The Capital Cycle Podcast - Passive’s Massive AI Gamble

Episode Date: June 30, 2026

Relatively less liquid mega-cap stocks and sector concentration have led to unintended risks for passive investors.Edward Chancellor talks to Tom Wharram, a North American Equities Analyst.For more information, or to access select articles from Marathon’s Global Investment Review publications which accompany this podcast series, please visit www.thecapitalcycle.co.uk Hosted on Acast. See acast.com/privacy for more information.

Hello and welcome to another episode of the Capycle podcast. This is Edward Chancellor and I have with me Tom Warram, who's an analyst on the US portfolios of marathon asset management. Welcome, Tom. Hello, lovely to see you again. I've spoken with your colleagues in earlier podcasts about the question of indexation, about the growth of the US stock market in the global industries and about the growing concentration of the US index around the AI theme and the concentration of the index in large capitalization stocks. But we're going to talk about something slightly different here. You have an argument that actually the process of indexation is actually

changing valuations, which I think is a very important point. Now, you start your piece by saying that passive investing rests on the proposition that active investors do the price discovery and index funds ride along on the weighted average of those decisions. So the, index funds are said to be free riders who take no view and have no influence in the setting of price, of market prices. Now, Tom, you say that this is an elegant theory, but doesn't stand up to scrutiny. And you think that the issue of liquidity in the market is key. Yes, I think intuitively the mental model most of us have is something along the lines of liquidity is proportional to a company's size, so the largest companies are the most liquid. And for marathon, that's correct.

That makes a lot of sense. We can trade in and out of our desired position weights much faster for the companies with the largest market caps rather than the smallest. But you say the same can't be said for the index investor. So here's the thing which isn't intuitive, and actually is very surprising. And let me explain it quite carefully because it's a bit nuanced. If you look at companies with the largest weights in the major indices, like, for example, the S&P 500, yes, those companies with the largest weights in the index are the most liquid, but they are less liquid than you'd expect based on their bigger free float. So if you take the liquidity, so the average daily traded value of the company, and divide that by the free float, you get the liquidity per dollar

of free float. And what you find is that the companies with the biggest weighting in the index, actually have lower liquidity per dollar of free float than the smallest. And why does this matter? This matters because major indices, like the S&P 500, are free float weighted. So what that means is that inflows and outflows into the index have a greater price impact on the companies with the largest weights compared to the smallest. Tom, you have two charts in your piece that show liquidity data for the MSCI U.S. index? Can you explain them to our listeners? Yes, and I should say I've used the MSCI U.S. index, as that's the benchmark for our U.S. portfolios, but a similar phenomenon can be seen for the major U.S. indices like the S&P 500. If we look at the 20 companies with the largest

weights in the MSCI U.S. index, 16 of them, so 80 percent, have liquidity as a percentage of free float that is lower than the index. average. So if we put this a different way, if you wanted to trade a large inflow into this index, it's going to take longer to trade the largest positions than the smallest positions. So the price impact of that inflow is going to be greater on the largest index constituents. And also that works in reverse. So it's the same for the outflows. They will have a greater price impact on the largest constituents. And you think that passive inflows into relatively electric mega caps are having an impact on valuation?

Yes, I mean, this is a strange paradox, really. The fact that the mega caps look less liquid on the measure that matters most for index investors, and I can't claim to know what the original cause of this is, but as we see continued flows into the index, that cements that liquidity difference. And there's this self-reinforcing loop, and it comes about because index funds buy and hold irrespective of a price. And when they do that, they effectively reduce the free float available for price discovery. And so the way the loop works is inflows into the index, push up the price of the largest companies in the index more. The index funds have to buy more of the things that have gone up,

and that buying pushes them up more. And then that increased passive ownership reduces the effective free float of the largest companies further. And so then that cements the liquidity and balance. why is the relative illiquidity of the large-cap stocks increasing relative to the low-cap with these flows? If the index flows into the market are pro rata according to market cap weight, why does that reduce the free-float liquidity more for the large-caps to the small-caps? Well, it's that self-reinforcing loop. So because the liquidity per dollar of free-float is lower for the large caps, you get more of a price impact on those large caps.

So they're pushed up more by the flows in. That means that the indices then have to buy even more of them. So I read a piece which you also read by Rob Arnott, who's one of the US quant pioneers and a strong critic of indexation. And what Rob is saying in his recent piece is that what inflows into index funds are doing is reinforcing momentum. When the momentum dries up a stock, the index investor comes in and locks in the momentum. So that's a slightly different way arguing from the point of view of liquidity,

but you're both coming to the same conclusions from a slightly different angle, which is always interesting. How big has indexation or passive investing got in the US stock market? Very big. There are various estimates that the one I use for this article is the data from Morningstar, which shows US passively managed funds at 19.4 trillion compared to 16 trillion in actively managed funds. And you say, and this is an important point, the flows are much more important than the actual stocks when it comes to indexation. Absolutely. So price discovery is determined not by holdings, but by flows.

And the flows interpassive have been huge. Net cumulative inflows interpassively managed US funds have been 6.4 trillion in the past 10 years. And on the other hand, active managers have seen outflows of 2.4 trillion. So investors are piling into the same portfolio, the index, and that portfolio has become increasingly concentrated in the largest companies. And investors are then selling funds which deviate from that index portfolio. I think that's another important point, which is made by Mike Green, the strategists that simplify asset managers. who for a long time, and I heard him make this argument about 12 years ago, Mike has been arguing that the growth of indexation has meant taking funds from active managers with a value

small cap bias and handing it to indexes which are value agnostic but with a large cap bias. So index flows give a disproportionate boost to the largest stocks, driving the index higher and causing the index portfolio to deviate from that of the average active manager. Goldman Sachs estimate, on average, the average large-cap mutual funds were seven percentage points underweight, magnificent seven in Q1. So the index funds are no longer simply mirroring the average actively managed portfolio. And that raises yet another important question, you say. Yeah, so we use the terms passive and index investing interchangeably. But if passive is both setting prices and the index portfolio differ substantially

from the average actively managed portfolio, can index investing really be considered passive? Or what I would suggest is that indices are just another portfolio, with weights determined by flows and liquidity, instead of thoughtful analysis of the underlying company values. And you say that it's little surprise that the broad indices have continued to outperform active managers during this process of ongoing indexation. Yes, and you raise the obvious counter. argument in favor of indices. But yeah, it's not surprising when you consider that flows set prices and flows have been

driven more and more capital into the same index portfolio while driving, selling pressure on other portfolios. So Tom, the original idea when people were mooting passive investment is that they said, oh, it'll be all right because all the second rate fund managers will leave the investment game, rather like in a poker game, when poker game becomes highly competitive, the worst poker players drop out, leaving the best players at the table. So that was the assumption for indexation. But the reality is that perhaps the smartest guys in the room are not setting market prices.

Because we see today, and this is a common feature of all speculative boom periods, that retail investors are playing a large and larger role. So perhaps the so-called apes on the Robin Hood app have more influence on stock prices today than the disciples of Ben Graham. So in 2010, retail was 10% of the US equity trading volumes. Last year was 20%. So that's a big increase in retail participation. And then on the other hand of that, if you look at long only and hedge fund institutional investors, that's fallen from 23% to 15%. So that's five points below what the retails.

Exactly. And bear in mind, a lot of those hedge funds will have quite short time horizons. So when you look at long-only institutional investors, they only account for 6% of trading volumes. Now, of course, that doesn't add up to 100, you'll notice. And the rest is market makers, high-frequency traders and quant trading, none of whom are placing trades based on sort of bottom-up analysis of what an underlying company is actually worth. And do we know how much of the market's trading volume is linked to passive? Exactly how much is hard to say. Many of the trades from market makers, high frequency traders and quants may ultimately be linked to the trading of passive funds. And Michael Green, who you mentioned earlier, the market strategist at Simplify Asset Management, he's quite outspoken on this. And he argues that as much as 80% of trading volumes could ultimately be linked to index investing. And how does the SpaceX IPO, the world's largest IPO, inflated valuation fit into your analysis. Given the context we've talked about, it's no surprise

that retail investors and soon indices will be acquiring a large portion of SpaceX, given that these groups are now the price setters in the market. And what happened to recap on the SpaceX IPO is that the company made a bid, might possibly say, to game the indices by seeking fast-track inclusion in the S&P and NASDAQ. It also sought, with regards to the S&P, to get rid of its trailing profitability requirement for new listings. S&P held its ground, but NASDAQ capitulated. Yeah, so NASDAQ adjusted its rules to allow SpaceX to enter the NASDAQ 100 index

in just 15 trading days. And then they also removed the minimum free-fellate. requirement, they're going to give SpaceX a weighting of three times the free float in the index. Now, admittedly, this is better than market cap weighting approach, but even so three times will amplify the index purchases and drive the price up further. Although one should bear in mind that the NASDAQ composite index is less funds tracking it than the broader S&P 500 index. But this question of overweighting a stock relative to its free float, in an index. Some people with long memories or long experience will remember that this was exactly

the problems that the MSCI indices had at the turn of the century. And a lot of marathons writing and global investment reviews written in the late 1990s and early 2000s were complaining about the fact that a number of large cap stocks like a Deutsche Telecom or France Telecom with a relatively small free float had full weighting. So it's quite clear that if you have a weighting in the index high relative to the free float, you have the potential, at least, to create squeezes in stocks. Now, traditionally, investors have thought of passive investing as being lower risk than active management, but you think that might not be the case. In a world where everyone is holding the same portfolio, i.e. the index. And that portfolio is being driven by

single theme, which is AI, it seems very unlikely to offer the level of diversification that investors are expecting. One fact that I find absolutely amazing is that if you look at the largest nine companies in the MSCIUS index, and it's the same for the S&P 500, every single one of those nine companies designed semiconductors in some capacity, and that's 37% of the index. I should say, for most of those, that semiconductor design forms a material part of the investment case. That just does not seem very diversified. And your colleague, Alex Duffy, has made the same point within emerging markets with the semiconductor stocks and tech companies having a higher and higher role in the emerging markets benchmark portfolio. And then if one sees it broadly with the

AQUI World Index, as you see the top 10 stocks, I think at least nine of the top 10 stocks now have a tech bias. It's always been the case at the peak of bubble markets that whenever you have a single theme predominating among the largest stocks in the index, that tends to be a sign that the end of the bubble is close. Now, Tom, you say that investors with Marathon get a different exposure in their US portfolio. Marathon does own some of the big technology companies, but we're significantly underweight. We are overweight corners of the market, unloved by passive and retail investors. And you think that that creates a great opportunity? Yes, the AI exuberance has left many companies in the dust, trading at valuations not seen for years, especially when compared to an expensive market.

A marathon, we've got exposure to smaller companies like TransUnion, a credit bureau or investor holdings, a dental manufacturer, both offering a compelling capital cycle investment thesis. And even our larger holdings, things like Visa offer high-quality business models at very attractive valuations, the opportunity presenting itself because these companies, don't fit the market's prevailing narrative. Thank you, Tom. Very interesting discussion. Thank you very much. Thank you for your time today. I hope you will listen to the next edition of the capital cycle. This communication is provided for information purposes only. Please refer to Marathon's website and the global investment reviews for further information, including important disclosures.