Pension funds cut active, lean into passive

By early 2026, pension funds like the Los Angeles City Employees' Retirement System have been actively reducing their exposure to active international equity managers due to persistent underperformance, particularly in growth and quality-focused portfolios that have struggled amid rising index concentration. This trend reflects a broader strategic pivot as funds increasingly terminate underperforming active mandates and bolster their passive allocations to mitigate risk and improve consistency.

In response to volatile geopolitical events and challenging market conditions, many consultants and pension funds are moving away from heavily tilted growth or quality portfolios toward more balanced core portfolios that blend growth and value exposures. This shift aims to reduce concentration risks and enhance resilience, while experts recommend integrating a balanced mix of active, passive, and systematic strategies to navigate ongoing market uncertainty and the limitations of purely active management.

The rise of passive investing has fundamentally transformed market dynamics by creating a class of price-insensitive investors who allocate capital based solely on index inclusion rather than company fundamentals. This mechanized flow, driven largely by a handful of dominant firms like BlackRock, Vanguard, and State Street managing roughly $25 trillion in assets, means capital is funneled automatically into index constituents without active scrutiny, distorting traditional price discovery and rewarding index eligibility over fundamental quality. As a result, ordinary investors have little control over where their money goes, with decisions effectively made by index committees and automated fund flows, which can amplify systemic risks and market fragility.

Passive investing’s market cap-weighted structure concentrates capital disproportionately into a handful of mega-cap stocks, creating a self-reinforcing loop that can sustain bull markets even amid broader economic softness. However, this concentration also heightens fragility during downturns, as forced selling by index managers may overwhelm the diminished pool of active buyers, potentially turning routine corrections into sharper sell-offs. Rachel’s analysis highlights how automated selling pressures can depress prices irrespective of a company’s fundamentals, paradoxically creating attractive entry points for patient, fundamentals-focused investors.

Market fragility is further exacerbated by the interplay of algorithmic and systematic trading strategies that amplify feedback loops detached from underlying fundamentals. Michael Green warns that during extreme events, markets are driven less by investor choice and more by forced actions and systematic flows, pushing the system toward a fragile state reminiscent of the 1929 crash and Great Depression. This fragility is compounded by the dramatic decline in active management—from over 80% to around 7% of market activity—and the rise of speculative retail trading, which now accounts for nearly 20%, fundamentally altering market behavior and increasing volatility and concentration risks.

The dominance of passive investing challenges traditional price discovery and market stability by weakening mean reversion and creating a curvature in returns that conventional alpha measurement tools fail to capture. Hari Krishnan and colleagues argue that rising passive ownership amplifies mega-cap concentration and fosters reflexive instability, while also complicating policymakers’ efforts to stabilize an increasingly fragile financial system. This fragility is intertwined with broader factors such as volatility targeting, leverage, inflation, and government intervention, raising concerns about what could trigger a systemic break in markets heavily influenced by passive flows and algorithmic trading.

By mid-2026, research led by Jeffrey Wurgler revealed that passive investing fundamentally alters stock price behavior by causing newly indexed stocks, such as those added to the S&P 500, to move in tighter lockstep with their index peers rather than reflecting their individual fundamentals. This herding effect inflates their beta relative to the index and distorts traditional valuation signals, as giant funds trade entire baskets simultaneously, diluting the influence of company-specific information on price formation. Concurrently, the growing dominance of passive holders—many of whom are indifferent or unaware of corporate earnings—has eroded the relevance of earnings reports in market pricing, with some even advocating for reduced reporting frequency, underscoring a profound shift in how market participants engage with fundamental data.

This distortion extends beyond equities into commodity futures markets, where Jonathan Brogaard, Matthew Ringgenberg, and David Sovich documented that inclusion of a commodity in passive futures indices leads to indiscriminate buying by passive investors, decoupling prices from traditional supply-demand dynamics. Their findings highlight that companies reliant on these commodities can face cost increases of approximately 6%, as passive flows inflate futures prices and complicate demand forecasting, signaling that passive investment strategies are reshaping price signals and cost structures across multiple asset classes.

The foundation of evidence-based investing was laid by rigorous academic research in the 1960s and 70s, notably Michael Jensen's study revealing the consistent underperformance of professional money managers. This empirical insight catalyzed a paradigm shift toward passive fund management and indexing, further advanced by pioneers like Fisher Black and Myron Scholes, who innovated index-linked portfolios with adjusted beta exposures to potentially enhance returns, exemplified by the $6 million Samsonite account. These developments underscored a move away from market timing toward scientifically grounded strategies that seek incremental gains through portfolio construction and trading efficiencies.

Dimensional Fund Advisors (DFA), co-founded by David Booth and influenced by academic luminaries such as Eugene Fama, epitomizes the evolution of scientific investing by blending evidence-based principles with practical innovations. DFA’s philosophy rejects rigid index tracking in favor of daily rebalancing and factor-based tilts toward value and profitability, aiming to capture higher expected returns while managing trading costs and tax efficiency. Booth emphasizes that this approach has transformed investing into a true science with testable hypotheses, leading to more sensible portfolios and significantly lower fees since DFA’s inception in 1971.

The rapid proliferation of ETFs has introduced a 'paradox of choice' for advisors, necessitating disciplined frameworks that prioritize investor goals, diversification, and comprehensive cost analysis beyond mere expense ratios. Dimensional addresses this complexity by aligning strategy, fees, and tax efficiency across mutual funds and ETFs, allowing investors to choose based on trading preferences such as end-of-day NAV or intraday liquidity. Moreover, DFA’s leadership in ETF innovation—such as petitioning the SEC to allow multiple ETF share classes following Vanguard’s patent expiration—has propelled the firm to a top active ETF manager status, reflecting a broader industry trend toward tax-efficient, flexible investment vehicles.

While pursuing outperformance through factor-based active strategies can offer higher expected returns, it also requires advisors to manage client expectations around volatility and tracking error, as deviating from market benchmarks naturally entails periods of underperformance. Additionally, fund longevity remains a critical consideration often overlooked; with fewer than half of mutual funds and ETFs from 20 years ago still open, investors face potential taxable events from fund closures or mergers. These realities underscore the importance of integrating scientific investing principles with practical portfolio construction and risk management to achieve sustainable long-term outcomes.