Active investing is suited to the challenging markets ahead

Decades of growth in passive, also known as index, investing reached a milestone at the end of 2023 when U.S. passive mutual funds and exchange-traded funds (ETFs) held slightly more assets than active funds for the first time. The conditions that fueled the growth of index investing are changing, however. The post‑global financial crisis (GFC) era of low rates and abundant liquidity is being replaced by one of higher rates, greater divergence of returns, and more volatile markets—which is already providing the key ingredients for active investors to potentially outperform.

The rise of passive funds, which seek to mirror the performance of indices rather than beat them, has been nothing if not dramatic. Over the past 30 years, passive has grown from less than 5% of the U.S. stock and bond mutual fund and ETF markets to more than 50% (Figure 1). The strong performance of index funds in recent years has been a key factor in this increase. While active and passive strategies historically have traded periods of outperformance, passive performed particularly well in the very low interest rate environment that followed the GFC.

After the onset of the crisis in 2008, central banks slashed worldwide policy rates—in some cases to 0%. Monetary policy was further loosened through quantitative easing—whereby central banks purchased securities from the open market to boost liquidity and encourage investment. This combination of very low rates and ample liquidity created the perfect conditions for equity markets to rise—from its post-GFC low point on March 9, 2009, to the end of June 2025, the S&P 500 Index delivered a cumulative price return of 817.2% and a cumulative total return (including dividends) of 1,152.3%.¹

The huge momentum generated by accommodative monetary policy helped drive the growth of index funds, which have tended to outperform during periods of low volatility, strong U.S. stock market performance, and rising stock correlations (Figure 2). Cost considerations have also supported the growth of passive investing. The fees charged by passive equity funds historically have been cheaper than those of actively managed equity funds, and the tax efficiency found in the ETF vehicle historically has been associated predominately with index products. However, the gap in fees has narrowed in recent years, and active ETFs have proliferated, complicating the perceived active/passive trade-off and lowering the hurdle for alpha, offsetting the fee differential.

The increase in indexing has also been noticeable in bond markets. However, the share of active in fixed income remains high and ahead of passive in many places. One reason is that it can be difficult to replicate the index in many fixed income strategies—more so than in equity index funds—because bond markets tend to be less liquid and more complex than stock markets, with higher transaction costs. This can lead to bond index funds underperforming their benchmark. Another reason why the share of active in fixed income is higher is that the gap between passive and active fixed income fund fees is smaller.

Index concentration has posed a challenge for active investors

As stocks rose and passive strategies grew in the years following the GFC, another important development occurred: Indexes became more concentrated. The large gains in the U.S. stock market, in particular, were driven mainly by the extraordinary growth of a small number of tech stocks, which dominated cap-weighted indices (in which each stock is weighted according to its market capitalization). These dominant firms were collectively labeled the FANG (Facebook, Amazon, Netflix, and Google) in the early 2010s before Apple was added to form the FAANG in 2017. The FAANG was eventually replaced by the current dominant group, the so-called Magnificent Seven—Apple, Microsoft, Alphabet, Amazon, Meta Platforms, NVIDIA, and Tesla. The Magnificent Seven composed just over 32% of the S&P 500 at the end of June 2025; a decade ago, the largest seven stocks in the S&P 500 composed around 14% of the total index.

While skilled active managers can excel during periods of concentrated equity markets, it becomes more difficult when the top performers are also the largest companies. In such environments, where a few major players drive most of the market’s gains, position sizing within these large companies can significantly affect portfolio returns. Active managers striving for diversification and prudent risk management are under pressure to allocate substantial capital to these dominant firms. 

While the extraordinary growth of the Magnificent Seven has boosted equity indices, it has also reduced the diversification benefits they can offer.² Heavy index concentration can help to drive returns for passive investors when the dominant firms perform well, but it is likely to pose a significant challenge when those firms perform poorly. For indexers that seek to replicate the performance of the cap-weighted version of the S&P, for example, the dominance of the Magnificent Seven was not a problem last year as those stocks outperformed. However, if in the future returns are generated from a less top-heavy group of index constituents, active investors with more diversified portfolios would be likely to perform better than those with portfolios with heavier allocations to this concentrated group.

An inflection point in markets

Markets are currently concentrated to a degree not seen in more than 50 years (Figure 3). History shows that the more skilled active managers typically have performed well coming out of concentrated markets. During the dot‑com bubble of the late 1990s, for example, the combined weight of the top 10 stocks in the S&P 500 peaked at 25%. In the aftermath of the bubble, index concentration fell sharply as tech companies plummeted in value. Active managers trailed indexers at the peak of the bubble in March 2000 but offered significant alpha (or excess returns) after it burst (Figure 4).

Similar patterns occurred in the Japan asset price bubble of the 1980s and the emerging markets rally of the 2000s. On both occasions, a surge in asset prices led to increasing index concentration before performance declined and dispersion returned. In both cases, flows surged into passive strategies as the bubble was forming, but the more skilled active managers outperformed after it burst.

Although it is difficult to predict when the current period of heavy index concentration is likely to recede meaningfully, it is clear we are going through an inflection point in markets. We appear to be moving from a world of benign disinflation to one of higher‑trend inflation, from a very low interest rate environment to a higher rate environment (Figure 5), and from a long period of low volatility to a period in which volatility is likely to be elevated—particularly if recent geopolitical tensions and trade disputes persist.

Greater dispersion and volatility loom

This paradigm shift could have long-lasting implications. If a more discerning market takes hold, investors will need to be more valuation‑sensitive than in recent times, when a rising tide lifted all boats. We believe that fundamental research, and the ability to identify stock drivers and risk, will continue to be essential. Active managers who adopt a more dynamic approach should be better positioned to take account of wider macroeconomic, social, and geopolitical factors along with company fundamentals.

Active investors, by definition, tend to go beyond benchmarks to increase diversification. For example, U.S.‑based active managers typically have outperformed when non-U.S. stocks beat U.S. stocks and when small-cap stocks performed well versus large­‑caps.

Large-cap U.S. tech stocks have dominated for much of the past decade, but many overseas stock markets have outperformed their U.S. counterparts this year. I believe this expansion of the opportunity set in stock markets is likely to continue in the period ahead.

The end of the period of very low rates will also, I expect, lead to greater dispersion and heightened volatility in fixed income markets. Active management can help for duration³ management purposes, as well as for managing country selection, yield curve positioning, and security selection.

In addition to the impact of the new rate environment, the world is undergoing a revolutionary technology transition toward artificial intelligence (AI). As in previous historic advances of this magnitude, this shift will likely widen the dispersion of company fundamentals. Active investors with the depth of research to discern the first‑ and second‑order beneficiaries of this process would have an advantage.

Conditions have shifted to favor active investing

Other, nonperformance-related factors behind the growth of passive funds may have also begun to fade. For example, while both active and passive funds have been subject to downward pressure on fees in recent years, the gap between them has narrowed (Figure 6). Passive strategies now have little scope for further fee reductions.

Tax-efficient vehicles, such as ETFs,⁴ have gained popularity. Historically, the ETF vehicle has been dominated by passive strategies. In recent years, however, there has been increasing choice for investors, and the growth of assets under management in active ETFs has outstripped that of passive ETFs now for 10 years running (Figure 7). Notably, this growth recently pushed assets in active ETFs to over USD 1 trillion.

Combined with the likely performance-related changes described above, I believe these developments have fundamentally shifted the investment landscape in a way that will favor skilled active investing—particularly active investment managers with global scale, deep research platforms, and a willingness to cast the net wide to identify the best outcomes for their clients. This does not mean I expect index investing to undergo a major retreat. However, I do think that active management could be a better option for clients as we shift toward a market that has more tax‑efficient options in the form of active ETFs, that is priced more competitively than in the past overall, and that may offer better outcomes during periods of greater volatility and dispersion.