, smaller companies get ignored, even if they are good companies with impressive upside.

This isn’t just uneven—it’s risky. If the market relies too much on a few giant companies, it’s like a cake that’s all sugar and no structure. If something goes wrong with those big players, the whole thing could collapse.

What Happens When the Oven Timer Dings?

Green’s biggest concern is what happens if the money stops pouring in—or if people start taking it out. Right now, passive investing works because people keep adding cash, especially through retirement plans. Every paycheck, a little more goes into these funds, pushing stock prices up—like sugar keeping the cake puffed up. But what if people stop baking—like during a recession—or start eating the cake (retirees cashing out)? Green warns that could flip everything.

If passive flows reverse, those overstuffed stocks could crash. And since passive funds don’t “think” about when to stop—they just follow the money—there might not be enough buyers to keep the cake from falling flat. Green says this could lead to a market crash, like the big one in 1929. It’s not guaranteed, but it’s a risk he thinks we’re overlooking.

Why the Chefs Can’t Fix It

You might think: “Won’t smart investors balance the recipe?” That’s what active investors—the ones who study companies and adjust their picks—used to do. If a stock got too pricey, they’d cut back; if it was a bargain, they’d scoop it up. But Green says passive investing has made their job tougher. With so much money dumped into index funds, active investors are a smaller part of the kitchen now. They can’t always fix the mix because the passive sugar flood is too strong. It’s like trying to adjust a cake recipe while someone keeps pouring in more sugar—you can’t keep up.

A Fragile Cake in the Oven

Green ties this to a bigger issue: the financial system. If passive flows keep pumping up stock prices, it could create a bubble—a cake that looks big and fluffy but is hollow inside. If that bubble pops, it’s not just investors who suffer. Companies might struggle, jobs could vanish, and the economy could feel the burn. He’s even warned big players—like the Federal Reserve—about this “clear and present danger.”

What Can You Do About It?

Most investors need to own stocks to have a high probability of financial success. It makes sense to own stocks even if the market has a new and growing source of risk. The nature of risk is always changing. Here’s how we approach the situation:

• Diversify across stocks – the S&P 500 only holds massive, U.S.-based companies and they are receiving the bulk of inflows from investors, so they are most exposed to this phenomenon. Also owning small and medium sized companies and including international companies reduces exposure to the risks of a reversal of automated passive flows.
• Dare to be different – rather than only buying stocks based on company size, investors can systematically prefer stocks with attractive prices compared to their profits and cash flows. These stocks are unloved relative to the giant companies featured in the S&P 500, so their prices don’t have as far to fall in a downturn. There are many alternatives to the standard index fund that take a similar approach to traditional index funds, but add a layer of decision making to reduce exposure to the most expensive stocks.

The Bottom Line

Mike Green’s research is like a warning label on that cake mix box. Passive investing seems easy and tasty, but its massive growth could be overloading the market with risks—like a recipe that’s all sugar and no substance. The lesson is simple: enjoy the convenience of index funds, but don’t assume the oven will always churn out a perfect cake.