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Passive investing has become the dominant force in global equity markets. Across global equity mutual funds and ETFs, passive strategies now account for more than 50% of assets.¹

Australia is not far behind. Index funds, ETFs and benchmark-aware superannuation strategies now represent a large share of domestic equity capital. Precise estimates are difficult because much of the Aussie market sits inside super funds, but when you include low-turnover, benchmark-hugging options, our best estimate is that around 45% of the Australian equity market behaves like passive capital.

This shift raises important questions. What happens to markets when passive becomes the dominant style? And where does that leave active managers?

For many investors, this shift has made sense. Index style investing, particularly in Australian large caps, has delivered strong results at low cost, making passive exposure a perfectly reasonable core allocation. But as passive becomes the dominant style in the ASX 200, the risks embedded in the top of the market have changed. We’re not arguing investors should abandon passive entirely; rather, it may be time to reconsider how much of a portfolio sits in the most crowded parts of the index.

This article covers:

1. Why passive investing has grown
2. How markets change when passive dominates
3. Where active managers still have an edge

1. Why passive investing has grown

Passive investing didn’t take over for one reason alone. Its rise began with the classic arguments—diversification, active managers underperforming, and lower fees—and has since been turbocharged by newer forces: regulation, short-term performance pressure, and momentum-driven flows.

a) Diversification and liquidity – in theory

Passive investing began as a low-cost way to get diversified exposure to an economy. Benchmarks such as the S&P 500 were designed to broadly represent the US corporate sector, giving investors simple, inexpensive and diversified access to long-run economic growth.

However, this logic breaks down in concentrated markets like Australia. The S&P/ASX 200 is dominated by banks, large-cap resources and a handful of other mega caps. Recent data show the top 20 stocks make up more than 60% of the ASX 200, with the top 10 close to half.²

Investors who think they are buying “the Australian economy” via an index are, in practice, taking big sector bets and stock-specific risk. As more money flows into cap-weighted products, this concentration has only increased.

Figure 1: When you buy the ASX 200, you’re mostly buying the top 10

Source: FactSet

On liquidity, index-style investing seems like an easy choice – large caps listed equities have to be highly liquid right? On the surface, that is the case: unit prices struck daily, money in and out on demand. But when most of that capital is tied to the same index-style building blocks, everyone is drawing on the same underlying pool of liquidity. As we show below, in a market dominated by passive and benchmark-aware strategies, that pool can shrink quickly just when investors need it most.

b) Underperformance of Aussie active funds

If you look at the number of Australian large-cap active funds that have underperformed over the last 15 years, it’s no surprise that many investors have switched to passive. The chart below shows net of retail fee performance for the Australian large-cap active peer group: 79% of managers have underperformed the ASX 200 over the last 15 years.

Figure 2: 79% of Aussie active large cap managers have underperformed the benchmark over the last 15 years

Past performance is not a reliable indicator of future performance
Source: Morningstar, Firetrail.

However, the picture changes completely once you move down the market-cap spectrum. Looking at the same dataset for small caps, only 7% of Australian small-cap managers have underperformed the Small Ordinaries Index over the last 15 years.

Figure 3: only 7% of Aussie active small cap managers underperformed the ASX Small Ordinaries

Past performance is not a reliable indicator of future performance
Source: Morningstar, Firetrail.

Note: These figures may be affected by survivorship bias (as underperforming managers are more likely to close or merge over time). However, even allowing for this, the results still provide a strong indication of the long-term strength of active management in Australian small caps.

So it’s fair to say: this is largely a large-cap problem.

But more specifically, it’s a mega-cap problem. Based on what we hear from institutional clients, asset consultants and research providers, most Australian large-cap active managers have been structurally underweight the ASX 10 over the past 15 years. That’s hardly surprising given stretched valuations and weak earnings growth at the very top of the market. But as the attribution chart from not owning the ASX 10 shows, that underweight has been a significant drag on performance.

Figure 4: Not owning the ASX10 over the last 15 years would have proven a significant drag on performance

Past performance is not a reliable indicator of future performance
Source: FactSet, Firetrail.

Importantly, you can also see that this headwind is starting to reverse this year to date, and we are of the view that we’ll continue to see this reversal.

So the story is nuanced. In aggregate, large-cap active funds have struggled versus their benchmark—driven in no small part by an underweight in expensive mega caps during a period when flows relentlessly chased them higher. By contrast, mid- and small-cap managers, operating in less index-dominated parts of the market, have delivered much stronger outcomes versus their benchmarks.

c) Fees: paying more for less

Costs have been another powerful driver. Active management fees are typically over three times higher than index tracking fees. When active hasn’t consistently delivered excess returns—particularly in large caps—investors have rationally tilted towards the cheaper option.

The next three reasons pushing the masses towards passive have been a product of recent market conditions and industry structure:

d) Regulation and peer pressure in the super system

The Your Future, Your Super (YFYS) performance test has accelerated the trend towards passive investing in Australia. Underperformance relative to a benchmark now triggers public naming, pressure to merge, and potential member outflows. The result is a system where funds are so wary of failing the annual performance test that they’re no longer incentivised to aim for the top of the pack—only to avoid the bottom. In practice, it’s far safer to stay comfortably in the middle than to take the active risks required to outperform.

The rational response for many large super funds is to stay close to the benchmark, keep tracking error low, and avoid idiosyncratic risk. That has contributed to:

• Fewer but much larger super funds
• Low-turnover, benchmark-aware strategies that behave like passive
• Large, mechanical flows into the biggest ASX companies

e) Short-termism and live data

Daily unit pricing and instant performance dashboards encourage short-term thinking. Investors can see underperformance immediately, making it harder for active managers to hold positions that take time to play out. Asset consultants –both institutional and wholesale– are also evaluated on recent relative returns and face strong commercial pressure to react when a manager or option falls behind over one- or three-year periods. Passive products avoid this behavioural pressure.

f) Momentum and self-reinforcing flows

Indexing is just a momentum strategy in disguise. Rising stocks become a larger part of cap-weighted indices, attract more passive flows, and often rise further. The process feeds on itself until something breaks. In benign markets this momentum feels painless; in a correction, it can work in reverse.

2. When passive dominates, markets change

The original appeal of passive investing was simple: low-cost diversification and easy liquidity. But now that passive and benchmark-aware strategies control large parts of the market, they’re delivering the opposite. Instead of smoothing markets, they amplify concentration, distort price signals, and create fragile liquidity at precisely the
wrong time.

Even Jack Bogle, founder of Vanguard and father of indexing said “If everybody indexed, the only word you could use is chaos, catastrophe… the markets would fail.”³

a) No price discovery, more concentration risk and fragile liquidity

Index funds do not consider valuation; they allocate capital in proportion to index weights. When money flows into passive products, it is mechanically pushed into the largest stocks, regardless of fundamentals. This has several consequences:

• • No price discovery: Rising passive ownership reduces price efficiency and weakens the link between fundamentals and valuations. Index funds’ constant demand for mega caps pushes mega-cap prices higher, higher prices increase their index weight, and larger weights attract further inflows. Over time, share-price movements in the largest companies become driven more by flows than fundamentals.
  • Less true diversification: Heavy concentration in a handful of mega caps means index investors are far more exposed to sector and single-stock risk than they realise. When the top 10 names make up nearly half the index, a “diversified” ASX 200 allocation is really a leveraged bet on the fortunes and valuations of a few big banks and resource stocks. If those stocks stumble, there is nowhere to hide inside the index.
  • A false sense of liquidity
    • Large cap liquidity decline: Compulsory super contributions and passive rebalancing create the impression of deep liquidity in the top end of the market. But this liquidity is mostly one-way. As figure 5 shows, liquidity at the top end of the market has actually declined over the last 10 years as more shares have been locked up in low-turnover super funds and index vehicles. Meanwhile, liquidity in smaller companies has increased as capital has rotated down the market-cap spectrum and active managers have become a larger share of the register, trading more frequently on fundamentals rather than simply holding for index exposure.

Figure 5: Aussie mega caps have become relatively less liquid over the past decade

Source: Bloomberg, FactSet, Firetrail October 2025.

o Liquidity can vanish in a downturn: If asset-allocation settings shift or markets enter a downturn, passive flows into index weight strategy will reverse mechanically. Selling pressure becomes concentrated in the same large companies that previously benefited from inflows. With valuations already stretched and fewer natural buyers at those levels, liquidity can deteriorate quickly.

b) Distortions in large caps – and opportunity elsewhere

Valuations at the top end of the Australian market have become stretched. In theory, passive investing shouldn’t affect valuations because index funds simply buy every stock in proportion to its size. But in reality, the biggest companies are now much less liquid than they used to be (figure 5), while passive funds make up a much larger share of daily trading. That means a large amount of price-insensitive buying is hitting a smaller pool of available shares, which pushes prices up. So even though passive doesn’t intend to move valuations, the combination of lower liquidity and bigger passive flows is now contributing to stretched valuations at the top end of the market.

Large caps now trade at elevated multiples and PEG ratios⁴ near historical highs, even though their earnings growth has lagged mid and small caps.

Figure 6: Large cap PEG ratio near historic highs…

Source: Bloomberg, FactSet, Firetrail October 2025.

Figure 7: … and large cap earnings growth lags smalls and mids

Source: Bloomberg, FactSet, Firetrail October 2025.

Note: For veracity, we included the COVID period, but it does somewhat distort the numbers. The 2013–17 figures provide a more accurate picture of underlying trends.

At the same time, opportunities are emerging outside the mega caps. Mid and small-cap companies generally offer lower valuations relative to large caps, stronger forward earnings profiles and far more varied, idiosyncratic drivers of performance. They also receive less research coverage and attract fewer flows from passive strategies, creating a richer environment for price discovery—and for skilled active managers.

c) Volatility, the “index effect” and the problematic incentives in company boardrooms

The rise of indexing has also changed how stocks respond to events. When so much capital is tied to benchmarks, any change in index weight or sentiment among benchmark-huggers creates forced buyers and sellers regardless of valuation, creating increased stock volatility. This volatility is particularly evident in reporting season where we now routinely see individual stocks move 10–20% on results or guidance while the index barely budges.

The other key time this volatility is seen is around index inclusions and exclusions. The “index effect” has become more pronounced, and it has produced some problematic incentives in boardrooms, company management, and their corporate advisers.

The “index effect” is simple but powerful: when a company is added to an index, index-tracking funds must buy, putting upward pressure on the share price. When a company is excluded from the index, index funds must sell and the share price drops. With index funds now dominating flows, index inclusion has become more desirable than ever. It offers a near-guaranteed source of demand for stocks– often an easier way to push up the share price than doing the hard yards of improving fundamentals.

The increased significance of the index effect has affected incentives in corporate management, and not for the better. Index inclusion is no longer just the outcome of running a successful business; it has become a target in its own right. Relative Total Shareholder Return (TSR)5 is by far the most popular long-term incentive (LTI) hurdle among ASX companies, ahead of more fundamental indicators like EPS or return on capital. Simply put, executives are more motivated to keep share prices high than to improve the quality and earnings power of the business.

This shift has encouraged behaviours where companies:

• prioritise corporate actions that protect or enhance index eligibility and index weight; and
• focus on short-term share price performance – including multiple expansion – over less visible drivers of long-term intrinsic value.

We saw this “index effect” optimising behaviour from TPG in August 2025. TPG announced a capital management plan involving up to $3.0bn of capital reduction and a Reinvestment Plan. In its ASX release, TPG explicitly stated that the Reinvestment Plan was designed to “support ASX200 index weighting” of TPG’s shares.⁶

d) What happens in a severe downturn?

A severe market correction in today’s passive-dominated environment would behave very differently to past downturns. When markets turn bearish, index funds and passive investors move as a herd and they must sell strictly in proportion to market cap. When this herd stampedes out of their passive investments, the active side of the market are unlikely to step in as buyers because stretched valuations still offer little margin of safety even after an initial fall.

We had a glimpse of this dynamic recently. In November 2025, Commonwealth Bank of Australia reported a quarterly profit broadly in line with expectations but highlighted rising costs and margin pressure. With the stock trading on a stretched multiple, the update was enough to trigger a sharp de-rating: CBA shares fell around 7% over just two trading days, wiping roughly $25 billion from its market value.⁷

This CBA event was not a financial crisis – simply an example of how quickly a heavily owned, index-dominant stock can move when the tide turns. In a true correction, forced selling across multiple mega caps, limited fundamental buyers, and high starting valuations could see the top of the index fall much faster than investors expect.

So… it’s not the cheeriest picture for index investors. The good news is that for patient investors, this is exactly when truly active managers can come to the rescue.

3. Where active managers have the edge

The current environment doesn’t reduce the value of active management; it changes where and how active adds value. The only ingredient missing in recent years is patience and time

a) Better valuations and growth outside the ASX 20

The most compelling opportunities now sit outside the ASX20. Mid and small-cap companies offer better value, stronger earnings growth and greater dispersion. These areas also suffer less passive distortion, making them fertile

Figure 8: Equities outside the ASX20 are offering cheaper growth

Source: Bloomberg, FactSet, Firetrail October 2025.
PEG ratios compare a company’s price-to-earning (P/E) multiple to its expected earnings growth, so higher PEGs mean investors are paying more for each unit of growth.

b) Using volatility as an advantage

Increased volatility at the individual stock level creates the kind of dispersion where fundamental research and conviction can really pay off. Figure 9 below shows the standard deviation of active returns for ASX 200 stocks on reporting day over time. The trend is clearly upwards, and the most recent reporting season (Aug-25, highlighted) was the most volatile in 15 years.

Figure 9: Multiyear high price variation this last reporting season

Source: Bloomberg, FactSet, Firetrail October 2025.

When this much single-stock volatility is occurring while the index itself looks relatively calm, it tells you flows and index events are driving big one-day moves. Index rebalances, passive flows and momentum-driven trading are all creating situations where prices temporarily disconnect from value.

For genuinely active managers, that volatility is an opportunity to:

• Accumulate high-conviction positions when short-term flows push prices below fair value
• Trim or exit holdings when valuations overshoot fundamentals
• Exploit forced buying and selling linked to indices and momentum strategies

In other words, the same volatility that can make index investors uncomfortable is a key source of alpha for active investors who are willing to lean against flow-driven moves and back fundamentals.

The key is having both volatility and liquidity: enough movement for mispricing to appear, and enough depth to act on it. Right now, that combination is most evident in mid and small caps, where fundamentals still matter and passive flows play a far smaller role.

c) Building genuinely diversified portfolios

Unlike passive investing, high-conviction investing does not mean giving up diversification. A well-constructed active portfolio can hold a focused set of positions while still avoiding the concentration risks embedded in cap-weighted indices. By investing across market caps, styles and sectors, active managers can achieve differentiated exposure even while maintaining discipline and conviction.

Conclusion

Active management is alive and well – as long as you know where to look.

Passive and benchmark-aware strategies were sold as cheap, diversified and liquid. In a market where they now dominate, they are increasingly delivering the opposite: crowded mega caps, fragile liquidity at the top end, prices driven by flows rather than fundamentals, and boardrooms obsessing over index status and TSR hurdles instead of long-term value creation.

The good news is that for patient investors, this is exactly when truly active managers can come to the rescue.

The real opportunity lies in the parts of the market less suffocated by passive flows. Outside the ASX 20, valuations are more reasonable, earnings growth is stronger and liquidity is set by investors who still care about cash flows, not just index weights. Outside the ASX50, this outlook is even better. Here, most small- and mid-cap managers have beaten their benchmarks over time.

Rising single-stock volatility only tilts the odds further towards active. Reporting seasons, index events and ETF rebalances regularly push prices well away from fair value. High-conviction managers can buy quality businesses when they are being sold for the wrong reasons and sell when momentum and multiples run too far.

In a market increasingly on autopilot, the edge belongs to those willing to stay active, do the work and allocate capital on fundamentals rather than flows.

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Footnotes:

¹Source: Bloomberg, Apollo Chief Economist

²FactSet

³Source: Jack Bogle, interview with Barron’s, 2017.

⁴PEG ratios compare a company’s price-to-earning (P/E) multiple to its expected earnings growth, so higher PEGs mean investors are paying more for each unit of growth.

⁵Total Shareholder Return (TSR) is the total return investors earn from a stock – combining share price gains and dividends.

⁶Source: TPG Telecom, ASX Announcement, “TPG announces capital management plans,” 5 August 2025.

⁷Source: Australian Financial Review, Joanne Tran, “CBA still the ‘premier bank’ for fundies despite $25b wipeout,” 12 November 2025.