The rise of passive funds has led to a self-reinforcing cycle. When investors pour money into tracker funds, they buy up the same few stocks at the top end of the market, which in turn grow in size and make up large proportions of the index, requiring funds to buy even more of their shares to keep up.
This flood of money into the largest companies in a market has been a common enough phenomenon in the US, where the tech-heavy ‘FAANG’ stocks made way for the also tech-heavy but slightly different ‘Magnificent Seven’.
However, right now the system is approaching breaking point, in my view, and making it almost impossible for active managers to beat the market.
Approximately 54% of total long-term US mutual fund and exchange-traded fund (ETF) assets are in passive strategies, according to industry data from the Investment Company Institute, but this is far from a US-only problem.
I would point to emerging markets as the most egregious example of a few companies causing problems for active managers.
Here, the AI boom has sent money pouring into semiconductor stocks such as TSMC in Taiwan and Samsung and SK Hynix in Korea.
These companies have ballooned in size. TSMC now represents 15.1% of the MSCI Emerging Markets index, while Samsung is at 8.2% and SK Hynix at 7.7%.
This is damaging for active fund managers, who must comply with UCITs rules by which they can have no more than 10% in one holding.
Contrast this with passive funds, which can have up to 20% in one stock (and up to 35% in ‘exceptional circumstances’).
So active managers who are fans of TSMC must underweight the stock, even if they think it will do well.
Meanwhile, although they can technically overweight Samsung and SK Hynix, most will be unable to for other reasons. One potentially limiting factor is that pushing up against the 10% barrier means if the stock performs well, managers must constantly sell it down once it approaches this level, incurring transaction costs that will eat into their returns.
Additionally, many risk models suggest that such high concentration in one holding is too much, which makes sense but nowadays seems set up for a world that no longer exists, where the passive juggernaut remains in check and the market is not led so dominantly by a handful of names.
There are similar problems everywhere, including the domestic market. At 8.7% of the FTSE All Share, few active managers will be able to overweight HSBC, while AstraZeneca is also tough to bet big on at 7.5% of the index.
All this implies that active managers are currently investing with one hand tied behind their backs. Whether it be through regulatory obligations or their own (potentially outdated) in-house risk frameworks, it is very difficult to take big stances on the most successful companies in the market.
However, investors should remember the opposite is also true. When the passive cogs start turning in the downward direction, the most-owned stocks will be the hardest hit and active managers should weather the storm better.
This is therefore not an advert for passive investing. Nor is it a get-out-of-jail-free card for active managers who have done a poor job. After all, for almost the entirety of the 2010s, value investing was out of favour, yet the best managers who invest using the style could still eke out credible performance.
But recent headlines have been hard on active managers. Rightly so, in some cases, but it is important to note that there is nuance. So when you see statistics like how just 42% of active funds beat their passive equivalents in the first half of 2026, it is worth asking why this is the case.
Don’t give your active funds a free pass but do cut them some slack if the performance is good, without beating the benchmark. That second part is not easy to do right now.
Jonathan Jones is editor of Trustnet. The views expressed above should not be taken as investment advice.