50 years ago, Jack Bogle’s firm, Vanguard, launched the first passive fund. The First Index Investment Trust offered investors the opportunity to simply achieve the return of the S&P500. The reasoning was that, over the long term, that would be a better outcome for the individual investor, rather than risking underperformance in the pursuit of outperformance through actively picking stocks.

Successful investing is all about common sense. Simple arithmetic suggests, and history confirms, that the winning strategy is to own all of the nation's publicly held businesses at very low cost.

Jack Bogle

Bogle was trying to provide investors with the ultimate diversification – owning the broad index. That is no longer the case with passive funds today, and that comes with possible repercussions for investors and the market alike.

Wealth managers switch to passive

While passive tracker funds were designed for retail investors, their adoption by institutional wealth managers has undoubtedly accelerated in recent years. As the industry consolidates and investment propositions become ever more centralised, the use of passive funds has grown to the extent that 35% of investment assets in the UK and 55% in the USA are held in passive vehicles*. In part this is because using these low-cost funds enable managers to limit the overall drag effect of fees on performance (and maintain their own fee rate). But one cannot deny that this shift in investment style is also due to the extraordinary outperformance of passive funds versus active managers in recent years.

Momentum works on the way up…

If the performance of an index, such as the FTSE All-Share, is a reflection of the aggregate outcome of all investment decisions actively taken in the UK market, then passive funds tracking that index should, in theory, deliver a return close to the average of all active managers before costs.

However, the Vanguard UK All-Share Tracker returned +66% over 5 years to March 2026. The average UK equity fund returned +32% in the same timeframe*. Such a difference in return cannot just be because passive funds charge lower fees.

That sort of return is possible largely because passive funds are hard-wired ‘momentum investors’ – they simply buy more of what is doing well. And because the indices that passive funds track are generally weighted by market-capitalisation, they buy more of the largest companies. So, as more money is invested passively, a greater proportion is invested in the largest companies. 

Tracker funds become less diversified

This has resulted in indices and the passive funds that track them having a greater concentration in a smaller number of stocks, far greater than the typical active manager. For example, the top ten companies in the S&P 500 currently make up 40% of the index, as they do in the Vanguard 500 Index Fund (the current name of the First Index Investment Trust). This is the most concentrated the index has been in 60 years. Furthermore, that concentration is distilled further by nine of those names all being technology companies of some sort, whereas until 2015 they were from a variety of sectors: technology, manufacturing, energy and healthcare.

The more that is invested in passive funds, the stronger the ‘buy the dip’ phenomenon is. Since 2015, US passive funds have had $6.4 trillion of net inflows, while active managers have seen net outflows of $2.4 trillion*. Of course, the flows of money from passive funds are not the only determinant of a company’s share price. But as the amount of money in passive funds has increased, the impact of this style of investment has become even greater, creating a virtuous circle. 

What happens on the way down?

If we see a significant market event, such as a Dotcom crash or Global Financial Crisis, which results in individuals moving out of the equity market entirely, we will see that momentum can be as powerful on the way down as on the way up.

For if a passive fund can outperform the average active manager by 34% over 5 years, it stands to reason that the same passive fund could underperform by the same amount over the same timeframe.

Indeed, the Vanguard 500 underperformed Church House’s Risk Model 7 portfolio* by 46% over a 7-year period from 2002. In fact, it took until 2020 for the Vanguard tracker fund to catch up*. And this does not include the down years of 2000 and 2001 when the S&P fell -9% and -12%, but which predates the Church House data.

The Dotcom crash was not an everyday event, but it took almost a decade for the S&P500 to regain the fall made in the wake of the internet bubble bursting. I am not suggesting we are in the same position today, but it is worth remembering Sir John Templeton’s famous maxim “The four most dangerous words in investing are: ‘This time it’s different’”.

The opportunity for active managers

While it took a decade for the S&P500 to regain the value it lost in the crash, over the same period the equal-weighted version of the index (i.e. each stock has the same weight) delivered an annualised return of +5.1%. This means that there are opportunities for active managers, who analyse the fundamentals of a company to try and determine its future prospects and that take note of the valuation of a share before purchasing.

At Church House, we do not invest by reference to benchmarks. We understand why people use them as a tool to try and explain the returns of their funds or their client portfolios, sometimes for better, sometimes for worse. But that is all an index is - a reference point. 

We are aware that avoiding permanent capital loss is far more important in the long run than short-term performance. We believe that an actively managed, genuinely diverse portfolio offers our clients the best possible chance of superior returns, whatever the market conditions.

Notes:

Church House’s Risk Model 7 portfolio is traditionally a 'capital growth' portfolio, aiming for long-term capital growth, with income being a low priority and accepting a higher volatility of returns.  It is invested predominantly in international equities, UK equities, and alternative investments.

Sources:

The Investment Association: Investment Management in the UK (2024-25 Survey)
Kerzérho, R., ‘The Passive vs. Active Fund Monitor’
Simon Evan-Cook: ‘Victory for Passive! 22 Thoughts and Questions’
Tim Edwards: In the shadows of giants (S&P Global)
Church House data
 

Important Information

The contents of this article are for information purposes only and do not constitute advice or a personal recommendation. Investors are advised to seek professional advice before entering into any investment arrangements. Please note that we are not tax experts, and you should seek professional advice concerning your personal tax affairs from qualified advisers, such as tax accountants.

Please also note that the value of investments and the income you get from them may fall as well as rise, and there is no certainty that you will get back the amount of your original investment. You should also be aware that past performance may not be a reliable guide to future performance.