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Passive investment strategies are widely seen as cost-effective and neutral – but this perception is misleading. Major index providers act as invisible fund managers, and their growing market dominance distorts capital allocation and creates systemic risks. “These risks are often underestimated,” warns Thorsten Fischer, Managing Director and Head of Portfolio Management at Moventum AM. To mitigate them, a tactical investment approach is essential.

Passive investment strategies, which track stock market indices, have been gaining ground for years. The success of ETFs and similar products is built on the promise of low costs, high transparency, and strong long-term performance. But what many investors overlook is that the growing capital power of index giants such as MSCI and S&P poses significant risks to the stability of global financial markets. What appears to be neutral on the surface is in fact highly rule-based and built upon far-reaching assumptions that are often insufficiently scrutinised.

The composition of mainstream indices is not determined by business fundamentals, but by market capitalisation, trading volumes or sector classifications. This creates structural distortions in capital allocation. A case in point: tech giants like Nvidia, Microsoft or Apple, each valued between three and four trillion US dollars. Nvidia’s market capitalisation alone has risen by three trillion dollars over the past two years. Here, self-reinforcing mechanisms are at play: a high index weighting attracts more passive investments, which in turn push the share price higher, exacerbating the overvaluation and further increasing its index weight – a dynamic entirely disconnected from real economic fundamentals.

“Another issue,” Fischer explains, “lies in the classification decisions made by index providers.” South Korea, despite its advanced infrastructure and economic strength, is still classified as an emerging market. Meanwhile, Greece – an EU and Eurozone member – is listed as an emerging market in certain indices. These judgements influence the movement of billions in capital flows.

Whereas active managers can make their own decisions and counteract during periods of heightened volatility, passive strategies lack this flexibility. Sharp market corrections can trigger massive outflows – not due to fundamentals, but purely as a result of index-driven rebalancing. This removes a stabilising anchor from the markets: “If all passive investors sell at the same time, it can lead to abrupt price collapses,” Fischer notes. The high market concentration amplifies this effect. Passive products increasingly behave in the same way – systematically making the same mistakes.

There are further shortcomings when it comes to ESG (Environmental, Social, Governance) factors. Traditional indices often fail to take sustainability aspects into account, even as demand for ethical, ecological, and socially responsible investing continues to rise. While ESG versions of many indices do exist, their methodologies are often opaque and inconsistent – a clear disadvantage compared to targeted stock selection in actively managed portfolios.

A rethink is needed, says Fischer: “The systemic weaknesses of passive strategies open the door for a renaissance of active approaches. In particular, tactical asset allocation is becoming increasingly important in multi-asset strategies and diversified portfolios.” Quality criteria, fundamental valuations, ESG factors and regional insights can all contribute to reducing passive risk and improving performance.

“Passive investing is not inherently bad,” Fischer clarifies. “But the assumption that it is risk-neutral and always more profitable is simply wrong.” In an environment of geopolitical tensions, technological upheaval and high equity valuations, active management is once again proving its worth. “Rather than drifting with the current, it’s better to swim under your own power,” Fischer advises.