Are Passive ETFs Quietly Increasing Systemic Risk?

Passive ETFs are investment funds that simply track a market index (like the S&P 500 or Nifty 50) by holding the same securities in the same proportions, instead of trying to beat the market. They are designed to be low-cost, rules-based, and hands-off, giving investors broad diversification with minimal trading or active management. Over the past two decades, they have quietly grown from a niche product into the backbone of global equity markets. But as trillions of dollars now track the same indices, a deeper question is emerging among economists and regulators alike: could the very popularity of passive ETFs be making markets more fragile during times of stress? Research suggests the answer is not straightforward, but it is no longer something that can be ignored.

The largest passive ETFs globally include funds like Vanguard S&P 500 ETF (VOO) and iShares Core S&P 500 ETF (IVV), which track the broad U.S. large-cap stock market by following the S&P 500 index. These major ETFs typically focus on equity markets, especially large-cap U.S. stocks and total market exposure and are among the highest-AUM passive equity ETFs in the world. Passive ETFs now account for a significant share of total equity market capitalization; on average passive vehicles own around ~20% of each constituent in the S&P 500, meaning passive ETFs collectively represent roughly a fifth of that market’s capitalisation.

One concern is that passive investing changes how prices are formed. When ETFs buy or sell stocks simply because they belong to an index, rather than because of company fundamentals, stocks start moving together. Studies show that higher ETF ownership is associated with greater stock volatility, suggesting that flows into and out of ETFs can amplify price swings. As more money chases the same benchmark names, market prices may reflect investor behaviour more than underlying business reality, weakening traditional price discovery.

The risks become more visible during market stress. ETFs trade like stocks, offering instant liquidity, but the shares they hold may not be as easy to sell when volatility spikes. Recent empirical work using quantile cointegration models finds that ETF flows are linked to higher volatility and elevated valuations in the S&P 500, particularly during extreme market conditions. This raises concerns about feedback loops, where redemptions force selling, prices fall further, and volatility feeds on itself.

Passive ETFs must sell stocks when they are removed from the index or when investors redeem ETF shares, because the fund needs to adjust its holdings to match the new index composition or return cash to investors, which puts selling pressure on those stocks. During periods of market stress, large outflows can force ETFs to sell broad baskets of stocks simultaneously, further driving prices down even if individual company fundamentals haven’t changed.

Regulators are paying close attention. A detailed CFA Institute Research Foundation report highlights structural risks tied to ETFs, including concentration in mega-cap stocks, reliance on authorized participants for liquidity, and stress in less liquid underlying assets. Importantly, the report does not argue that ETFs are inherently dangerous, but rather that their scale means small structural weaknesses can have outsized systemic effects if left unmanaged.

Still, the story is not one-sided. Passive funds do not dominate daily trading volume, and active investors continue to play a key role in setting prices. ETFs have also made markets more accessible and transparent for millions of investors worldwide. The real takeaway is not that passive ETFs are “bad,” but that their success has changed market plumbing in subtle ways. As passive investing continues to grow, understanding and monitoring its impact on systemic stability may be just as important as enjoying its low fees and simplicity.